**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q**

 
| **ý**                                                                                                                                                                                                                                                                                        | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                                                                                                              |
| **For the Quarterly Period Ended June 30, 2003**                                                                                                                                                                                                                                                  |
|                                                                                                                                                                                                                                                                                              |
| **OR**                                                                                                                                                                                                                                                                                            |
|                                                                                                                                                                                                                                                                                              |
| **o**                                                                                                                                                                                                                                                                                             | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                                                                                                                                                                                                                                                                                              |
| **For the transition period                         to                       ** |
|                                                                                                                                                                                                                                                                                              |
| **Commission File Number 1-14472**                                                                                                                                                                                                                                                                |

 

**CORNELL COMPANIES, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                    |   | **76-0433642**                        |
|-----------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction  of incorporation or organization) |   | (I.R.S. Employer  Identification No.) |
|                                                            |   |                                  |
| **1700 West Loop South, Suite 1500, Houston, Texas**            |   | **77027**                             |
| (Address of Principal Executive Offices)                        |   | (Zip Code)                            |
|                                                            |   |                                  |
| Registrant’s telephone number, including area  code:       |   | **(713) 623-0790**                    |

 

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

 

Yes  ý  No  o

 

Indicate by a check mark whether Registrantis an accelerated filer (as defined in Exchange Act Rule 12b-2).

 

Yes  ý  No  o

 

AtJuly 31, 2003 Registrant had outstanding 13,325,432 shares of its Common Stock.

 

 

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

 

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

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

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

 
|                                                                                                                                 |   | **June 30,  2003** |    | **December 31,  2002** |   |
|--------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|---------|------------------------|--------|
| ASSETS                                                                                                                               |   |               |    |                   |   |
| CURRENT ASSETS:                                                                                                                      |   |               |    |                   |   |
| Cash and cash equivalents                                                                                                            |   | $                  | 51,541  |                   | $      | 52,610 |   |
| Accounts receivable, net                                                                                                             |   | 56,487             |    | 60,035                 |   |
| Deferred tax asset                                                                                                                   |   | 3,300              |    | 3,300                  |   |
| Prepaids and other                                                                                                                   |   | 6,249              |    | 5,528                  |   |
| Other restricted assets                                                                                                              |   | 20,271             |    | 14,767                 |   |
| Total current assets                                                                                                                 |   | 137,848            |    | 136,240                |   |
| PROPERTY AND EQUIPMENT, net                                                                                                          |   | 257,120            |    | 255,450                |   |
| OTHER ASSETS:                                                                                                                        |   |               |    |                   |   |
| Debt service reserve fund                                                                                                            |   | 24,163             |    | 24,157                 |   |
| Intangible assets, net                                                                                                               |   | 12,683             |    | 13,062                 |   |
| Deferred costs and other                                                                                                             |   | 12,174             |    | 12,382                 |   |
| Total assets                                                                                                                         |   | $                  | 443,988 |                   | $      | 441,291 |   |
|                                                                                                                                 |   |               |    |                   |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                                            |   |               |    |                   |   |
|                                                                                                                                 |   |               |    |                   |   |
| CURRENT LIABILITIES:                                                                                                                 |   |               |    |                   |   |
| Accounts payable and accrued liabilities                                                                                             |   | $                  | 29,160  |                   | $      | 32,622 |   |
| Current portion of long-term debt                                                                                                    |   | 7,623              |    | 7,630                  |   |
| Total current liabilities                                                                                                            |   | 36,783             |    | 40,252                 |   |
| LONG-TERM DEBT, net of current portion                                                                                               |   | 232,894            |    | 232,258                |   |
| DEFERRED TAX LIABILITIES                                                                                                             |   | 5,824              |    | 4,954                  |   |
| OTHER LONG-TERM LIABILITIES                                                                                                          |   | 1,241              |    | 3,875                  |   |
|                                                                                                                                 |   |               |    |                   |   |
| Total liabilities                                                                                                                    |   | 276,742            |    | 281,339                |   |
|                                                                                                                                 |   |               |    |                   |   |
| COMMITMENTS AND CONTINGENCIES                                                                                                        |   |               |    |                   |   |
|                                                                                                                                 |   |               |    |                   |   |
| STOCKHOLDERS’ EQUITY:                                                                                                           |   |               |    |                   |   |
| Preferred stock, $.001 par value,  10,000,000 shares authorized, none outstanding                                                    |   | —             |    | —                 |   |
| Common stock, $.001 par value, 30,000,000  shares authorized, 14,514,522 and 14,201,038 shares issued and outstanding,  respectively |   | 14                 |    | 14                     |   |
| Additional paid-in capital                                                                                                           |   | 142,746            |    | 140,085                |   |
| Notes from shareholders                                                                                                              |   | (432               | )       | (442                   | )      |
| Retained earnings                                                                                                                    |   | 34,383             |    | 30,248                 |   |
| Treasury stock (1,490,938 and 1,429,586  shares of common stock, respectively, at cost)                                              |   | (11,776            | )       | (11,038                | )      |
| Deferred compensation                                                                                                                |   | (1,015             | )       | (811                   | )      |
| Other comprehensive income                                                                                                           |   | 3,326              |    | 1,896                  |   |
| Total stockholders’ equity                                                                                                      |   | 167,246            |    | 159,952                |   |
| Total liabilities and stockholders’ equity                                                                                      |   | $                  | 443,988 |                   | $      | 441,291 |   |

 

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

 

2

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVEINCOME**

**(Unaudited)**

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

 
|                                                                                                    |   | **Three Months Ended  June 30,** |       | **Six Months Ended  June 30,** |       |
|---------------------------------------------------------------------------------------------------------|--------|----------------------------------|------------|--------------------------------|------------|
|                                                                                                    |   | **2003**                         |       | **2002**                       |       | **2003** |   | **2002** |   |
|                                                                                                    |   |                             | ** ** |                           | ** ** |   | ** ** |   | ** ** |
| REVENUES                                                                                                |   | $                                | 67,586     |                           | $          | 69,077 |   | $ | 133,612 |   | $ | 137,552 |   |
| OPERATING EXPENSES                                                                                      |   | 51,758                           |       | 53,511                         |       | 103,452 |   | 107,317 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                       |   | 306                              |       | —                         |       | 393 |   | — |   |
| DEPRECIATION AND AMORTIZATION                                                                           |   | 2,604                            |       | 2,374                          |       | 5,173 |   | 4,580 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                     |   | 4,722                            |       | 5,304                          |       | 8,620 |   | 11,391 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                  |   | 8,196                            |       | 7,888                          |       | 15,974 |   | 14,264 |   |
| INTEREST EXPENSE                                                                                        |   | 4,946                            |       | 5,000                          |       | 9,793 |   | 10,795 |   |
| INTEREST INCOME                                                                                         |   | (440                             | )          | (387                           | )          | (825 | ) | (915 | ) |
| MINORITY INTEREST IN LOSSES OF CONSOLIDATED  SPECIAL PURPOSE ENTITIES                                   |   | —                           |       | —                         |       | — |   | (40 | ) |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| INCOME BEFORE PROVISION FOR INCOME TAXES  AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE       |   | 3,690                            |       | 3,275                          |       | 7,006 |   | 4,424 |   |
| PROVISION FOR INCOME TAXES                                                                              |   | 1,513                            |       | 1,301                          |       | 2,873 |   | 1,813 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| INCOME BEFORE CUMULATIVE EFFECT OF CHANGE  IN ACCOUNTING PRINCIPLE                                      |   | 2,177                            |       | 1,974                          |       | 4,133 |   | 2,611 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING  PRINCIPLE, NET OF RELATED INCOME TAX BENEFIT OF $671 IN 2002 |   | —                           |       | —                         |       | — |   | (965 | ) |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| NET INCOME                                                                                              |   | $                                | 2,177      |                           | $          | 1,974 |   | $ | 4,133 |   | $ | 1,646 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| EARNINGS PER SHARE:                                                                                     |   |                             |       |                           |       |   |   |   |   |
| BASIC                                                                                                   |   |                             |       |                           |       |   |   |   |   |
| Income before cumulative effect of change  in accounting principle                                      |   | $                                | .17        |                           | $          | .15 |   | $ | .32 |   | $ | .20 |   |
| Cumulative effect of change in accounting  principle                                                    |   | —                           |       | —                         |       | — |   | (.07 | ) |
| Net income                                                                                              |   | $                                | .17        |                           | $          | .15 |   | $ | .32 |   | $ | .13 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| DILUTED                                                                                                 |   |                             |       |                           |       |   |   |   |   |
| Income before cumulative effect of change  in accounting principle                                      |   | $                                | .17        |                           | $          | .15 |   | $ | .32 |   | $ | .19 |   |
| Cumulative effect of change in accounting  principle                                                    |   | —                           |       | —                         |       | — |   | (.07 | ) |
| Net income                                                                                              |   | $                                | .17        |                           | $          | .15 |   | $ | .32 |   | $ | .12 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE  COMPUTATION:                                                        |   |                             |       |                           |       |   |   |   |   |
| BASIC                                                                                                   |   | 12,854                           |       | 13,004                         |       | 12,817 |   | 12,978 |   |
| DILUTED                                                                                                 |   | 13,173                           |       | 13,307                         |       | 13,055 |   | 13,406 |   |
|                                                                                                    |   |                             |       |                           |       |   |   |   |   |
| Comprehensive income:                                                                                   |   |                             |       |                           |       |   |   |   |   |
| Net income                                                                                              |   | $                                | 2,177      |                           | $          | 1,974 |   | $ | 4,133 |   | $ | 1,646 |   |
| Unrealized gain on derivative instruments                                                               |   | 981                              |       | 200                            |       | 1,430 |   | 200 |   |
| Comprehensive income                                                                                    |   | $                                | 3,158      |                           | $          | 2,174 |   | $ | 5,563 |   | $ | 1,846 |   |

 

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

 

