**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 September 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**

 

**CORNELL COMPANIES, 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 TelephoneNumber, 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 such shorterperiod that the registrant was required to file such reports), and (2) has beensubject to such filing requirements for the past 90 days.

 

Yes  x  No o

 

Indicate by a check mark whether theregistrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and largeaccelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):

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

 

Indicate by check mark whether the registrantis a shell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes  o  No x

 

At October 31, 2007 the registrant had14,616,752 shares of common stock outstanding.

 

 

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**Cornell Companies, Inc.**

** **

**Tableof 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                                                                                    |       |

 

2

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

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

 

**CORNELLCOMPANIES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

**(Unaudited)**

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

 
| ** **                                                                                                                                                            | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| **ASSETS**                                                                                                                                                            |       |                   |       |                  |       |
|                                                                                                                                                                  |       |                   |       |                  |       |
| **CURRENT  ASSETS:**                                                                                                                                                  |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                                                            |       | $                      | 903        |                  | $          | 18,529 |   |
| Investment securities  available for sale                                                                                                                             |       | 750                    |       | 11,925                |       |
| Accounts receivable -  trade (net of allowance for doubtful accounts of $3,994 and $3,644,  respectively)                                                             |       | 63,654                 |       | 72,723                |       |
| Other receivables (net  of allowance for doubtful accounts of $5,297)                                                                                                 |       | 2,806                  |       | 3,751                 |       |
| Debt service fund and other  restricted assets                                                                                                                        |       | 20,446                 |       | 24,611                |       |
| Deferred tax assets                                                                                                                                                   |       | 7,843                  |       | 6,672                 |       |
| Prepaid expenses and  other                                                                                                                                           |       | 5,785                  |       | 7,540                 |       |
| Total current assets                                                                                                                                                  |       | 102,187                |       | 145,751               |       |
| **PROPERTY  AND EQUIPMENT, net**                                                                                                                                      |       | 369,334                |       | 319,064               |       |
| **OTHER  ASSETS:**                                                                                                                                                    |       |                   |       |                  |       |
| Debt service reserve  fund                                                                                                                                            |       | 23,547                 |       | 23,801                |       |
| Goodwill, net                                                                                                                                                         |       | 13,355                 |       | 12,339                |       |
| Intangible assets, net                                                                                                                                                |       | 5,249                  |       | 6,926                 |       |
| Deferred costs and  other                                                                                                                                             |       | 23,356                 |       | 15,652                |       |
| **Total  assets**                                                                                                                                                     |       | $                      | 537,028    |                  | $          | 523,533 |   |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                         |       |                   |       |                  |       |
| ** **                                                                                                                                                            | ** ** | ** **             | ** ** | ** **            | ** ** |
| **CURRENT  LIABILITIES:**                                                                                                                                             |       |                   |       |                  |       |
| Accounts payable and  accrued liabilities                                                                                                                             |       | $                      | 57,949     |                  | $          | 60,163 |   |
| Current portion of  long-term debt                                                                                                                                    |       | 21,411                 |       | 10,510                |       |
| **Total  current liabilities**                                                                                                                                        |       | 79,360                 |       | 70,673                |       |
| **LONG-TERM  DEBT, net of current portion**                                                                                                                           |       | 245,083                |       | 255,471               |       |
| **DEFERRED  TAX LIABILITIES**                                                                                                                                         |       | 12,583                 |       | 11,373                |       |
| **OTHER  LONG-TERM LIABILITIES**                                                                                                                                      |       | 6,210                  |       | 4,452                 |       |
| **Total  liabilities**                                                                                                                                                |       | 343,236                |       | 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, 15,841,576 and 15,603,917 shares issued  and 14,326,530 and 14,063,523 shares outstanding, respectively |       | 16                     |       | 16                    |       |
| Additional paid-in  capital                                                                                                                                           |       | 159,532                |       | 154,411               |       |
| Retained earnings                                                                                                                                                     |       | 45,741                 |       | 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                                                                                                                               |       | 608                    |       | 481                   |       |
| **Total  stockholders’ equity**                                                                                                                                  |       | 193,792                |       | 181,564               |       |
| **Total  liabilities and stockholders’ equity**                                                                                                                  |       | $                      | 537,028    |                  | $          | 523,533 |   |

 

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

 

3

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**CORNELL COMPANIES,INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME**

**(Unaudited)**

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

 
| ** **                                                                                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                                             | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                                                                                             | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| REVENUES                                                                                                                               |       | $                                | 87,327     |                            | $          | 92,383 |   | $ | 268,465 |   | $ | 266,728 |   |
| OPERATING EXPENSES                                                                                                                     |       | 68,485                           |       | 71,457                          |       | 206,458 |   | 203,735 |   |
| PRE-OPENING AND  START-UP EXPENSES                                                                                                     |       | —                           |       | —                          |       | — |   | 2,657 |   |
| DEPRECIATION AND  AMORTIZATION                                                                                                         |       | 3,988                            |       | 4,317                           |       | 11,740 |   | 12,256 |   |
| GENERAL AND  ADMINISTRATIVE EXPENSES                                                                                                   |       | 4,316                            |       | 6,053                           |       | 19,848 |   | 16,604 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                                 |       | 10,538                           |       | 10,556                          |       | 30,419 |   | 31,476 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| INTEREST EXPENSE                                                                                                                       |       | 6,340                            |       | 7,119                           |       | 19,808 |   | 19,903 |   |
| INTEREST INCOME                                                                                                                        |       | (309                             | )          | (619                            | )          | (1,223 | ) | (1,766 | ) |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| INCOME FROM CONTINUING  OPERATIONS BEFORE PROVISION FOR INCOME TAXES                                                                   |       | 4,507                            |       | 4,056                           |       | 11,834 |   | 13,339 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| PROVISION FOR INCOME  TAXES                                                                                                            |       | 2,090                            |       | 1,472                           |       | 5,308 |   | 5,480 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| INCOME FROM CONTINUING  OPERATIONS                                                                                                     |       | 2,417                            |       | 2,584                           |       | 6,526 |   | 7,859 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| DISCONTINUED  OPERATIONS, NET OF TAX BENEFIT OF $381 IN 2006                                                                           |       | —                           |       | —                          |       | — |   | (707 | ) |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| NET INCOME                                                                                                                             |       | $                                | 2,417      |                            | $          | 2,584 |   | $ | 6,526 |   | $ | 7,152 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| EARNINGS (LOSS) PER  SHARE:                                                                                                            |       |                             |       |                            |       |   |   |   |   |
| BASIC                                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Income from continuing  operations                                                                                                     |       | $                                | .17        |                            | $          | .19 |   | $ | .46 |   | $ | .56 |   |
| Loss from discontinued  operations, net of tax                                                                                         |       | —                           |       | —                          |       | — |   | (.05 | ) |
| Net income                                                                                                                             |       | $                                | .17        |                            | $          | .19 |   | $ | .46 |   | $ | .51 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| DILUTED                                                                                                                                |       |                             |       |                            |       |   |   |   |   |
| Income from continuing  operations                                                                                                     |       | $                                | .17        |                            | $          | .18 |   | $ | .45 |   | $ | .56 |   |
| Loss from discontinued  operations, net of tax                                                                                         |       | —                           |       | —                          |       | — |   | (.05 | ) |
| Net income                                                                                                                             |       | $                                | .17        |                            | $          | .18 |   | $ | .45 |   | $ | .51 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| NUMBER OF SHARES USED  IN PER SHARE COMPUTATION:                                                                                       |       |                             |       |                            |       |   |   |   |   |
| BASIC                                                                                                                                  |       | 14,214                           |       | 13,962                          |       | 14,116 |   | 13,898 |   |
| DILUTED                                                                                                                                |       | 14,559                           |       | 14,113                          |       | 14,443 |   | 14,036 |   |
|                                                                                                                                   |       |                             |       |                            |       |   |   |   |   |
| COMPREHENSIVE INCOME:                                                                                                                  |       |                             |       |                            |       |   |   |   |   |
| Net income                                                                                                                             |       | $                                | 2,417      |                            | $          | 2,584 |   | $ | 6,526 |   | $ | 7,152 |   |
| Unrealized gain (loss)  on derivative instruments, net of tax provision (benefit) of $465 and $89 in  2007 and $327 and ($209) in 2006 |       | 669                              |       | 470                             |       | 127 |   | (301 | ) |
| Comprehensive income                                                                                                                   |       | $                                | 3,086      |                            | $          | 3,054 |   | $ | 6,653 |   | $ | 6,851 |   |

 

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

 

4

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**CORNELLCOMPANIES, INC.**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                               | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                               | ** ** | **September 30,**          | ** ** |
| ** **                                                                                               | ** ** | **2007**                        | ** ** | **2006** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                   |       |                            |       |   |   |
| Net income                                                                                               |       | $                               | 6,526      |   | $ | 7,152 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities -                      |       |                            |       |   |   |
| Depreciation                                                                                             |       | 10,063                          |       | 10,684 |   |
| Amortization of  intangibles and other assets                                                            |       | 1,677                           |       | 1,682 |   |
| Amortization of  deferred financing costs                                                                |       | 1,183                           |       | 1,329 |   |
| Amortization of Senior  Notes discount                                                                   |       | 138                             |       | 138 |   |
| Stock-based  compensation                                                                                |       | 1,929                           |       | 1,599 |   |
| Provision for bad debts                                                                                  |       | 1,416                           |       | 1,612 |   |
| Gain on sale of  property and equipment                                                                  |       | (279                            | )          | (155 | ) |
| Deferred income taxes                                                                                    |       | (50                             | )          | 507 |   |
| Change in assets and  liabilities, net of acquisitions:                                                  |       |                            |       |   |   |
| Accounts receivable                                                                                      |       | 673                             |       | (9,506 | ) |
| Other restricted assets                                                                                  |       | (167                            | )          | 1,102 |   |
| Other assets                                                                                             |       | 542                             |       | 1,711 |   |
| Accounts payable and  accrued liabilities                                                                |       | (6,023                          | )          | (6,368 | ) |
| Deferred revenues and  other liabilities                                                                 |       | (10                             | )          | 110 |   |
| Net cash provided by  operating activities                                                               |       | 17,618                          |       | 11,597 |   |
|                                                                                                     |       |                            |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                   |       |                            |       |   |   |
| Capital expenditures                                                                                     |       | (30,555                         | )          | (10,557 | ) |
| Purchases of investment  securities                                                                      |       | (241,425                        | )          | (296,975 | ) |
| Sales of investment  securities                                                                          |       | 252,600                         |       | 294,250 |   |
| Facility acquisitions                                                                                    |       | (18,554                         | )          | — |   |
| Site acquisitions                                                                                        |       | (5,053                          | )          | — |   |
| Withdrawals from restricted  debt payment account, net                                                   |       | 4,586                           |       | 3,942 |   |
| Proceeds from sale of  property and equipment                                                            |       | 371                             |       | 2,890 |   |
| Net cash used in  investing activities                                                                   |       | (38,030                         | )          | (6,450 | ) |
|                                                                                                     |       |                            |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                   |       |                            |       |   |   |
| Payments of MCF bonds                                                                                    |       | (10,500                         | )          | (9,700 | ) |
| Proceeds from line of  credit                                                                            |       | 10,000                          |       | — |   |
| Payments of capital  lease obligations                                                                   |       | (8                              | )          | (8 | ) |
| Tax benefit of stock  option exercises                                                                   |       | 508                             |       | 223 |   |
| Proceeds from exercise  of stock options and warrants                                                    |       | 2,786                           |       | 2,088 |   |
| Net cash provided by (used  in) financing activities                                                     |       | 2,786                           |       | (7,397 | ) |
|                                                                                                     |       |                            |       |   |   |
| NET DECREASE IN CASH  AND CASH EQUIVALENTS                                                               |       | (17,626                         | )          | (2,250 | ) |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF PERIOD                                                        |       | 18,529                          |       | 13,723 |   |
| CASH AND CASH  EQUIVALENTS AT END OF PERIOD                                                              |       | $                               | 903        |   | $ | 11,473 |   |
|                                                                                                     |       |                            |       |   |   |
| OTHER NON-CASH  INVESTING AND FINANCING ACTIVITIES:                                                      |       |                            |       |   |   |
| Increase (decrease) in  fair value of interest rate swap                                                 |       | $                               | 883        |   | $ | (864 | ) |
| Other comprehensive income  (loss), net of tax                                                           |       | 127                             |       | (301 | ) |
| Common stock issued for  board of directors fees                                                         |       | 135                             |       | 395 |   |
| Purchases and additions  to property and equipment included in accounts payable and accrued  liabilities |       | 6,263                           |       | — |   |
| Equipment additions  under capital leases                                                                |       | —                          |       | 56 |   |

 

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

 

5

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**CORNELLCOMPANIES, INC.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

Theaccompanying unaudited consolidated financial statements have been prepared byCornell Companies, Inc. (collectively with its subsidiaries and consolidatedspecial purpose entities, the “Company,” “we,” “us” or “our”) pursuant to therules and regulations of the Securities and Exchange Commission. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles in theUnited States (“GAAP”) have been condensed or omitted pursuant to such rulesand regulations. The year-end consolidated balance sheet was derived fromaudited financial statements but does not include all disclosures required byGAAP. In the opinion of management, adjustments and disclosures necessary for afair presentation of these financial statements have been included. Estimateswere used in the preparation of these financial statements. Actual resultscould differ from those estimates. These financial statements should be read inconjunction with the financial statements and notes thereto included in theCompany’s 2006 Annual Report on Form 10-K as filed with the Securities andExchange Commission.

 

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

 

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

 

***Adoption of Financial AccountingStandards Board Interpretation No. 48***

 

In July 2006, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No.48, “Accounting for Uncertainty in Income Taxes – an Interpretation of FASBStatement No. 109” (“FIN No. 48”). FIN No. 48 establishes a single model toaddress the accounting for uncertain tax positions. 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 provides guidance on the measurement,derecognition, classification and disclosure of tax positions, as well as theaccounting for the related interest and penalties, transition and accounting ininterim periods. FIN No. 48 is effective for fiscal years beginning afterDecember 15, 2006 and requires that the impact of the adoption of FIN No. 48 berecorded as an adjustment to beginning retained earnings at January 1, 2007.

 

We adopted the provisionsof 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 theadoption of FIN No. 48, we recorded a cumulative effect adjustment ofapproximately $0.3 million which increased retained earnings at January 1, 2007.The amount of unrecognized tax benefits did not materially change in the ninemonths ended September 30, 2007.

 

Included in theunrecognized tax benefits balance as of January 1, 2007, are approximately $0.8million of tax benefits that, if recognized in future periods, would impact oureffective tax rate. The difference of approximately $2.2 million between thetotal amount of unrecognized tax benefits of $3.0 million and the amount thatwould impact our effective tax rate was offset by an increase in deferred taxassets, primarily related to net operating loss carry forwards, as of January1, 2007.

 

Estimated interest andpenalties related to the underpayment of income taxes are classified as acomponent of income tax expense in the Consolidated Statements of Operationsand Comprehensive Income and totaled approximately $0.2 million and $0.3million in the three and nine months ended September 30, 2007. Accrued interestand penalties were approximately $0.6 million and $0.3 million at September 30,2007 and January 1, 2007, respectively.

 

We are subject to incometax in the United States and many of the individual states we operate in. Wecurrently have significant operations in Texas, California and Pennsylvania. Stateincome tax returns are generally subject to examination for a period of threeto five years after filing. The state impact of any changes made to the federalreturn remains subject to examination by various states for a period up to oneyear after formal notification to the state. We are open to United StatesFederal Income Tax examinations for the tax years ended December 31, 2004through December 31, 2006.

