** **

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION****Washington,DC 20549**

**FORM 10-Q**
| **x**                                             | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)  OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|---------------------------------------------------|------------|-----------------------------------------------------------------------------------------------|
| ** **                                        | ** ** | ** **                                                                                    |
| **For the  Quarterly Period Ended June 30, 2006** |
|                                              |       |                                                                                          |
| **OR**                                            |
|                                              |       |                                                                                          |
| **o**                                             | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |

 

**For thetransition period from               to             **

**CommissionFile Number 1-14472**

**CORNELL COMPANIES, INC.**(Exact Name of Registrant as Specified in Its Charter)

| **Delaware**                                          |   | **76-0433642**       |
|-------------------------------------------------------|--------|----------------------|
| (State or Other  Jurisdiction                         |   | (I.R.S. Employer     |
| of Incorporation  or Organization)                    |   | Identification  No.) |
|                                                  |   |                 |
| **1700  West Loop South, Suite 1500, Houston, Texas** |   | **77027**            |
| (Address of  Principal Executive Offices)             |   | (Zip Code)           |

 

Registrant’s Telephone Number, Including AreaCode:  **(713)623-0790**

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

Yes  x  No o

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

 

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

Yes  o No x

At July 31, 2006, the registrant had 14,028,558shares of common stock outstanding.

 

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**Cornell Companies, Inc.**

**Table of Contents**

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

 

2

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**PART I      FINANCIALINFORMATION**

**ITEM 1.      Financial Statements.**

**CORNELLCOMPANIES, INC.CONSOLIDATED BALANCE SHEETS(Unaudited)(in thousands, except share data)**
| ** **                                                                                                                                                     | ** ** | **June 30,  2006** | ** ** | **December 31,  2005** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                                                     | ** ** | ** **              | ** ** | ** **                  | ** ** |
| **CURRENT ASSETS:**                                                                                                                                            | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Cash and cash  equivalents                                                                                                                                     |       | $                       | 9,222      |                        | $          | 13,723 |   |
| Investment  securities available for sale                                                                                                                      |       | 8,975                   |       | 7,250                       |       |
| Accounts  receivable – trade (net of allowance for doubtful accounts of $3,383 and  $3,278, respectively)                                                 |       | 64,983                  |       | 58,701                      |       |
| Other  receivables (net of allowance for doubtful accounts of $5,040)                                                                                          |       | 1,520                   |       | 9,726                       |       |
| Debt service  fund and other restricted assets                                                                                                                 |       | 27,906                  |       | 22,219                      |       |
| Deferred tax  assets                                                                                                                                           |       | 5,089                   |       | 5,089                       |       |
| Prepaid expenses  and other                                                                                                                                    |       | 7,556                   |       | 9,076                       |       |
| **Total  current assets**                                                                                                                                      |       | 125,251                 |       | 125,784                     |       |
| **PROPERTY AND EQUIPMENT, net**                                                                                                                                |       | 326,170                 |       | 323,861                     |       |
| **OTHER ASSETS:**                                                                                                                                              |       |                    |       |                        |       |
| Debt service  reserve fund                                                                                                                                     |       | 23,800                  |       | 23,802                      |       |
| Goodwill                                                                                                                                                       |       | 12,655                  |       | 12,577                      |       |
| Intangible  assets, net                                                                                                                                        |       | 8,027                   |       | 9,089                       |       |
| Deferred costs  and other                                                                                                                                      |       | 18,384                  |       | 15,515                      |       |
| **Total  assets**                                                                                                                                              |       | $                       | 514,287    |                        | $          | 510,628 |   |
|                                                                                                                                                           |       |                    |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                 | ** ** | ** **              | ** ** | ** **                  | ** ** |
|                                                                                                                                                           |       |                    |       |                        |       |
| **CURRENT LIABILITIES:**                                                                                                                                       | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Accounts payable  and accrued liabilities                                                                                                                      |       | $                       | 51,699     |                        | $          | 58,797 |   |
| Current portion  of long-term debt                                                                                                                             |       | 9,710                   |       | 9,701                       |       |
| **Total  current liabilities**                                                                                                                                 |       | 61,409                  |       | 68,498                      |       |
| **LONG-TERM DEBT, net of current  portion**                                                                                                                    |       | 263,852                 |       | 266,659                     |       |
| **DEFERRED TAX LIABILITIES**                                                                                                                                   |       | 9,049                   |       | 6,708                       |       |
| **OTHER LONG-TERM LIABILITIES**                                                                                                                                |       | 7,566                   |       | 3,302                       |       |
| **Total  liabilities**                                                                                                                                         |       | 341,876                 |       | 345,167                     |       |
|                                                                                                                                                           |       |                    |       |                        |       |
| **COMMITMENTS AND CONTINGENCIES**                                                                                                                              | ** ** | ** **              | ** ** | ** **                  | ** ** |
|                                                                                                                                                           |       |                    |       |                        |       |
| **STOCKHOLDERS’ EQUITY:**                                                                                                                                 | ** ** | ** **              | ** ** | ** **                  | ** ** |
| Preferred stock,  $.001 par value, 10,000,000 shares authorized, none issued                                                                                   |       | 3⁄4                  |       | —                      |       |
| Common stock,  $.001 par value, 30,000,000 shares authorized, 15,559,020 and 15,352,159  shares issued and 14,018,626 and 13,789,172 outstanding, respectively |       | 16                      |       | 15                          |       |
| Additional  paid-in capital                                                                                                                                    |       | 153,226                 |       | 150,339                     |       |
| Retained  earnings                                                                                                                                             |       | 31,659                  |       | 27,091                      |       |
| Treasury stock  (1,540,394 and 1,562,987 shares of common stock, at cost, respectively)                                                                        |       | (12,308                 | )          | (12,573                     | )          |
| Accumulated  other comprehensive income (loss)                                                                                                                 |       | (182                    | )          | 589                         |       |
| **Total  stockholders’ equity**                                                                                                                           |       | 172,411                 |       | 165,461                     |       |
| **Total liabilities and  stockholders’ equity**                                                                                                           |       | $                       | 514,287    |                        | $          | 510,628 |   |

 

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

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**CORNELL COMPANIES, INC.CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)(Unaudited)(in thousands, except per share data)**
| ** **                                                                                                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                                                                                               | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| REVENUES                                                                                                                                 |       | $                                | 90,497     |                           | $          | 78,502 |   | $ | 174,345 |   | $ | 152,142 |   |
| OPERATING EXPENSES                                                                                                                       |       | 67,135                           |       | 59,508                         |       | 132,278 |   | 114,039 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                                        |       | 3⁄4                           |       | 2,152                          |       | 2,657 |   | 6,846 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                            |       | 4,213                            |       | 3,816                          |       | 7,939 |   | 7,545 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                                      |       | 5,438                            |       | 4,899                          |       | 10,550 |   | 11,237 |   |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                                   |       | 13,711                           |       | 8,127                          |       | 20,921 |   | 12,475 |   |
| INTEREST EXPENSE                                                                                                                         |       | 7,220                            |       | 6,244                          |       | 12,785 |   | 12,584 |   |
| INTEREST INCOME                                                                                                                          |       | (625                             | )          | (664                           | )          | (1,148 | ) | (1,260 | ) |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM CONTINUING OPERATIONS BEFORE PROVISION FOR INCOME  TAXES                                                                     |       | 7,116                            |       | 2,547                          |       | 9,284 |   | 1,151 |   |
| PROVISION FOR INCOME TAXES                                                                                                               |       | 3,053                            |       | 1,176                          |       | 4,009 |   | 620 |   |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| INCOME FROM CONTINUING OPERATIONS                                                                                                        |       | 4,063                            |       | 1,371                          |       | 5,275 |   | 531 |   |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX BENEFIT OF $98 AND $381 IN  2006 AND $904 AND $1,677 IN 2005                                         |       | (182                             | )          | (1,682                         | )          | (707 | ) | (3,115 | ) |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| NET INCOME (LOSS)                                                                                                                        |       | $                                | 3,881      |                           | $          | (311 | ) | $ | 4,568 |   | $ | (2,584 | ) |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| BASIC                                                                                                                                    |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                                                                                                       |       | $                                | .29        |                           | $          | .10 |   | $ | .38 |   | $ | .04 |   |
| Loss from  discontinued operations, net of tax                                                                                           |       | (.01                             | )          | (.12                           | )          | (.05 | ) | (.23 | ) |
| Net income  (loss)                                                                                                                       |       | $                                | .28        |                           | $          | (.02 | ) | $ | .33 |   | $ | (.19 | ) |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| DILUTED                                                                                                                                  |       |                             |       |                           |       |   |   |   |   |
| Income from  continuing operations                                                                                                       |       | $                                | .29        |                           | $          | .10 |   | $ | .38 |   | $ | .04 |   |
| Loss from  discontinued operations, net of tax                                                                                           |       | (.01                             | )          | (.12                           | )          | (.05 | ) | (.23 | ) |
| Net income  (loss)                                                                                                                       |       | $                                | .28        |                           | $          | (.02 | ) | $ | .33 |   | $ | (.19 | ) |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| NUMBER OF SHARES USED IN PER SHARE COMPUTATION:                                                                                          |       |                             |       |                           |       |   |   |   |   |
| BASIC                                                                                                                                    |       | 13,906                           |       | 13,474                         |       | 13,865 |   | 13,451 |   |
| DILUTED                                                                                                                                  |       | 14,034                           |       | 13,600                         |       | 14,000 |   | 13,686 |   |
|                                                                                                                                     |       |                             |       |                           |       |   |   |   |   |
| COMPREHENSIVE INCOME (LOSS):                                                                                                             |       |                             |       |                           |       |   |   |   |   |
| Net income (loss)                                                                                                                        |       | $                                | 3,881      |                           | $          | (311 | ) | $ | 4,568 |   | $ | (2,584 | ) |
| Unrealized gain  (loss) on derivative instruments, net of tax (benefit) provision of ($327)  and ($536) in 2006 and $239 and $53 in 2005 |       | (470                             | )          | 344                            |       | (771 | ) | 77 |   |
| Comprehensive income (loss)                                                                                                              |       | $                                | 3,411      |                           | $          | 33 |   | $ | 3,797 |   | $ | (2,507 | ) |