3

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
|                                                                                     |   | **Six Months Ended  June 30,** |   |
|------------------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                                     |   | **2003**                       |   | **2002** |   |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                    |   |                           |   |   |   |
| Net income                                                                               |   | $                              | 4,133  |   | $ | 1,646 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities – |   |                           |   |   |   |
| Cumulative effect of change in accounting  principle                                     |   | —                         |   | 965 |   |
| Minority interest in losses of consolidated  special purpose entities                    |   | —                         |   | (40 | ) |
| Depreciation                                                                             |   | 4,734                          |   | 4,141 |   |
| Amortization of intangibles and other  assets                                            |   | 439                            |   | 439 |   |
| Amortization of deferred compensation                                                    |   | 290                            |   | 40 |   |
| Amortization of deferred financing costs                                                 |   | 578                            |   | 529 |   |
| Provision for bad debts                                                                  |   | 1,224                          |   | 322 |   |
| Loss on sale of property and equipment                                                   |   | 46                             |   | — |   |
| Deferred income taxes                                                                    |   | 870                            |   | (672 | ) |
| Change in assets and liabilities:                                                        |   |                           |   |   |   |
| Accounts receivable                                                                      |   | 2,324                          |   | 1,630 |   |
| Restricted assets                                                                        |   | 47                             |   | (236 | ) |
| Other assets                                                                             |   | (1,140                         | )      | (161 | ) |
| Accounts payable and accrued liabilities                                                 |   | (3,462                         | )      | (5,622 | ) |
| Deferred revenues and other liabilities                                                  |   | (1,238                         | )      | (804 | ) |
| Net cash provided by operating activities                                                |   | 8,845                          |   | 2,177 |   |
|                                                                                     |   |                           |   |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                    |   |                           |   |   |   |
| Capital expenditures                                                                     |   | (6,447                         | )      | (5,018 | ) |
| Escrow deposit on non-compete agreement                                                  |   | (1,000                         | )      | — |   |
| Return of restricted assets from deferred  bonus plan                                    |   | —                         |   | 1,000 |   |
| Payments to restricted debt payment  account, net                                        |   | (4,557                         | )      | (5,087 | ) |
| Purchases of marketable securities, net                                                  |   | —                         |   | (98 | ) |
| Net cash used in investing activities                                                    |   | (12,004                        | )      | (9,203 | ) |
|                                                                                     |   |                           |   |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                    |   |                           |   |   |   |
| Proceeds from long-term debt                                                             |   | 641                            |   | 542 |   |
| Payments of capital lease obligations                                                    |   | (14                            | )      | (72 | ) |
| Proceeds from exercise of stock options and  warrants                                    |   | 2,054                          |   | 466 |   |
| Purchases of treasury stock                                                              |   | (591                           | )      | (443 | ) |
| Net cash provided by financing activities                                                |   | 2,090                          |   | 493 |   |
|                                                                                     |   |                           |   |   |   |
| NET DECREASE IN CASH AND CASH EQUIVALENTS                                                |   | (1,069                         | )      | (6,533 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                        |   | 52,610                         |   | 53,244 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                               |   | $                              | 51,541 |   | $ | 46,711 |   |
|                                                                                     |   |                           |   |   |   |
| OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:                                      |   |                           |   |   |   |
| Purchases of treasury stock by deferred  bonus plan                                      |   | 146                            |   | 249 |   |
| Other comprehensive income                                                               |   | 1,430                          |   | 200 |   |
| Borrowings under capital leases                                                          |   | 3                              |   | — |   |

 

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

 

4

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**CORNELL COMPANIES, INC.NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

The accompanying unauditedconsolidated financial statements have been prepared by Cornell Companies, Inc.(the “Company”) pursuant to the rules and regulations of the Securities andExchange Commission.  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.  In the opinion ofmanagement, adjustments and disclosures necessary for a fair presentation ofthese financial statements have been included. Estimates were used in the preparation of these financialstatements.  Actual results could differfrom those estimates.  These financialstatements should be read in conjunction with the financial statements andnotes thereto included in the Company’s 2002 Annual Report on Form 10-K/A asfiled with the Securities and Exchange Commission.

 

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

 

See a description of theCompany’s accounting policies in the Company’s 2002 Annual Report on Form10-K/A.

 

The Company accounts for itsstock-based compensation plans in accordance with Accounting Principles BoardOpinion No. 25, “Accounting for Stock Issued to Employees” (“APB No.25”).  In accordance with the provisionsof APB No. 25, stock-based employee compensation cost is not reflected in netincome, as all options granted under those plans had an exercise price equal toor in excess of the market value of the underlying common stock on the date ofgrant.  The following table illustrates,in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 148,the effect of net income and earnings per share as if the Company had appliedthe fair value recognition provisions of SFAS No. 123, “Accounting forStock-Based Compensation,” to stock-based employee compensation (in thousands,expect per share amounts):

 
|                                                                                                                                        |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                                                                        |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                                                                                                                        |   |                             |   |                           |   |   |   |   |   |
| Net income, as reported                                                                                                                     |   | $                                | 2,177  |                           | $      | 1,974 |   | $ | 4,133 |   | $ | 1,646 |   |
| Add: stock based employee compensation  expense, net of related tax effect                                                                  |   | —                           |   | —                         |   | — |   | — |   |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |   | (345                             | )      | (530                           | )      | (880 | ) | (799 | ) |
| Pro forma net income                                                                                                                        |   | $                                | 1,832  |                           | $      | 1,444 |   | $ | 3,253 |   | $ | 847 |   |
| Earnings per share:                                                                                                                         |   |                             |   |                           |   |   |   |   |   |
| Basic, as reported                                                                                                                          |   | $                                | .17    |                           | $      | .15 |   | $ | .32 |   | $ | .13 |   |
| Basic, pro forma                                                                                                                            |   | .14                              |   | .11                            |   | .25 |   | .07 |   |
| Diluted, as reported                                                                                                                        |   | .17                              |   | .15                            |   | .32 |   | .12 |   |
| Diluted, pro forma                                                                                                                          |   | .14                              |   | .11                            |   | .25 |   | .06 |   |

 

***New Accounting Pronouncements***

 

The Company implemented SFASNo. 143, SFAS No. 146 and SFAS No. 148 and FIN 45 in the six months ended June30, 2003 with no impact on the Company’s reported financial position or resultsof operations.

 

5

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In April 2002, the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 145, “Rescission of FASBStatements No. 4, 44, 64, Amendment of FASB Statement No. 13, and TechnicalCorrections”, effective for fiscal years beginning after May 15, 2002.  SFAS No. 145 rescinds FASB Statement No. 4,44, 64 and amends SFAS No. 13, “Accounting for Leases,” to eliminate aninconsistency between the required accounting for sale-leaseback transactionsand the required accounting for certain lease modifications that have economiceffects that are similar to sale-leaseback transactions.  Additionally, SFAS No. 145 requires thatgains and losses on the extinguishment of debt be classified as income or lossfrom continuing operations rather than as extraordinary items as previouslyrequired under SFAS No. 4.  The Companyadopted SFAS No. 145 as required on January 1, 2003 and will affect theclassification of the extraordinary losses previously reported in the third andfourth quarter of 2001.

 

In January 2003, the FASBissued Interpretation No. 46, “Consolidation of Variable Interest Entities”(“FIN 46”), which addresses the consolidation of variable interest entities asdefined in the Interpretation.  FIN 46requires an assessment of equity investments to determine if they are variableinterest entities.  FIN 46 is effectiveimmediately for all variable interest entities created after January 31,2003.  For variable interest entitiescreated before February 1, 2003, the provisions of FIN 46 must be applied nolater than the beginning of the first interim period or annual reporting periodbeginning after June 15, 2003.   Inaddition, if it is reasonably possible that an enterprise will consolidate ordisclose information about a variable interest entity, the enterprise must discussthe following information in all financial statements issued after January 31,2003: (1) the nature, purpose, size or activities of the variable interestentity and (2) the enterprise’s maximum exposure to loss as a result of itsinvolvement with the variable interest entity. The Company’s adoption of FIN 46 does not change the Company’saccounting for the 2000 synthetic lease transaction and the 2001 Sale andLeaseback Transaction, which are consolidated for reporting purposes.  The Company may enter into futurearrangements for the development of new facilities or to operate facilitieswhich may become subject to the provisions of FIN 46 and, in some cases, may berequired to consolidate the related activities, facilities and financings.

 

In April 2003 the FASBissued SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instruments andHedging Activities” (SFAS No. 149). SFAS No. 149 amends and clarifies the accounting for derivativeinstruments, including certain derivative instruments embedded in othercontracts, and for hedging activities under SFAS No. 133.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003 and for hedging relationshipsdesignated after June 30, 2003, and should be applied prospectively.  The provisions of SFAS No. 149 that relateto SFAS No. 133 implementation issues that have been effective for fiscalquarters that began prior to June 15, 2003 should continue to be applied inaccordance with their respective effective dates.  The Company does not expect the adoption of SFAS No. 149 to havea material effect on the Company’s financial position or results of operations.

 

In May 2003 the FASB issuedSFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity.”  SFAS No. 150 establishes standards for how an issuer classifiesand measures certain financial instruments with characteristics of bothliabilities and equity in its statements of financial position.  SFAS No. 150 is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003 and must beapplied prospectively by reporting the cumulative effect of a change in anaccounting principle for financial instruments created before the issuance dateof the statement and still existing at the beginning of the interim period ofadoption.  The Company does not expectSFAS No. 150 to have a material effect on its results of operations orfinancial position.

 

In May 2003, the EmergingIssues Task Force (“EITF”) reached a consensus on EITF 01-8 “DeterminingWhether an Arrangement Contains a Lease.” EITF 01-8 provides guidance fordetermining whether an arrangement contains a lease that is within the scope ofSFAS No. 13 and is effective for arrangements initiated 

 

6

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after the beginning of the first interimperiod beginning after May 28, 2003. The Company adopted the provisions of EITF01-8 as of July 1, 2003 and is currently determining the impact of EITF 01-8 onthe Company’s consolidated financial statements.

 

**3.****             ****Change in AccountingPrinciple**

 

In June 2001, the FASBissued SFAS No. 141, “Business Combinations” and SFAS No. 142, “Goodwill andOther Intangible Assets,” effective for fiscal years beginning after December15, 2001. The new rules under these statements require that the purchase methodof accounting be used for all business combinations initiated after June 30,2001 and specifies the criteria for the recognition of intangible assetsseparately from goodwill.  Under the newrules, goodwill is no longer amortized but is subject to an impairmenttest  annually.  Other intangible assets that meet the newcriteria under the new rules will continue to be amortized over their remaininguseful lives.  The Company adopted SFASNo. 141 and SFAS No. 142 as of January 1, 2002 and recorded a cumulative effectof change in accounting principle charge of $965,000, net of tax, related tothe impairment of goodwill for an acquisition made in November 1999.

 

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

 

Other intangible assets atJune 30, 2003 and December 31, 2002 consisted of the following (in thousands):

 
|                     |   | **June 30, 2003** |   | **December 31, 2002** |   |
|--------------------------|--------|-------------------|--------|-----------------------|--------|
|                     |   |              |   |                  |   |
| Non-compete agreements   |   | $                 | 8,360  |                  | $      | 8,300 |   |
| Accumulated amortization |   | (3,398            | )      | (2,959                | )      |
| Other intangibles, net   |   | $                 | 4,962  |                  | $      | 5,341 |   |

 

Amortization expense fornon-compete agreements was approximately $220,000 and $440,000 for the threeand six months ended June 30, 2003 and 2002. Amortization expense for non-compete agreements is expected to beapproximately $878,000 for each of the fiscal years ended December 31 for thenext five years.