 

We do not anticipate asignificant change in the balance of our unrecognized tax benefits within thenext 12 months.

 

6

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**Accounting For Stock-Based Compensation**

** **

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

 

Additionally, we have an employeestock purchase plan (“ESPP”)underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yeartypically begins each January 1st (the “Grant Date”) and ends on December 31st(the “Exercise Date”). For 2007, however, the plan year began April 1, 2007. Purchasesof common stock are made at the end of the year using the lower of the fairmarket value on either the Grant Date or Exercise Date, less a 15% discount. Under SFAS No. 123R our employee-stockpurchase plan is considered to be a compensatory ESPP, and therefore, we arerequired to recognize compensation cost over the requisite service period forgrants made under the ESPP.

 

At September30, 2006, 60,000 shares of restricted stock were outstanding subject toperformance-based vesting criteria (30,000 of these are considered market-basedrestricted stock under SFAS No. 123R). Additionally, 137,200 stock options wereoutstanding subject to performance-based vesting criteria (16,100 of these wereconsidered market-based options under SFAS No. 123R). The 30,000 shares ofrestricted stock and the 16,100 stock options which were consideredmarket-based stock awards were valued using a Monte Carlo simulationprobability model to estimate future stock returns. The grant date fair valueof these awards was $9.05 per share for a total value of $0.5 million. Werecognized $0.04 million and $0.11 million of expense associated with theseshares of restricted stock and options during the three and nine months endedSeptember 30, 2006, respectively.

 

AtSeptember 30, 2007, 132,500 shares of restricted stock were outstanding subjectto performance-based vesting criteria (37,500 of these restricted shares wereconsidered market-based restricted stock under SFAS No. 123R). There were also79,000 stock options outstanding subject to performance-based vesting criteria.We recognized $0.1 million and $0.4 million of expense associated with theseshares of restricted stock and stock options during the three and nine monthsended September 30, 2007.

 

The amounts above relate to theimpact of recognizing compensation expense related to stock options andrestricted stock. Compensation expense related to stock options (79,000 shares)and restricted stock (95,000 shares) that vest based upon performanceconditions is not recorded for such performance-based awards until it has beendeemed probable that the related performance targets allowing the vesting ofthese options and restricted stock will be met. We are required to periodicallyre-assess the probability that these options will vest and record expense atthe point in time. During the fourth quarter of 2006 it was deemed probablethat the performance targets pertaining to certain restricted stock and stockoptions would be achieved by their vesting date. Accordingly, compensationexpense of approximately $0.06 million and $0.20 million has been recognizedfor the three and nine months ended September 30, 2007, respectively, relatedto 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 ninemonths ended September 30, 2007 and 2006 were estimated at the date ofgrant using a Black-Scholes option pricing model with the followingweighted-average assumptions:

 
| ** **                       | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------|------------|---------------------------------|------------|
| ** **                       | ** ** | **September 30,**          | ** ** |
| ** **                       | ** ** | **2007**                        | ** ** | **2006** | ** ** |
|                             |       |                            |       |   |   |
| Risk-free rate of return         |       | 4.56                            | %          | 4.31 | % |
| Expected life of award           |       | 5.6 years                       |       | 5 years |   |
| Expected dividend yield of stock |       | 0                               | %          | 0 | % |
| Expected volatility of stock     |       | 42.19                           | %          | 45.48 | % |
| Weighted-average fair value      |       | $                               | 9.86       |   | $ | 6.24 |   |
|                                  |            |                                 |            |  |  |  |  |

 

7

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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 nine monthsended September 30, 2007 and 2006.

 

Stock-basedaward activity during the nine months ended September 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                                            |       | 72,950                 |       | 21.40                                  |       |                                                |       |                            |       |
| Exercised                                          |       | (161,390               | )          | 12.41                                  |       |                                                |       |                            |       |
| Canceled                                           |       | (72,728                | )          | 13.47                                  |       |                                                |       |                            |       |
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at September 30, 2007                  |       | 494,092                |       | $                                      | 14.19      |                                                | 7.5        |                            | $          | 7.0 |   |
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Vested and expected to vest at September  30, 2007 |       | 393,662                |       | $                                      | 14.14      |                                                | 7.6        |                            | $          | 5.6 |   |
|                                               |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at September 30, 2007                  |       | 272,223                |       | $                                      | 13.56      |                                                | 7.1        |                            | $          | 3.7 |   |

 

The total intrinsic value of stock options exercisedduring the nine months ended September 30, 2007 and 2006 was $1.4 million and$0.6 million, respectively. Net cash proceeds from the exercise of stockoptions were approximately $2.8 million and $2.1 million for the nine monthsended September 30, 2007 and 2006, respectively.

 

Asof September 30, 2007, approximately $0.6 million of estimated expense withrespect to time-based nonvested stock option awards has yet to be recognizedand will be amortized into expense over the employee’s remaining requisiteservice period of approximately 3.0 years. As of September 30, 2007,approximately $0.4 million of estimated expense with respect toperformance based nonvested stock option awards has yet to be recognized andwill be recorded if it becomes probable that these options will vest.

 

Thefollowing table summarizes information with respect to stock optionsoutstanding and exercisable at September 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       |       | 25,710                  |       | 4.0                                                 |       | $                                      | 5.74       |                    | 25,137     |                                   | $          | 5.68 |   |
| $10.01  to  $13.50      |       | 177,382                 |       | 6.9                                                 |       | 12.78                                  |       | 95,186                  |       | 12.79                                  |       |
| $13.51  to $14.50            |       | 209,800                 |       | 7.9                                                 |       | 13.96                                  |       | 111,900                 |       | 13.86                                  |       |
| $14.51  to $25.00            |       | 81,200                  |       | 9.3                                                 |       | 20.55                                  |       | 40,000                  |       | 19.53                                  |       |
|                                        |       | 494,092                 |       |                                                |       | $                                      | 14.19      |                    | 272,223    |                                   | $          | 13.56 |   |

 

Stock-basedaward activity for nonvested awards during the nine months ended September 30,2007 was as follows:

 

8

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| ** **                      | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------------------|------------|---------------------------------------------------------|------------|
| Nonvested at December 31, 2006  |       | 322,170                |       | $                                                       | 13.40      |   |
| Granted                         |       | 72,950                 |       | 21.40                                                   |       |
| Vested                          |       | (100,523               | )          | 15.73                                                   |       |
| Canceled                        |       | (72,728                | )          | 13.47                                                   |       |
|                            |       |                   |       |                                                    |       |
| Nonvested at September 30, 2007 |       | 221,869                |       | $                                                       | 14.96      |   |

 

***Restricted Stock***

 

We have previously issuedrestricted stock in connection with certain employment agreements which vestsover a specific period of time, generally three to five years. During the ninemonths ended September 30, 2007, we issued restricted stock in connection withcertain employment agreements and as part of our normal equity awards, all ofwhich was issued under our 2006 Equity Incentive plan. These shares ofrestricted common stock are subject to restrictions on transfer and certainconditions to vesting.

 

Restricted stock activityfor the nine months ended September 30, 2007 was as follows:

 
| ** **                      | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Grant Date  Fair Value** | ** ** |
|---------------------------------|------------|------------------------|------------|---------------------------------------------------------|------------|
| Nonvested at December 31, 2006  |       | 85,000                 |       | $                                                       | 10.87      |   |
| Granted                         |       | 287,000                |       | 22.30                                                   |       |
| Vested                          |       | —                 |       |                                                    |       |
| Canceled                        |       | (64,000                | )          | 9.80                                                    |       |
|                            |       |                   |       |                                                    |       |
| Nonvested at September 30, 2007 |       | 308,000                |       | $                                                       | 21.74      |   |

 

We recognized $0.3million and $0.5 million of expense associated with nonvested time-basedrestricted stock awards during the three and nine months ended September 30,2007. As of September 30, 2007, approximately $3.1 million of estimated expensewith respect to nonvested time-based restricted stock awards had yet to berecognized and will be amortized over a weighted average period of 2.7 years.Approximately $2.8 million of estimated expense with respect to nonvestedperformance-based restricted stock option awards had yet to be recognized as ofSeptember 30, 2007.

 

9

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**3.****     Merger Agreement**

 

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

 

OurBoard of Directors unanimously approved the Merger Agreement. In connectionwith the Merger, the Parent and certain of 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 our stockholders held on January 23, 2007, theproposed Merger Agreement was rejected.

 

Underthe terms of the Merger Agreement, because the Merger was terminated, wereimbursed $2.5 million of costs incurred by Veritas, Parent and Merger Sub inconnection with the proposed merger in February 2007. Such costs for legal andexternal professional and consulting fees are reflected in general andadministrative expenses for the nine months ended September 30, 2007.

 

**4.****    ****Discontinued Operations**

 

We classify as discontinuedoperations those components of our business that we hold for sale or that havebeen disposed and have cash flows that are clearly distinguishableoperationally and for financial reporting purposes from the rest of ouroperations. For those components, we have no significant continuing involvementafter completion of disposal and their operations are eliminated from ourongoing operations. During the year ended December 31, 2005, we classifiedcertain components as discontinued operations as the result of a managementdecision to close certain facilities. Notifications were made to the requiredcontracting entities regarding the termination of the related programs. AtSeptember 30, 2007, we did not have any significant net property and equipmentbalances pertaining to these former operations. There were no revenuesgenerated by these discontinued operations in the three and nine months endedSeptember 30, 2007 and 2006.

 

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

 

Intangible assets at September 30,2007 and December 31, 2006 consisted of the following (in thousands):

 
| ** **                                              | ** ** | **September 30,  2007** | ** ** | **December 31,  2006** | ** ** |
|---------------------------------------------------------|------------|------------------------------|------------|-----------------------------|------------|
|                                                    |       |                         |       |                        |       |
| Non-compete agreements                                  |       | $                            | 10,040     |                        | $          | 10,040 |   |
| Accumulated amortization – non-compete  agreements |       | (8,088                       | )          | (7,240                      | )          |
| Acquired contract value                                 |       | 6,442                        |       | 6,442                       |       |
| Accumulated amortization – contract value          |       | (3,145                       | )          | (2,316                      | )          |
| Identified intangibles, net                             |       | 5,249                        |       | 6,926                       |       |
| Goodwill, net                                           |       | 13,355                       |       | 12,339                      |       |
| Total intangibles, net                                  |       | $                            | 18,604     |                        | $          | 19,265 |   |

 

Thechanges in the carrying amount of goodwill in the nine months ended September30, 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 September 30, 2007 |       | $                 | 1,509      |         | $          | 1,060                        |       | $         | 10,786     |   | $ | 13,355 |   |

 

During the nine months ended September30, 2007, we recorded an addition to goodwill as a result of the final releaseof amounts previously placed in escrow related to the acquisition ofCorrectional Systems, Inc. in April 2005.

 

10

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Amortizationexpense for our non-compete agreements was approximately $0.3 million for thethree months ended September 30, 2007 and 2006 and approximately $0.8 millionand $0.9 million for the nine months ended September 30, 2007 and 2006,respectively. Amortization expense for our non-compete agreements is expectedto be approximately $1.1 million for each of the next two years ended December31 and approximately $0.7 million for the third year.

 

Amortizationexpense for our acquired contract value was approximately $0.3 million for thethree months ended September 30, 2007 and 2006 and approximately $0.8 millionfor the nine months ended September 30, 2007 and 2006. Amortization expense forour acquired contract value is expected to be approximately $1.1 million foreach of the next three years ended December 31 and approximately $0.6 millionfor the fourth year.

 

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

 

Our long-term debt at September 30,2007 and December 31, 2006 consisted of the following (in thousands):

 
| ** **                                                                                                                                                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                     | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| **Debt  of Cornell Companies, Inc.:**                                                                                                                     |       |                   |       |                  |       |
| Senior Notes,  unsecured, due July 2012 with an interest rate of 10.75%, net of  discount of $874 and $1,013, respectively                                |       | $                      | 111,125    |                  | $          | 110,987 |   |
| Fair-value adjustment  of Senior Notes as a result of interest rate swap                                                                                       |       | (171                   | )          | (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”) |       | 10,000                 |       | —                |       |
| Capital lease  obligations                                                                                                                                     |       | 40                     |       | 47                    |       |
| Subtotal                                                                                                                                                       |       | 120,994                |       | 109,981               |       |
| ** **                                                                                                                                                     | ** ** | ** **             | ** ** | ** **            | ** ** |
| **Debt  of Special Purpose Entity:**                                                                                                                           |       |                   |       |                  |       |
| 8.47% Bonds due 2016                                                                                                                                           |       | 145,500                |       | 156,000               |       |
|                                                                                                                                                           |       |                   |       |                  |       |
| Total consolidated debt                                                                                                                                        |       | 266,494                |       | 265,981               |       |
|                                                                                                                                                           |       |                   |       |                  |       |
| Less: current  maturities                                                                                                                                      |       | (21,411                | )          | (10,510               | )          |
|                                                                                                                                                           |       |                   |       |                  |       |
| Consolidated long-term  debt                                                                                                                                   |       | $                      | 245,083    |                  | $          | 255,471 |   |

 

***Long-Term Credit Facilities.***Our Credit Facility provided for borrowingsof up to $60.0 million under a revolving line of credit, and was reduced byoutstanding letters of credit. The available commitment under our CreditFacility was approximately $39.7 million at September 30, 2007. We hadoutstanding borrowings of $10.0 million under our Credit Facility at September30, 2007 and had outstanding letters of credit of approximately $10.3 million. Subjectto certain requirements, we had the right to increase the commitments under ourCredit Facility up to an aggregate amount of $100.0 million. Our CreditFacility matured in June 2008 and bore interest, at our election, depending onour total leverage ratio, at either the prime rate plus a margin ranging from0.75% to 2.00%, or a rate which ranged from 2.25% to 3.50% above the applicableLIBOR rate. Our Credit Facility was collateralized by substantially all of ourassets, including the assets and stock of all of our subsidiaries. Our CreditFacility was not secured by the assets of Municipal Corrections Finance, LP (“MCF”).Our Credit Facility contained standard covenants including compliance withlaws, limitations on capital expenditures, restrictions on dividend payments,limitations on financing transactions and mergers and compliance with financialcovenants.

 

In October 2007, we amended our existingCredit Facility (the “Amended Credit Facility”). The Amended Credit Facility,which provides for borrowings up to $100.0 million (including letters ofcredit), will mature in December 2011 and bears interest, at our electiondepending on our total leverage ratio, at either the prime rate plus a margin rangingfrom 0.00% to 0.75%, or a rate which ranges from 1.50% to 2.25% above theapplicable LIBOR rate. Subject to certain requirements, we have the right toincrease the commitments under our Amended Credit Facility up to an aggregateamount of $150.0 million. The Amended Credit Facility is collateralized bysubstantially all of our assets, including the assets and stock of all of oursubsidiaries. The Amended Credit Facility is not secured by the assets of MCF.The Amended Credit Facility contains standard covenants including compliancewith laws, limitations on certain financing transactions and mergers andcompliance with financial covenants, although the covenants in the AmendedCredit Facility were amended to provide 

 

11

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greater flexibility in certain instances,including deletion of the minimum net worth and minimum asset coveragerequirements contained in the Credit Facility and more favorable leverageratios.