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

4

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**CORNELL COMPANIES, INC.****CONSOLIDATED STATEMENTS OF CASH FLOWS****(Unaudited)(in thousands)**
| ** **                                                                        | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                        | ** ** | **June 30,**              | ** ** |
| ** **                                                                        | ** ** | **2006**                       | ** ** | **2005** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                             |       |                           |       |   |   |
| Net income  (loss)                                                                |       | $                              | 4,568      |   | $ | (2,584 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities - |       |                           |       |   |   |
| Depreciation                                                                      |       | 6,818                          |       | 6,722 |   |
| Amortization of  intangibles and other assets                                     |       | 1,208                          |       | 973 |   |
| Amortization of  deferred compensation                                            |       | (21                            | )          | (401 | ) |
| Amortization of  deferred financing costs                                         |       | 799                            |       | 886 |   |
| Amortization of  Senior Notes discount                                            |       | 92                             |       | 92 |   |
| Stock-based  compensation                                                         |       | 1,156                          |       | — |   |
| Provision for  bad debts                                                          |       | 1,005                          |       | 1,958 |   |
| Loss (gain) on  sale of property and equipment                                    |       | 2                              |       | (7 | ) |
| Deferred income  taxes                                                            |       | 2,877                          |       | (2,955 | ) |
| Change in  assets and liabilities, net of effects of acquisitions:                |       |                           |       |   |   |
| Accounts  receivable                                                              |       | (8,360                         | )          | 8,205 |   |
| Other restricted  assets                                                          |       | 609                            |       | 119 |   |
| Other assets                                                                      |       | 1,932                          |       | 2,812 |   |
| Accounts  payable and accrued liabilities                                         |       | (1,857                         | )          | 4,817 |   |
| Other long-term  liabilities                                                      |       | 16                             |       | (109 | ) |
| Net cash  provided by operating activities                                        |       | 10,844                         |       | 20,528 |   |
|                                                                              |       |                           |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                             |       |                           |       |   |   |
| Capital  expenditures                                                             |       | (9,073                         | )          | (14,552 | ) |
| Purchases of  investment securities                                               |       | (185,050                       | )          | (665,845 | ) |
| Sales of  investment securities                                                   |       | 183,325                        |       | 678,135 |   |
| Acquisition of  a business                                                        |       | —                         |       | (9,064 | ) |
| Payments to restricted  debt payment account, net                                 |       | (6,294                         | )          | (5,795 | ) |
| Net cash used  in investing activities                                            |       | (17,092                        | )          | (17,121 | ) |
|                                                                              |       |                           |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                             |       |                           |       |   |   |
| Payments on  acquired debt                                                        |       | —                         |       | (1,905 | ) |
| Tax benefit of  stock option exercises                                            |       | 198                            |       | — |   |
| Payments on  capital lease obligations                                            |       | (5                             | )          | (170 | ) |
| Proceeds from  exercise of stock options                                          |       | 1,554                          |       | 1,720 |   |
| Net cash  provided by (used in) financing activities                              |       | 1,747                          |       | (355 | ) |
|                                                                              |       |                           |       |   |   |
| NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                              |       | (4,501                         | )          | 3,052 |   |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD                                  |       | 13,723                         |       | 9,895 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                        |       | $                              | 9,222      |   | $ | 12,947 |   |
|                                                                              |       |                           |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:                                |       |                           |       |   |   |
| Decrease in  fair value of interest rate swap                                     |       | $                              | 2,941      |   | $ | 38 |   |
| Other  comprehensive income (loss), net of tax                                    |       | (771                           | )          | 77 |   |
| Common stock  issued for board of directors fees                                  |       | 266                            |       | 111 |   |
| Borrowings under capital leases                                                   |       | 56                             |       | — |   |

 

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

5

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

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

The accompanying unaudited consolidatedfinancial statements have been prepared by Cornell Companies, Inc. (the “Company”)pursuant to the rules and regulations of the Securities and ExchangeCommission.  Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles in the United States (“GAAP”)have been condensed or omitted pursuant to such rules and regulations.  In the opinion of management, adjustments anddisclosures necessary for a fair presentation of these financial statementshave been included.  Estimates were usedin the preparation of these financial statements.  Actual results could differ from those estimates.  These financial statements should be read inconjunction with the financial statements and notes thereto included in theCompany’s 2005 Annual Report on Form 10-K as filed with the Securities andExchange Commission.

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

See a description of ouraccounting policies in our 2005 Annual Report on Form 10-K.

### ***Accounting For Stock-Based Compensation***

Our stock incentive plans provide for thegranting of incentive options and nonqualified options to officers, directorsand key employees of the Company. Grants under these plans vest over periods upto seven years after the date of grant and expire no more than 10 years aftergrant.

Prior to January 1, 2006, we accounted for ourstock option and stock-based compensation plans using the intrinsic-valuemethod outlined by Accounting Principles Board (“APB”) Opinion No. 25.Accordingly, we computed compensation cost for each employee stock optiongranted as the amount by which the quoted market price of our shares on thedate of grant exceeded the amount the employee must pay to acquire the shares.The amount of compensation cost, if any, would be charged to income over thevesting period. No compensation cost had been recognized for the optionsgranted, as the grant price was equal to the market price.

Effective January 1, 2006, we adopted theprovisions of the Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standard (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method. Under this method,compensation cost recognized for the three and six months ended June 30, 2006,includes the applicable amounts of: (a) compensation cost of all stock-basedawards granted prior to, but not yet vested, as of January 1, 2006 (based onthe grant-date fair value estimated in accordance with the original provisionsof SFAS No. 123 and previously presented in pro forma footnote disclosures),and (b) compensation cost for all stock-based awards granted subsequent toJanuary 1, 2006 (based on the grant-date fair value estimated in accordancewith the provisions of SFAS No. 123(R)). Results for prior periods have notbeen restated.

Additionally,we have an employee stock purchase plan (“ESPP”) underwhich employees can make contributions to purchase our common stock.Participation in the plan is elected annually by employees. The plan yearbegins each January 1st (the “Grant Date”) and ends on December 31st (the “ExerciseDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Grant Date or Exercise Date, lessa 15% discount. Prior to January 1, 2006, we were not required torecognize any compensation cost related to our employee-stock purchase Plan.Under SFAS No. 123R our employee-stock purchase plan is considered to be acompensatory ESPP and; therefore, we are required to recognize compensationcost over the requisite service period for grants made under the ESPP.

SFAS No.123R amends SFAS No. 95, “Statement of Cash Flows,” to require reporting of taxbenefits as a financing cash flow, rather than as a reduction of taxes paid.These tax benefits result from tax deductions in excess of the compensationexpense recognized for options exercised. Prior to the adoption of SFAS No.123R, we presented all tax benefits resulting from the exercise of stockoptions as operating cash flows in our consolidated statement of cash flows.

On March29, 2005, the SEC issued Staff Accounting Bulletin (“SAB”) 107 to addresscertain issues related to SFAS No. 123R. SAB 107 provides guidance ontransition methods, valuation methods, income tax effects and other share-basedpayment topics, and we had also applied this guidance in our adoption of SFASNo. 123R.

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On November10, 2005, the Financial Accounting Standards Board (the “FASB”) issued FASBStaff Position (“FSP”) No. FAS 123(R)-3, “Transition Election Related toAccounting for Tax Effects of Share-Based Payment Awards” (“FSP 123R-3”). FSP123R-3 provides for an alternative transition method for establishing thebeginning balance of the additional paid-in capital pool (“APIC pool”) relatedto the tax effects of employee share-based compensation, which is available toabsorb tax deficiencies recognized subsequent to the adoption of SFAS No. 123R.We have elected to adopt this alternative transition method, otherwise known asthe “simplified method,” in establishing our beginning APIC pool at January 1,2006.

*Effect of Adopting SFAS No. 123(R)*

The following is the effect of adopting**SFAS No. 123(R)  asof January 1, 2006 (in thousands, except per share amounts):
|                                                           | ** ** | **Three Months  Ended June 30,  2006** | ** ** | **Six Months  Ended June 30,  2006** | ** ** |
|-----------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Stock-based  compensation expense – stock options    |       | $                                                     | 425        |                                                | $          | 999 |   |
| Stock-based  compensation expense – restricted stock |       | 54                                                    |       | 109                                                 |       |
| Employee-stock  purchase plan                             |       | 24                                                    |       | 48                                                  |       |
| Related deferred  income tax benefit                      |       | 206                                                   |       | 477                                                 |       |
|                                                      |       |                                                  |       |                                                |       |
| Decrease in basic earnings per share                      |       | $                                                     | 0.02       |                                                | $          | 0.05 |   |
|                                                      |       |                                                  |       |                                                |       |
| Decrease in  diluted earnings per share                   |       | $                                                     | 0.02       |                                                | $          | 0.05 |   |

 

At June 30, 2006, 60,000 restricted shares ofour common stock were outstanding subject to performance-based vesting criteria(30,000 of these are considered market-based restricted stock under SFAS No,123 (R)). Additionally, 152,200 stock options were outstanding subject toperformance-based vesting criteria (19,600 of these are considered market-basedoptions under SFAS No, 123 (R)).