 

7

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

 

The Company’s long-term debtconsisted of the following (in thousands):

 
|                                                                                     |   | **June 30,  2003** |    | **December 31,  2002** |   |
|------------------------------------------------------------------------------------------|--------|--------------------|---------|------------------------|--------|
|                                                                                     |   |               |    |                   |   |
| **Debt of Cornell Companies, Inc.:**                                                     |   |               |    |                   |   |
| Capital lease obligations                                                                |   | $                  | 25      |                   | $      | 37 |   |
| Subtotal                                                                                 |   | 25                 |    | 37                     |   |
|                                                                                     |   |               |    |                   |   |
| **Debt of Consolidated Special Purpose  Entities:**                                      |   |               |    |                   |   |
| Synthetic Lease Investor Note A due July  2005 with an interest rate of LIBOR plus 3.25% |   | 41,662             |    | 41,117                 |   |
| Synthetic Lease Investor Note B due July  2005 with an interest rate of LIBOR plus 3.50% |   | 8,230              |    | 8,134                  |   |
| MCF 8.47% Bonds due 2016                                                                 |   | 190,600            |    | 190,600                |   |
| Subtotal                                                                                 |   | 240,492            |    | 239,851                |   |
|                                                                                     |   |               |    |                   |   |
| Consolidated total debt                                                                  |   | $                  | 240,517 |                   | $      | 239,888 |   |
|                                                                                     |   |               |    |                   |   |
| Less: current maturities                                                                 |   | (7,623             | )       | (7,630                 | )      |
|                                                                                     |   |               |    |                   |   |
| Consolidated long-term debt                                                              |   | $                  | 232,894 |                   | $      | 232,258 |   |

 

The Company’s 2000 CreditFacility, as amended, provides for borrowings of up to $45.0 million under arevolving line of credit.  Thecommitment amount is reduced by $1.6 million quarterly beginning in July 2002and by outstanding letters of credit. The Company had outstanding letters of credit of approximately $5.1million at June 30, 2003.  Accordingly,as of June 30, 2003, the Company had $33.5 million of available commitment  under its revolving line of credit.  The amended 2000 Credit Facility matures inJuly 2005 and bears interest, at the election of the Company, at either theprime rate plus a margin of 2.0%, or a rate which is 3.0% above the applicableLIBOR rate.  The amended 2000 CreditFacility is collateralized by substantially all of the Company’s assets, includingthe stock of all of the Company’s subsidiaries; does not permit the payment ofcash dividends; and requires the Company to comply with certain leverage, networth and debt service coverage covenants. Additionally, the Company is limited to $2.5 million annually for therepurchase of its common stock with an aggregate limit of $7.5 million.  Due to the consolidation, for financialreporting purposes, of MCF as of August 14, 2001, the Company was not incompliance with certain leverage ratio covenants.  On April 5, 2002, the 2000 Credit Facility was amended to waivesuch non-compliance and to revise the covenants to levels that accommodate theCompany’s consolidation of special purpose entities in its consolidated balancesheets, statements of operations and cash flows.  As a result of this waiver and amendment, the Company recognizeda pre-tax charge to interest expense of approximately $825,000 during the firstquarter of 2002 for lender and other professional fees.  Additionally, the Company has obtained awaiver from the lenders under the amended 2000 Credit Facility regarding thepending contractual default for the Moshannon Valley Correctional Center’sconstruction delay (see Note 6).  Thiswaiver is effective through October 31, 2004. Included in the Company’s cash and cash equivalents at June 30, 2003 isapproximately $39.6 million that is invested in a separate account that isavailable to the Company for investment purposes or working capital with theapproval of the lenders under the amended 2000 Credit Facility.  The lenders could limit the Company’sability to use such funds.  Thisseparate account is maintained, in part, to assure future credit availability.

 

Additionally, the amended2000 Credit Facility provides the Company with the ability to enter into 

 

8

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synthetic lease agreements for theacquisition or development of operating facilities.  This synthetic lease financing arrangement provides for fundingto the lessor under the operating leases of up to $100.0 million, of which approximately$51.7 million had been utilized as of June 30, 2003.  The Company expects to utilize the remaining capacity under thissynthetic lease financing arrangement for construction of the Moshannon ValleyCorrectional Center.  The SyntheticLease Investor’s Note A and Note B have total credit commitments of $81.4million and $15.1 million, respectively. The Company pays commitment fees at a rate of 0.5% annually for theunused portion of the synthetic lease financing capacity.  The Synthetic Lease Investor’s Notes A and Bare cross-collateralized with the Company’s revolving line of credit andcontain cross-default provisions.  Underthe provisions of FIN 46, utilization of this synthetic lease financing arrangementto complete the construction of the Moshannon Valley Correctional Center willresult in the continued consolidation of the facility and the related financingin the Company’s financial statements.

 

**6.****             ****New Facilities and ProjectsUnder Development**

 

The Company closed the NewMorgan Academy in the fourth quarter of 2002 and is currently consideringseveral options ranging from the sale or lease of the facility to utilizationof the facility for another type of program. The Company is using a small staff to maintain the facility while theCompany considers its options for the use or sale or lease of the facility.

 

The carrying value of theproperty and equipment at the New Morgan Academy was approximately $30.9million at June 30, 2003.  Currently,management of the Company believes that its long-lived assets at the New MorganAcademy are recoverable either from the cash flows of an alternative programoperating at the facility or upon the sale or lease of the facility to a thirdparty, and accordingly, pursuant to the provisions of SFAS No. 144, animpairment provision is not deemed necessary as of June 30, 2003.  However, management estimates that, were theCompany to sell the facility, it is reasonably possible that the Company maynot be able to fully recover the carrying value of its long-lived assets forthis facility.

 

In January 2003, the Companyexecuted a lease for the Bernalillo County Jail in Albuquerque, NewMexico.  The facility, which has beenvacated by the County in favor of a new jail, is expected to be remodeled bythe Company and used to provide adult secure confinement for a wide array ofgovernment agencies that have demonstrated a need for additional bedspace.  The facility added approximately1,000 beds to the Company’s current service capacity.  The lease must be approved by the State Attorney General andrequires monthly rental payments of approximately $80,000 to $100,000 over thefive year lease term.

 

In May 2003, the Companyacquired a building in San Antonio, Texas for approximately $2.1 million incash.  The Company is currentlyrenovating this 121 bed residential juvenile facility called the TexasAdolescent Center and expects it to become operational in the fourth quarter of2003.

 

In June 2003, the Companyentered into an agreement with a developer to purchase a 160 bed residentialtreatment center for juveniles upon completion of construction of the facilityby the developer.  This facility isnamed the Southern Peaks Regional Treatment Center and is located near CanonCity, Colorado.  Under the developmentagreement, the Company is obligated to fund into an escrow account the purchaseprice of the real property of approximately $13.0 million by August 15, 2003.

 

In March 2003, the Companyreached an agreement with the Commonwealth of Pennsylvania that resolved all outstandingadministrative issues relative to the contract awarded to the Company by theFederal Bureau of Prisons (“BOP”) to operate the Moshannon Valley CorrectionalCenter.  If the Company is able tonegotiate an amendment to the contract with the BOP, this agreement will allowthe Company to move forward with the construction and operation of thefacility, subject to re-approval of the project by the lenders under theCompany’s amended 2000 Credit Facility, and agreement by such lenders to amendcertain financial covenants and provisions of the 2000 Credit Facility.

 

9

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As of June 30, 2003, theCompany had incurred approximately $16.8 million for construction and landdevelopment costs and capitalized interest related to the Moshannon ValleyCorrectional Center.  According to theBOP contract, as amended, the Company is required to complete the constructionof the project by October 15, 2003.  TheCompany does not anticipate completing construction by that date andanticipates obtaining another long-term contract amendment from the BOPextending the construction deadline.  Inthe event the Company is not able to negotiate a contract amendment with theBOP, then the BOP may have the right to assert that the Company has notcompleted construction of the facility within the time frame provided in theBOP contract, as amended.  Managementexpects that the contract will be amended to address cost and constructiontiming matters resulting from the extended delay.  In the event that the BOP decides not to continue with theconstruction of the Moshannon Valley Correctional Center and terminates thecontract, management believes that the Company has the right to and willrecover its invested costs.  In theevent any portion of these costs are determined not to be recoverable uponcontract termination by the BOP, such costs would be expensed.  Management currently believes that theinvested costs would be fully recoverable in the event of this contract beingterminated.

 

At June 30, 2003, accountsreceivable include costs totaling approximately $1.4 million for direct costsincurred by the Company since the issuance of the Stop-Work Order in June 1999for payroll and other operating costs related to the Moshannon Valley CorrectionalCenter.  These costs were incurred withthe understanding that such costs would be reimbursed by the BOP.  Although no formal written agreement exists,management believes that these costs will be reimbursed by the BOP in the nearterm.  In the event any portion of thesecosts are determined not to be reimbursable, such costs will be expensed in theperiod such determination is made.

 

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

 

Basic earnings per share(“EPS”) is computed by dividing net income by the weighted average number ofshares of common stock outstanding during the period.  Diluted EPS reflects the potential dilution from common stockequivalents such as stock options and warrants.  For the three months ended June 30, 2003 and 2002, there were360,489 shares ($14.16 average price) and 279,880 shares ($15.23 averageprice), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.  For the six months ended June 30, 2003 and2002 there were 633,946 shares ($12.38 average price) and 533,663 shares($10.36 average price), respectively, of stock options that were not includedin the computation of diluted EPS because to do so would have beenanti-dilutive.

 

**8.****             ****Commitments andContingencies**

 

*Litigation*

 

In March and April 2002, theCompany, Steven W. Logan, and John L. Hendrix, were named as defendants in fourfederal putative class action lawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the Southern District ofTexas, Houston Division; (3) *Louis A. Daly,On Behalf of Himself and All Others Similarly Situated v. Cornell Companies,Inc., et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1567, in the United States District Court for the Southern District ofTexas, Houston Division.  Theaforementioned lawsuits are putative class action lawsuits brought on behalf ofall purchasers of the Company’s common stock between March 6, 2001 and March 5,2002.  The lawsuits involve disclosuresmade concerning two 

 

10

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prior transactions executed by the Company:the August 2001 sale leaseback transaction and the 2000 synthetic leasetransaction.  These four lawsuits haveall been consolidated into the *GraydonWilliams* action.  FlylinePartners, LP has been appointed as the lead plaintiff and has filed aconsolidated complaint.  Theconsolidated complaint alleges that the defendants violated Section 10(b) ofthe Securities Exchange Act of 1934 (the “Exchange Act”), Rule 10b-5promulgated under Section 10(b) of the Exchange Act, Section 20(a) of theExchange Act and Section 11 of the Securities Act of 1933.  The consolidated complaint seeks, amongother things, restitution damages, compensatory damages, rescission or a rescissorymeasure of damages, costs, expenses, attorneys’ fees and expert fees.  A motion to dismiss is currentlypending.  The Company believes that ithas good defenses to each of the plaintiffs’ claims and intends to vigorouslydefend against each of these claims.

 

In March 2002, the Company,its directors, and its former independent auditor Arthur Andersen LLP, weresued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant Cornell Companies,Inc. v. Anthony R. Chase, et al.*, No. 2002-15614, in the 127thJudicial District Court of Harris County, Texas.  The lawsuit alleges breaches of fiduciary duty by all of theindividual defendants and asserts breach of contract and professionalnegligence claims only against Arthur Andersen LLP.  The Company believes that it has good defenses to each of theplaintiff’s claims and intends to vigorously defend against each of theseclaims.

 

In May and June 2002, theCompany and its directors were sued in three other derivative lawsuits styledas follows: (1) *Juan Guitierrez,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the Southern District ofTexas, Houston Division; (2) *Thomas Pagano,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.*,No. H-02-1896, in the United Stated District Court for the Southern District ofTexas, Houston Division; and (3) *JesseMenning, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan,et. al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits all allege breaches of fiduciary duty and waste of corporate assets byall of the defendants.  A motion to dismissthe *Guitierrez* and *Pagano* lawsuits was filed.  The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez* action is still pending.  A motion to dismiss the *Menning* action is also pending.  The Company believes that it has gooddefenses to each of the plaintiffs’ claims and intend to vigorously defendagainst each of these claims.