 

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

 

In June 2004, we issued $112.0 million inprincipal of 10.75% Senior Notes (the “Senior Notes”) due July 1, 2012. TheSenior Notes are unsecured senior indebtedness and are guaranteed by all of ourexisting and future subsidiaries (collectively, the “Guarantors”). The SeniorNotes are not guaranteed by MCF (the “Non-Guarantor”). Interest on the SeniorNotes is payable semi-annually on January 1 and July 1 of each year, commencingJanuary 1, 2005. On or after July 1, 2008, we may redeem all or a portion ofthe Senior Notes at the redemption prices (expressed as a percentage of theprincipal amount) listed below, plus accrued and unpaid interest, if any, onthe Senior Notes redeemed, to the applicable date of redemption, if redeemedduring the 12-month period commencing on July 1 of the years 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. TheSenior Notes were issued under an indenture that limits our ability and theability of our Guarantors to, among other things, incur additionalindebtedness, pay dividends or make other distributions, make other restrictedpayments and investments, create liens, incur restrictions on the ability of theGuarantors to pay dividends or other payments to us, enter into transactionswith affiliates, and engage in mergers, consolidations and certain sales ofassets.

 

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 ofthis transaction was to convert future interest due on $84.0 million of theSenior Notes to a variable rate. The terms of the interest rate swap contractand the underlying debt instrument are identical. We have designated the swapagreement as a fair value hedge. The swap has a notional amount of $84.0million and matures in July 2012 to mirror the maturity of the Senior Notes. Underthe agreement, we pay on a semi-annual basis (each January 1 and July 1) afloating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the three and nine months endedSeptember 30, 2007, we recorded interest expense related to this interest rateswap of approximately $0.07 million and $0.2 million, respectively, which isreflected as interest expense in the accompanying financial statements. For thethree and nine months ended September 30, 2006, we recorded interest expenserelated to this interest rate swap of approximately $0.1 million and $0.2million, respectively, which is reflected as interest expense in theaccompanying financial statements. The swap agreements are marked to marketeach quarter with a corresponding mark-to-market adjustment reflected as eithera discount or premium on the Senior Notes. At September 30, 2007 and December31, 2006, the fair value of this derivative instrument was approximately ($0.2)million and ($1.1) million, respectively, and is included in other long-termliabilities in the accompanying financial statements. The carrying value of theSenior Notes as of these dates was adjusted accordingly by the same amount.Because the swap agreement is an effective fair-value hedge, there will be noeffect on our results of operations from the mark-to-market adjustment as longas the swap is in effect. In October 2007, we terminated the swap agreementwith the financial institution. We received approximately $0.2 million inconjunction with the termination, which will be amortized over the remainingterm of the Senior Notes.

 

12

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

 

Basic earnings per share (EPS) iscomputed by dividing net income by the weighted average number of shares ofcommon stock outstanding during the period. Diluted EPS reflects the potentialdilution from common stock equivalents such as stock options and warrants. Forthe three months ended September 30, 2007, there were 15,000 shares ($25.00average price) of stock options that were not included in the computation ofdiluted EPS because to do so would have been anti-dilutive. There were none forthe three months ended September 30, 2006. For the nine months ended September 30,2007 and 2006 there were 19,200 shares ($24.56 average price) and 30,000 shares($15.68 average price), respectively, of stock options that were not includedin the computation of diluted EPS because to do so would have beenanti-dilutive.

 

The following table summarizes the calculation of net earnings (loss)and weighted average common shares and common equivalent shares outstanding forpurposes of the computation of earnings (loss) per share (in thousands, exceptper share data):

 
| ** **                                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                               | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                               | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Income from continuing  operations                                       |       | $                                | 2,417      |                            | $          | 2,584 |   | $ | 6,526 |   | $ | 7,859 |   |
| Discontinued  operations, net of taxes                                   |       | —                           |       | —                          |       | — |   | (707 | ) |
| Net income                                                               |       | $                                | 2,417      |                            | $          | 2,584 |   | $ | 6,526 |   | $ | 7,152 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  shares outstanding                              |       | 14,214                           |       | 13,962                          |       | 14,116 |   | 13,898 |   |
| Weighted average common  share equivalents outstanding                   |       | 345                              |       | 151                             |       | 327 |   | 138 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Weighted average common  shares and common share equivalents outstanding |       | 14,559                           |       | 14,113                          |       | 14,443 |   | 14,036 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Basic earnings (loss)  per share:                                        |       |                             |       |                            |       |   |   |   |   |
| Income from continuing  operations                                       |       | $                                | .17        |                            | $          | .19 |   | $ | .46 |   | $ | .56 |   |
| Loss from discontinued  operations, net of tax                           |       | —                           |       | —                          |       | — |   | (.05 | ) |
| Net income                                                               |       | $                                | .17        |                            | $          | .19 |   | $ | .46 |   | $ | .51 |   |
|                                                                     |       |                             |       |                            |       |   |   |   |   |
| Diluted earnings (loss)  per share:                                      |       |                             |       |                            |       |   |   |   |   |
| Income from continuing  operations                                       |       | $                                | .17        |                            | $          | .18 |   | $ | .45 |   | $ | .56 |   |
| Loss from discontinued  operations, net of tax                           |       | —                           |       | —                          |       | — |   | (.05 | ) |
| Net income                                                               |       | $                                | .17        |                            | $          | .18 |   | $ | .45 |   | $ | .51 |   |

 

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

 

**Legal Proceedings**

** **

***Valencia County DetentionCenter***

*** ***

In April 2007, a lawsuit was filed against the Company in the FederalDistrict court in Albuquerque, New Mexico, by Joe Torres and Eufrasio Armijo,who each alleged that he was strip searched at the Valencia County DetentionCenter (“VCDC”) in New Mexico in violation of his federal rights under theFourth, Fourteenth and Eighth amendments to the U.S. constitution.  Theclaimants also allege violation of their rights under state law and seek tobring the case as a class action on behalf of themselves and all detainees atVCDC during the applicable statues of limitation.  The plaintiffs seekdamages and declaratory and injunctive relief.  The lawsuit is in itsearly stages and no discovery has been conducted. The ultimate outcome of thelawsuit cannot be determined at this time. However, we intend to vigorouslydefend this lawsuit.  We have not recorded any loss accruals related tothis lawsuit.

 

***LincolnCounty Detention Center***

*** ***

In August 2005, a lawsuit was filed by a detainee at the Lincoln CountyDetention Center (“LCDC”) in the U.S. District Court of New Mexico (Santa Fe)seeking unspecified damages. The lawsuit relates to the former LCDC policy thatrequired 

 

13

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strip and visual body cavity searches for all detainees and inmates andalleges that such policy violates a detainee’s Fourth and Fourteenth Amendmentrights 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 settlement amount under the terms of the agreement is$1.6 million, and will be funded principally through our general liability andprofessional liability coverage.

 

In the year ended December 31, 2005, we recorded a charge of $0.2million related to this lawsuit. In addition, we previously have providedinsurance reserves for this matter (as part of our regular review of reportedand unreported claims) totaling approximately $0.5 million. During the thirdquarter of 2006, we recorded an additional settlement charge of approximately$0.9 million and the related reimbursement from our general liability andprofessional liability insurance. The charge and reimbursement were recognizedin general and administrative expenses for the year ended December 31, 2006.The reimbursement was funded by the insurance carrier in the first quarter of2007 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 Service Center***

 

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas. The lawsuit alleges that we violated the rights ofLakeisha Shantrail Brown, the deceased daughter of Juana Michelle Brown, underthe U.S. Constitution and the laws of the State of Arkansas by denying Ms.Brown medical treatment that caused her death and sought unspecified actual andpunitive damages. In September 2006, the plaintiff filed, and the courtgranted, an order for voluntary dismissal without prejudice. The lawsuit wasrefiled in December 2006 as *Juana MichelleBrown, Administratrix of the Estate of Lakeisha Shantrail Brown, Deceased, v.Cornell Interventions, Inc. et al.,*No. 4-06 CV17808*,*in theUnited States District Court for the Eastern District of Arkansas. We havereached an agreement with the plaintiff to settle the matter, and thesettlement must be approved by a probate court. Our insurance coverage is sufficientto cover the settlement subject to our normal deductible.

 

***Southern Peaks Regional Treatment Center***

 

In January 2004, we initiated legal proceedings in the lawsuitstyled *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 atSeptember 30, 2007. In December 2004, the jury awarded us approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, plus attorneys’ fees. The actual damages portion of the award underthe final Judgment and Decree (“Judgment”) entered on December 20, 2006 wasadjusted downward to the $5.4 million actually lost by us. The award forcompensatory damages accrues pre-judgment interest at a rate of 7 percent fromthe date of loss through the date of judgment. Following the jury verdicts, wecollected approximately $0.4 million in January 2005 in funds that hadbeen previously frozen under a temporary restraining order issued at the timethat we commenced this litigation. Currently, one of the defendants has filedan appeal of the Judgment. Due to the continued uncertainty surrounding theultimate recovery of the funds previously deposited, we recorded an additionalreserve in the amount of approximately $0.3 million in the quarter endedDecember 31, 2006. We will continue to maintain our existing reserve ofapproximately $5.3 million in an allowance for doubtful accounts against thecorresponding balance as carried in other receivables at September 30, 2007 andDecember 31, 2006.

 

***Shareholder Lawsuits***

 

OnOctober 19, 2006, a purported class action complaint was filed in the DistrictCourt of Harris County, Texas, 269th Judicial District (No. 2006-67413) by TedKinbergy, an alleged stockholder of Cornell. The complaint names as defendantsCornell and each member of our board of directors as well as Veritas CapitalFund III, L.P. (“Veritas”). The complaint alleges, among other things, that (i)the defendants have breached fiduciary duties they assertedly owed to ourstockholders in connection with our entering into the Agreement and Plan ofMerger, dated as of October 6, 2006, with Veritas, Cornell Holding Corp., andCCI Acquisition Corp., and (ii) the merger consideration is unfair andinadequate. The plaintiffs sought, among other things, an injunction againstthe consummation of the merger. The proposed merger was rejected at a special 

 

14

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meetingof our stockholders held on January 23, 2007. We believe that the lawsuit iswithout merit and intend to defend ourselves vigorously.

 

We hold insurance policies to cover potential director and officerliability, some of which may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decisionin these matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, it could have a material adverse effecton us, our financial condition, results of operations and future cash flows.

 

***Settlement of Claim***

 

In August 2007, we settled a lawsuit we had filed in the 333rdState District Court in Houston, Texas, Cause No. 2005-55083 against LockeLiddell & Sapp PLLC and an individual partner of Locke Liddell & SappPLLC, (the “Defendants”) relating to the Defendant’s representation of theCompany in a transaction involving our Southern Peaks Regional Treatment Centerin Canon City, Colorado. Under the terms of the settlement, we received $1.85million in August 2007, which was recorded as a reduction to general andadministrative expenses for the three and nine months ended September 30, 2007.We incurred approximately $0.3 million in expenses related to this matter inthe third quarter of 2007.

 

***Other***

 

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

 

During the period from August 2000 through May 2003, ourgeneral liability and professional liability coverage was provided by SpecialtySurplus Insurance Company, a Kemper Insurance Company (“Kemper”) group member.In June 2004, the Illinois Department of Insurance gave Kemper permissionto proceed with a run-off plan it had previously submitted. The three-year planis designed to help Kemper meet its goal of resolving, to the maximum extentpossible, all valid policyholder claims. In view of the risks and uncertaintiesinvolved in implementing the plan, including the need to achieve significantpolicy buybacks, commutation of reinsurance agreements, and further agreementswith regulators, the plan may not be successfully implemented by Kemper. In theyear ended December 31, 2004, we accrued a provision of $0.6 million, andestimated our range of additional exposure to be approximately $0.5 millionwith respect to outstanding claims incurred during this policy period withKemper which would become our obligation to resolve if not settled throughKemper. During the year ended December 31, 2005, Kemper continued toimplement its run-off plan. As a result, several of our significant claims weresettled by Kemper during 2005. In conjunction with these settlements, werecorded a charge against our existing accrual in the amount of $0.3 million.Based on our analysis of the claims activity during the third quarter of 2005,we felt it necessary to accrue an additional provision in the amount ofapproximately $0.2 million during the third quarter of 2005. Additionalsignificant claims continued to be settled by Kemper during the second half of2006. As a result, we released reserves of approximately $0.4 million duringthe quarter ended December 31, 2006. At September 30, 2007, we do not believethere is significant exposure above our existing $0.1 million accrual for thoseoutstanding claims which could become our obligation to resolve if not settledthrough Kemper.

 

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

 

**9.****     Facility Acquisitions**

** **

***High Plains Correctional Facility***

 

InMay 2007, we acquired from GRW Corporation the High Plains CorrectionalFacility in Brush, Colorado. The facility currently has the capacity to houseapproximately 270 medium-security female inmates and operates under anIntergovernmental Agreement with the City of Brush and the Colorado Departmentof Corrections. The purchase price was approximately $8.9 million and wasallocated entirely to the property and equipment acquired.

 

15

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***Washington, D.C. Facility***

 

InSeptember 2007, we acquired a formerly leased facility in Washington, D.C. Thisfacility which has a service capacity of 70 beds can provide both juvenileresidential and community-based services, as well as educational,rehabilitation and treatment programs. The purchase price was approximately$9.6 million and was allocated entirely to the property and equipment acquired.Our prior lease with the seller would have run to July 2013 and we would haveincurred approximately $0.8 million in annual rent.

 

**10.****  Derivative Financial Instrumentsand Guarantees**

 

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

*** ***

InAugust 2001, MCF completed a bond offering to finance the 2001 Sale andLeaseback Transaction. In connection with this bond offering, two reserve fundaccounts were established by MCF pursuant to the terms of the indenture: (1)MCF’s Debt Service Reserve Fund, aggregating approximately $23.5 million atSeptember 30, 2007, was established to make payments on MCF’s outstanding bondsin the event we (as lessee) should fail to make the scheduled rental paymentsto MCF and (2) MCF’s Debt Service Fund, aggregating approximately $18.4 millionat September 30, 2007, used to accumulate the monthly lease payments that MCFreceives from us until such funds are used to pay MCF’s semi-annual bondinterest and annual bond principal payments. Both reserve fund accounts aresubject to the agreements with the MCF Equity Investors whereby guaranteedrates of return of 3.0% and 5.08%, respectively, are provided for in thebalance of the Debt Service Reserve Fund and the Debt Service Fund. Theguaranteed rates of return are characterized as cash flow hedge derivativeinstruments. At inception, the derivatives had an aggregate fair value of $4.0million, which has been recorded as a decrease to the equity investment in MCFmade by the MCF Equity Investors (MCF minority interest) and as a deferredliability in our Consolidated Balance Sheets. Changes in the fair value of thederivative instruments are recorded as an adjustment to other long-termliabilities and reported as other comprehensive income (loss) in ourConsolidated Statements of Operations and Comprehensive Income. At September30, 2007 and December 31, 2006, the fair value of these derivative instrumentswas approximately $3.0 million and $3.2 million, respectively. OurConsolidated Statements of Operations and Comprehensive Income includeunrealized income on these derivative instruments of approximately $0.7 millionand $0.1 million for the three and nine months ended September 30, 2007,respectively. For the three and nine months ended September 30, 2006, wereported an unrealized gain (loss) on these derivative instruments ofapproximately $0.5 million and ($0.3) million, respectively.

 

Inconnection with MCF’s bond offering, the MCF Equity Investor provided aguarantee of the Debt Service Reserve Fund if a bankruptcy of the Company wereto occur and a trustee for the estate of the Company were to include the DebtService Reserve Fund as an asset of the Company’s estate. This guarantee ischaracterized as an insurance contract and is being amortized to expense overthe life of the debt.