The 30,000 shares of restricted stock and the19,600 stock options which are considered market-based restricted stock werevalued using a Monte Carlo simulation probability model to estimated futurestock returns. The grant date fair value of these shares was $9.05 per sharefor a total value of $0.5 million. We recognized $0.04 million and $0.08million of expense associated with these options during the three and sixmonths ended June 30, 2006, respectively.

The amountsabove relate to the impact of recognizing compensation expense related to stockoptions, restricted stock and our employee-stock purchase plan. Compensationexpense related to stock options (132,600 shares) and restricted stock grants(30,000 shares) that vest based upon performance conditions are not includedabove. No compensation expense has been recorded for our performance-basedawards because it has not been deemed probable that the related performancetargets will be met that would allow such options time to vest. We are requiredto periodically re-assess the probability and record expense at the point intime, if ever, it becomes probable these options will vest.

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

7

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*Prior Period Pro Forma Presentation*

Under the modified prospective applicationmethod, results for prior periods have not been restated to reflect the effectsof implementing SFAS No, 123 (R). The following pro forma information, asrequired by SFAS No. 148, “Accounting for Stock-Based Compensation Transitionand Disclosure, an Amendment of FASB Statement No. 123” is presented forcomparative purposes and illustrates the pro forma effect on net income andearnings per ordinary share for the period presented as if we had applied the fairvalue recognition provisions of SFAS No. 123 to stock-based employeecompensation prior to January 1, 2006 (in thousands, except per-share amounts):

|                                                                                                                                             | ** ** | **Three Months  Ended June 30,  2005** | ** ** | **Six Months  Ended June 30,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|-----------------------------------------------------|------------|
| Net loss, as  reported                                                                                                                      |       | $                                                     | (311       | )                                                   | $          | (2,584 | ) |
| Add: total  stock-based compensation recorded, net of tax                                                                                   |       | 31                                                    |       | 65                                                  |       |
| Less: total  stock-based employee compensation expense determined under fair value based  method for all awards, net of related tax effects |       | 427                                                   |       | 832                                                 |       |
| Pro forma net  loss                                                                                                                         |       | $                                                     | (707       | )                                                   | $          | (3,351 | ) |
|                                                                                                                                        |       |                                                  |       |                                                |       |
| Income per  share:                                                                                                                          |       |                                                  |       |                                                |       |
| Basic, as reported                                                                                                                          |       | $                                                     | (.02       | )                                                   | $          | (.19 | ) |
| Basic, pro forma                                                                                                                            |       | (.05                                                  | )          | (.25                                                | )          |
| Diluted, as reported                                                                                                                        |       | (.02                                                  | )          | (.19                                                | )          |
| Diluted, pro  forma                                                                                                                         |       | (.05                                                  | )          | (.25                                                | )          |

 

*Assumptions*

The fair values for the significant stock-based awardsgranted during the six months ended June 30, 2006 and 2005 were estimated atthe date of grant using a Black-Scholes option pricing model with the followingweighted-average assumptions:
|                                   | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------|------------|-----------------------------------------------|------------|
| ** **                        | ** ** | **2006**                                      | ** ** | **2005** | ** ** |
| Risk-free rate  of return         |       | 4.31                                          | %          | 4.37 | % |
| Expected life of  award           |       | 5 years                                       |       | 7 years |   |
| Expected  dividend yield of stock |       | 0                                             | %          | 0 | % |
| Expected  volatility of stock     |       | 45.48                                         | %          | 53.55 | % |
| Weighted-average fair  value      |       | $                                             | 6.24       |   | $ | 8.00 |   |
|                                   |            |                                               |            |  |  |  |  |

 

The expected volatility of stock assumption wasderived by referring to changes in the Company’s historical common stock pricesover a timeframe similar to that of the expected life of the award. Wecurrently have no reason to believe that future stock volatility willsignificantly differ from historical stock volatility. Estimated forfeiturerates are derived from historical forfeiture patterns. We believe the historicalexperience method is the best estimate of forfeitures currently available.

In accordance with SAB 107, we used the “simplified”method for “plain vanilla” options to estimate the expected term of optionsgranted during 2006.

8

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Stock-based award activity during the six months endedJune 30, 2006 was as follows (aggregate intrinsic value in millions):
|                                 | ** ** | **Number  of  Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Weighted  Average  Remaining  Contractual  Term** | ** ** | **Aggregate  Intrinsic  Value** | ** ** |
|---------------------------------|------------|------------------------|------------|----------------------------------------|------------|-----------------------------------------------------|------------|---------------------------------|------------|
| Outstanding at  January 1, 2006 |       | 697,706                |       | $                                      | 12.21      |                                                | 7.2        |                            | $          | 8.5 |   |
| Granted                         |       | 45,000                 |       | 13.71                                  |       | 10.0                                                |       |                            |       |
| Exercised                       |       | (128,461               | )          | 9.97                                   |       |                                                |       |                            |       |
| Canceled                        |       | (53,760                | )          | 13.18                                  |       |                                                |       |                            |       |
|                            |       |                   |       |                                   |       |                                                |       |                            |       |
| Outstanding at  June 30, 2006   |       | 560,485                |       | $                                      | 12.75      |                                                | 7.53       |                            | $          | 7.1 |   |
|                            |       |                   |       |                                   |       |                                                |       |                            |       |
| Exercisable at June 30,  2006   |       | 315,631                |       | $                                      | 12.34      |                                                | 6.65       |                            | $          | 3.9 |   |

 

The total intrinsic value of stock options exercisedduring the six months ended June 30, 2006 and 2005 were $0.6 million and $0.9million, respectively. Net cash proceeds from the exercise of stock optionswere approximately $1.6 million and $1.7 million for the six months ended June30, 2006 and 2005, respectively.

As of June 30, 2006, approximately $1.4 million ofestimated expense with respect to nonvested stock-based awards has yet to berecognized and will be amortized into expense over the employee’s remaining weightedaverage service period of approximately 8.67 years.

The following table summarizes information withrespect to stock options outstanding and exercisable at June 30, 2006.
| Range of Exercise Prices         | ** ** | **Number  Outstanding** | ** ** | **Weighted  Average  Remaining  Life (Years)** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|-----------------------------------------------------|------------|----------------------------------------|------------|-------------------------|------------|----------------------------------------|------------|
| $3.75  to  $6.50            |       | 25,180                  |       | 4.5                                                 |       | $                                      | 4.11       |                    | 25,180     |                                   | $          | 4.11 |   |
|   6.51  to  10.00 |       | 37,755                  |       | 6.5                                                 |       | 8.40                                   |       | 35,889                  |       | 8.40                                   |       |
| 10.01  to  13.50            |       | 214,450                 |       | 7.8                                                 |       | 12.56                                  |       | 92,712                  |       | 12.26                                  |       |
| 13.51  to  16.00            |       | 283,100                 |       | 7.8                                                 |       | 14.25                                  |       | 161,850                 |       | 14.54                                  |       |
|                                            |       | 560,485                 |       | 7.5                                                 |       | 12.75                                  |       | 315,631                 |       | 12.34                                  |       |
|                                                 |            |                         |            |                                                     |            |                                        |            |                         |            |                                        |            |  |  |

 

Stock-basedaward activity for nonvested awards during the six months ended June 30,2006 is as follows:

|                               | ** ** | **Number  of  Shares** | ** ** | **Weighted Average  Grant Date  Fair Value** | ** ** |
|-------------------------------|------------|------------------------|------------|-------------------------------------------------------------|------------|
| Nonvested at  January 1, 2006 |       | 323,469                |       | $                                                           | 13.17      |   |
| Granted                       |       | 45,000                 |       | 13.71                                                       |       |
| Vested                        |       | (117,035               | )          | 13.08                                                       |       |
| Canceled                      |       | (6,580                 | )          | 13.24                                                       |       |
|                          |       |                   |       |                                                        |       |
| Nonvested at June 30,  2006   |       | 244,854                |       | $                                                           | 13.29      |   |

 

*Restricted Stock*

We have issued restricted stock under certainemployment agreements and a deferred bonus plan which vests over a specifiedperiod of time, generally three to five years. These shares of restrictedcommon stock are subject to restrictions on transfer and certain conditions tovesting.

Restricted stock activity for the six months endedJune 30, 2006 is as follows:

|                                   | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------|------------|------------------------|------------|----------------------------------------------------------|------------|
| Nonvested at January 1, 2006 |       | 51,673                 |       | $                                                        | 16.23      |   |
| Granted                           |       | —                 |       |                                                     |       |
| Vested                            |       | —                 |       |                                                     |       |
| Canceled                          |       | (9,308                 | )          | 17.15                                                    |       |
|                              |       |                   |       |                                                     |       |
| Nonvested at  June 30, 2006  |       | 42,365                 |       | $                                                        | 16.02      |   |

 

As of June 30, 2006, approximately $0.2 millionof estimated expense with respect to nonvested restricted stock awards has yetto be recognized and will be amortized over a weighted average period of 1.5years.

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*** ***

***Financial Accounting Standards Board Interpretation No. 48***

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes” (“FIN 48”),to clarify the accounting for uncertainty in income taxes recognized in anentity’s financial statements in accordance with SFAS No. 109, “Accounting forIncome Taxes.”  FIN 48 is effective forfiscal years beginning after December 15, 2006. We are currently reviewing this new guidance to determine the impact onour financial statements.