 

While the plaintiffs inthese cases have not quantified their claim of damages and the outcome of thematters discussed above cannot be predicted with certainty, based oninformation known to date, management believes that the ultimate resolution ofthese matters will not have a material adverse effect on the Company’sfinancial position, operating results or cash flow.

 

Additionally, the Companycurrently and from time to time is subject to claims and suits arising in theordinary course of business, including claims for damages for personal injuriesor for wrongful restriction of or interference with offender privileges andemployment matters.  The outcome of suchmatters cannot be predicated with certainty, based on the information known todate, management believes that the ultimate resolution of these matters willnot have a material adverse effect on the Company’s financial position, operatingresults or cash flow.

 

**9.****             ****Segment Disclosure**

 

The Company’s threeoperating divisions are its reportable segments.  The adult secure institutional segment consists of the operationof secure adult incarceration facilities. The juvenile segment consists of providing residential treatment andeducational programs and non-residential community-based programs to juvenilesbetween the ages of ten and 17 who have either been adjudicated or suffer frombehavioral problems.  The pre-releasesegment consists of providing pre-release and halfway house programs for adultoffenders who are either on probation or serving the last three to six monthsof their sentences on parole and 

 

11

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preparing for re-entry into society at largeas well as community-based treatment and education programs as an alternativeto incarceration.  All of the Company’scustomers and long-lived assets are located in the United States of America.  Intangible assets are not included in eachsegment’s reportable assets, and the amortization of intangible assets is notincluded in the determination of a segment’s operating income.  The Company evaluates performance based onincome or loss from operations before general and administrative expenses,incentive bonuses, amortization of intangibles, interest and income taxes.  Corporate and other assets are comprisedprimarily of cash, certain accounts receivable, deposits, property andequipment, deferred taxes, deferred costs and other assets.

 

The only significantnon-cash item reported in the respective segment’s income or loss fromoperations is depreciation and amortization.

 
|                               |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                               |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                               |   |                             |   |                           |   |   |   |   |   |
| Revenues                           |   |                             |   |                           |   |   |   |   |   |
| Adult secure institutional         |   | $                                | 25,593 |                           | $      | 24,937 |   | $ | 50,656 |   | $ | 48,945 |   |
| Juvenile                           |   | 29,463                           |   | 31,786                         |   | 58,029 |   | 63,596 |   |
| Pre-release                        |   | 12,530                           |   | 12,354                         |   | 24,927 |   | 25,011 |   |
| Total revenues                     |   | $                                | 67,586 |                           | $      | 69,077 |   | $ | 133,612 |   | $ | 137,552 |   |
|                               |   |                             |   |                           |   |   |   |   |   |
| Pre-opening and start-up expenses  |   |                             |   |                           |   |   |   |   |   |
| Adult secure institutional         |   | $                                | 62     |                           | $      | — |   | $ | 149 |   | $ | — |   |
| Juvenile                           |   | 244                              |   | —                         |   | 244 |   | — |   |
| Pre-release                        |   | —                           |   | —                         |   | — |   | — |   |
|                               |   | $                                | 306    |                           | $      | — |   | $ | 393 |   | $ | — |   |
| Income from operations             |   |                             |   |                           |   |   |   |   |   |
| Adult secure institutional         |   | $                                | 6,600  |                           | $      | 6,422 |   | $ | 13,276 |   | $ | 12,412 |   |
| Juvenile                           |   | 3,917                            |   | 4,873                          |   | 7,001 |   | 8,824 |   |
| Pre-release                        |   | 2,599                            |   | 2,610                          |   | 5,060 |   | 5,739 |   |
| General and administrative expense |   | (4,722                           | )      | (5,304                         | )      | (8,620 | ) | (11,391 | ) |
| Incentive bonuses                  |   | —                           |   | —                         |   | — |   | (197 | ) |
| Amortization of intangibles        |   | (220                             | )      | (218                           | )      | (439 | ) | (439 | ) |
| Corporate and other                |   | 22                               |   | (495                           | )      | (304 | ) | (684 | ) |
| Total income from operations       |   | $                                | 8,196  |                           | $      | 7,888 |   | $ | 15,974 |   | $ | 14,264 |   |

 
|                       |   | **June 30,  2003** |    | **December 31,  2002** |   |
|----------------------------|--------|--------------------|---------|------------------------|--------|
| Assets                     |   |               |    |                   |   |
| Adult secure institutional |   | $                  | 154,208 |                   | $      | 156,315 |   |
| Juvenile                   |   | 97,296             |    | 96,239                 |   |
| Pre-release                |   | 56,616             |    | 58,071                 |   |
| Intangible assets, net     |   | 12,683             |    | 13,062                 |   |
| Corporate and other        |   | 123,185            |    | 117,604                |   |
| Total assets               |   | $                  | 443,988 |                   | $      | 441,291 |   |

 

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**ITEM 2.****    ****Management’s Discussion andAnalysis of Financial Condition and Results of Operations**

 

**General**

 

The Company is a leadingprovider of privatized correctional, treatment and educational servicesoutsourced by federal, state and local government agencies.  The Company provides a diversified portfolioof services for adults and juveniles through its three operating divisions: (1)adult secure institutional services, (2) juvenile treatment, educational anddetention services and (3) pre-release correctional and treatmentservices.  As of June 30, 2003, theCompany was developing or had contracts to operate 70 facilities with a totalservice capacity of 16,514.  TheCompany’s facilities are located in 14 states and the District of Columbia.

 

The following table setsforth for the periods indicated total service capacity, the service capacityand contracted beds in operation at the end of the periods shown and theaverage occupancy percentages.

 
|                                                             |   | **June 30,  2003** |   | **June 30,  2002** |   |
|------------------------------------------------------------------|--------|--------------------|--------|--------------------|--------|
|                                                             |   |               |   |               |   |
| Total service capacity (1):                                      |   |               |   |               |   |
| Residential                                                      |   | 12,378             |   | 11,267             |   |
| Non-residential community-based                                  |   | 4,136              |   | 4,177              |   |
| Total                                                            |   | 16,514             |   | 15,444             |   |
| Service capacity in operation (end of  period)                   |   | 13,971             |   | 14,349             |   |
| Contracted beds in operation (end of  period)                    |   | 9,492              |   | 9,503              |   |
| Average occupancy based on contracted beds  in operation (2) (3) |   | 99.9               | %      | 98.7               | %      |
| Average occupancy excluding start-up  operations (2)             |   | 100.0              | %      | 98.7               | %      |

 

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(1)          TheCompany’s service capacity is comprised of the number of beds available forservice upon completion of construction of residential facilities and theaverage program capacity of non-residential community-based programs.

(2)          Occupancypercentages are based on contracted service capacity of residential facilitiesin operation.  Since certain facilitieshave service capacities that exceed contracted capacities, occupancypercentages can exceed 100% of contracted capacity.

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

 

The Company derivessubstantially all its revenues from providing corrections, treatment andeducational services outsourced by federal, state and local government agenciesin the United States.  Revenues for theCompany’s 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.  Revenues may fluctuate from year to year dueto changes in government funding policies, the number of people referred to theCompany’s facilities by governmental agencies or the opening of additionalfacilities.

 

Factors that the Companyconsiders in determining the per diem rate to charge include (1) the programsspecified by the contract and the related staffing levels, (2) wage levelscustomary in the respective geographic areas, (3) whether the proposed facilityis to be leased or purchased and (4) the anticipated average occupancy levelsthat the Company believes could reasonably be maintained.

 

The Company has historicallyexperienced higher operating margins in its adult secure institutional andpre-release divisions as compared to the juvenile division.  Additionally, the Company’s operatingmargins within a division can vary from facility to facility based on whether afacility is owned or leased, the level of competition for the contract award,the proposed length of the contract, the occupancy levels for a facility, thelevel of capital commitment required with respect to a facility, theanticipated changes in operating costs 

 

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over the term of the contract, and theCompany’s ability to increase a facility’s contract revenue.  A decline in occupancy of certain juveniledivision facilities may have a more significant impact on operating resultsthan the adult secure division due to higher per diem revenues of certain juvenilefacilities. The Company has experienced and expects to experience interimperiod operating margin fluctuations due to the number of calendar days in theperiod, higher payroll taxes in the first half of the year, and salary and wageincreases that are incurred prior to certain contract revenue increases.

 

The Company is generallyresponsible for all facility operating costs, except for certain debt serviceand lease payments with respect to facilities for which the Company has only amanagement contract (10 facilities in operation at June 30, 2003 and 11facilities in operation at June 30, 2002).

 

A majority of the Company’sfacility operating costs consists of fixed costs.  These fixed costs include lease and rental expense, insurance,utilities and depreciation.  As a result,when the Company commences operation of new or expanded facilities, fixedoperating costs increase.  The amount ofthe Company’s variable operating costs, including food, medical services,supplies and clothing, depend on occupancy levels at the facilities operated bythe Company.  The Company’s largestsingle operating cost, facility payroll expense and related employment taxesand costs, has both a fixed and a variable component.  The Company can adjust a facility’s staffing levels and therelated payroll expense to a certain extent based on occupancy at a facility,however a minimum fixed number of employees is required to operate and maintainany facility regardless of occupancy levels. Personnel costs are subject to increases in tightening labor marketsbased on local economic and other conditions.

 

Following a contract award,the Company incurs pre-opening and start-up expenses including payroll,benefits, training and other operating costs prior to opening a new or expandedfacility and during the period of operation while occupancy is ramping up.  These costs vary by contract.  Since pre-opening and start-up costs arefactored into the revenue per diem rate that is charged to the contractingagency, the Company typically expects to recover these upfront costs over thelife of the contract.  Because occupancyrates during a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, the Company may incur additionalpost-opening start-up costs.  TheCompany does not anticipate post-opening start-up costs at facilities operatedunder any future contracts with the BOP because these contracts are currentlyand expected to continue to be take-or-pay contracts, meaning that the BOP willpay the Company at least 95.0% of the contractual monthly revenue once thefacility opens regardless of actual occupancy.

 

Newly opened facilities arestaffed according to contract requirements when the Company begins receivingoffenders or clients.  Offenders orclients are typically assigned to a newly opened facility on a phased-in basisover a one- to six-month period, although certain programs require a longertime period to reach break-even occupancy levels.  The Company incurs start-up operating losses at new facilitiesuntil break-even occupancy levels are reached. Although the Company typically recovers these upfront costs over thelife of the contract, quarterly results can be substantially affected by thetiming of the commencement of operations as well as development andconstruction of new facilities.

 

Working capital requirementsgenerally increase immediately prior to the Company’s commencing management ofa new or expanded facility as the Company incurs start-up costs and purchasesnecessary equipment and supplies before facility management revenue iscollected.

 

For the three and six monthsended June 30, 2003, the Company incurred pre-opening and start-up costs of$306,000 and $393,000, respectively, related to the combined pre-opening andstart-up operations of the Bernalillo County Jail, the Jos-Arz ResidentialTreatment Center and the Texas Adolescent Center.  Revenues attributable to start-up operations were $54,000 for thethree and six months ended June 30, 2003 and were attributable to the Jos-ArzResidential Treatment Center.

 

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General and administrativeexpenses consist primarily of costs for the Company’s corporate andadministrative personnel who provide senior management, finance, accounting,human resources, payroll and information systems, business development andrelated costs of business development and outside professional fees.