 

**11.**** ****Segment Disclosure**

 

Ourthree operating divisions are our reportable segments. The adult secureinstitutional services segment consists of the operations of secure adultincarceration 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 adultcommunity-based corrections and treatment services segment consists ofproviding pre-release and halfway house programs for adult offenders who areeither on probation or serving the last three to six-months of their sentenceson parole and preparing for re-entry into society at large as well ascommunity-based treatment and education programs as an alternative toincarceration. All of our customers and long-lived assets are located in theUnited States of America. The accounting policies of our reportable segmentsare the same as those described in the summary of significant accountingpolicies in our 2006 Annual Report on Form 10-K. Intangible assets are notincluded in each segment’s reportable assets, and the related amortization ofintangible assets is not included in the determination of a segment’s incomefrom operations. We evaluate performance based on income or loss fromoperations before general and administrative expenses, incentive bonuses,amortization of intangibles, interest and income taxes. Corporate and otherassets are comprised primarily of cash, investment securities available forsale, accounts receivable, debt service fund, deposits, property and equipment,deferred taxes, deferred costs and other assets. Corporate and other expensefrom operations primarily consists of depreciation on the corporate officefacilities and equipment and specific general and administrative chargespertaining to corporate personnel (including the $1.85 million legal settlementreceived in the third quarter of 2007 as discussed in Note 8 to theaccompanying consolidated financial statements), and is presented separately assuch charges cannot be readily identified for allocation to a particular segment.

 

16

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The followingtable excludes the results of discontinued operations for the revenue,pre-opening and start-up expenses and income from operations categories for allperiods presented. The only significant non-cash item reported in therespective segment’s income from operations is depreciation and amortization(excluding intangibles) (in thousands).

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                         | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                         | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Revenues:                                          |       |                             |       |                            |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                | 43,088     |                            | $          | 47,243 |   | $ | 137,373 |   | $ | 130,953 |   |
| Juvenile                                           |       | 27,084                           |       | 28,410                          |       | 80,648 |   | 86,401 |   |
| Adult community-based                              |       | 17,155                           |       | 16,730                          |       | 50,444 |   | 49,374 |   |
| Total revenues                                     |       | $                                | 87,327     |                            | $          | 92,383 |   | $ | 268,465 |   | $ | 266,728 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| 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                        |       | $                                | 8,651      |                            | $          | 11,587 |   | $ | 32,279 |   | $ | 32,251 |   |
| Juvenile                                           |       | 2,684                            |       | 2,629                           |       | 8,804 |   | 9,258 |   |
| Adult community-based                              |       | 4,281                            |       | 3,216                           |       | 11,434 |   | 9,088 |   |
| Subtotal                                           |       | 15,616                           |       | 17,432                          |       | 52,517 |   | 50,597 |   |
| General and  administrative expense                |       | (4,316                           | )          | (6,053                          | )          | (19,848 | ) | (16,604 | ) |
| Amortization of  intangibles                       |       | (556                             | )          | (561                            | )          | (1,677 | ) | (1,682 | ) |
| Corporate and other                                |       | (206                             | )          | (262                            | )          | (573 | ) | (835 | ) |
| Total income from  operations                      |       | $                                | 10,538     |                            | $          | 10,556 |   | $ | 30,419 |   | $ | 31,476 |   |
|                                               |       |                             |       |                            |       |   |   |   |   |
| Loss on discontinued  operations, net of tax:      |       |                             |       |                            |       |   |   |   |   |
| Adult secure  institutional                        |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | —                           |       | —                          |       | — |   | (707 | ) |
| Adult community-based                              |       | —                           |       | —                          |       | — |   | — |   |
| Total loss on  discontinued operations, net of tax |       | $                                | —     |                            | $          | — |   | $ | — |   | $ | (707 | ) |

 
| ** **                  | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2007**               | ** ** | **2006**              | ** ** |
| Assets                      |       |                   |       |                  |       |
| Adult secure  institutional |       | $                      | 271,990    |                  | $          | 233,670 |   |
| Juvenile                    |       | 111,808                |       | 100,366               |       |
| Adult community-based       |       | 60,534                 |       | 63,105                |       |
| Intangible assets, net      |       | 18,604                 |       | 19,265                |       |
| Corporate and other         |       | 74,092                 |       | 107,127               |       |
| Total assets                |       | $                      | 537,028    |                  | $          | 523,533 |   |

 

**12.**** ****Guarantor Disclosures**

 

We completed an offering of $112.0million of Senior Notes in June 2004. The Senior Notes are guaranteed byeach of our subsidiaries (the “Guarantor Subsidiaries”). These guarantees arejoint and several obligations of the Guarantor Subsidiaries. MCF does notguarantee the Senior Notes (the “Non-Guarantor Subsidiary”). The followingcondensed consolidating financial information presents the financial condition,results of operations and cash flows of the Guarantor Subsidiaries and theNon-Guarantor Subsidiary, together with the consolidating adjustments necessaryto present our results on a consolidated basis.

 

17

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**CondensedConsolidating Balance Sheet as of September 30, 2007 (in thousands)(unaudited)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |                |       |             |       |             |       |
|                                             |       |       |       |             |       |                |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 634        |             | $          | 224                 |       | $                | 45         |             | $          | — |   | $ | 903 |   |
| Investment securities                            |       | 750        |       | —           |       | —              |       | —           |       | 750              |       |
| Accounts receivable                              |       | 1,624      |       | 64,483           |       | 353                 |       | —           |       | 66,460           |       |
| Debt service fund and  other restricted assets   |       | —     |       | 2,079            |       | 18,959              |       | (592             | )          | 20,446           |       |
| Prepaids and other                               |       | 12,595     |       | 1,033            |       | —              |       | —           |       | 13,628           |       |
| Total current assets                             |       | 15,603     |       | 67,819           |       | 19,357              |       | (592             | )          | 102,187          |       |
| Property and equipment,  net                     |       | 209        |       | 226,782          |       | 147,252             |       | (4,909           | )          | 369,334          |       |
| Other assets:                                    |       |       |       |             |       |                |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —           |       | 23,547              |       | —           |       | 23,547           |       |
| Deferred costs and  other                        |       | 54,393     |       | 28,386           |       | 6,215               |       | (47,034          | )          | 41,960           |       |
| Investment in  subsidiaries                      |       | 31,053     |       | 1,856            |       | —              |       | (32,909          | )          | —           |       |
| Total assets                                     |       | $          | 101,258    |             | $          | 324,843             |       | $                | 196,371    |             | $          | (85,444 | ) | $ | 537,028 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and Stockholders’ Equity**    |       |       |       |             |       |                |       |             |       |             |       |
|                                             |       |       |       |             |       |                |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |                |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 39,611     |             | $          | 17,510              |       | $                | 2,062      |             | $          | (1,234 | ) | $ | 57,949 |   |
| Current portion of  long-term debt               |       | 10,000     |       | 11               |       | 11,400              |       | —           |       | 21,411           |       |
| Total current  liabilities                       |       | 49,611     |       | 17,521           |       | 13,462              |       | (1,234           | )          | 79,360           |       |
| Long-term debt, net of  current portion          |       | 110,954    |       | 29               |       | 134,100             |       | —           |       | 245,083          |       |
| Deferred tax  liabilities                        |       | 12,081     |       | 94               |       | —              |       | 408              |       | 12,583           |       |
| Other long-term  liabilities                     |       | 7,739      |       | 201              |       | 47,696              |       | (49,426          | )          | 6,210            |       |
| Intercompany                                     |       | (272,919   | )          | 272,919          |       | —              |       | —           |       | —           |       |
| Total liabilities                                |       | (92,534    | )          | 290,764          |       | 195,258             |       | (50,252          | )          | 343,236          |       |
| Stockholders’ equity                        |       | 193,792    |       | 34,079           |       | 1,113               |       | (35,192          | )          | 193,792          |       |
| Total liabilities and  stockholders’ equity |       | $          | 101,258    |             | $          | 324,843             |       | $                | 196,371    |             | $          | (85,444 | ) | $ | 537,028 |   |

 

18

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**Condensed Consolidating Balance Sheet as of December 31,2006 (in thousands)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |                |       |             |       |             |       |
|                                             |       |       |       |             |       |                |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 18,083     |             | $          | 371                 |       | $                | 75         |             | $          | — |   | $ | 18,529 |   |
| Investment securities                            |       | 11,925     |       | 3⁄4           |       | 3⁄4              |       | 3⁄4           |       | 11,925           |       |
| Accounts receivable                              |       | 2,661      |       | 73,448           |       | 365                 |       | 3⁄4           |       | 76,474           |       |
| Restricted assets                                |       | 3⁄4     |       | 1,658            |       | 22,953              |       | 3⁄4           |       | 24,611           |       |
| Prepaids 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 |   |

 

19

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

**(inthousands) (unaudited)**

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

 

20

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**CondensedConsolidating Statement of Operations for the three months endedSeptember 30, 2006**

**(inthousands) (unaudited)**

 
| ** **                                                                  | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                  | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                  | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                    |       | $          | 4,502      |             | $          | 105,376             |       | $                | 4,502      |             | $          | (21,997 | ) | $ | 92,383 |   |
| Operating expenses                                                          |       | 7,223      |       | 86,144           |       | —              |       | (21,910          | )          | 71,457           |       |
| Depreciation and  amortization                                              |       | —     |       | 3,402            |       | 1,055               |       | (140             | )          | 4,317            |       |
| General and  administrative expenses                                        |       | 6,007      |       | —           |       | 46                  |       | —           |       | 6,053            |       |
| Income (loss) from  operations                                              |       | (8,728     | )          | 15,830           |       | 3,401               |       | 53               |       | 10,556           |       |
| Overhead allocations                                                        |       | (12,631    | )          | 12,631           |       | —              |       | —           |       | —           |       |
| Interest, net                                                               |       | 2,088      |       | 1,272            |       | 3,129               |       | 11               |       | 6,500            |       |
| Equity earnings in  subsidiaries                                            |       | 2,112      |       | —           |       | —              |       | (2,112           | )          | —           |       |
| Income (loss) from continuing  operations before provision for income taxes |       | 3,927      |       | 1,927            |       | 272                 |       | (2,070           | )          | 4,056            |       |
| Provision for income  taxes                                                 |       | 1,343      |       | —           |       | —              |       | 129              |       | 1,472            |       |
| Income (loss) from  continuing operations                                   |       | 2,584      |       | 1,927            |       | 272                 |       | (2,199           | )          | 2,584            |       |
| Discontinued operations                                                     |       | —     |       | —           |       | —              |       | —           |       | —           |       |
| Net income (loss)                                                           |       | $          | 2,584      |             | $          | 1,927               |       | $                | 272        |             | $          | (2,199 | ) | $ | 2,584 |   |

 

21

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

**(inthousands) (unaudited)**

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

 

22

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**CondensedConsolidating Statement of Operations for the nine months endedSeptember 30, 2006**

**(inthousands) (unaudited)**

 
| ** **                                                                  | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                  | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                  | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                    |       | $          | 13,506     |             | $          | 303,067             |       | $                | 13,506     |             | $          | (63,351 | ) | $ | 266,728 |   |
| Operating expenses                                                          |       | 17,295     |       | 249,503          |       | 33                  |       | (63,096          | )          | 203,735          |       |
| Pre-opening and  start-up expenses                                          |       | —     |       | 2,657            |       | —              |       | —           |       | 2,657            |       |
| Depreciation and  amortization                                              |       | —     |       | 9,492            |       | 3,166               |       | (402             | )          | 12,256           |       |
| General and  administrative expenses                                        |       | 16,520     |       | —           |       | 84                  |       | —           |       | 16,604           |       |
| Income (loss) from  operations                                              |       | (20,309    | )          | 41,415           |       | 10,223              |       | 147              |       | 31,476           |       |
| Overhead allocations                                                        |       | (30,034    | )          | 30,034           |       | —              |       | —           |       | —           |       |
| Interest, net                                                               |       | 4,685      |       | 3,812            |       | 9,608               |       | 32               |       | 18,137           |       |
| Equity earnings in  subsidiaries                                            |       | 7,293      |       | —           |       | —              |       | (7,293           | )          | —           |       |
| Income (loss) from  continuing operations before provision for income taxes |       | 12,333     |       | 7,569            |       | 615                 |       | (7,178           | )          | 13,339           |       |
| Provision for income  taxes                                                 |       | 5,181      |       | —           |       | —              |       | 299              |       | 5,480            |       |
| Income (loss) from  continuing operations                                   |       | 7,152      |       | 7,569            |       | 615                 |       | (7,477           | )          | 7,859            |       |
| Discontinued  operations, net of income tax benefit of $381                 |       | —     |       | (707             | )          | —              |       | —           |       | (707             | )          |
| Net income (loss)                                                           |       | $          | 7,152      |             | $          | 6,862               |       | $                | 615        |             | $          | (7,477 | ) | $ | 7,152 |   |

 

23

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

**(inthousands) (unaudited)**

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

 

24

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**Condensed Consolidating Statement of CashFlows for the nine months ended September 30, 2006**

**(in thousands) (unaudited)**

 
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Consolidated** | ** ** |
| **Cash  flows from operating activities:**                |       |       |       |             |       |                |       |             |       |
| Net cash provided by  (used in) operating activities      |       | $          | (1,060     | )                | $          | 6,869               |       | $                | 5,788      |   | $ | 11,597 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**                |       |       |       |             |       |                |       |             |       |
| Capital expenditures                                      |       | —     |       | (10,557          | )          | —              |       | (10,557          | )          |
| Purchases of investment  securities                       |       | (296,975   | )          | —           |       | —              |       | (296,975         | )          |
| Sales of investment  securities                           |       | 294,250    |       | —           |       | —              |       | 294,250          |       |
| Withdrawals from  restricted debt payment account, net    |       | —     |       | —           |       | 3,942               |       | 3,942            |       |
| Proceeds from the sale  of property and equipment         |       | —     |       | 2,890            |       | —              |       | 2,890            |       |
| Net cash used in investing  activities                    |       | (2,725     | )          | (7,667           | )          | 3,942               |       | (6,450           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash  flows from financing activities:**                |       |       |       |             |       |                |       |             |       |
| Payments of MCF bonds                                     |       | —     |       | —           |       | (9,700              | )          | (9,700           | )          |
| Payments of capital  lease obligations                    |       | —     |       | (8               | )          | —              |       | (8               | )          |
| Tax benefit of stock  option exercise                     |       | 223        |       | —           |       | —              |       | 223              |       |
| Proceeds from exercise  of stock options                  |       | 2,088      |       | —           |       | —              |       | 2,088            |       |
| Net cash provided by  (used in) financing activities      |       | 2,311      |       | (8               | )          | (9,700              | )          | (7,397           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Net  (decrease) increase in cash and cash equivalents** |       | (1,474     | )          | (806             | )          | 30                  |       | (2,250           | )          |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at beginning of period**     |       | 12,579     |       | 1,114            |       | 30                  |       | 13,723           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at end of period**           |       | $          | 11,105     |             | $          | 308                 |       | $                | 60         |   | $ | 11,473 |   |

 

25

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

 

**General**

 

We are a leading provider of correctional,detention, educational, rehabilitation and treatment services outsourced byfederal, state and local government agencies. We provide a diversifiedportfolio of services for adults and juveniles through our three operatingdivisions: (1) adult secure institution and detention services;(2) juvenile justice, educational and treatment services and(3) adult community-based corrections and treatment services. AtSeptember 30, 2007, we operated 74 facilities with a total servicecapacity of 17,532. We also had one facility that was vacant at September 30,2007 with a service capacity of 70. Our facilities are located in 15 states andthe District of Columbia.

 

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

 
| ** **                                                                         | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                                         | ** ** | **2007**               | ** ** | **2006**               | ** ** |
| **Residential**                                                                    | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (1)  (2)                                                          |       | 14,581                 |       | 14,634                 |       |
| Contracted beds in  operation (end of period) (1) (3)                              |       | 13,472                 |       | 13,508                 |       |
| Average contract  occupancy based on contracted beds in operation (1) (4) (5) |       | 102.1                  | %          | 96.4                   | %          |
| Average contract  occupancy excluding start-up operations (1) (4) (5)         |       | 102.1                  | %          | 96.4                   | %          |
| **Non-Residential**                                                                | ** ** | ** **             | ** ** | ** **             | ** ** |
| Service capacity (1)  (6)                                                          |       | 3,021                  |       | 4,592                  |       |

 

----

(1)   Data presented excludes discontinued operating facilities.