**3.****             ****Discontinued Operations**

We classify as discontinued operations those components of our businessthat we hold for sale or that have been disposed and have cash flows that areclearly distinguishable operationally and for financial reporting purposes fromthe rest of our operations. For those components, we have no significantcontinuing involvement after completion of disposal and their operations areeliminated from our ongoing operations. During the year ended December 31,2005, we classified certain components as discontinued operations as the resultof a management decision to close certain facilities. Notifications were made tothe required contracting entities regarding the termination of the relatedprograms. At June 30, 2006, we did not have any significant net property andequipment balances pertaining to these operations.  There were no revenues generated by thesediscontinued operations in the three and six months ended June 30, 2006. Thesediscontinued operations generated revenues of approximately $0.7 million and$2.6 million in the three and six months ended June 30, 2005, respectively.

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

Intangibleassets at June 30, 2006 and December 31, 2005 consisted of thefollowing (in thousands):

|                              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Non-compete agreements       |       | $                 | 10,020     |                  | $          | 9,960 |   |
| Acquired contract value      |       | 6,442             |       | 6,442                 |       |
| Accumulated amortization     |       | (8,435            | )          | (7,313                | )          |
| Identified intangibles,  net |       | 8,027             |       | 9,089                 |       |
| Goodwill                     |       | 12,655            |       | 12,577                |       |
| Total intangibles, net       |       | $                 | 20,682     |                  | $          | 21,666 |   |

 

The changes inthe carrying amount of goodwill for the six months ended June 30, 2006 are asfollows (in thousands):

|                                  | ** ** | **Adult  Secure** | ** ** | **Juvenile** | ** ** | **Pre-  Release** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-------------------|------------|--------------|------------|-------------------|------------|-----------|------------|
| Balance as of  December 31, 2005 |       | $                 | 2,902      |         | $          | 1,060             |       | $         | 8,615      |   | $ | 12,577 |   |
| Addition to  goodwill            |       | —            |       | —       |       | 78                |       | 78        |       |
| Balance as of June 30,  2006     |       | $                 | 2,902      |         | $          | 1,060             |       | $         | 8,693      |   | $ | 12,655 |   |

 

Amortizationexpense for our non-compete agreements was approximately $0.3 million for the threemonths ended June 30, 2006 and 2005 and approximately $0.6 million for thesix months ended June 30, 2006 and 2005. Amortization expense for our non-compete agreements is expected to beapproximately $1.1 million for each of the next four years ended December 31and approximately $0.7 million for the fifth year.

Amortizationexpense for our acquired contract value was approximately $0.3 million for thethree months ended June 30, 2006 and 2005 and approximately $0.6 million and$0.4 million for the six months ended June 30, 2006 and 2005,respectively.  Amortization expense forour acquired contract value is expected to be approximately $1.1 million foreach of the next four years ended December 31 and approximately $0.6million for the fifth year.

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

Our long-termdebt at June 30, 2006 and December 31, 2005 consisted of thefollowing (in thousands):

|                                                                                                                                                                | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                     | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| **Debt of Cornell Companies, Inc.:**                                                                                                                      | ** ** | ** **        | ** ** | ** **            | ** ** |
| Senior Notes,  unsecured, due July 2012 with an interest rate of 10.75%, net of  discount                                                                 |       | $                 | 110,896    |                  | $          | 110,803 |   |
| Fair-value  adjustment of Senior Notes as a result of interest rate swap                                                                                       |       | (3,086            | )          | (145                  | )          |
| Revolving Line  of Credit due June 2008 with an interest rate of LIBOR plus 2.25% to  3.5% or prime plus 0.75% to 2.00% (the “Credit Facility”) |       | 3⁄4            |       | —                |       |
| Capital lease  obligations                                                                                                                                     |       | 52                |       | 2                     |       |
| Subtotal                                                                                                                                                       |       | 107,862           |       | 110,660               |       |
| ** **                                                                                                                                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| **Debt of Special Purpose Entity:**                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| 8.47% Bonds due  2016                                                                                                                                          |       | 165,700           |       | 165,700               |       |
|                                                                                                                                                           |       |              |       |                  |       |
| Total consolidated debt                                                                                                                                        |       | 273,562           |       | 276,360               |       |
|                                                                                                                                                           |       |              |       |                  |       |
| Less: current maturities                                                                                                                                       |       | (9,710            | )          | (9,701                | )          |
|                                                                                                                                                           |       |              |       |                  |       |
| Consolidated long-term debt                                                                                                                                    |       | $                 | 263,852    |                  | $          | 266,659 |   |

 

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under our CreditFacility was approximately $49.8 million at June 30, 2006.  We had no outstanding borrowings on ourCredit Facility at June 30, 2006, but we had outstanding letters of credit ofapproximately $10.2 million.  Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder our Credit Facility up to an aggregate amount of $100.0 million.  Our Credit Facility matures in June 2008 andbears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit Facility contains standardcovenants including compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

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

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

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

 

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Any time prior to July 1, 2007, we may redeem up to 35% of the originalaggregate principal amount of the Senior Notes at a redemption price of 110.75%of the principal amount thereof with the net cash of public offerings ofequity, provided that at least 65% of the original aggregate principal amountof the Notes remains outstanding after the redemption and other conditions aremet.  Upon the occurrence of specifiedchange of control events, unless we have exercised our option to redeem all theSenior Notes as described above, each holder will have the right to require usto repurchase all or a portion of such holder’s Senior Notes at a purchaseprice in cash equal to 101% of the aggregate principal amount of the notesrepurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) that limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to paydividends or other payments to us, enter into transactions with affiliates, andengage in mergers, consolidations and certain sales of assets.

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our SeniorNotes.  The purpose of this transactionwas to convert future interest due on $84.0 million of the Senior Notes to avariable rate.  The terms of the interestrate swap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree and six months ended June 30, 2006, we recorded interest expense relatedto this interest rate swap of approximately $0.1 million and $0.04 million,respectively, which is reflected as interest expense in the accompanyingfinancial statements.  For the three andsix months ended June 30, 2005, we recorded interest savings related to thisinterest rate swap of approximately $0.3 million and $0.8 million,respectively, which is reflected as a reduction to interest expense in theaccompanying financial statements.  Theswap agreements are marked to market each quarter with a correspondingmark-to-market adjustment reflected as either a discount or premium on theSenior Notes.  At June 30, 2006 andDecember 31, 2005, the fair value of this derivative instrument wasapproximately ($3.1) million and ($0.1) million, respectively, and is includedin other liabilities.  The carrying valueof the Senior Notes as of these dates was reduced by the same amount. Becausethe swap agreement is an effective fair-value hedge, there is no effect on ourresults of operations from the mark-to-market adjustment as long as the swap isin effect.

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**6.****             ****Earnings Per Share**

Basic earningsper share (EPS) is computed by dividing net income by the weighted averagenumber of shares of common stock outstanding during the period.  Diluted EPS reflects the potential dilutionfrom common stock equivalents such as stock options and warrants.  For the three months ended June 30, 2006and 2005, there were 69,100 shares ($15.58 average price) and 317,546 shares ($12.63average price), 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, 2006and 2005 there were 71,600 shares ($15.55 average price) and 203,207 shares ($16.83average price), respectively, of stock options that were not included in the computationof diluted EPS because to do so would have been anti-dilutive.

The following table summarizes the calculation of net earnings (loss)and weighted average common shares and common equivalent shares outstanding forpurposes of the computation of earnings (loss) per share (in thousands, exceptper share data):
|                                                                          | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                               | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| Income from continuing operations                                        |       | $                                | 4,063      |                           | $          | 1,371 |   | $ | 5,275 |   | $ | 531 |   |
| Loss from discontinued operations, net of taxes                          |       | (182                             | )          | (1,682                         | )          | (707 | ) | (3,115 | ) |
| Net income (loss)                                                        |       | $                                | 3,881      |                           | $          | (311 | ) | $ | 4,568 |   | $ | (2,584 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares outstanding                               |       | 13,906                           |       | 13,474                         |       | 13,865 |   | 13,451 |   |
| Weighted average common share equivalents outstanding                    |       | 128                              |       | 126                            |       | 135 |   | 235 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares and common share equivalents  outstanding |       | 14,034                           |       | 13,600                         |       | 14,000 |   | 13,686 |   |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Basic earnings (loss) per share:                                         |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations                                        |       | $                                | .29        |                           | $          | .10 |   | $ | .38 |   | $ | .04 |   |
| Loss from discontinued operations, net of tax                            |       | (.01                             | )          | (.12                           | )          | (.05 | ) | (.23 | ) |
| Net income (loss)                                                        |       | $                                | .28        |                           | $          | (.02 | ) | $ | .33 |   | $ | (.19 | ) |
|                                                                     |       |                             |       |                           |       |   |   |   |   |
| Diluted earnings (loss) per share:                                       |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations                                        |       | $                                | .29        |                           | $          | .10 |   | $ | .38 |   | $ | .04 |   |
| Loss from discontinued operations, net of tax                            |       | (.01                             | )          | (.12                           | )          | (.05 | ) | (.23 | ) |
| Net income (loss)                                                        |       | $                                | .28        |                           | $          | (.02 | ) | $ | .33 |   | $ | (.19 | ) |

 

**7.     Commitments and Contingencies**

**Legal Proceedings**

***Lincoln County Detention Center***

In August 2005, a lawsuit was filed by a detainee atthe Lincoln County Detention Center (“LCDC”) in the U.S. District Court of NewMexico (Santa Fe) seeking unspecified damages. The lawsuit relates to theformer LCDC policy that required strip and visual body cavity searches for alldetainees and inmates and alleges that such policy violates a detainee’s Fourthand Fourteenth Amendment right. The lawsuit was filed as a putative classaction lawsuit brought on behalf of all inmates who were searched at the LCDCfrom May 2002 to July 2005. This lawsuit is in its early stages and no materialdiscovery has been conducted. In the year ended December 31, 2005, we recordeda charge of $0.2 million related to this lawsuit. As of June 30, 2006, we haveestimated our range of additional exposure to be approximately $0.3 million. Wehave insurance coverage in the event our actual exposure exceeds our estimatedexposure. In addition, in connection with our acquisition of the LCDC facility,certain amounts were placed in escrow to offset any undisclosed liabilityrelating to such acquisition. We have given notice to the prior owner of LCDCthat we will seek to recover from the escrow any losses we may incur as aresult of this litigation. The ultimate outcome of the lawsuit cannot bedetermined at this time and we intend to aggressively defend this lawsuit.