 

**NewAccounting Pronouncements**

 

The Company implementedStatement of Financial Accounting Standard (“SFAS”) No. 143, SFAS No. 146 andSFAS No. 148 and FIN 45 in the six months ended June 30, 2003 with no impact onthe Company’s reported financial position or results of operations.

 

In April 2002, the FASBissued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, 64, Amendment ofFASB Statement No. 13, and Technical Corrections” (“SFAS No. 145”), effectivefor fiscal years beginning after May 15, 2002. SFAS No. 145 rescinds FASB Statement No. 4, 44, 64 and amends SFAS No.13, “Accounting for Leases,” to eliminate an inconsistency between the requiredaccounting for sale-leaseback transactions and the required accounting forcertain lease modifications that have economic effects that are similar tosale-leaseback transactions. Additionally, SFAS No. 145 requires that gains and losses on the extinguishmentof debt to be classified as income or loss from continuing operations ratherthan as extraordinary items as previously required under SFAS No. 4.  The Company adopted SFAS No. 145 as requiredon January 1, 2003 and will affect the classification of the extraordinarylosses previously reported in the third and fourth quarter of 2001.

 

In January 2003, the FASBissued Interpretation No. 46, “Consolidation of Variable Interest Entities”(“FIN 46”), which addresses the consolidation of variable interest entities asdefined in the Interpretation.  FIN 46requires an assessment of equity investments to determine if they are variableinterest entities.  FIN 46 is effectiveimmediately for all variable interest entities created after January 31,2003.  For variable interest entitiescreated before February 1, 2003, the provisions of FIN 46 must be applied nolater than the beginning of the first interim period or annual reporting periodbeginning after June 15, 2003.   Inaddition, if it is reasonably possible that an enterprise will consolidate ordisclose information about a variable interest entity, the enterprise mustdiscuss the following information in all financial statements issued afterJanuary 31, 2003: (1) the nature, purpose, size or activities of the variableinterest entity and (2) the enterprise’s maximum exposure to loss as a resultof its involvement with the variable interest entity.  The Company’s adoption of FIN 46 does not change the Company’saccounting for the 2000 synthetic lease transaction and the 2001 Sale andLeaseback Transaction, which are consolidated for reporting purposes.  The Company may enter into futurearrangements for the development of new facilities or to operate facilitieswhich may become subject to the provisions of FIN 46 and, in some cases, may berequired to consolidate the related activities, facilities and financings.

 

In April 2003 the FASBissued SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instruments andHedging Activities” (SFAS No. 149). SFAS No. 149 amends and clarifies the accounting for derivativeinstruments, including certain derivative instruments embedded in othercontracts, and for hedging activities under SFAS No. 133.  SFAS No. 149 is effective for contractsentered into or modified after June 30, 2003 and for hedging relationshipsdesignated after June 30, 2003, and should be applied prospectively.  The provisions of SFAS No. 149 that relateto SFAS No. 133 implementation issues that have been effective for fiscalquarters that began prior to June 15, 2003 should continue to be applied inaccordance with their respective effective dates.  The Company does not expect the adoption of SFAS No. 149 to havea material effect on the Company’s financial position or results of operations.

 

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In May 2003 the FASB issuedSFAS No. 150, “Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity.”  SFAS No. 150 establishes standards for how an issuer classifiesand measures certain financial instruments with characteristics of bothliabilities and equity in its statements of financial position.  SFAS No. 150 is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003 and must be applied prospectively by reporting the cumulative effect of achange in an accounting principle for financial instruments created before theissuance date of the statement and still existing at the beginning of theinterim period of adoption.  The Companydoes not expect SFAS No. 150 to have a material effect on its results ofoperations or financial position.

 

In May 2003, the EmergingIssues Task Force (“EITF”) reached a consensus on EITF 01-8 “DeterminingWhether an Arrangement Contains a Lease.” EITF 01-8 provides guidance fordetermining whether an arrangement contains a lease that is within the scope ofSFAS No. 13 and is effective for arrangements initiated after the beginning ofthe first interim period beginning after May 28, 2003. The Company adopted theprovisions of EITF 01-8 as of July 1, 2003 and is currently determining theimpact of EITF 01-8 on the Company’s consolidated financial statements.

 

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**Results ofOperations**

 

The following table setsforth for the periods indicated the percentages of revenue represented bycertain items in the Company’s historical consolidated statements ofoperations:

 
|                                                                                               |   | **Three Months  Ended June 30,** |   | **Six Months  Ended June 30,** |   |
|----------------------------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                                               |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                                                                               |   |                             |   |                           |   |   |   |   |   |
| Revenues                                                                                           |   | 100.0                            | %      | 100.0                          | %      | 100.0 | % | 100.0 | % |
| Operating expenses                                                                                 |   | 76.6                             |   | 77.5                           |   | 77.4 |   | 78.0 |   |
| Pre-opening and start-up expenses                                                                  |   | 0.5                              |   | 0.0                            |   | 0.3 |   | 0.0 |   |
| Depreciation and amortization                                                                      |   | 3.8                              |   | 3.4                            |   | 3.9 |   | 3.3 |   |
| General and administrative expenses                                                                |   | 7.0                              |   | 7.7                            |   | 6.5 |   | 8.3 |   |
| Income from operations                                                                             |   | 12.1                             |   | 11.4                           |   | 11.9 |   | 10.4 |   |
| Interest expense, net                                                                              |   | 6.7                              |   | 6.7                            |   | 6.7 |   | 7.2 |   |
| Minority interest in losses of consolidated  special purpose entities                              |   | 0.0                              |   | 0.0                            |   | 0.0 |   | 0.0 |   |
| Income before provision for income taxes  and cumulative effect of changes in accounting principle |   | 5.4                              |   | 4.7                            |   | 5.2 |   | 3.2 |   |
| Provision for income taxes                                                                         |   | 2.2                              |   | 1.9                            |   | 2.2 |   | 1.3 |   |
| Income before cumulative effect of changes  in accounting principle                                |   | 3.2                              | %      | 2.8                            | %      | 3.0 | % | 1.9 | % |

* *

*ThreeMonths Ended June 30, 2003 Compared to Three Months Ended June 30, 2002*

 

*Revenues*.  Revenues decreased 2.2% to$67.6 million for the three months ended June 30, 2003 from $69.1 million for thethree months ended June 30, 2002.

 

Adult secure institutionaldivision revenues increased 2.6% to $25.6 million for the three months endedJune 30, 2003 from $24.9 million for the three months ended June 30, 2002 dueprimarily to increased occupancy at the Big Spring Complex, the Baker CommunityCorrectional Facility and the Leo Chesney Community Correctional Facility.  In the three months ended June 30, 2002, theBaker and Leo Chesney facilities had a reduction in occupancy as thesefacilities were preparing for potential closure in June 2002.  The contracts were subsequently renewed and,as a result, occupancy was at contract levels during the three months endedJune 30, 2003.  Average occupancy was100.3% for the three months ended June 30, 2003 compared to 98.9% for the threemonths ended June 30, 2002.   There wereno revenues attributable to start-up operations for the three months ended June30, 2003 and 2002.

 

Juvenile division revenuesdecreased 7.3% to $29.5 million for the three months ended June 30, 2003 from$31.8 million for the three months ended June 30, 2002 due primarily to theclosure of the New Morgan Academy in the fourth quarter of 2002, offset inpart, by an increase in revenue due to increased occupancy and service hours atvarious juvenile facilities and programs. The closure of the New Morgan Academy decreased revenues byapproximately $4.6 million in the second quarter of 2003 as compared to thesame quarter of 2002.  This decrease wasoffset by a net increase in revenue of approximately $2.2 million as a resultof increased occupancy at various facilities and programs including theAlexander Youth Center, Dauphin Mental Health, the Leadership DevelopmentProgram (“LDP”) and Cornell Abraxas I (“A-1”). Revenues attributable to start-up operations were approximately $54,000for the three months ended June 30, 2003 and were attributable to the Jos-ArzResidential Treatment Center.  Excludingthe occupancy and contract capacity for the New Morgan Academy and the start-upactivities of the Jos-Arz Residential Treatment Center in 2003, averageoccupancy for the three months ended June 30, 2003 was 92.2% compared 

 

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to 94.2% for the three months ended June 30,2002.

 

Pre-release division revenuesincreased 1.4% to $12.5 million for the three months ended June 30, 2003 from$12.4 million for the three months ended June 30, 2002 due to overall increasedoccupancy throughout the division.  Average occupancy was 109.7% for the three months ended June 30, 2003compared to 109.5% for the three months ended June 30, 2002.

 

*Operating Expenses.*  Operating expenses decreased3.3% to $51.8 million for the three months ended June 30, 2003 from $53.5million for the three months ended June 30, 2002.

 

Adult secure institutionaldivision operating expenses increased 2.1% to $18.0 million for the threemonths ended June 30, 2003 from $17.6 million for the three months ended June30, 2002 due primarily to increased staffing and other services due to the higheroccupancy levels at the Big Spring Complex, the Baker Community CorrectionalFacility and the Leo Chesney Community Correctional Facility in the threemonths ended June 30, 2003 as compared to the same period of the prior year.  As a percentage of segment revenues, adultsecure institutional division operating expenses were 70.3% for the threemonths ended June 30, 2003 compared to 70.4% for the three months ended June30, 2002.

 

Juvenile division operatingexpenses decreased 6.6% to $24.6 million for the three months ended June 30,2003 from $26.3 million for the three months ended June 30, 2002 due toprimarily to the closure of the New Morgan Academy in the fourth quarter of2002.  Operating expenses for the NewMorgan Academy were approximately $0.4 million for the three months ended June30, 2003 compared to $3.7 million for the three months ended June 30,2002.  Excluding the New MorganAcademy’s operating expenses in both periods, juvenile division operatingexpenses increased 6.9%, or $1.6 million, due to increased staffing and otherservices due to the increased occupancy at various facilities and programsincluding the Alexander Youth Center, Dauphin Mental Health, LDP and A-1.  As a percentage of segment revenues,operating expenses were 83.5% for the three months ended June 30, 2003 comparedto 82.7% for three months ended June 30, 2002. Excluding start-up operations in 2003 and the operations of the NewMorgan Academy in both periods, juvenile division operating expenses, as apercentage of segment revenue, were 82.3% and 83.2% respectively.  The 2003 operating margin was favorablyimpacted by the revenue increases at the facilities discussed above.

 

Pre-release divisionoperating expenses increased 0.6% to $9.5 million for the three months endedJune 30, 2003 from $9.4 million for the three months ended June 30, 2002.  As a percentage of revenues, operatingexpenses were 75.6% for the three months ended June 30, 2003 compared to 76.2%for the three months ended June 30, 2002.

 

*Pre-Opening and Start-up Expenses.* Pre-opening and start-up expenses for the three months ended June 30,2003 were approximately $0.3 million and related to the pre-opening andstart-up operations of the Bernalillo County Jail, the Texas Adolescent Centerand the Jos-Arz Residential Treatment Center.

 

*Depreciation and Amortization*. Depreciation and amortization was $2.6 million for the three monthsended June 30, 2003 compared to $2.4 million for the three months ended June30, 2002.  The increase in depreciationand amortization expense was primarily due to current year property andequipment purchases.  Amortization ofintangibles was approximately $220,000 for the three months ended June 30, 2003and 2002.