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

(3)   Atcertain residential facilities, the contracted capacity is lower than thefacility’s service capacity. We could increase a facility’s contracted capacityby obtaining additional contracts or by renegotiating existing contracts toincrease the number of beds covered. However, we may not be able to obtaincontracts that provide occupancy levels at a facility’s service capacity orthat current contracted capacities can be maintained in future periods.

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

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

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

 

Wederive substantially all of our revenues from providing adult corrections andtreatment and juvenile justice, educational and treatment services outsourcedby federal, state and local government agencies in the United States. Revenuesfor our services are generally recognized on a per diem rate based upon thenumber of occupant days or hours served for the period, on a guaranteedtake-or-pay basis or on a cost-plus reimbursement basis. For the threemonths ended September 30, 2007, our revenue base consisted of 75.3% forservices provided under per diem contracts, 17.9% for services provided undertake-or-pay and management contracts, 4.5% for services provided undercost-plus reimbursement contracts, 2.0% for services provided under fee-for-servicecontracts and 0.4% from other miscellaneous sources. For the nine months endedSeptember 30, 2007, our revenue base consisted of 73.5% for servicesprovided under per diem contracts, 19.3% for services provided undertake-or-pay and management contracts, 4.7% for services provided undercost-plus reimbursement contracts, 2.1% for services provided underfee-for-service contracts and 0.4% from other miscellaneous sources. Whilethese percentages are generally consistent with comparable statistics for thethree and nine months ended September 30, 2006, there has been a decrease inthe percentage of revenues for services provided under per diem contracts andin the percentage of revenues provided under cost-plus reimbursement contracts,and an increase in the percentage of revenues provided under take-or-paycontracts between the comparable periods. The decrease in the percentage ofrevenues for

 

26

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services provided under per diem contracts and the increase in thepercentage of revenues for services provided under take-or-pay contracts isprimarily due to the operations of the Moshannon Valley Correctional Centerwhich opened in April 2006. The decrease in the percentage of revenues forservices provided under cost-plus reimbursement contracts is due primarily tothe termination of our management contracts at the Alexander Youth ServicesCenter in January 2007, at the South Mountain Secure Treatment Unit (“SMSTU”)in June 2006 and at the Donald W. Wyatt Detention Center in July 2007. 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 ofcontracts for a facility or the closure of a facility.

 

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

 

Revenuesfor our adult secure institutional services division are primarily generatedfrom per diem, take-or-pay and management contracts. We believe thatthese types of contracts will continue to be offered to the private sector asfederal, state and local government agencies face challenges posed byincreasing inmate populations. In addition, heightened focus on border patroland 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 threemonths ended September 30, 2007 and 2006, we realized average per diemrates on our adult secure institution facilities of approximately $53.54 and $56.49,respectively. For the nine months ended September 30, 2007 and 2006, werealized average per diem rates of approximately $54.65 and $56.40,respectively. Thedecrease in the average per diem rate in 2007 is principally a result of theincreased population at the Moshannon Valley Correctional Center which openedin April 2006 as the facility ramped up. This facility operates under atake-or-pay contract.

 

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 ourability to work with highly-troubled youth offers our customers a solution toaddressing the unique needs of specialized juvenile populations. Through ourAbraxas Youth and Family Services operations, we continue to look foropportunities where our expertise at servicing these populations is of value tocounties, school districts and other contracting agencies. In addition, weintend to leverage our national footprint and scale to compete in anincreasingly regulated market place.

 

For the three months ended September 30,2007 and 2006, we realized average per diem rates on our residential juvenilefacilities of approximately $176.26 and $172.08, respectively. For the ninemonths ended September 30, 2007 and 2006, we realized average per diemrates of approximately $171.11 and $169.26, respectively. The increase in theaverage per diem rate in 2007 was due primarily to the reactivation of theCornell Abraxas Academy (formerly the New Morgan Academy) in October 2006 andthe Hector Garza Residential Treatment Center in September 2007. For the threemonths ended September 30, 2007 and 2006, we realized averagefee-for-service rates for our non-residential community-based juvenilefacilities and programs, including rates that are limited by Medicaid and otherprivate insurance providers, of approximately $44.81 and $38.13, respectively. Forthe nine months ended September 30, 2007 and 2006, we realized averagefee-for-service rates of approximately $44.81 and $36.41, respectively. Theincrease in the average fee-for-service rate in 2007 is due to changes in themix of services provided by our various juvenile justice, educational andtreatment programs and facilities. The majority of our juvenile servicescontracts renew annually.

 

Revenues for our adult community-basedcorrections and treatment services division are primarily generated from perdiem and fee-for-service contracts. We believe that these contracts,when coupled with our adult secure institutional offerings, position us toservice the full spectrum of adult corrections needs. Increasing numbers ofprobationers and parolees, along with an emphasis on providing re-entryservices for these populations, suggest that market conditions will continue tofavor programs like those operated by us. We expect that our national presenceand demonstrated experience in this sector will allow us to effectively competefor new contracts.

 

For the three months ended September 30, 2007and 2006, we realized average per diem rates on our residential adultcommunity-based facilities of approximately $62.61 and $61.81, respectively. Forthe nine months ended September 30, 2007 and 2006, we realized average perdiem rates of $62.47 and $61.38, respectively. For the three months endedSeptember 30, 2007 and 2006, we realized average fee-for-service rates onour non-residential adult community-based programs of approximately $11.34 and$10.23, respectively. For the nine months ended September 30, 2007 and2006, we realized average fee-for-service rates of approximately $12.71 and$10.10, respectively. Our average fee-for-service rates can fluctuate fromyear-to-year due to changes in the mix of services provided by our variousadult community-based corrections and treatment facilities and programs.

 

27

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We have historically experienced higher operatingmargins in our adult secure institution and detention services division andadult community-based corrections and treatment services division as comparedto our juvenile justice, educational and treatment services division.Additionally, our operating margins within a division can vary from facility tofacility based on a number of factors, including whether a facility is owned orleased, the level of competition for the contract award, the proposed length ofthe contract, the occupancy levels for a facility, the level of capitalcommitment required with respect to a facility, the anticipated changes inoperating costs over the term of the contract and our ability to increase afacility’s contract revenue. Under take-or-pay contracts, such as the MoshannonValley Correctional Center, operating margins are typically higher during theearly stages of the contract as the facility’s population ramps up (as revenuesare received at contract percentages regardless of actual occupancy). As thevariable costs (primarily resident related and certain facility costs) increasewith population growth, operating margins will generally decline to astabilized level. Following its activation in April 2006, we experienced suchoperating margin impacts pertaining to the Moshannon Valley Correctional Centerin the three and nine months ended September 30, 2007. A decline in occupancyof certain juvenile facilities and programs can have a more significant impacton operating margins than the adult secure institutional services division dueto higher per diem rates at certain juvenile facilities.

 

We have experienced and expect to continue toexperience interim period operating margin fluctuations due to the number ofcalendar days in the period, higher payroll taxes in the first half of the yearand salary and wage increases and insurance cost increases that are incurredprior to certain contract rate increases. Periodically, many of thegovernmental agencies with whom we contract may experience budget pressures andmay approach us to limit or reduce per diem rates. Decreases in, or thelack of anticipated increases in, per diem rates could adversely impact ouroperating margin. Additionally, a decrease in per diem rates without acorresponding decrease in operating expenses could also adversely affect ouroperating margin.

 

We are responsible for all facility operating costs,except for certain debt service and interest or lease payments for facilitieswhere we have a management contract only. At these facilities, the facilityowner is responsible for all debt service and interest or lease paymentsrelated to the facility. We are responsible for all other operating expenses atthese facilities. We operated 16 and 18 facilities under management contractsat September 30, 2007 and 2006, respectively.

 

A majority of our facility operating costs consistsof fixed costs. These fixed costs include lease and rental expense, insurance,utilities and depreciation. As a result, when we commence operation of new orexpanded facilities, fixed operating costs increase. The amount of our variableoperating costs, including food, medical services, supplies and clothing,depend on occupancy levels at the facilities we operate. Our largest singleoperating cost, facility payroll expense and related employment taxes andexpenses, has both a fixed and a variable component. We can adjust a facility’sstaffing levels and the related payroll expense to a certain extent based onoccupancy at a facility, however a minimum fixed number of employees isrequired to operate and maintain any facility regardless of occupancy levels.Personnel costs are subject to increases in tightening labor markets based onlocal economic and other conditions. Moreover, periodic trend increases incosts such as insurance and medical services can adversely affect our operatingmargin. Such costs have been increasing in recent years, and we anticipate thatthis trend will continue in 2008.

 

We incurpre-opening and start-up expenses including payroll and related taxes,benefits, training and other operating costs prior to opening a new or expandedfacility and during the period of operation that occupancy is ramping up. Thesecosts vary by contract. Since pre-opening and start-up costs are generallyfactored into the per diem rate that is charged to the contracting agency, wetypically expect to recover these upfront costs over the life of the contract.Because occupancy rates during a facility’s start-up phase typically result incapacity under-utilization for at least 90 to 180 days, we may incuradditional post-opening start-up costs. We do not anticipate post-opening start-upcosts at any adult secure facilities operated under any future contracts withthe Federal Bureau of Prisons (“BOP”) because these contracts are currentlyexpected to be operated under guaranteed take-or-pay contracts, meaning thatthe BOP will pay at least 80.0% of the contractual monthly revenue when thefacility opens, regardless of actual occupancy.

 

Newly openedfacilities are staffed according to applicable regulatory or contractualrequirements when we begin receiving offenders or clients. Offenders or clientsare typically assigned to a newly opened facility on a phased-in basis over aone- to six-month period. Our start-up period for new juvenile operations is 12months from 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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Working capital requirementsgenerally increase immediately prior to commencing operation of a new orexpanded facility as we incur start-up costs and purchase necessary equipmentand supplies before facility management revenue is realized.

 

General and administrative expenses consistprimarily of costs for corporate and administrative personnel who providesenior management, legal, finance, accounting, human resources, payroll andinformation systems services, 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 fees of approximately $3.7 million, including cost reimbursementof $2.5 million related to the Merger Agreement in the nine months endedSeptember 30, 2007. In addition, as discussed in Note 8 to the accompanyingconsolidated financial statements, we received a legal settlement of $1.85million during the third quarter of 2007 which was recorded as a reduction ofgeneral and administrative expenses.

 

#### **RecentDevelopments**

#### ** **

***Big Spring Correctional Center***

 

During2006, the BOP solicited an 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 intergovernmental agreements(“IGA”) for such services, including the IGA relating to our Big SpringCorrectional Center. In January 2007, we were awarded a contract from the BOPto operate the Big Spring Correctional Center. This guaranteed take-or-paycontract, which is effective April 1, 2007, provides for an initial contractterm of four years with three two-year renewal option periods. In conjunctionwith this contract, we are undertaking certain facility expansion activities in2007. As of September 30, 2007, we had incurred and capitalized costs ofapproximately $11.4 million related to these expansion activities, which havebeen completed effective November 1, 2007.

 

As a result of completing the expansion we now have the right to beginbilling the BOP under the increased pricing schedule, and we plan to startbilling the BOP at the new contracted rates for the expanded facility effectiveNovember 1st.  However, the BOP indicated last week that theyare presently unable to increase their population usage at the facility asstated in the contract due to an inability of the federal government to pass afederal fiscal year 2008 budget.  We believe the BOP is obligated to beginpaying the increased rates under the terms of the CAR-6 contract as of November1, 2007.  The new billing rates would be expected to produce incrementalearnings for the company of approximately $0.5 million each month based uponrecent operating results of the facility.

 

***Site Acquisition in Colorado***

 

InAugust 2007, we acquired a site in Hudson, Colorado for our development projectfor the Colorado Department of Corrections. The purchase price wasapproximately $5.1 million. Construction is currently expected to begin in2008.

 

***Facility Acquisitions***

 

***Washington, D.C. Facility***

 

In September 2007, we acquired a formerly leasedfacility in Washington, D.C. This facility which has a service capacity of 70beds can provide both juvenile residential and community-based services, aswell as educational, rehabilitation and treatment programs. The purchase price wasapproximately $9.6 million and was allocated entirely to the property andequipment acquired. Our prior lease with the seller would have run to July 2013and we would have incurred approximately $0.8 million in annual rent.

 

***High Plains Correctional Facility***

 

InMay 2007, we acquired from GRW Corporation the High Plains CorrectionalFacility in Brush, Colorado. The facility currently has the capacity to houseapproximately 270 medium-security female inmates and operates under an IGA withthe City of Brush and the Colorado Department of Corrections. The purchaseprice was approximately $8.9 million and was allocated entirely to the propertyand equipment acquired.

 

***Great Plains Correctional Facility***

 

In May 2007, we were awarded a contract by theArizona Department of Corrections for our Great Plains Correctional Facility inHinton, Oklahoma. The contract calls for a total of 2,000 medium-securityinmates to be housed at the facility. 

 

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We expect to house approximately916 inmates at the existing facility and the remainder would be housed throughan expansion of the existing facility. We currently estimate that the expansioncost will be approximately $55.0 million, pending the finalization of designand construction agreements. We began receiving inmates in September 2007 andexpect to complete the initial ramp-up of occupancy at the facility toapproximately 916 inmates in December 2007. The expansion of the facility toaccommodate all 2,000 inmates commenced in the fourth quarter of 2007 and isexpected to be completed by the fourth quarter of 2008. We believe that ourexisting cash and available balance under our Amended Credit Facility willprovide adequate funding to complete this facility expansion.

 

***D. Ray James Prison***

 

We are currently expanding the D. Ray James Prisonin Georgia to increase its current service capacity of 1,640 beds to 1,940 beds.As of September 30, 2007, we had incurred and capitalized costs ofapproximately $10.5 million related to this expansion.

 

In August 2007, we announced that we were initiatinga second expansion of the D. Ray James Prison. This expansion will increase thefacility’s service capacity by an additional 700 beds. We currently anticipatethat this expansion activity will begin in 2008 and be completed early in 2009.We currently estimate that the capital expenditures related to this expansionwill range from $28.0 million to $33.0 million, depending on the finalizationof the design and construction agreements. We believe that our existing cashand available balance under our Amended Credit Facility will provide adequatefunding to complete this facility expansion.

 

***Regional Correctional Center***

 

InJuly 2007, we were notified by Immigration and Customs Enforcement (“ICE”) thatthey were removing all ICE detainees from our Regional Correctional Center inAlbuquerque, New Mexico. The withdrawal was completed in early August 2007.Refer to “*Contractual Uncertainties Relatedto Certain Facilities, Regional Correctional Center*” for moreinformation concerning this development.

 

***Settlement of Claim***

 

InAugust 2007, we settled a lawsuit we had filed in the 333rd StateDistrict Court in Houston, Texas, Cause No. 2005-55083 against Locke Liddell& Sapp PLLC and an individual partner of Locke Liddell & Sapp PLLC,(collectively the “Defendants”) relating to the Defendant’s representation ofthe Company in a transaction involving our Southern Peaks Regional TreatmentCenter in Canon City, Colorado. Under the terms of the settlement, we receivedapproximately $1.85 million in August 2007 which was recorded as a reduction ofgeneral and administrative expenses for the three and nine months endedSeptember 30, 2007. We incurred approximately $0.3 million in expense relatedto this matter in the three months ended September 30, 2007.