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##### ***Alexander Youth Service Center***

In April 2006, we were sued in an action styled as *Juana Michelle Brown, Administratrix of the Estate ofLakeisha Shantrail Brown, Deceased, v. Cornell Interventions, Inc. et al.,*No. 4-06 CV00000434, in the United States District Court for the EasternDistrict of Arkansas.  The lawsuitalleges that we violated the rights of Lakeisha Shantrail Brown, the deceaseddaughter of Juana Michelle Brown, under the Eighth Amendment of theConstitution of the United States and the laws of the State of Arkansas bydenying Ms. Brown medical treatment that caused her death and seeks unspecifiedactual and punitive damages.  Thislawsuit is in its very early stages and no discovery has been conducted.  We are therefore unable to estimate ourfinancial exposure relating to this lawsuit. We have insurance coverage.  Weintend to vigorously defend this lawsuit; however, the ultimate outcome of thislawsuit cannot be determined at this time.

##### ***Southern Peaks Regional Treatment Center***

In January 2004, we initiated legal proceedingsin the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*.,No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theoriesof fraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atJune 30, 2006. In December 2004, the case was tried before a jury and thejury verdict awarded approximately $6.5 million in compensatory damages andapproximately $1.4 million in punitive damages, plus attorneys’ fees. We expectthat the actual damages awarded under the verdict will be adjusted downward tothe $5.4 million actually lost by us and that the punitive damages award may beadjusted downward because of a Georgia statute regarding caps on punitivedamages awards. No judgment has yet been entered on this verdict. The award forcompensatory damages accrues pre-judgment interest at a rate of seven percentfrom the date of loss through the date of judgment. Following the juryverdicts, we collected approximately $0.4 million in January 2005 in fundsthat had been previously frozen under a temporary restraining order issued atthe time that we commenced this litigation. Currently, certain of thedefendants have filed motions for a new trial. No judgment will be entered onthe verdict until after these motions for a new trial have been heard and ruledon by the court. Due to the continued uncertainty surrounding the ultimaterecovery of the funds previously deposited, we will continue to maintain ourexisting reserve of approximately $5.0 million in an allowance for doubtfulaccounts against the corresponding balance as carried in other receivables atJune 30, 2006.

###### ***Shareholder Lawsuits***

In March and April 2002, Cornell, Steven W.Logan (our former President and Chief Executive Officer), and John L. Hendrix(our former Chief Financial Officer), were named as defendants in four federalputative 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 SouthernDistrict of Texas, Houston Division; (2) *RichardPicard, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc., et al.*, No. H-02-1075, in the UnitedStates District Court for the Southern District of Texas, Houston Division;(3) *Louis A. Daly, On Behalf of Himselfand All Others Similarly Situated v. Cornell Companies, Inc., et al.,*No. H-02-1522, in the United States District Court for the SouthernDistrict of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and All Others SimilarlySituated v. Cornell Companies, Inc., et al.,*No. H-02-1567, in the United States District Court for the SouthernDistrict of Texas, Houston Division. The aforementioned lawsuits were putativeclass action lawsuits brought on behalf of all purchasers of our common stockbetween March 6, 2001 and March 5, 2002 and relate to our restatementin 2002 of certain financial statements. The lawsuits involved disclosures madeconcerning two prior transactions executed by us: the August 2001 saleleaseback transaction and the 2000 synthetic lease transaction. These fourlawsuits were consolidated into the *GraydonWilliams* action and Flyline Partners, LP was appointed leadplaintiff. As a result, a consolidated complaint was filed by Flyline Partners,LP. Richard Picard and Anthony Scolaro were also named as plaintiffs. Sincethen, the court allowed plaintiffs to file an amended consolidated complaint.The amended consolidated complaint alleges that the defendants violatedSection 10(b) of the Securities Exchange Act of 1934 (the “ExchangeAct”), Rule 10b-5 promulgated under Section 10(b) of theExchange Act, Section 20(a) of the Exchange Act, Section 11 ofthe Securities Act of 1933 (the “Securities Act”) and/or Section 15 of theSecurities Act. The amended consolidated complaint seeks, among other things,restitution damages, compensatory damages, rescission or a rescissory measureof damages, costs, expenses, attorneys’ fees and expert fees. In February 2006,the court approved the settlement of this matter. Under the settlementagreement, Cornell has not admitted any wrongdoing. Settlement in the amount of$7.0 million has been funded through our directors’ and officers’ liabilityinsurance. During the fourth quarter of 2005, we recorded the settlement chargeof $7.0 million and the related reimbursement of $7.0 million from our director’sand officer’s liability insurance. The charge and reimbursement was recognizedin general and administrative expenses in our Consolidated Statements ofOperations and Comprehensive 

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Income(Loss) for the year ended December 31, 2005. The liability was carried inaccounts payable and accrued liabilities and the reimbursement was included inother receivables at December 31, 2005. The reimbursement was funded by theinsurance carrier in 2005 into a trust account and funds were disbursed fromthe trust account to plaintiffs’ counsel’s escrow account upon court approvalof the settlement in February 2006.

In March 2002, Cornell, its directors, and itsformer independent auditor Arthur Andersen LLP, were sued in a derivative actionstyled as *William Williams, Derivatively andon Behalf of Nominal Defendant Cornell Companies, Inc. v. Anthony R.Chase, et al.*, No. 2002-15614, in the 127th Judicial District Court of Harris County,Texas. The lawsuit related to our restatement in 2002 of certain financialstatements. The lawsuit alleged breaches of fiduciary duty by all of theindividual defendants and asserted breach of contract and professionalnegligence claims only against Arthur Andersen LLP. This lawsuit has beendismissed without prejudice by agreement. In January 2004, we received aletter from William Williams, the plaintiff in the *William Williams* action discussed above, demanding that wepursue breach of fiduciary duty claims against various officers and directorsbased on the August 2001 sale leaseback transaction and the subsequentrestatement. We have issued a preliminary response to the letter indicatingthat the Board will consider the request and inform Mr. Williams of itsdecision. In May and September 2002, the Company and our thendirectors were sued in three other derivative lawsuits styled as follows:(1) *Juan Guitierrez, Derivatively onBehalf of Cornell Companies, Inc. v. Steven W. Logan, et. al.,*No. H-02-1812, in the United Stated District Court for the SouthernDistrict of Texas, Houston Division; (2) *ThomasPagano, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.*, No. H-02-1896, in the United Stated DistrictCourt for the Southern District of Texas, Houston Division; and (3) *Jesse Menning, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.,*No. 2002-28924, in the 164th Judicial District Court of Harris County,Texas. These lawsuits relate to our restatement in 2002 of certain financialstatements. These lawsuits all allege breaches of fiduciary duty and waste ofcorporate assets by all of the defendants and seeks unspecified damages. Amotion to dismiss the *Guitierrez*and *Pagano* lawsuits was filed.The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action. The court granted the motion to dismiss the *Guitierrez* action and the plaintiffs have appealed thatruling. The *Menning* action hasbeen dismissed, but with an agreement that the plaintiff’s claims as to Cornellare tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.The plaintiffs in these cases have not quantified their claim of damages andthe outcome of the matters discussed above cannot be predicted with certainty.However, our management believes that we have good defenses and intends tovigorously defend against the claims asserted in these actions. We have notrecorded any loss accruals related to these claims.

Certain insurance policies held by us to cover potential director andofficer liability may limit our cash outflows in the event of a decisionadverse to us in the matters discussed above. However, if an adverse decisionin these matters exceeds the insurance coverage or if the insurance coverage isdeemed not to apply to these matters, an adverse decision to us in thesematters could have a material adverse effect on us, our financial condition,results of operations and cash flows.

***Other***

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

During the period of August 2000 throughMay 2003, our general liability and professional liability coverage wasprovided by Specialty Surplus Insurance Company, a Kemper Insurance Company (“Kemper”)group member. In June 2004, the Illinois Department of Insurance gaveKemper permission to proceed with a run-off plan it had previously submitted.The three-year plan is designed to help Kemper meet its goal of resolving, tothe maximum extent possible, all valid policyholder claims. In view of therisks and uncertainties involved in implementing the plan, including the needto achieve significant policy buybacks, commutation of reinsurance agreements,and further agreements with regulators, no assurance can be given that the planwill be successfully implemented by Kemper. In the year ended December 31,2004, we accrued a provision of $0.6 million, and estimated our range ofadditional exposure to be approximately $0.5 million with respect tooutstanding claims incurred during this policy period with Kemper which wouldbecome our obligation to resolve if not settled through Kemper. During the yearended December 31, 2005, Kemper continued to implement its run-off plan. As aresult, several of our significant claims were settled by Kemper in the secondquarter of 2005. In conjunction with these settlements, we recorded a chargeagainst our existing accrual in the amount of $0.3 million. We believe that theuncertainty surrounding the ability of Kemper to settle our remainingoutstanding claims still exists. Based on our analysis of the claims activityduring 

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thethird quarter of 2005, we felt it necessary to accrue an additional provisionin the amount of approximately $0.2 million during the third quarter of 2005.At June 30, 2006, we believe our estimated range of exposure, above ourexisting $0.5 million accrual, to be approximately $0.1 million related to theoutstanding claims which could become our obligation to resolve if not settledthrough Kemper.