 

*General and Administrative Expenses.* General and administrative expenses decreased 11.0% to $4.7 million forthe three months ended June 30, 2003 from $5.3 million for the three monthsended June 30, 2002.  Included ingeneral and administrative expenses for the three months ended June 30, 2003were costs of approximately $580,000 for site acquisition costs and legalexpenses primarily associated with the Company’s increased development activityand a charge related to the deferred compensation plan.  Included 

 

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in general and administrative expenses forthe three months ended June 30, 2002 was a charge of approximately $1.0 millionrelated to the write-off of deferred project financing costs associated withthe Bureau of Prisons (“BOP”) Southeast Project.  This contract was not awarded to the Company and all associatedcosts were charged to expense.  Alsoincluded in general and administrative expenses for the three months ended June30, 2002 is approximately $200,000 of legal and professional fees related tothe special committee review.  Excludingthe above charges from the applicable 2003 and 2002 periods, general andadministrative expenses increased 0.9% from the same period of the prior year.

 

*Interest.*  Interest expense, net ofinterest income, decreased to $4.5 million for the three months ended June 30,2003 from $4.6 million for the three months ended June 30, 2002.  Capitalized interest for the three monthsended June 30, 2003 and 2002 was approximately $200,000 and related to theMoshannon Valley Correctional Center.

 

*Income Taxes.*  For the three months endedJune 30, 2003 and 2002, the Company recognized a provision for income taxes atan estimated effective rate of 41.0% and 40.0%, respectively.  The increase in the  effective rate was due to increased taxableincome in certain states having higher rates.

 

*Six MonthsEnded June 30, 2003 Compared to Six Months Ended June 30, 2002*

 

*Revenues*.  Revenues decreased 2.9% to$133.6 million for the six months ended June 30, 2003 from $137.6 million forthe six months ended June 30, 2002.

 

Adult secure institutionaldivision revenues increased 3.4% to $50.7 million for the six months ended June30, 2003 from $48.9 million for the six months ended June 30, 2002 dueprimarily to increased occupancy at the Big Spring Complex, the Baker CommunityCorrectional Facility and the Leo Chesney Community Correctional Facility.  In the six months ended June 30, 2002, theBaker and Leo Chesney facilities had a reduction in occupancy as thesefacilities were preparing for potential closure in June 2002.  These contracts were subsequently renewedand as a result occupancy was at contract levels during the six months endedJune 30, 2003.  There were no revenuesattributable to start-up operations for the six months ended June 30, 2003 and2002.  Average occupancy was 99.0% forthe six months ended June 30, 2003 compared to 97.7% for the six months endedJune 30, 2002.

 

Juvenile division revenuesdecreased 8.8% to $58.0 million for the six months ended June 30, 2003 from$63.6 million for the six months ended June 30, 2002 due primarily to theclosure of the New Morgan Academy in the fourth quarter of 2002, offset inpart, by an increase in revenue due to increased occupancy and service hours atvarious juvenile facilities and programs. Revenues attributable to the New Morgan Academy were $26,000 in the sixmonths ended June 30, 2003 as compared to $9.4 million in the six months endedJune 30, 2002. This decrease was offset by a net increase in revenue ofapproximately $3.7 million as a result of improved occupancy and service hoursat various facilities including the Alexander Youth Center, A-1, the CornellAbraxas Center for Adolescent Females (“ACAF”), Dauphin Mental Health and theGriffin Juvenile Facility.  Revenuesattributable to start-up operations were approximately $54,000 for the sixmonths ended June 30, 2003 and were attributable to the start-up operations ofthe Jos-Arz Residential Treatment Center. Excluding the occupancy and contract capacity for the New Morgan Academyand the start-up activities of the Jos-Arz Residential Treatment Center in2003, average occupancy for the six months ended June 30, 2003 was 92.3%compared to 92.9% for the six months ended June 30, 2002.

 

Pre-release divisionrevenues decreased 0.3% to $24.9 million for the six months ended June 30, 2003from $25.0 million for the six months ended June 30, 2002 due primarily to thetermination of the Santa Barbara Center contract in March 2003, offset in part,by overall improved occupancy throughout the division.  There were no revenues attributable tostart-up operations for the six months ended June 30, 2003 

 

19

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and 2002. Average occupancy was 109.7% for the six months ended June 30, 2003compared to 107.7% for the six months ended June 30, 2002.

 

*Operating Expenses.*  Operating expenses decreased3.6% to $103.5 million for the six months ended June 30, 2003 from $107.3million for the six months ended June 30, 2002.

 

Adult secure institutionaldivision operating expenses increased 1.5% to $35.3 million for the six monthsended June 30, 2003 from $34.8 million for the six months ended June 30, 2002due primarily to increased staffing and other services due to increasedoccupancy at the Big Spring Complex, the Baker Community Correctional Facilityand the Leo Chesney Community Correctional Facility.  As a percentage of segment revenues, adult secure institutionaldivision operating expenses were 69.8% for the six months ended June 30, 2003compared to 71.1% for the six months ended June 30, 2002.   The 2003 operating margin was impactedfavorably as a result of lower inmate medical costs at certain facilities inthe six months ended June 30, 2003 as compared to the same period of 2002.

 

Juvenile division operatingexpenses decreased 7.7% to $49.5 million for the six months ended June 30, 2003from $53.7 million for the six months ended June 30, 2002 due primarily to theclosure of the New Morgan Academy in the fourth quarter of 2002 offset, inpart, by increased occupancy and service hours at various juvenilefacilities.  Operating expenses for theNew Morgan Academy were approximately $0.8 million in the six months ended June30, 2003 compared to $7.8 million in the six months ended June 30, 2002.  Excluding the New Morgan Academy’s operatingexpenses in both periods, juvenile division operating expenses increased 6.4%,or $2.9 million, due to increased staffing and other services due to increasedoccupancy and service hours at various facilities and programs including theAlexander Youth Center, Dauphin Mental Health, LDP and A-1.  As a percentage of segment revenues,operating expenses were 85.4% for the six months ended June 30, 2003 comparedto 84.4% for six months ended June 30, 2002. Excluding start-up operations in 2003 and the operations of the NewMorgan Academy in the six months ended June 30, 2003 and 2002, juveniledivision operating expenses, as a percentage of segment revenue, were 84.0% and84.4% respectively.

 

Pre-release divisionoperating expenses increased 2.6% to $19.2 million for the six months endedJune 30, 2003 from $18.7 million for the six months ended June 30, 2002 dueprimarily to a charge to bad debt expense of approximately $0.6 million in thesix months ended June 30, 2003 to provide an allowance for certain insuranceand medicaid receivable accounts. Excluding this 2003 charge, operating expenses decreased 0.6%, or$106,000.  As a percentage of segmentrevenues, excluding the 2003 charge, operating expenses were 74.4% for the sixmonths ended June 30, compared to 74.6% for the six months ended June 30, 2002.

 

*Pre-Opening and Start-up Expenses.* Pre-opening and start-up expenses for the six months ended June 30, 2003were approximately $393,000 and were attributable to the pre-opening andstart-up operations of the Bernalillo County Jail, the Texas Adolescent Centerand the Jos-Arz Residential Treatment Center. There were no pre-opening and start-up expenses for the six months endedJune 30, 2002.

 

*Depreciation and Amortization*. Depreciation and amortization was $5.2 million for the six months endedJune 30, 2003 compared to $4.6 million for the six months ended June 30,2002.  The increase in depreciation andamortization expense was due to depreciation and amortization related to currentyear property and equipment purchases. Amortization of intangibles was approximately $439,000 for the sixmonths ended June 30, 2003 and 2002.

 

*General and Administrative Expenses.* General and administrative expenses decreased 24.3% to $8.6 million forthe six months ended June 30, 2003 from $11.2 million for the six months endedJune 30, 2002.  Included in the generaland administrative expenses for the six months ended June 30, 2003 were costsof approximately $580,000 for site acquisition costs and legal expensesprimarily associated with the 

 

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Company’s increased development activity anda charge related to the deferred compensation plan.  General and administrative expenses for the six months ended June30, 2002 included approximately $1.9 million of legal and professional feesrelated to the special committee review and restatement of the Company’sfinancial statements and defense of our shareholder litigation.  Also included in general and administrativeexpenses for the six months ended June 30, 2002 was a charge of approximately$1.0 million related to the write-off of deferred project financing costsassociated with the BOP Southeast Project. This contract was not awarded to the Company and all associated costswere charged to expense.  Excluding theabove charges from the applicable 2003 and 2002 periods, general andadministrative expenses decreased 5.7% from the same period of the prior yeardue  primarily to cost managementstrategies implemented by management in late 2002.  The majority of these savings were realized from a reduction inpersonnel and related costs.  Managementexpects general and administrative expenses to increase over the remainingquarters of 2003 as certain open positions are filled and professional andother costs are incurred related to compliance with the Sarbanes-Oxley Act of2002.

 

*Interest.*  Interest expense, net ofinterest income, decreased to $9.0 million for the six months ended June 30,2003 from $9.9 million for the six months ended June 30, 2002.  For the six months ended June 30, 2002,interest expense includes approximately $825,000 for lenders’ fees and relatedprofessional fees incurred to obtain certain waivers and amendments to theCompany’s credit agreement obtained in conjunction with the restatement of theCompany’s financial statements. Capitalized interest for the six months ended June 30, 2003 and 2002 wasapproximately $384,000 and $410,000, respectively, and related to the MoshannonValley Correctional Center.

 

*Minority Interest in Losses of Consolidated Special PurposeEntities*.  Minority interest in consolidated specialpurpose entities represents third party equity contributed to the specialpurpose entities consolidated by the Company for financial reportingpurposes.  Minority interest is adjustedfor income and losses of the special purpose entities.  The cumulative losses of MCF exceeded therecorded minority interest of MCF during the first quarter of 2002.  The cumulative losses of the Synthetic LeaseInvestor exceeded the recorded minority interest of the Synthetic LeaseInvestor during the third quarter of 2001. Since the cumulative losses of MCF and the Synthetic Lease Investorexceed the equity which is recorded as minority interest by the Company, theexcess losses are being recorded in the Company’s Consolidated Statement ofOperations.

 

*Income Taxes.*  For the six months ended June30, 2003 and 2002, the Company recognized a provision for income taxes at anestimated effective rate of 41.0%.

 

*Cumulative Effect of Change in Accounting Principle.*  TheCompany recorded a cumulative effect of a change in accounting principle chargeof $965,000, net of tax, in the six months ended June 30, 2002 related to theimpairment of certain goodwill that arose from an acquisition made in November1999.

 

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**Liquidityand Capital Resources**

 

*General*.  The Company’s primary capitalrequirements have generally been and are expected to be for (1) construction ofnew facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operating contracts,(5) acquisitions, (6) information systems hardware and software, and(7) furniture, fixtures and equipment. Working capital requirements generally increase immediately prior to theCompany commencing management of a new facility as the Company incurs start-upcosts and purchases necessary equipment and supplies before facility managementrevenue is realized.

 

*Contractual Obligations and Commercial Commitments*.  TheCompany has assumed various financial obligations and commitments in theordinary course of conducting its business. The Company has contractual obligations requiring future cash paymentsunder its existing contractual arrangements, such as management, consultativeand non-competition agreements.