 

***Walnut Grove Youth Correctional Facility***

 

In August 2007, we were notified by the State ofMississippi that funding had been approved for a 500 bed expansion of the 914bed Walnut Grove Youth Correctional Facility that we have been managing since2004. Expansion of the facility, which is being entirely funded by the State ofMississippi, began in the third quarter of 2007 and is currently expected to becompleted and operational in the fourth quarter of 2008.

 

***Amended Credit Facility***

 

In October 2007, we amended our existingCredit Facility (the “Amended Credit Facility”). The Amended Credit Facility,which provides for borrowings up to $100.0 million (including letters ofcredit), matures in December 2011 and bears interest, at our election dependingon our total leverage ratio, at either the prime rate plus a margin rangingfrom 0.00% to 0.75%, or a rate which ranges from 1.50% to 2.25% above theapplicable LIBOR rate. Subject to certain requirements, we have the right toincrease the commitments under our Amended Credit Facility up to $150.0million. The Amended Credit Facility is collateralized by substantially all ofour assets, including the assets and stock of all of our subsidiaries. TheAmended Credit Facility is not secured by the assets of MCF. The Amended CreditFacility contains standard covenants including compliance with laws,limitations on certain financing transactions and mergers and compliance withfinancial covenants, although the covenants in the Amended Credit Facility wereamended to provide greater flexibility in certain instances, including deletionof the minimum net worth and minimum asset coverage requirements contained inthe Credit Facility and more favorable leverage ratios.

 

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***Other Contract Terminations***

 

Wetransitioned our management contract at the Donald W. Wyatt Detention Center tothe owner in July 2007.  Refer to “*Resultsof Operations, Three Months Ended September 30, 2007 Compared to ThreeMonths Ended September 30, 2006, Adult Secure*” for moreinformation concerning the termination of this contract.  In July 2007, wewere notified that the funding for our Harrisburg Alternative Education SchoolProgram had been eliminated for the 2007-2008 school year.  Refer to “*Results of Operations, Three Months EndedSeptember 30, 2007 Compared to Three Months Ended September 30, 2006,Juvenile*” for more information concerning the termination of thisprogram.

 

**NewAccounting Pronouncements**

 

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

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued Statement of Financial Accounting Standard (“SFAS”)No. 157, “Fair Value Measurements.” This statement establishes a framework formeasuring fair value within generally accepted accounting principles andexpands the required disclosures concerning fair value measurements. SFAS No.157 is effective for financial statements issued for fiscal years beginningafter November 15, 2007, and interim periods within those fiscal years. Theprovisions of SFAS No. 157 must be applied prospectively as of the beginning ofthe fiscal year in which it is adopted, except in limited circumstances. Weplan to adopt the provisions of SFAS No. 157 effective January 1, 2008. We arecurrently evaluating the impact that the adoption of this standard may have onour consolidated financial statements.

 

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

 

In February 2007, the FASB issued SFAS No. 159, “TheFair Value Option for Financial Assets and Financial Liabilities – Including anamendment of FASB Statement No. 115.” This statement, for which adoption isoptional, permits entities to choose to measure many financial instruments andcertain other items at fair value that are not currently required to bemeasured at fair value and establishes presentation and disclosure requirementsdesigned to facilitate comparisons between entities that choose differentmeasurement attributes for similar types of assets and liabilities. SFAS No.159 is effective as of the beginning of an entity’s first fiscal year thatbegins after November 15, 2007. Early adoption is permitted as of the beginningof a fiscal year that begins on or before November 15, 2007, provided theentity also elects to apply the provisions of SFAS No. 157, “Fair ValueMeasurements.”  We are currentlyevaluating the impact the adoption of this standard may have on ourconsolidated financial statements

 

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**Results ofOperations**

 

The following table sets forth for theperiods indicated the percentages of revenue represented by certain items in ourhistorical consolidated statements of operations.

 
| ** **                                                           | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                           | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| ** **                                                           | ** ** | **2007**                         | ** ** | **2006**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                 |       |                             |       |                            |       |   |   |   |   |
| Revenues                                                             |       | 100.0                            | %          | 100.0                           | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                   |       | 78.4                             |       | 77.3                            |       | 76.9 |   | 76.4 |   |
| Pre-opening and  start-up expenses                                   |       | —                           |       | —                          |       | — |   | 1.0 |   |
| Depreciation and  amortization                                       |       | 4.6                              |       | 4.7                             |       | 4.4 |   | 4.6 |   |
| General and  administrative expenses                                 |       | 4.9                              |       | 6.6                             |       | 7.4 |   | 6.2 |   |
| Income from operations                                               |       | 12.1                             |       | 11.4                            |       | 11.3 |   | 11.8 |   |
| Interest expense, net                                                |       | 6.9                              |       | 7.0                             |       | 6.9 |   | 6.8 |   |
| Income from continuing  operations before provision for income taxes |       | 5.2                              |       | 4.4                             |       | 4.4 |   | 5.0 |   |
| Provision for income  taxes                                          |       | 2.4                              |       | 1.6                             |       | 2.0 |   | 2.1 |   |
| Income from continuing  operations                                   |       | 2.8                              |       | 2.8                             |       | 2.4 |   | 2.9 |   |
| Loss on discontinued  operations, net of tax                         |       | —                           |       | —                          |       | — |   | (0.3 | ) |
| Net income                                                           |       | 2.8                              | %          | 2.8                             | %          | 2.4 | % | 2.6 | % |

 

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

 

***Revenues*****.**Revenues decreased approximately $5.1million, or 5.5%, to $87.3 million for the three months ended September 30, 2007from $92.4 million for the three months ended September 30, 2006.

 

*Adult Secure.*****Adult secure institutional servicesdivision revenues decreased approximately $4.1 million, or 8.7%, to $43.1million for the three months ended September 30, 2007 from $47.2 millionfor the three months ended September 30, 2006 due primarily to (1)a decrease in revenues of approximately $3.1 million at the Great PlainsCorrectional Facility due to our termination of our management contract withthe Oklahoma Department of Corrections (“OKDOC”) in April 2007 (the facilitybegan receiving inmates under our contract with the Arizona Department ofCorrections in September 2007), (2) a decrease in revenues of approximately$2.0 million at the Regional Correctional Center due to a reduction inoccupancy resulting from the withdrawal of inmates by ICE during the thirdquarter of 2007 and (3) a decrease in revenues of approximately $1.4 million atthe Donald W. Wyatt Detention Center due to the transition of our managementcontract for this facility to the owner in July 2007. The decrease in revenuesdue to the above was offset, in part, by (1) revenues of approximately $1.1million from the High Plains Correctional Facility acquired in May 2007 and (2)an increase in revenues of approximately $0.3 million at the D. Ray JamesPrison due to increased occupancy. The remaining net increase in revenues of$1.0 million was due to various insignificant fluctuations in revenues at ourother adult secure facilities.

 

Our adult secure institutional services divisionrevenues are primarily generated from contracts with federal and stategovernment agencies. At September 30, 2007, we operated 10 adult secureinstitutional facilities with an aggregate service capacity of 9,505.

 

Average contract occupancy was 99.6% for the threemonths ended September 30, 2007 compared to 98.7% for the three monthsended September 30, 2006. The average per diem rate for our adult securefacilities was approximately $53.54 and $56.49 for the three months endedSeptember 30, 2007 and 2006, respectively. There were no revenuesattributable to start-up operations for the three months ended September 30,2007 and 2006.

 

*Juvenile.*Juvenilejustice, educational and treatment services division revenues decreasedapproximately $1.3 million, or 4.6%, to $27.1 million for the three monthsended September 30, 2007 from $28.4 million for the three months ended September 30,2006 due primarily to (1) a decrease in revenues of approximately $2.9million due to the termination of our management contract at the AlexanderYouth Services Center in January 2007 and (2) a decrease in revenues ofapproximately $0.9 million due to the termination of our contract at theHarrisburg Alternative Education School Program. In July 2007, we were notifiedthat the funding for this program was discontinued for the 2007-2008 schoolyear. The decrease in revenues due to the above was offset, in part, by (1)revenues of approximately $1.0 million at the Cornell Abraxas Academy (formerlythe New Morgan Academy) which we reactivated in October 2006, (2) revenues ofapproximately $0.2 million at the Hector Garza Residential Treatment Center(formerly the Campbell Griffin Treatment 

 

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Center) which we reopened in August 2007, (3) an increase in revenuesof approximately $0.2 million at the Southern Peaks Regional Treatment Centerdue to improved occupancy, (4) an increase in revenues of approximately $0.2million at the Leadership Development Program due to increased occupancy and(5) an increase in revenues of approximately $0.2 million at the CornellAbraxas Center for Adolescent Females (“ACAF”) due to improved occupancy. Theremaining net increase in revenues of $0.7 million was due to variousinsignificant fluctuations in revenues at our other juvenile facilities andprograms.

 

At September 30, 2007, we operated 17residential juvenile facilities and 12 non-residential juvenile community-basedprograms with an aggregate service capacity of 3,638. Additionally, wehad one juvenile residential facility with a service capacity of 70 that wasvacant at September 30, 2007. Ourcontracts for these facilities and programs are generally with state and localgovernment agencies and generally renew annually.

 

Average contract occupancy for the three months endedSeptember 30, 2007 was 91.8% compared to 93.5% for the three months endedSeptember 30, 2006.

 

The average per diem rate for our residential juvenile facilities wasapproximately $176.26 for the three months ended September 30, 2007compared to $172.08 for the three months ended September 30, 2006. Ouraverage fee-for-service rate for our non-residential juvenile community-basedfacilities and programs was approximately $44.81 for the three months endedSeptember 30, 2007 compared to $38.13 for the three months endedSeptember 30, 2006. There were no revenues attributable to start-upoperations for the three months ended September 30, 2007 and 2006.

 

*AdultCommunity-Based.*Adult community-based corrections andtreatment services division revenues increased approximately $0.5 million, or3.0%, to $17.2 million for the three months ended September 30, 2007 from $16.7million for the three months ended September 30, 2006 due primarily to anincrease in revenues of approximately $0.2 million from the operations of twojails in California which we began managing in January 2007. The remaining netincrease in revenues of $0.3 million was due to various insignificantfluctuations in revenues at our other adult community-based facilities andprograms.

 

At September 30, 2007, we operated28 residential adult community-based facilities and 7 non-residential adultcommunity-based programs with an aggregate service capacity of 4,389. Average contractoccupancy was 102.3% for the three months ended September 30, 2007compared to 96.6% for the three months ended September 30, 2006. Theoccupancy increase was spread across the various facilities in the adult community-baseddivision.

 

The average per diem rate for our residential adult community-basedfacilities was approximately $62.61 for the three months endedSeptember 30, 2007 compared to $61.81 for the three months endedSeptember 30, 2006. The average fee-for-service rate for ournon-residential adult community-based programs was approximately $11.34 for thethree months ended September 30, 2007 compared to $10.23 for the threemonths ended September 30, 2006. There were no revenues attributable tostart-up operations for the three months ended September 30, 2007 and 2006.

 

***OperatingExpenses****.*Operatingexpenses decreased approximately $3.0 million, or 4.2%, to $68.5 million forthe three months ended September 30, 2007 from $71.5 million for the threemonths ended September 30, 2006.

 

*Adult Secure.*****Adult secure institutional servicesdivision operating expenses decreased approximately $1.2 million, or 3.6%, to $32.3million for the three months ended September 30, 2007 from $33.5 millionfor the three months ended September 30, 2006 due primarily to (1) adecrease in operating expenses of approximately $1.1 million at the GreatPlains Correctional Facility due to our termination of our management contractwith OKDOC in April 2007 (the facility began receiving inmates under our newcontract with the Arizona Department of Corrections in September 2007) and (2)a decrease in operating expenses of approximately $1.0 million at the Donald W.Wyatt Detention Center due to the transition of our management contract to theowner in July 2007. The decrease in operating expenses due to the above wasoffset, in part, by (1) an increase in operating expenses of approximately $1.1million at the Moshannon Valley Correctional Center due to increased occupancyand (2) an increase in operating expenses of approximately $1.0 million at theHigh Plains Correctional Facility acquired in May 2007. The remaining netdecrease in operating expenses of $1.2 million was due to various insignificantfluctuations in operating expenses at our other adult secure facilities.

 

As a percentage of segment revenues, adultsecure institutional services division operating expenses were 74.9% for thethree months ended September 30, 2007 compared to 70.8% for the threemonths ended September 30, 2006. The increase in the 2007 percentagereflects the stabilization of the operating margin at the Moshannon ValleyCorrectional Center (which operates under a take-or-pay contract) subsequent toits activation in April 2006. Additionally, the 2007 third quarter operatingmargin was negatively impacted by the termination of our management contractsat the Great Plains Correctional 

 

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Facility inApril 2007 as we transitioned to its reactivation in September 2007 under ournew contract with the Arizona Department of Corrections and the transition ofour management contract at the Donald W. Wyatt Detention Center to the owner inJuly 2007.

 

*Juvenile.*****Juvenile justice, educational andtreatment services division operating expenses decreased approximately $1.3million, or 5.2%, to $23.7 million for the three months ended September 30,2007 from $25.0 million for the three months ended September 30, 2006 dueprimarily to (1) a decrease in operating expenses of approximately $2.6million due to the termination of our management contract at the AlexanderYouth Services Center in January 2007 and (2) a decrease in operating expensesof approximately $0.3 million due to the termination of our contract for theHarrisburg Alternative Education School Program. In July 2007, we were notifiedthat the funding for this program was discontinued for the 2007-2008 schoolyear. The decrease in operating expenses due to the above was offset, in part,by various insignificant fluctuations in operating expenses at our otherjuvenile facilities and programs, including the opening of the Cornell AbraxasAcademy (formerly the New Morgan Academy) in October 2006 which incurredoperating expenses of approximately $0.3 million in the three months endedSeptember 30, 2007.

 

As a percentage of segment revenues, juvenileservices division operating expenses were 87.6% for the three months endedSeptember 30, 2007 compared to 87.9% for three months ended September 30,2006.

 

*AdultCommunity-Based.* Adult community-based corrections andtreatment services division operating expenses decreased approximately $0.5million, or 3.8% to $12.5 million for the three months ended September 30,2007 from $13.0 million for the three months ended September 30, 2006.The net decrease in operating expenses was due to various insignificantfluctuations in operating expenses at our adult community-based facilities andprograms. Asa percentage of segment revenues, adult community-based division operatingexpenses were 72.8% for the three months ended September 30, 2007 compared to77.7% for the three months ended September 30, 2006. The 2007 operatingmargin was favorably impacted by lower divisional administration costs in thethree months ended September 30, 2007 as compared to the same period of 2006.

 

***Pre-Openingand Start-up Expenses.*** There were no pre-opening andstart-up expenses for the three months ended September 30, 2007 and 2006.

 

***Depreciationand Amortization*****.**Depreciationand amortization decreased approximately $0.3 million, or 7.0%, to $4.0 millionfor the three months ended September 30, 2007 from $4.3 million for thethree months ended September 30, 2006. Depreciation of property andequipment was $3.4 million and $3.8 million for the three months endedSeptember 30, 2007 and 2006, respectively. Amortization of intangibles wasapproximately $0.6 million for the three months ended September 30, 2007and 2006.

 

***Generaland Administrative Expenses.*** General and administrativeexpenses decreased approximately $1.8 million, or 29.5%, to $4.3 million forthe three months ended September 30, 2007 from $6.1 million for the threemonths ended September 30, 2006 due primarily to the $1.85 millionreceived during the three months ended September 30, 2007 related to thesettlement with Locke Liddell Sapp PLLC as discussed in Note 8 to theaccompanying consolidated financial statements.