While the outcome of these other matters cannot bepredicated with certainty, based on the information known to date, we believethat the ultimate resolution of these matters will not have a material adverseeffect on our financial condition, operating results or cash flows.

**8.****              Derivative FinancialInstruments and Guarantees**

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

In August 2001, MCF completed a bond offeringto finance the 2001 Sale and Leaseback Transaction.  In connection with this bond offering, tworeserve fund accounts were established by MCF pursuant to the terms of theindenture: (1) MCF’s Debt Service Reserve Fund, aggregating $23.8 millionat June 30, 2006, was established to make payments on MCF’s outstandingbonds in the event we (as lessee) should fail to make the scheduled rentalpayments to MCF and (2) MCF’s Debt Service Fund, aggregating $25.9 millionand $19.6 million at June 30, 2006 and December 31, 2005,respectively, used to accumulate the monthly lease payments that MCF receivesfrom us until such funds are used to pay MCF’s semi-annual bond interest andannual bond principal payments.  Bothreserve fund accounts are subject to the agreements with the MCF EquityInvestors whereby guaranteed rates of return of 3.0% and 5.08%, respectively,are provided for in the balance of the Debt Service Reserve Fund and the DebtService Fund.  The guaranteed rates ofreturn are characterized as cash flow hedge derivative instruments.  At inception, the derivatives had anaggregate fair value of $4.0 million, which has been recorded as a decrease tothe equity investment in MCF made by the MCF Equity Investors (MCF minorityinterest) and as a deferred liability in our Consolidated Balance Sheets.Changes in the fair value of the derivative instruments are recorded as anadjustment to other long-term liabilities and reported as other comprehensiveincome (loss) in our Consolidated Statements of Operations and ComprehensiveIncome (Loss).  At June 30, 2006 andDecember 31, 2005, the fair value of these derivative instruments was approximately$4.3 million and $3.0 million, respectively. As a result, our Consolidated Statements of Operations and ComprehensiveIncome (Loss) include other comprehensive loss of approximately ($0.5) millionand ($0.8) million for the three and six months ended June 30, 2006,respectively.  For the three and sixmonths ended June 30, 2005, we reported unrealized gains in other comprehensiveincome of approximately $0.3 million and $0.1 million, respectively, related tothese derivative instruments.  The $0.1million unrealized gain reported in comprehensive income (loss) for the sixmonths ended June 30, 2005 includes an adjustment of $0.6 million for thetax effect of changes in fair value during the years ended December 31,2002 and 2003 not previously recorded. This adjustment decreased accumulatedother comprehensive income and increased deferred tax liabilities in ourConsolidated Balance Sheet as of June 30, 2005.

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

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

Our three operatingdivisions are our reportable segments. The adult secure institutional services segment consists of theoperations of secure adult incarceration facilities.  The juvenile segment consists of providingresidential treatment and educational programs and non-residentialcommunity-based programs to juveniles between the ages of ten and 17 who haveeither been adjudicated or suffer from behavioral problems.  The adult community-based corrections andtreatment services segment consists of providing pre-release and halfway houseprograms for adult offenders who are either on probation or serving the lastthree to six-months of their sentences on parole and preparing for re-entryinto society at large as well as community-based treatment and educationprograms as an alternative to incarceration. All of our customers and long-lived assets are located in the UnitedStates of America.  The accountingpolicies of our reportable segments are the same as those described in thesummary of significant accounting policies in our 2005 Annual Report on Form10-K.  Intangible assets are not includedin each segment’s reportable assets, and the amortization of intangible assetsis not included in the determination of a segment’s operating income.  We evaluate performance based on income orloss from operations before general and administrative expenses, incentivebonuses, amortization of intangibles, interest and income taxes.  Corporate and other assets are comprisedprimarily of cash, investment securities available for sale, accountsreceivable, debt service fund, deposits, property and equipment, deferredtaxes, deferred costs and other assets. Corporate and other expense from 

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operations primarily consists of depreciation andamortization on the corporate office facilities and equipment, and is presentedseparately as such charges cannot be readily identified for allocation to aparticular segment.

Thefollowing table excludes the results of discontinued operations for therevenue, pre-opening and start-up expenses and income from operationscategories for all periods presented.  Theonly significant non-cash item reported in the respective segment’s income fromoperations is depreciation and amortization (excluding intangibles) (inthousands).
| ** **                                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                        | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
| ** **                                        | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenues                                          |       |                             |       |                           |       |   |   |   |   |
| Adult secure  institutional                       |       | $                                | 46,267     |                           | $          | 31,698 |   | $ | 84,588 |   | $ | 62,557 |   |
| Juvenile                                          |       | 28,699                           |       | 30,319                         |       | 57,992 |   | 60,454 |   |
| Adult  community-based                            |       | 15,531                           |       | 16,485                         |       | 31,765 |   | 29,131 |   |
| Total revenues                                    |       | $                                | 90,497     |                           | $          | 78,502 |   | $ | 174,345 |   | $ | 152,142 |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Pre-opening and start-up expenses                 |       |                             |       |                           |       |   |   |   |   |
| Adult secure  institutional                       |       | $                                | —     |                           | $          | 2,152 |   | $ | 2,657 |   | $ | 5,042 |   |
| Juvenile                                          |       | —                           |       | —                         |       | — |   | 1,804 |   |
| Adult  community-based                            |       | —                           |       | —                         |       | — |   | — |   |
| Total pre-opening and start-up expenses           |       | $                                | —     |                           | $          | 2,152 |   | $ | 2,657 |   | $ | 6,846 |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Income from operations                            |       |                             |       |                           |       |   |   |   |   |
| Adult secure  institutional                       |       | $                                | 13,188     |                           | $          | 6,206 |   | $ | 20,809 |   | $ | 12,315 |   |
| Juvenile                                          |       | 4,098                            |       | 4,468                          |       | 6,611 |   | 7,693 |   |
| Adult  community-based                            |       | 2,684                            |       | 3,234                          |       | 5,746 |   | 5,422 |   |
| Subtotal                                          |       | 19,970                           |       | 13,908                         |       | 33,166 |   | 25,430 |   |
| General and  administrative expense               |       | (5,438                           | )          | (4,899                         | )          | (10,550 | ) | (11,237 | ) |
| Amortization of  intangibles                      |       | (561                             | )          | (545                           | )          | (1,121 | ) | (973 | ) |
| Corporate and  other                              |       | (260                             | )          | (337                           | )          | (574 | ) | (745 | ) |
| Total income from operations                      |       | $                                | 13,711     |                           | $          | 8,127 |   | $ | 20,921 |   | $ | 12,475 |   |
|                                              |       |                             |       |                           |       |   |   |   |   |
| Loss on discontinued operations, net of tax       |       |                             |       |                           |       |   |   |   |   |
| Adult secure  institutional                       |       | $                                | —     |                           | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                          |       | (183                             | )          | (1,639                         | )          | (707 | ) | (3,087 | ) |
| Adult  community-based                            |       | 1                                |       | (43                            | )          | — |   | (28 | ) |
| Total loss on discontinued operations, net of tax |       | $                                | (182       | )                              | $          | (1,682 | ) | $ | (707 | ) | $ | (3,115 | ) |

 
|                             | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2006**          | ** ** | **2005**              | ** ** |
| Assets                      |       |              |       |                  |       |
| Adult secure  institutional |       | $                 | 232,416    |                  | $          | 212,583 |   |
| Juvenile                    |       | 98,588            |       | 106,408               |       |
| Adult  community-based      |       | 65,209            |       | 67,871                |       |
| Intangible  assets, net     |       | 20,682            |       | 21,666                |       |
| Corporate and  other        |       | 97,392            |       | 102,100               |       |
| Total assets                |       | $                 | 514,287    |                  | $          | 510,628 |   |

 