 

The Company maintainsoperating leases in the ordinary course of its business activities.  These leases include those for operatingfacilities, office space and office and operating equipment, and the terms ofthe agreements vary from 2003 until 2075. As of June 30, 2003, the Company’s total commitment under theseoperating leases was approximately $33.9 million.

 

The following table detailsthe Company’s known future cash payments (on an undiscounted basis) related tovarious contractual obligations as of June 30, 2003 (in thousands):

 
|                                        |   | **Payments Due by Period** |    |
|---------------------------------------------|--------|----------------------------|---------|
|                                        |   | **Total**                  |    | **2003** |   | **2004 -  2005** |   | **2006 -  2007** |   | **Thereafter** |   |
|                                        |   |                       |    |   |   |   |   |   |   |   |   |
| Contractual Obligations:                    |   |                       |    |   |   |   |   |   |   |   |   |
| Long-term debt                              |   |                       |    |   |   |   |   |   |   |   |   |
| - Special Purpose Entities                  |   | $                          | 240,492 |   | $ | 7,600 |   | $ | 17,941 |   | $ | 69,451 |   | $ | 145,500 |   |
| Capital lease obligations                   |   |                       |    |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.                   |   | 25                         |    | 25 |   | — |   | — |   | — |   |
|                                        |   |                       |    |   |   |   |   |   |   |   |   |
| Operating leases                            |   | 33,915                     |    | 3,304 |   | 6,930 |   | 4,706 |   | 18,975 |   |
| Consultative and non-competition agreements |   | 1,330                      |    | 410 |   | 720 |   | 200 |   | — |   |
| Total contractual cash obligations          |   | $                          | 275,762 |   | $ | 11,339 |   | $ | 25,591 |   | $ | 74,357 |   | $ | 164,475 |   |

 

The Company enters intoletters of credit in the ordinary course of its operating and financingactivities.  As of June 30, 2003, theCompany had outstanding letters of credit of $5.1 million related to insuranceand other operating activities.  Thefollowing table details the Company’s letter of credit commitments as of June30, 2003 (in thousands):

 
|                      |   | **Total  Amounts  Committed** |                  | **Amount of Commitment Expiration Per Period** |          |
|---------------------------|--------|-------------------------------|-----------------------|------------------------------------------------|---------------|
|                      |   |                          | **Less than  1 Year** |                                           | **1-3 Years** |   | **4-5 Years** |   | **Over  5 Years** |   |
|                      |   |                          |                  |                                           |          |   |   |   |   |   |   |
| Commercial Commitments:   |   |                          |                  |                                           |          |   |   |   |   |   |   |
| Standby letters of credit |   | $                             | 5,108                 |                                           | $             | 5,108 |   | $ | — |   | $ | — |   | $ | — |   |
|                           |        |                               |                       |                                                |               |  |  |  |  |  |  |  |  |  |  |  |

 

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*Long-Term Credit Facilities.*  TheCompany’s 2000 Credit Facility, as amended, provides for borrowings of up to$45.0 million under a revolving line of credit.  The commitment amount is reduced by $1.6 million quarterlybeginning in July 2002 and by outstanding letters of credit.  The Company had outstanding letters ofcredit of approximately $5.1 million at June 30, 2003.  Accordingly, as of June 30, 2003, theCompany had $33.5 million of available commitment under its revolving line ofcredit.  The amended 2000 CreditFacility matures in July 2005 and bears interest, at the election of theCompany, at either the prime rate plus a margin of 2.0%, or a rate which is3.0% above the applicable LIBOR rate. The amended 2000 Credit Facility is collateralized by substantially allof the Company’s assets, including the stock of all of the Company’ssubsidiaries; does not permit the payment of cash dividends; and requires theCompany to comply with certain leverage, net worth and debt service coveragecovenants.  Additionally, the Company islimited to $2.5 million annually for the repurchase of its common stock with anaggregate limit of $7.5 million.  Due tothe consolidation, for financial reporting purposes, of MCF as of August 14,2001, the Company was not in compliance with certain leverage ratiocovenants.  On April 5, 2002, the 2000Credit Facility was amended to waive such non-compliance and to revise thecovenants to levels that accommodate the Company’s consolidation of specialpurpose entities in its consolidated balance sheets, statements of operationsand cash flows.  As a result of thiswaiver and amendment, the Company recognized a pre-tax charge to interestexpense of approximately $825,000 during the first quarter of 2002 for lenderand other professional fees. Additionally, the Company has obtained a waiver from the lenders underthe amended 2000 Credit Facility regarding the pending contractual default forthe Moshannon Valley Correctional Center’s construction delay (see Note6).  This waiver is effective throughOctober 31, 2004.  Included in theCompany’s cash and cash equivalents at June 30, 2003 is approximately $39.6million that is invested in a separate account that is available to the Companyfor investment purposes or working capital with the approval of the lendersunder the amended 2000 Credit Facility. The lenders could limit the Company's ability to use such funds.  This separate account is maintained, inpart, to assure future credit availability.

 

Additionally, the amended2000 Credit Facility provides the Company with the ability to enter intosynthetic lease agreements for the acquisition or development of operatingfacilities.  This synthetic leasefinancing arrangement provides for funding to the lessor under the operatingleases of up to $100.0 million, of which approximately $51.7 million had beenutilized as of June 30, 2003.  TheCompany expects to utilize the remaining capacity under this synthetic leasefinancing arrangement for construction of the Moshannon Valley CorrectionalCenter.  The Synthetic Lease Investor’sNote A and Note B have total credit commitments of $81.4 million and $15.1million, respectively.  The Company payscommitment fees at a rate of 0.5% annually for the unused portion of thesynthetic lease financing capacity.  TheSynthetic Lease Investor’s Notes A and B are cross-collateralized with theCompany’s revolving line of credit and contain cross-default provisions.  Under the provisions of FIN 46, utilizationof this synthetic lease financing arrangement to complete the construction ofthe Moshannon Valley Correctional Center will also result in the consolidationof the facility and the related financing in the Company’s financialstatements.

 

*Cash Flows From Operating Activities.*  Cashflows provided by operations were approximately $8.8 million for the six monthsended June 30, 2003 compared to approximately $2.2 million for the six monthsended June 30, 2002.  The increase isprimarily attributable to increased earnings and working capital changes.

 

*Cash Flows From Investing Activities*. Cash used in investing activities was approximately $12.0 million forthe six months ended June 30, 2003 and included deposit payments to therestricted debt payment account, net of amounts withdrawn for debt servicepayments, and capital expenditures of approximately $6.4 million related to thepurchase and renovation of the Texas Adolescent Center, various facilityimprovements and/or expansions, information technology and software developmentcosts.  Additionally, the Company made adeposit of $1.0 million into an escrow account for a non-compete agreementrelated to the Jos-Arz Residential Treatment Center management contract.  Cash used in investing activities wasapproximately $9.2 million for the six months ended June 30, 2002 primarily dueto capital expenditures 

 

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of approximately $5.0 million and depositpayments to the restricted debt payment account, net of amounts withdrawn fordebt service payments.

 

*Cash Flows From Financing Activities*. Cash provided by financing activities was approximately $2.1 million forthe six months ended June 30, 2003 due primarily to proceeds from stock optionexercises of approximately $2.1 million and proceeds from borrowings on theCompany’s Synthetic Lease Facility of approximately $0.6 million offset, inpart, by purchases of approximately $0.6 million of treasury shares.  Cash provided by the financing activitiesfor the six months ended June 30, 2002 was approximately $0.5 million dueprimarily to proceeds from borrowings on the Company’s Synthetic Lease Facilityof approximately $0.5 million and proceeds from stock option exercises ofapproximately $0.5 million offset by cash used for treasury stock purchases of$0.4 million.  Annual MCF Bond principalpayments due August 1 will be reflected as an outflow from financing activitieswhen disbursed from the restricted debt payment account.

 

*Treasury Stock/Repurchases.*  Asof January 1, 2003, the Company could purchase approximately $2.1 million ofits common stock as permitted under the terms of the amended 2000 CreditFacility.  The Company purchased in theopen market 57,500 shares of its common stock for approximately $0.6 millionduring the six months ended June 30, 2003. Accordingly, the Company can purchase approximately $1.5 million ofshares during the remaining term of the 2000 Credit Facility.

 

*New Facilities and Project Under Development.*  InJanuary 2003, the Company executed a lease for the Bernalillo County Jail inAlbuquerque, New Mexico.  The facility,which has been vacated by the County in favor of a new jail, is expected to beremodeled by the Company and used to provide adult secure confinement for awide array of government agencies that have demonstrated a need for additionalbed space.  The facility addedapproximately 1,000 beds to the Company’s current service capacity.  The lease must be approved by the StateAttorney General and requires monthly rental payments of approximately $80,000to $100,000 over the five year lease term.

 

In May 2003, the Companyacquired a building in San Antonio, Texas for approximately $2.1 million incash.  The Company is currentlyrenovating this 121 bed residential juvenile facility called the TexasAdolescent Center and expects it to become operational in the fourth quarter of2003.

 

In June 2003, the Companyentered into an agreement with a developer to purchase a 160 bed residentialtreatment center for juveniles upon completion of construction of the facilityby the developer.  This facility isnamed the Southern Peaks Regional Treatment Center and is located near CanonCity, Colorado.  Under the developmentagreement, the Company is obligated to fund into an escrow account the purchaseprice of the real property of approximately $13.0 million by August 15, 2003.

 

In March 2003, the Companyreached an agreement with the Commonwealth of Pennsylvania that resolved all outstandingadministrative issues relative to the contract awarded to the Company by theBOP to operate the Moshannon Valley Correctional Center.  If the Company is able to negotiate anamendment to the contract with the BOP, this agreement will allow the Companyto move forward with the construction and operation of the facility, subject tore-approval of the project by the lenders under the Company’s amended 2000Credit Facility, and agreement by such lenders to amend certain financialcovenants and provisions of the 2000 Credit Facility.

 

As of June 30, 2003, theCompany had incurred approximately $16.8 million for construction and landdevelopment costs and capitalized interest related to the Moshannon ValleyCorrectional Center.  According to the BOPcontract, as amended, the Company is required to complete the construction ofthe project by October 15, 2003.  TheCompany does not anticipate completing construction by that date andanticipates obtaining another long-term contract amendment from the BOP extending

 

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the construction deadline.  In the event the Company is not able tonegotiate a contract amendment with the BOP, then the BOP may have the right toassert that the Company has not completed construction of the facility withinthe time frame provided in the BOP contract, as amended.  Management expects that the contract will beamended to address cost and construction timing matters resulting from theextended delay.  In the event that theBOP decides not to continue with the construction of the Moshannon ValleyCorrectional Center and terminates the contract, management believes that theCompany has the right to and will recover its invested costs.  In the event any portion of these costs aredetermined not to be recoverable upon contract termination by the BOP, suchcosts would be expensed.  Managementcurrently believes that the invested costs would be fully recoverable in theevent of this contract being terminated.