 

***Interest.***Interest expense, net of interest income, decreased to approximately $6.0million for the three months ended September 30, 2007 from $6.5 millionfor the three months ended September 30, 2006. For the three monthsended September 30, 2007 and 2006, we recognized interest expense related tothe interest rate swap of $0.07 million and $0.1 million, respectively. For thethree months ended September 30, 2007, we capitalized interest of approximately$0.4 million related to the expansion projects at the Big Spring CorrectionalCenter and the D. Ray James Prison. We did not capitalize any interest in thethree months ended September 30, 2006. Additionally, MCF made an annual bondprincipal payment of $10.5 million on July 31, 2007 which reduced bond interestexpense for the three months ended September 30, 2007 by approximately $0.2million as compared to the same period of 2006.

 

***IncomeTaxes.*** For the three months ended September 30, 2007, werecognized a provision for income taxes at an estimated effective rate of 46.4%.For the three months ended September 30, 2006, we recognized a provisionfor income taxes at an estimated effective rate of 36.3%. The change in ourestimated effective tax rate in 2007 resulted from an increase in operatingincome across certain of our business segments and apportionment to highertaxing jurisdictions, tax law changes in some jurisdictions, as well as anincrease in nondeductible equity compensation expense attributable to certainshare-based awards.

 

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***NineMonths Ended September 30, 2007 Compared to Nine Months Ended September 30,2006***

 

***Revenues*****.** Revenues increased approximately $1.8million, or 0.7%, to $268.5 million for the nine months ended September 30,2007 from $266.7 million for the nine months ended September 30, 2006.

 

*Adult Secure.*****Adult secure institutional servicesdivision revenues increased approximately $6.4 million, or 4.9%, to $137.4million for the nine months ended September 30, 2007 from $131.0 millionfor the nine months ended September 30, 2006 due primarily to (1) anincrease in revenues of approximately $9.4 million at the Moshannon ValleyCorrectional Center which opened in April 2006, (2) revenues of approximately$1.7 million at the High Plains Correctional Facility acquired in May 2007, (3)an increase in revenues of approximately $1.2 million at the Leo ChesneyCommunity Correctional Facility due to improved occupancy, (4) an increase inrevenues of approximately $1.0 million at the D. Ray James Prison due to increasedoccupancy, (5) an increase in revenues at the Big Spring Correctional Center ofapproximately $0.7 million due to an increase in occupancy and (6) an increasein revenues of approximately $0.7 million at the Donald W. Wyatt DetentionCenter due to increased occupancy prior to the transition of our management contractto the owner. The increase in revenues due to the above was offset, in part, by(1) a decrease in revenues of approximately $7.6 million due to our terminationof our management contract with the OKDOC at the Great Plains CorrectionalFacility in April 2007 and (2) a decrease in revenues of approximately $1.1million at the Regional Correctional Center due to reduced occupancy as aresult of the withdrawal of inmates by ICE during the third quarter of 2007. Theremaining net increase in revenues of $0.4 million was due to variousinsignificant fluctuations in revenues at our 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 $8.0 million and $7.3 million in the nine months endedSeptember 30, 2007 and 2006, respectively.

 

Averagecontract occupancy for the nine months ended September 30, 2007 was 103.8%compared to 96.8% for the nine months ended September 30, 2006. Theincrease in average contract occupancy in the nine months ended September 30,2007 was principally due to increased occupancy at the D. Ray James Prison, theRegional Correctional Center, the Big Spring Correctional Center and theMoshannon Valley Correctional Center.

 

Theaverage per diem rate for our adult secure facilities was approximately $54.65and $56.40 for the nine months ended September 30, 2007 and 2006, respectively.There were no revenues attributable to start-up operations for the nine monthsended September 30, 2007 and 2006.

 

*Juvenile.*****Juvenile justice, educational andtreatment services division revenues decreased approximately $5.8 million, or6.7%, to $80.6 million for the nine months ended September 30, 2007 from $86.4million for the nine months ended September 30, 2006 due primarily to (1) adecrease in revenues of approximately $7.0 million due to the termination ofour management contract at the Alexander Youth Services Center in January 2007,(2) a decrease in revenues of approximately $1.9 million due to the terminationof our management contract at the South Mountain Secure Treatment Unit("SMSTU") in June 2006 and (3) a decrease in revenues of approximately$0.9 million at the Danville Center for Adolescent Females due to theexpiration of our management contract in March 2006. The decrease in revenuesdue to the above was offset, in part, by (1) revenues of approximately $2.0million at the Cornell Abraxas Academy (formerly the New Morgan Academy) whichwe reopened in October 2006, (2) an increase in revenues of approximately $1.4million at the Leadership Development Program due to increased occupancy and(3) an increase in revenues of approximately $0.9 million at ACAF due toincreased occupancy. The remaining net decrease in revenues of $0.3 million wasdue to various insignificant fluctuations in revenues at our other juvenilefacilities and programs.

 

In July 2007, we were notified by our contracting agency for theHarrisburg Alternative Education School Program that funding had beendiscontinued for the 2007-2008 school year. This program generated revenues ofapproximately $1.8 million and $2.1 million in the nine months ended September30, 2007 and 2006, respectively.

 

Averagecontract occupancy was 92.7% for the nine months ended September 30, 2007compared to 92.7% for the nine months ended September 30, 2006. The average perdiem rate for our residential juvenile facilities was approximately $171.11 and$169.26 for the nine months ended September 30, 2007 and 2006,respectively. Our average fee-for-service rate for our non-residential juvenilecommunity-based facilities and programs was approximately $44.81 and $36.41 forthe nine months ended September 30, 2007 and 2006, respectively. Therewere no revenues attributable to start-up operations for the nine months endedSeptember 30, 2007 and 2006.

 

*AdultCommunity-Based.* Adult community-based corrections andtreatment services division revenues increased approximately $1.0 million, or2.0%, to $50.4 million for the nine months ended September 30, 2007 from $49.4million for 

 

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the nine months ended September 30,2006 due to various insignificant fluctuations in revenues at our adultcommunity-based facilities and programs including an increase in revenues ofapproximately $0.6 million resulting from the two new jails in California webegan managing in January 2007 and an increase in revenues of approximately$0.4 million at the Las Vegas Center due to increased occupancy. Additionally,we had a decrease in revenues of approximately $0.8 million due to thetermination of our management contract for the SWICC Turning Point program inOctober 2006.

 

Averagecontract occupancy for the nine months ended September 30, 2007 was 101.3%compared to 97.0% for the nine months ended September 30, 2006. Theaverage per diem rate for our residential adult community-based facilities was$62.47 and $61.38 for the nine months ended September 30, 2007 and 2006,respectively. The average fee-for-service rate for our non-residential adultcommunity-based programs was $12.71 and $10.10 for the nine months endedSeptember 30, 2007 and 2006, respectively. There were no revenuesattributable to start-up operations for the nine months endedSeptember 30, 2007 and 2006.

 

***OperatingExpenses.*** Operating expenses increasedapproximately $2.8 million, or 1.4%, to $206.5 million for the nine monthsended September 30, 2007 from $203.7 million for the nine months endedSeptember 30, 2006.

 

*Adult Secure.*****Adult secure institutional servicesdivision operating expenses increased approximately $8.7 million, or 9.7%, to $98.8million for the nine months ended September 30, 2007 from $90.1 millionfor the nine months ended September 30, 2006 due primarily to (1) anincrease in operating expenses of approximately $7.7 million at the MoshannonValley Correctional Center which opened in April 2006, (2) an increase inoperating expenses of approximately $1.7 million at the High PlainsCorrectional Facility acquired in May 2007 and (3) an increase in operatingexpenses of approximately $1.4 million at the Regional Correctional Center dueto increased occupancy principally during the period January 2007 to July 2007.The increase in operating expenses due to the above was offset, in part, by adecrease in operating expenses of approximately $2.9 million at the GreatPlains Correctional Facility due to our termination of our contract with the OKDOCin April 2007. The remaining net increase in operating expenses ofapproximately $0.8 million was due to various fluctuations in operatingexpenses at our other adult secure facilities.

 

As a percentage of segment revenues,adult secure institutional services division operating expenses were 71.9% forthe nine months ended September 30, 2007 compared to 68.8% for the ninemonths ended September 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 termination of ourmanagement contracts at the Great Plains Correctional Facility in April 2007(and its subsequent reactivation in September 2007) and the Donald W. WyattDetention Center in July 2007.

 

*Juvenile.*****Juvenile justice, educational andtreatment services division operating expenses decreased approximately $5.0million, or 6.7%, to $69.8 million for the nine months ended September 30,2007 from $74.8 million for the nine months ended September 30, 2006 dueprimarily to (1) a decrease in operating expenses of approximately $6.3 millionat the Alexander Youth Services Center due to the termination of our managementcontract in January 2007 and (2) a decrease in operating expenses ofapproximately $1.7 million at the South Mountain Secure Treatment Unit due tothe termination of our management contract in June 2006. The decrease inoperating expenses due to the above was offset, in part, by (1) an increase inoperating expenses of approximately $1.4 million at the Cornell Abraxas Academy(formerly the New Morgan Academy) that opened in October 2006 and (2) anincrease in operating expenses of approximately $0.6 million as such expenseswere reflected in discontinued operations in the nine months ended September30, 2006. The remaining net increase in operating expenses of $1.0 million wasdue to various insignificant fluctuations in operating expenses at our otherjuvenile facilities and programs.

 

 Asa percentage of segment revenues, juvenile services division operating expenseswere 86.6% for the nine months ended September 30, 2007 compared to 86.5%for the nine months ended September 30, 2006.

 

*Adult Community-Based.* Adultcommunity-based corrections and treatment services division operating expenses decreasedapproximately $0.9 million, or 2.3%, to $37.9 million for the nine months endedSeptember 30, 2007 from $38.8 million for the nine months ended September 30,2006 due primarily to a decrease in operating expenses of approximately$0.8 million due to the termination of our management contract for the SWICCTurning Point Program in October 2006. The remaining net decrease in operatingexpenses of $0.1 million was due to various insignificant fluctuations inoperating expenses at our other adult community-based facilities and programs.

 

Asa percentage of segment revenues, adult community-based corrections andtreatment services division operating expenses were 75.1% for the nine monthsended September 30, 2007 compared to 78.7% for the nine months endedSeptember 30, 2006. The 2007 operating margin was favorablyimpacted by lower divisional administration costs in the three months endedSeptember 30, 2007 as compared to the same period of 2006.

 

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***Pre-Openingand Start-up Expenses.*** There were no pre-opening andstart-up expenses for the nine months ended September 30, 2007. Pre-opening andstart-up expenses for the nine months ended September 30, 2006 wereapproximately $2.7 million and were attributable to the pre-opening activitiesof the Moshannon Valley Correctional Center.

 

***Depreciationand Amortization*****.**Depreciationand amortization expense decreased approximately $0.6 million, or 4.9%, to $11.7million for the nine months ended September 30, 2007 from $12.3 millionfor the nine months ended September 30, 2006. Depreciation andamortization of property and equipment was approximately $10.1 million and$10.7 million for the nine months ended September 30, 2007 and 2006,respectively. Amortization of intangibles was approximately $1.7 million forthe nine months ended September 30, 2007 and 2006.

 

***Generaland Administrative Expenses.*** General and administrativeexpenses increased approximately $3.2 million, or 19.3%, to $19.8 million forthe nine months ended September 30, 2007 from $16.6 million for the ninemonths ended September 30, 2006 due primarily to (1) ourreimbursement to Veritas of approximately $2.5 million of costs 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 of approximately$0.4 million. This was partially offset by the net $1.5 million legal claim settlementreceived in August 2007 as discussed in Note 8 to the accompanying consolidatedfinancial statements.

 

***Interest.***Interest expense, net of interest income, increased to $18.6 million for thenine months ended September 30, 2007 from $18.1 million for the ninemonths ended September 30, 2006. For the nine months ended September 30,2007 and 2006, we recognized interest expense related to the interest rate swapof approximately $0.2 million. At current interest rate levels, we expect toincur additional interest expense related to our interest rate swap. Anyadditional rise in interest rates would increase our interest expense. Additionally,MCF made an annual principal payment of $10.5 million on their outstandingbonds which reduced interest expense for the nine months ended September 30,2007 by approximately $0.6 million from the period of 2006. Furthermore,interest expense increased approximately $0.9 million due to a decrease incapitalized interest in 2007 as compared to 2006. For the nine months endedSeptember 30, 2007, we capitalized interest of approximately $0.6 millionrelated to the facility expansion projects at the Big Spring CorrectionalCenter and the D. Ray James Prison. For the nine months ended September 30,2006, we capitalized interest of approximately $1.5 million related to theconstruction of the Moshannon Valley Correctional Center.

 

***IncomeTaxes.*** For the nine months ended September 30, 2007, we recognizeda provision for income taxes at an estimated effective rate of 44.9%. For thenine months ended September 30, 2006, we recognized a provision for incometaxes at an estimated effective rate of 41.1%. The change in our estimatedeffective rate in 2007 was related to an increase in operating income acrosscertain of our business segments and apportionment to higher tax jurisdictions,as well as an increase in nondeductible equity compensation expenseattributable to certain share-based awards.

 

**Liquidity and CapitalResources**

 

***General*****.**Our primary capital requirements are for(1) purchases, construction or renovation of new facilities, (2) expansionsof existing facilities, (3) working capital, (4) pre-opening andstart-up costs related to new operating contracts, (5) acquisitions, (6) informationsystems hardware and software, and (7) furniture, fixtures and equipment. Workingcapital requirements generally increase immediately prior to commencingmanagement of a new facility as we incur start-up costs and purchase necessaryequipment and supplies before facility management revenue is realized.

 

***CashFlows From Operating Activities.***Cash provided byoperations was approximately $17.6 million for the nine months ended September30, 2007. Cash provided by operations was approximately $11.6 million for thenine months ended September 30, 2006. The increase is principally driven due toa reduction in accounts receivable due to the timing of collections within theperiod.

 

***CashFlows From Investing Activities*****.**Cashused in investing activities was approximately $38.0 million for the ninemonths ended September 30, 2007 due primarily to the High Plains CorrectionalFacility and the formerly leased Washington, D.C. facility purchases for anaggregate cost of approximately $18.6 million, the $5.1 million purchase of theHudson, Colorado site (to be utilized under our contract with the ColoradoDepartment of Corrections) and capital expenditures of approximately $30.6million related primarily to the expansion projects at the Big SpringCorrectional Center and the D. Ray James Prison. Additionally, we had net salesof investment securities of $11.2 million and withdrawals from the restricteddebt payment account, net, of $4.6 million.****Cashused in investing activities was approximately $6.5 million for the nine monthsended September 30, 2006 due to capital expenditures of approximately $10.6million and net purchases of 

 

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investment securities of $2.7 million, offset by net withdrawals fromthe restricted debt payment account of $3.9 million and proceeds from the saleof property and equipment of approximately $2.9 million.

 

***CashFlows From Financing Activities*****.**Cashflows provided by financing activities was approximately $2.8 million dueprimarily to proceeds from the exercise of stock options and warrants, and therelated tax benefit, of $3.3 million and proceeds from the borrowings under ourCredit Facility of $10.0 million, offset by MCF’s annual principal payment of$10.5 million in July 2007. Cash flows used in financing activities wasapproximately $7.4 million for the nine months ended September 30, 2006 dueprimarily to MCF’s annual bond principal payment of $9.7 million made in July2006 offset by proceeds from the exercise of stock options of $2.1 million andthe tax benefit of stock option exercises of $0.2 million.