**10.****      ****Guarantor Disclosures**

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

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**Condensed Consolidating Balance Sheet as ofJune 30, 2006 (in thousands)**
| ** **                                      | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                 |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash  equivalents                      |       | $          | 8,516      |             | $          | 651                 |       | $                | 55         |             | $          | — |   | $ | 9,222 |   |
| Investment  securities                          |       | 8,975      |       | —           |       | —              |       | —           |       | 8,975            |       |
| Accounts  receivable                            |       | 625        |       | 65,516           |       | 362                 |       | —           |       | 66,503           |       |
| Debt service fund  and other restricted assets  |       | —     |       | 2,026            |       | 25,880              |       | —           |       | 27,906           |       |
| Prepaids and  other                             |       | 10,261     |       | 2,384            |       | —              |       | —           |       | 12,645           |       |
| Total current  assets                           |       | 28,377     |       | 70,577           |       | 26,297              |       | —           |       | 125,251          |       |
| Property and equipment, net                     |       | 107        |       | 179,085          |       | 152,530             |       | (5,552           | )          | 326,170          |       |
| Other assets:                                   |       |       |       |             |       |                |       |             |       |             |       |
| Debt service  reserve fund                      |       | —     |       | —           |       | 23,800              |       | —           |       | 23,800           |       |
| Deferred costs  and other                       |       | 45,331     |       | 26,242           |       | 8,476               |       | (40,983          | )          | 39,066           |       |
| Investment in  subsidiaries                     |       | 19,956     |       | 1,856            |       | —              |       | (21,812          | )          | —           |       |
| Total assets                                    |       | $          | 93,771     |             | $          | 277,760             |       | $                | 211,103    |             | $          | (68,347 | ) | $ | 514,287 |   |
| ** **                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and  stockholders’ equity**  | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                            |       |       |       |             |       |                |       |             |       |             |       |
| Current liabilities:                            |       |       |       |             |       |                |       |             |       |             |       |
| Accounts  payable and accrued liabilities       |       | $          | 38,890     |             | $          | 9,349               |       | $                | 5,855      |             | $          | (2,395 | ) | $ | 51,699 |   |
| Current portion  of long-term debt              |       | —     |       | 10               |       | 9,700               |       | —           |       | 9,710            |       |
| Total current  liabilities                      |       | 38,890     |       | 9,359            |       | 15,555              |       | (2,395           | )          | 61,409           |       |
| Long-term debt, net of current portion          |       | 107,809    |       | 43               |       | 156,000             |       | —           |       | 263,852          |       |
| Deferred tax liabilities                        |       | 10,953     |       | (1,763           | )          | —              |       | (141             | )          | 9,049            |       |
| Other long-term liabilities                     |       | 8,277      |       | 107              |       | 39,222              |       | (40,040          | )          | 7,566            |       |
| Intercompany                                    |       | (244,569   | )          | 244,569          |       | —              |       | —           |       | —           |       |
| Total  liabilities                              |       | (78,640    | )          | 252,315          |       | 210,777             |       | (42,576          | )          | 341,876          |       |
| Stockholders’ equity                       |       | 172,411    |       | 25,445           |       | 326                 |       | (25,771          | )          | 172,411          |       |
| Total liabilities and stockholders’ equity |       | $          | 93,771     |             | $          | 277,760             |       | $                | 211,103    |             | $          | (68,347 | ) | $ | 514,287 |   |

 

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**Condensed Consolidating Balance Sheet as ofDecember 31, 2005 (in thousands)**
| ** **                                      | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                      | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current assets:                                 |       |       |       |             |       |                |       |             |       |             |       |
| Cash and cash  equivalents                      |       | $          | 12,579     |             | $          | 1,114               |       | $                | 30         |             | $          | — |   | $ | 13,723 |   |
| Investment  securities                          |       | 7,250      |       | 3⁄4           |       | 3⁄4              |       | 3⁄4           |       | 7,250            |       |
| Accounts  receivable                            |       | 7,718      |       | 60,337           |       | 372                 |       | 3⁄4           |       | 68,427           |       |
| Restricted  assets                              |       | 3⁄4     |       | 2,633            |       | 19,586              |       | 3⁄4           |       | 22,219           |       |
| Prepaids and  other                             |       | 11,828     |       | 2,337            |       | 3⁄4              |       | 3⁄4           |       | 14,165           |       |
| Total current  assets                           |       | 39,375     |       | 66,421           |       | 19,988              |       | 3⁄4           |       | 125,784          |       |
| Property and equipment, net                     |       | 148        |       | 174,886          |       | 154,641             |       | (5,814           | )          | 323,861          |       |
| Other assets:                                   |       |       |       |             |       |                |       |             |       |             |       |
| Debt service  reserve fund                      |       | 3⁄4     |       | 3⁄4           |       | 23,802              |       | 3⁄4           |       | 23,802           |       |
| Deferred costs  and other                       |       | 41,926     |       | 23,861           |       | 8,772               |       | (37,378          | )          | 37,181           |       |
| Investment in  subsidiaries                     |       | 14,602     |       | 3,806            |       | 3⁄4              |       | (18,408          | )          | 3⁄4           |       |
| Total assets                                    |       | $          | 96,051     |             | $          | 268,974             |       | $                | 207,203    |             | $          | (61,600 | ) | $ | 510,628 |   |
| ** **                                      | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and  stockholders’ equity**  | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Current liabilities:                            |       |       |       |             |       |                |       |             |       |             |       |
| Accounts  payable and accrued liabilities       |       | $          | 43,561     |             | $          | 11,920              |       | $                | 5,879      |             | $          | (2,563 | ) | $ | 58,797 |   |
| Current portion  of long-term debt              |       | 3⁄4     |       | 1                |       | 9,700               |       | 3⁄4           |       | 9,701            |       |
| Total current  liabilities                      |       | 43,561     |       | 11,921           |       | 15,579              |       | (2,563           | )          | 68,498           |       |
| Long-term debt, net of current portion          |       | 110,659    |       | —           |       | 156,000             |       | 3⁄4           |       | 266,659          |       |
| Deferred tax liabilities                        |       | 8,076      |       | (1,763           | )          | 3⁄4              |       | 395              |       | 6,708            |       |
| Other long-term liabilities                     |       | 5,490      |       | 108              |       | 35,640              |       | (37,936          | )          | 3,302            |       |
| Intercompany                                    |       | (237,196   | )          | 237,196          |       | 3⁄4              |       | 3⁄4           |       | 3⁄4           |       |
| Total  liabilities                              |       | (69,410    | )          | 247,462          |       | 207,219             |       | (40,104          | )          | 345,167          |       |
| Stockholders’ equity                       |       | 165,461    |       | 21,512           |       | (16                 | )          | (21,496          | )          | 165,461          |       |
| Total liabilities and stockholders’ equity |       | $          | 96,051     |             | $          | 268,974             |       | $                | 207,203    |             | $          | (61,600 | ) | $ | 510,628 |   |

 

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

 

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**Condensed Consolidating Statement ofOperations for the three months ended June 30, 2005****(in thousands)**
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| Revenues                                                                              |       | $          | 4,483      |             | $          | 88,270              |       | $                | 4,502      |             | $          | (18,753 | ) | $ | 78,502 |   |
| Operating expenses                                                                    |       | 4,197      |       | 73,716           |       | 14                  |       | (18,419          | )          | 59,508           |       |
| Pre-opening and start-up expenses                                                     |       | —     |       | 2,152            |       | —              |       | —           |       | 2,152            |       |
| Depreciation and amortization                                                         |       | 21         |       | 2,843            |       | 1,055               |       | (103             | )          | 3,816            |       |
| General and administrative expenses                                                   |       | 4,880      |       | —           |       | 19                  |       | —           |       | 4,899            |       |
| Income (loss) from operations                                                         |       | (4,615     | )          | 9,559            |       | 3,414               |       | (231             | )          | 8,127            |       |
| Overhead allocations                                                                  |       | (6,665     | )          | 6,665            |       | —              |       | —           |       | —           |       |
| Interest, net                                                                         |       | 557        |       | 1,527            |       | 3,485               |       | 11               |       | 5,580            |       |
| Equity earnings in subsidiaries                                                       |       | (601       | )          | —           |       | —              |       | 601              |       | —           |       |
| Income (loss) from continuing operations before provision  (benefit) for income taxes |       | 892        |       | 1,367            |       | (71                 | )          | 359              |       | 2,547            |       |
| Provision (benefit) for income taxes                                                  |       | 1,203      |       | —           |       | —              |       | (27              | )          | 1,176            |       |
| Income (loss) from continuing operations                                              |       | (311       | )          | 1,367            |       | (71                 | )          | 386              |       | 1,371            |       |
| Discontinued operations, net of income tax benefit of $904                            |       | —     |       | (1,682           | )          | —              |       | —           |       | (1,682           | )          |
| Net income (loss)                                                                     |       | $          | (311       | )                | $          | (315                | )          | $                | (71        | )                | $          | 386 |   | $ | (311 | ) |

 

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

 

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**Condensed Consolidating Statement ofOperations for the six months ended June 30, 2005****(in thousands)**
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-  Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|---------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**      | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **          | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 9,010      |             | $          | 171,727             |       | $                | 9,004      |             | $          | (37,599 | ) | $ | 152,142 |   |
| Operating expenses                                                                    |       | 8,462      |       | 142,485          |       | 24                  |       | (36,932          | )          | 114,039          |       |
| Pre-opening and start-up expenses                                                     |       | —     |       | 6,846            |       | —              |       | —           |       | 6,846            |       |
| Depreciation and amortization                                                         |       | 42         |       | 5,592            |       | 2,111               |       | (200             | )          | 7,545            |       |
| General and administrative expenses                                                   |       | 11,199     |       | —           |       | 38                  |       | —           |       | 11,237           |       |
| Income (loss) from operations                                                         |       | (10,693    | )          | 16,804           |       | 6,831               |       | (467             | )          | 12,475           |       |
| Overhead allocations                                                                  |       | (15,590    | )          | 15,590           |       | —              |       | —           |       | —           |       |
| Interest, net                                                                         |       | 1,478      |       | 2,800            |       | 7,025               |       | 21               |       | 11,324           |       |
| Equity earnings in subsidiaries                                                       |       | (5,307     | )          | —           |       | —              |       | 5,307            |       | —           |       |
| Income (loss) from continuing operations before provision  (benefit) for income taxes |       | (1,888     | )          | (1,586           | )          | (194                | )          | 4,819            |       | 1,151            |       |
| Provision (benefit) for income taxes                                                  |       | 696        |       | —           |       | —              |       | (76              | )          | 620              |       |
| Income (loss) from continuing operations                                              |       | (2,584     | )          | (1,586           | )          | (194                | )          | 4,895            |       | 531              |       |
| Discontinued operations, net of income tax benefit of $1,677                          |       | —     |       | (3,115           | )          | —              |       | —           |       | (3,115           | )          |
| Net income (loss)                                                                     |       | $          | (2,584     | )                | $          | (4,701              | )          | $                | (194       | )                | $          | 4,895 |   | $ | (2,584 | ) |