 

At June 30, 2003, accounts receivableinclude costs totaling $1.4 million for direct costs incurred by the Companysince the issuance of the Stop-Work Order in June 1999 for payroll and otheroperating costs related to the Moshannon Valley Correctional Center.  These costs were incurred with theunderstanding that such costs would be reimbursed.  Although no formal written agreement exists, management believesthat these costs will be reimbursed by the BOP in the near term.  In the event any portion of these costs arenot reimbursed, such costs will be expensed if they are determined not to bereimbursable.

 

*Future Liquidity*.  Management believes that theCompany’s cash and the cash flows generated from operations, together with thecredit available under the amended 2000 Credit Facility and the operating leasecapacity thereunder, will provide sufficient liquidity to meet the Company’scommitted capital and working capital requirements for currently awardedcontracts.  In order to finance the constructionof the Moshannon Valley Correctional Center, the lenders under the 2000 CreditFacility must re-approve the project and agree to amend certain financialcovenants and provisions of the 2000 Credit Facility.  To the extent the Company’s cash and current financingarrangements do not provide sufficient financing to fund construction costsrelated to future adult secure institutional contract awards or significantfacility expansions, the Company anticipates obtaining additional sources offinancing to fund such activities. However, there can be no assurance that such financing will be availableor will be available on terms favorable to the Company.

 

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

 

In the normal course ofbusiness, the Company is exposed to market risk, primarily from changes ininterest rates.  The Company continuallymonitors exposure to market risk and develops appropriate strategies to managethis risk.  The Company is not exposedto any other significant market risks, including commodity price risk, foreigncurrency exchange risk or interest rate risks from the use of derivativefinancial instruments.  Management doesnot use derivative financial instruments for trading or to speculate on changesin interest rates or commodity prices.

 

**InterestRate Exposure**

 

The Company’s exposure tochanges in interest rates primarily results from its long-term debt with bothfixed and floating interest rates.  Thedebt on the Company’s consolidated financial statements with fixed interestrates consists of the 8.47% Bonds issued by MCF in August 2001 in connectionwith the 2001 Sale and Leaseback Transaction. At June 30, 2003, approximately 21% ($49.9 million of debt outstandingto the Synthetic Lease Investor) of the Company’s consolidated long-term debtwas subject to variable interest rates. The detrimental effect of a hypothetical 100 basis point increase ininterest rates would be to reduce income before provision for income taxes byapproximately $125,000 and $250,000 for the three and six months ended June 30,2003.  At June 30, 2003, the fair valueof the Company’s consolidated fixed rate debt approximated carrying value basedupon discounted future cash flows using current market prices.

 

**ForwardLooking Statement Disclaimer**

 

This quarterly report onForm 10-Q contains forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. These statements are based on currentplans and actual future activities and results of operations may be materiallydifferent from those set forth in the forward-looking statements. Importantfactors that could cause actual results to differ include, among others, (1)the outcomes of pending putative class action shareholder and derivative lawsuits,and related insurance coverage, (2) risks associated with acquisitions and theintegration thereof (including the ability to achieve administrative andoperating cost savings and anticipated synergies), (3) the timing and costs ofthe opening of new programs and facilities or the expansions of existingfacilities, (4) changes in governmental policy and/or funding to discontinue ornot renew existing arrangements or to eliminate or discourage the privatizationof correctional, detention and pre-release services in the United States, (5)the availability of debt and equity financing on terms that are favorable tothe Company, (6) fluctuations in operating results because of occupancy,competition (including competition from two competitors that are substantiallylarger than the Company), increases in cost of operations, fluctuations ininterest rates and risks of operations, (7) significant charges to expense ofdeferred costs associated with financing and other projects in development ifmanagement determines that one or more of such projects is unlikely to besuccessfully concluded, (8) results from alternative deployment or sale offacilities such as the New Morgan Academy and (9) the Company’s ability tonegotiate a contract amendment with the BOP related to the Moshannon ValleyCorrectional Center.

 

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

 

Under the supervision andwith the participation of our management, including our principal executiveofficer and principal financial officer, we have evaluated the effectiveness ofthe design and operation of our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, asamended (the “Exchange Act”) and as required by paragraph (b) of Rules 13a-15and 15d-15(e) of the Exchange Act, as of the end of our second fiscal quarterof 2003.  Based on that evaluation, ourprincipal executive officer and principal financial officer have concluded thatthese controls and procedures are effective as of that date.

 

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Disclosure controls andprocedures are our controls and other procedures that are designed to ensurethat information required to be disclosed by us in the reports that we file orsubmit under the Exchange Act is recorded, processed, summarized and reported,within the time periods specified under the Exchange Act.  Disclosure controls and procedures include,without limitation, controls and procedures designed to ensure that informationrequired to be disclosed by us in the reports that we file under the ExchangeAct is accumulated and communicated to our management, including our principalexecutive officer and principal financial officer, as appropriate to allowtimely decisions regarding required disclosure.

 

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

 

**ITEM 1.****    ****Legal Proceedings**

 

In March and April 2002, theCompany, Steven W. Logan, and John L. Hendrix, were named as defendants in fourfederal putative class action lawsuits styled as follows: (1) *Graydon Williams, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc, et al.*, No. H-02-0866,in the United States District Court for the Southern District of Texas, HoustonDivision; (2) *Richard Picard, On Behalf ofHimself and All Others Similarly Situated v. Cornell Companies, Inc., et al.*,No. H-02-1075, in the United States District Court for the Southern District ofTexas, Houston Division; (3) *Louis A. Daly,On Behalf of Himself and All Others Similarly Situated v. Cornell Companies,Inc., et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1567, in the United States District Court for the Southern District ofTexas, Houston Division.  Theaforementioned lawsuits are putative class action lawsuits brought on behalf ofall purchasers of the Company’s common stock between March 6, 2001 and March 5,2002.  The lawsuits involve disclosuresmade concerning two prior transactions executed by the Company: the August 2001sale leaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits have all beenconsolidated into the *Graydon Williams*action.  Flyline Partners, LP has beenappointed as the lead plaintiff and has filed a consolidated complaint.  The consolidated complaint alleges that thedefendants violated Section 10(b) of the Securities Exchange Act of 1934 (the“Exchange Act”), Rule 10b-5 promulgated under Section 10(b) of the ExchangeAct, Section 20(a) of the Exchange Act and Section 11 of the Securities Act of1933.  The consolidated complaint seeks,among other things, restitution damages, compensatory damages, rescission or arescissory measure of damages, costs, expenses, attorneys’ fees and expertfees.  A motion to dismiss is currentlypending.  The Company believes that ithas good defenses to each of the plaintiffs’ claims and intends to vigorouslydefend against each of these claims.

 

In March 2002, the Company,its directors, and its former independent auditor Arthur Andersen LLP, weresued in a derivative action styled as *WilliamWilliams, Derivatively and on Behalf of Nominal Defendant Cornell Companies,Inc. v. Anthony R. Chase, et al.*, No. 2002-15614, in the 127thJudicial District Court of Harris County, Texas.  The lawsuit alleges breaches of fiduciary duty by all of theindividual defendants and asserts breach of contract and professionalnegligence claims only against Arthur Andersen LLP.  The Company believes that it has good defenses to each of theplaintiff’s claims and intends to vigorously defend against each of theseclaims.

 

In May and June 2002, theCompany and its directors were sued in three other derivative lawsuits styledas follows: (1) *Juan Guitierrez,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the Southern District ofTexas, Houston Division; (2) *Thomas Pagano,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.*,No. H-02-1896, in the United Stated District Court for the Southern District ofTexas, Houston Division; and (3) *JesseMenning, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan,et. al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits all allege breaches of fiduciary duty and waste of corporate assets byall of the defendants.  A motion todismiss the *Guitierrez* and *Pagano* lawsuits was filed.  The court dismissed the *Pagano* action as duplicative of the *Guitierrez* action.  The motion to dismiss the *Guitierrez* action is still pending.  A motion to dismiss the *Menning* action is also pending.  The Company believes that it has gooddefenses to each of the plaintiffs’ claims and intend to vigorously defendagainst each of these claims.

 

While the plaintiffs inthese cases have not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty, based on information knownto date, management believes that the ultimate resolution of these matters willnot have a material adverse effect on the Company’s financial position,operating results or cash flow.

 

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The Company currently andfrom time to time is subject to claims and suits arising in the ordinary courseof business, including claims for damages for personal injuries or for wrongfulrestriction of, or interference with, offender privileges and employmentmatters.  The outcome of such matterscannot be predicated with certainty, based on the information known to date,management believes that the ultimate resolution of these matters will not havea material adverse effect on the Company’s financial position, operatingresults or cash flow.

 

**ITEM 4.   Submission of Matters to aVote of Security Holders**

 

On June 12, 2003, theCompany held its 2003 Annual Meeting of Stockholders.  The matters voted on at the meeting and the results thereof areas follows:

 

Stockholders elected thepersons listed below as directors whose terms expire at the 2004 Annual Meetingof Stockholders.  Results by nomineewere:

 
|                   |   | **Voted For** |   | **Authority  Withheld** |   |
|------------------------|--------|---------------|--------|-------------------------|--------|
|                   |   |          |   |                    |   |
| Anthony R. Chase       |   | 11,871,347    |   | 54,443                  |   |
| Arlene R. Lissner      |   | 11,730,759    |   | 195,031                 |   |
| Harry J. Phillips, Jr. |   | 11,730,759    |   | 195,031                 |   |
| D. Stephen Slack       |   | 11,870,568    |   | 55,222                  |   |
| Tucker Taylor          |   | 11,731,217    |   | 194,573                 |   |
| Marcus A. Watts        |   | 10,878,393    |   | 1,047,397               |   |

 

Stockholders ratified theappointment of Pricewaterhouse Coopers LLP as the Company’s independent publicaccountants for the fiscal year ending December 31, 2003, with 11,825,988shares voted for, 99,004 shares voted against and 798 abstained.

 

**ITEM 6.   Exhibitsand Reports on Form 8-K**

 
| a.     | Exhibits                                                                                                                                                                    |
|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                        |
|   | 11.1                                                                                                                                                                        | Computation of Per Share  Earnings |
|   | 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 |
|   |                                                                                                                                                                        |
| b.     | Reports on Form 8-K                                                                                                                                                         |
|   |                                                                                                                                                                        |
|   | The Company filed a  Current Report on Form 8-K dated May 7, 2003 reporting a press release  announcing its financial results for the first quarter ended March 31, 2003.   |
|   |                                                                                                                                                                        |
|   | The Company filed a  Current Report on From 8-K dated July 31, 2003 reporting a press release  announcing its financial results for the second quarter ended June 30, 2003. |

 

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

 
|                                    |   | **CORNELL  COMPANIES, INC.**                                                            |
|-----------------------------------------|--------|-----------------------------------------------------------------------------------------|
|                                    |   |                                                                                    |
|                                    |   |                                                                                    |
| Date:   August  14, 2003 | By:    | /s/ Harry J. Phillips, Jr.                                                              |
|                                    |   | HARRY J. PHILLIPS, JR.                                                                  |
|                                    |   | Executive Chairman,  Chairman of the  Board and Director  (Principal Executive Officer) |
|                                    |   |                                                                                    |
|                                    |   |                                                                                    |
| Date:   August  14, 2003 | By:    | /s/ John L. Hendrix                                                                     |
|                                    |   | JOHN L. HENDRIX                                                                         |
|                                    |   | Executive Vice President  and  Chief Financial Officer  (Principal Financial Officer)   |

 

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