 

***Long-Term CreditFacilities.***OurCredit Facility provided for borrowings of up to $60.0 million under arevolving line of credit, and was reduced by outstanding letters of credit. Theavailable commitment under our Credit Facility was approximately $39.7 millionat September 30, 2007. We had outstanding borrowings on our Credit Facility of$10.0 million at September 30, 2007 and had outstanding letters of credit ofapproximately $10.3 million. Subject to certain requirements, we had the rightto increase the aggregate commitments under our Credit Facility up to anaggregate amount of $100.0 million. Our Credit Facility matured in June 2008and bore 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 ranged from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility was collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility was notsecured by the assets of Municipal Corrections Finance, LP (“MCF”). Our CreditFacility contained standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on financing transactions and mergers and compliance with financialcovenants.

 

In October 2007, we amended our existingCredit Facility (the “Amended Credit Facility”). The Amended Credit Facility,which provides for borrowings up to $100.0 million (including letters ofcredit), matures in December 2011 and bears interest, at our election dependingon our total leverage ratio, at either the prime rate plus a margin rangingfrom 0.00% to 0.75%, or a rate which ranges from 1.50% to 2.25% above theapplicable LIBOR rate. Subject to certain requirements, we have the right toincrease the commitments under our Amended Credit Facility up to $150.0 million.The Amended Credit Facility is collateralized by substantially all of ourassets, including the assets and stock of all of our subsidiaries. The AmendedCredit Facility is not secured by the assets of MCF. Our Amended CreditFacility contains standard covenants including compliance with laws,limitations on certain financing transactions and mergers and compliance withfinancial covenants, although the covenants in the Amended Credit Facility wereamended to provide greater flexibility in certain instances, including deletionof the minimum net worth and minimum asset coverage requirements contained inthe Credit Facility and more favorable leverage ratios.

 

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

 

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

 

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underan indenture that limits our ability and the ability of our Guarantors to,among other things, incur additional indebtedness, pay dividends or make otherdistributions, make other restricted payments and investments, create liens,incur restrictions on the ability of the Guarantors to pay dividends or otherpayments to us, enter into transactions with affiliates, and engage in mergers,consolidations and certain sales of assets.

 

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 ofthis transaction was to convert future interest due on $84.0 million of theSenior Notes to a variable rate. The terms of the interest rate swap contractand the underlying debt instrument are identical. We have designated the swapagreement as a fair value hedge. The swap has a notional amount of $84.0million and matures in July 2012 to mirror the maturity of the Senior Notes. Underthe agreement, we pay on a semi-annual basis (each January 1 and July 1) afloating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the three and nine months endedSeptember 30, 2007, we recorded interest expense related to this interest rateswap of approximately $0.07 million and $0.2 million, respectively, which isreflected as interest expense in the accompanying financial statements. For thethree and nine months ended September 30, 2006, we recorded interest expenserelated to this interest rate swap of approximately $0.1 million and $0.2million, respectively, which is reflected as interest expense in theaccompanying financial statements. The swap agreements are marked to marketeach quarter with a corresponding mark-to-market adjustment reflected as eithera discount or premium on the Senior Notes. At September 30, 2007 and December31, 2006, the fair value of this derivative instrument was approximately ($0.2)million and ($1.1) million, respectively, and is included in other long-termliabilities in the accompanying financial statements. The carrying value of theSenior Notes as of these dates was adjusted accordingly by the same amount.Because the swap agreement is an effective fair-value hedge, there will be noeffect on our results of operations from the mark-to-market adjustment as longas the swap is in effect. In October 2007, we terminated the swap agreementwith the financial institution. We received approximately $0.2 million inconjunction with the termination, which will be amortized over the remainingterm of the Senior Notes.

 

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

 

***Regional Correctional Center.***In July 2007, we were notified by Immigrationand Customs Enforcement (“ICE”) that they were removing all ICE detaineeshoused at the facility. As of August 2007, all ICE detainees had been removed. Thefacility currently serves the U.S. Marshal’s Service (“Marshals”), andcontinues to operate under a guaranteed minimum contract with both ICE and theMarshals. Revenues for this facility were approximately $11.8 million and $12.9million for the nine months ended September 30, 2007 and 2006, respectively.The net carrying value of this facility was approximately $3.9 million and $5.3million at September 30, 2007 and December 31, 2006, respectively. The facilityhad operated at its service capacity during portions of the nine months endedSeptember 30, 2007. Our lease for this facility requires monthly rent paymentsof approximately $0.13 million for the remaining two 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 our financialcondition, results of operations and liquidity.

 

***Cornell Abraxas Academy (formerlythe New Morgan Academy).***We closed the Cornell Abraxas Academy (formerly the New Morgan Academy)in the fourth quarter of 2002. The facility, which we reactivated in October2006, operates as a residential treatment facility for youth sex offenders. Thenet carrying value of the property and equipment for this facility wasapproximately $19.2 million and $19.5 million at September 30, 2007 andDecember 31, 2006, respectively. We believe that, pursuant to theprovisions of SFAS No. 144, no impairment to the carrying value of thisfacility has occurred.

 

***Great PlainsCorrectional Facility.***In May 2007, we were awarded a contract by the Arizona Department ofCorrections for our Great Plains Correctional Facility in Hinton, Oklahoma. Thecontract calls 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 existing facility.We currently estimate that the expansion cost will be approximately $55.0million, pending the finalization of design and construction agreements. Webegan receiving inmates in September 2007 and expect to complete the initialramp-up of population at the facility to approximately 916 inmates in December2007. The expansion of the facility to accommodate all 2,000 inmates commencedin the fourth quarter of 2007 and is expected to be completed by the fourth quarterof 2008.

 

***Hector Garza Residential TreatmentCenter (formerly the Campbell Griffin Treatment Center).***In October 2005, we initiated the temporaryclosure of this leased facility in San Antonio, Texas. We reactivated thisfacility during the third quarter of 2007 for a federal customer. Our netcarrying value for this facility at September 30, 2007 and December 31, 2006was approximately $4.2 million. We believe that no impairment to the carryingvalue of this facility has occurred.

 

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***Future Liquidity*****.**We believe that the existing cash and thecash flows generated from operations, together with the credit available underour Amended Credit Facility, will provide sufficient liquidity to meet ourcommitted capital and working capital requirements for currently awarded andcertain potential future development contracts. To the extent our cash andcurrent financing arrangements do not provide sufficient financing to fundconstruction costs related to future adult secure institutional contract awardsor significant facility expansions, we anticipate obtaining additional sourcesof financing to fund such activities. However, there can be no assurance thatsuch financing will be available or will be available on terms favorable to us.

 

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

 

We maintainoperating leases in the ordinary course of our business activities. Theseleases include those for operating facilities, office space and office andoperating equipment, and the terms of these agreements range from 2007 until2075. As of September 30, 2007, our total commitment under these operatingleases was approximately $24.2 million.

 

The following table details our knownfuture cash payments (on an undiscounted basis) related to various contractualobligations as of September 30, 2007 (in thousands):

 
| ** **                                  | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                  | ** ** | ** **                                | ** ** | ** ** | ** ** | **2008 -** | ** ** | **2010 -** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Total**                                 | ** ** | **2007** | ** ** | **2009** | ** ** | **2011** | ** ** | **Thereafter** | ** ** |
|                                        |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual Obligations:                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                  |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| •  Special Purpose Entities            |       | 145,500                                   |       | — |   | 23,800 |   | 28,000 |   | 93,700 |   |
| Long-term debt - interest (1)               |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | 57,644                                    |       | 3,051 |   | 24,283 |   | 24,258 |   | 6,052 |   |
| •  Special Purpose Entities            |       | 68,260                                    |       | — |   | 23,682 |   | 19,482 |   | 25,096 |   |
| Revolving line of credit-principal          |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | 10,000                                    |       | 10,000 |   | — |   | — |   | — |   |
| Revolving line of credit-interest           |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | 60                                        |       | 60 |   | — |   | — |   | — |   |
| Capital lease obligations                   |       |                                      |       |   |   |   |   |   |   |   |   |
| •  Cornell Companies, Inc.        |       | 40                                        |       | 4 |   | 28 |   | 8 |   | — |   |
| Construction commitments                    |       | 52,853                                    |       | 18,097 |   | 34,756 |   | — |   | — |   |
| Operating leases                            |       | 24,188                                    |       | 1,837 |   | 11,289 |   | 3,345 |   | 7,717 |   |
| Consultative and non-competition agreements |       | 250                                       |       | — |   | 250 |   | — |   | — |   |
| Total contractual cash obligations          |       | $                                         | 470,795    |   | $ | 33,049 |   | $ | 118,088 |   | $ | 75,093 |   | $ | 244,565 |   |

 

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(1)   We have an interest rate swap agreement under whichwe receive a fixed interest rate and pay a floating interest rate. The futurecash payments on the interest related to Cornell Companies, Inc. long-termdebt assume an effective rate of 10.71% on the related interest rate swap contract.An increase in the six-month U.S. dollar LIBOR rate would increase futureinterest payments as required under this arrangement.

 

We enter into letters of credit in theordinary course of our operating and financing activities. As of September 30,2007, we had outstanding letters of credit of approximately $10.3 millionrelated to insurance and other operating activities. The following tabledetails our letter of credit commitments as of September 30, 2007 (inthousands):

 
| ** **                 | ** ** | **Total**     | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|----------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                 | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Over** | ** ** |
| ** **                 | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
|                       |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Commercial Commitments:    |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of  credit |       | $             | 10,251     |                                                                    | $          | 9,501 |   | $ | 750 |   | $ | — |   | $ | — |   |
|                            |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

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###### ***Forward-Looking Statements***

###### ** **

The statements included in this quarterly reportregarding future financial and operational performance, expected future actionsand activities, results of operations and other statements that are nothistorical facts are forward-looking statements within the meaning of Section27A of the Securities Act of 1933 and Section 21E of the Securities ExchangeAct of 1934 as amended (the “Exchange Act”). Statements to the effect that weor management “will,” “anticipates,” “believes,” “budgets,” “estimates,” “expects,”“forecasts,” “intends,” “plans,” “predicts,” or “projects” a particular resultor course of events, or that such result or course of events “could,” “might,” “may,”“scheduled” or “should” occur, and similar expressions, are also intended toidentify forward-looking statements. Forward-looking statements in thisquarterly report include, but are not limited to, revenues, revenue mix,expenses, personnel costs, operating margins, financial results, liquidity,working capital requirements, pricing, per diem rates, utilization, increasingnumber of parolees and inmates, effectiveness of our strategy, capitalrequirements, capital expenditures, our contract from the Arizona Department ofCorrections for our Great Plains Correctional Facility, operations at andresults from our Regional Correctional Center, planned projects, expansions,the timing and cost of completion of capital projects, including withoutlimitation the D. Ray James Prison and Big Spring Correctional Centerexpansions, the applicable pricing for our Big Spring Correctional Center, performanceof acquired facilities and businesses, demand, supply, customer programs,contract commencements, future activity and market outlook in our variousmarket sectors, debt levels and other uses of excess cash, our effective taxrate, changes in laws and 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.

 

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**ITEM 3.****       ****Quantitative and 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 tomarket risk and develop appropriate strategies to manage this risk. We are notexposed to any other significant market risks, including commodity price riskor, foreign currency exchange risk or interest rate risks from the use ofderivative financial instruments. In conjunction with the issuance of theSenior Notes, we entered into an interest rate swap of $84.0 million related tothe interest obligations under the Senior Notes in effect converting them to afloating rate based on six-month LIBOR. As discussed in Part I, Item I, Note 6to the accompanying financial statements, we terminated the interest rate swapin October 2007.

 

**Interest Rate Exposure**

 

Our exposure to changes in interest ratesprimarily results from our long-term debt with both fixed and floating interestrates. The debt on our consolidated financial statements with fixed interestrates consists of the 8.47% Bonds issued by MCF in August 2001 inconnection with the 2001 Sale and Leaseback Transaction, approximately $28.0million of the Senior Notes (not hedged by our interest rate swap agreement)and $10.0 million on our Credit Facility. At September 30, 2007, 31.5%($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. Thedetrimental effect of a hypothetical 100 basis point increase in interest rateswould be to reduce income before provision for income taxes by approximately $0.2million and $0.6 million for the three and nine months ended September 30,2007. At September 30, 2007, the fair value of our consolidated fixed ratedebt approximated carrying value based upon discounted future cash flows usingcurrent market prices.

 

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

 

**Evaluation ofDisclosure Controls and Procedures**

 

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

 

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

 

Under the supervision and with the participation ofour management, including our principal executive officer and principalfinancial officer, and as required by paragraph (b) of Rules 13a-15 and 15d-15of the Exchange Act, we have evaluated the effectiveness of the design andoperation of our disclosure controls and procedures (as defined inRules 13a-15(e) and 15d-15(e) of the Exchange Act) as of the endof the period required by this report. Based on that evaluation, our principalexecutive officer and principal financial officer have concluded that thesecontrols and procedures are effective as of that date.

 

**Changes in Internal Control over Financial Reporting**

 

In connection with the evaluation as required by paragraph (d) of Rules13a-15 and 15d-15 of the Exchange Act, we have not identified any change in ourinternal control over financial reporting (as such term is defined inRules 13a-15(f) and 15d-15(f) under Exchange Act) during ourfiscal quarter ended September 30, 2007 that has materially affected, oris reasonably likely to materially affect, our internal control over financialreporting.

 

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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 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.**                                                                                                                                                          |
| ** **   | ** ** | ** **                                                                                                                                                                                                        | ** ** | ** ** |
|         |       | None                                                                                                                                                                                                              |
|         |       |                                                                                                                                                                                                              |   |   |
| **ITEM 5.**  | ** ** | **Other Information.**                                                                                                                                                                                            |
| ** **   | ** ** | ** **                                                                                                                                                                                                        | ** ** | ** ** |
|         |       | None.                                                                                                                                                                                                             |
|         |       |                                                                                                                                                                                                              |   |   |
| **ITEM 6.**  |       | **Exhibits.**                                                                                                                                                                                                     |   |   |
|         |       | 10.1                                                                                                                                                                                                              |   | Amended and Restated Credit Agreement dated October 10, 2007 among  Cornell Companies, Inc., its subsidiaries, JPMorgan Chase Bank N.A., as  Administrative Agent, Bank of America, N.A., as Syndication Agent and the  Lenders party thereto (incorporated by reference to Exhibit 10.1 to the  Company’s Form 8-K filed on October 12, 2007). |
|         |       | 10.2                                                                                                                                                                                                              |   | Amended and Restated Employment Agreement between Cornell Companies,  Inc. and James E. Hyman dated effective August 2, 2007 (incorporated by  reference to Exhibit 10.1 to the Company’s Form 8-K filed on August 6, 2007). |
|         |       | 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. |
|--------|--------|---|--------|-----------------|

 

43

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**SIGNATURES**

 

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

 

 
| ** **                                      | ** ** | **CORNELL COMPANIES,  INC.**          |   |
|-------------------------------------------------|------------|---------------------------------------|--------|
|                                            |       |                                  |   |
|                                            |       |                                  |   |
| Date:    November  9, 2007  | By:        | /s/  James E. Hyman                   |   |   |
|                                            |       | JAMES  E. HYMAN                       |   |
|                                            |       | Chief  Executive Officer,             |   |
|                                            |       | President  and Chairman of the Board  |   |
|                                            |       | (Principal  Executive Officer)        |   |
|                                            |       |                                  |   |
|                                            |       |                                  |   |
| Date:    November  9,  2007 | By:        | /s/ John R. Nieser                    |   |   |
|                                            |       | JOHN R. NIESER                        |   |
|                                            |       | Chief Financial Officer and Treasurer |   |
|                                            |       | (Principal Financial Officer)         |   |

 

44

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