 

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

 

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**Condensed Consolidating Statement ofCash Flows for the six months ended June 30, 2005 (in thousands)**
| ** **                                            | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-  Guarantor  Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------|------------|------------|------------|-----------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
| **Cash flows from operating activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Net cash  provided by (used in) operating activities  |       | $          | (905       | )                           | $          | 15,597                          |       | $                | 5,836      |             | $          | — |   | $ | 20,528 |   |
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from investing activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Capital  expenditures                                 |       | —     |       | (14,552                     | )          |                            |       |             |       | (14,552          | )          |
| Acquisition of  a business                            |       | (9,064     | )          | —                      |       | —                          |       | —           |       | (9,064           | )          |
| Purchases of  investment securities                   |       | (665,845   | )          | —                      |       | —                          |       | —           |       | (665,845         | )          |
| Sales of  investment securities                       |       | 678,135    |       | —                      |       | —                          |       | —           |       | 678,135          |       |
| Payments to  restricted debt payment account, net     |       | —     |       | —                      |       | (5,795                          | )          | —           |       | (5,795           | )          |
| Net cash provided by (used) in investing activities   |       | $          | 3,226      |                        | $          | (14,552                         | )          | $                | (5,795     | )                | $          | — |   | $ | (17,121 | ) |
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash flows from financing activities:**             | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| Payments on  acquired debt                            |       | (1,905     | )          | —                      |       | —                          |       | —           |       | (1,905           | )          |
| Payments on  capital lease obligations                |       | —     |       | (170                        | )          | —                          |       | —           |       | (170             | )          |
| Proceeds from  exercise of stock options              |       | 1,720      |       |                        |       |                            |       |             |       | 1,720            |       |
| Net cash used in financing activities                 |       | (185       | )          | (170                        | )          | —                          |       | —           |       | (355             | )          |
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Net increase in cash and cash equivalents**         |       | 2,136      |       | 875                         |       | 41                              |       | —           |       | 3,052            |       |
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at beginning of  period** |       | 9,559      |       | 296                         |       | 40                              |       | —           |       | 9,895            |       |
| ** **                                            | ** ** | ** ** | ** ** | ** **                  | ** ** | ** **                      | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash and cash equivalents at end of period**        |       | $          | 11,695     |                        | $          | 1,171                           |       | $                | 81         |             | $          | — |   | $ | 12,947 |   |

 

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

**General**

We are a leading provider of correctional, detention,educational, rehabilitation and treatment services outsourced by federal, stateand local government agencies. We provide a diversified portfolio of servicesfor adults and juveniles through our three operating divisions: (1) adultsecure institution and detention services; (2) juvenile justice, educationaland treatment services and (3) adult community-based corrections and treatmentservices. At June 30, 2006, we operated 80 facilities with a total servicecapacity of 19,140. We also had three facilities that were substantially vacantwith an aggregate service capacity of 406. Our facilities are located in 18states and the District of Columbia.

The following table(which excludes data related to discontinued operating facilities) sets forthfor the periods indicated total residential service capacity and contractedbeds in operation at the end of the periods shown, average contract occupancypercentages and total non-residential service capacity.

|                                                                                    | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                         | ** ** | **2006**          | ** ** | **2005**          | ** ** |
| **Residential**                                                                    |       |              |       |              |       |
| Service  capacity (1) (2)                                                          |       | 14,348            |       | 14,324            |       |
| Contracted beds  in operation (end of period) (1) (3)                              |       | 13,624            |       | 11,997            |       |
| Average  contract occupancy based on contracted beds in operation (1) (4) (5) |       | 95.7              | %          | 95.8              | %          |
| Average  contract occupancy excluding start-up operations (1) (4) (5)         |       | 95.7              | %          | 102.7             | %          |
| **Non-Residential**                                                                |       |              |       |              |       |
| Service capacity (1) (6)                                                           |       | 4,792             |       | 4,942             |       |

 

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(1)  Data presented excludes discontinuedoperating facilities.

(2)  Residential service capacity is comprised ofthe number of beds currently available for service or available upon thecompletion of construction or renovation of residential facilities.

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

(4)  Occupancy percentages reflect less thannormalized occupancy during the start-up phase of any applicable facility,resulting in a lower average occupancy in periods when we have substantialstart-up activities.

(5)  Average contract occupancy percentages arecalculated based on actual occupancy for the period as a percentage of thecontracted capacity for residential facilities in operation.  These percentages do not reflect theoperations of non-residential community-based programs.  At certain residential facilities, ourcontracted capacity is lower than the facility’s service capacity.  Additionally, certain facilities have and arecurrently operating above the contracted capacity.  As a result, average contract occupancypercentages can exceed 100% if the average actual occupancy exceeded contractedcapacity.

(6)  Service capacity for non-residential programsis based on either contractual terms or an estimate of the number of clients tobe served.  We update these estimates atleast annually based on the program’s budget and other factors.

Wederive substantially all of our revenues from providing adult corrections andtreatment and juvenile justice, educational and treatment services outsourcedby federal, state and local government agencies in the United States.  Revenues for our services are generallyrecognized on a per diem rate based upon the number of occupant days or hoursserved for the period, on a guaranteed take-or-pay basis or on a cost-plusreimbursement basis. For the three months ended June 30, 2006, our revenue baseconsisted of 70.5% for services provided under per diem contracts, 18.7% forservices provided under take-or-pay and management contracts, 7.2% for servicesprovided under cost-plus reimbursement contracts, 2.4% for services providedunder

26

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fee-for-service contracts and 1.2% from othermiscellaneous sources. For the six months ended June 30, 2006, our revenuebase consisted of 73.9% for services provided under per diem contracts, 14.3%for services provided under take-or-pay and management contracts, 8.0% forservices provided under cost-plus reimbursement contracts, 2.6% for servicesprovided under fee-for-service contracts and 1.2% from other miscellaneoussources.  While these percentages aregenerally consistant with comparable statistics for the three months ended June30, 2005, there has been a decrease in the percentage of revenues for servicesprovided under per diem contracts and in the percentage of revenues providedunder fee-for-service contracts, and an increase in the percentage of revenuesprovided under take-or-pay contracts between the comparable periods.  The increase in the percentage of revenuesprovided under take-or-pay contracts is primarily due to the start ofoperations at the Moshannon Valley Correctional Center in April 2006.  Revenues can fluctuate from period to period due to changes ingovernment funding policies, changes in the number of people referred to ourfacilities by governmental agencies, the opening of new facilities or theexpansion of existing facilities and the termination of contracts for afacility or the closure of a facility.

Revenues for our adultsecure institutional services division are primarily generated from per diem,take-or-pay and management contracts. For the three months ended June 30, 2006 and 2005, we realizedaverage per diem rates on our adult secure institutional facilities ofapproximately $58.45 and $48.22, respectively.  For the six months ended June 30, 2006 and 2005, we realizedaverage per diem rates of approximately $56.18 and $48.35, respectively. Theincrease in the average per diem rates in 2006 is due primarily to the openingof the Moshannon Valley Correctional Center in April 2006.

Revenues for our juvenile justice, educational andtreatment services division are primarily generated from per diem,fee-for-service and cost-plus reimbursement contracts.  For the three months ended June 30, 2006and 2005, we realized average per diem rates on our residential juvenilefacilities of approximately $164.28 and $161.61, respectively.  For the six months ended June 30, 2006and 2005, we realized average per diem rates of approximately $168.89 and$162.95, respectively.  For the threemonths ended June 30, 2006 and 2005, we realized average fee-for-servicerates for our non-residential community-based juvenile facilities and programs,including rates that are limited by Medicaid and other private insuranceproviders, of approximately $36.33 and $32.00, respectively.  For the six months ended June 30, 2006and 2005, we realized average fee-for-service rates of approximately $35.63 and$31.57, respectively.  The increase inthe average fee-for-service rates for 2006 is due to changes in the mix ofservices provided at our non-residential juvenile facilities and programs, aswell as the addition of several new alternative education programs in 2005. Themajority of our juvenile services contracts renew annually.

Revenues for our adult community-based corrections andtreatment services division are primarily generated from per diem andfee-for-service contracts.  For the threemonths ended June 30, 2006 and 2005, we realized average per diem rates onour residential adult community-based facilities of approximately $60.33 and$61.16, respectively.  For the six monthsended June 30, 2006 and 2005, we realized average per diem rates of $62.62and $61.36, respectively.  For the threemonths ended June 30, 2006 and 2005, we realized average fee-for-servicerates on our non-residential adult community-based programs of approximately$10.16 and $9.55, respectively.  For thesix months ended June 30, 2006 and 2005, we realized average fee-for-servicerates of approximately $8.75 and $8.54, respectively.

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

We have historicallyexperienced higher operating margins in our adult secure institutional servicesand adult community-based corrections and treatment services as compared to thejuvenile justice, educational and treatment services division. Additionally,our operating margins within a division can vary from facility to facilitybased on whether a facility is owned or leased, the level of competition forthe contract award, the proposed length of the contract, the occupancy levelsfor a facility, the level of capital commitment required with respect to afacility, the anticipated changes in operating costs over the term of thecontract, and our ability to increase a facility’s contract revenue. Undertake-or-pay contracts, such as the Moshannon Valley Correctional Center,operating margins are typically higher during the early stages of the contractas the facility’s population ramps up (as revenues are received at contractpercentages regardless of actual occupancy). As the variable costs (primarily resident related and certain facilitycosts) increase as the population grows, operating margins will generallydecline to a stabilized level.  We wouldexpect such margin impact pertaining to our Moshannon Valley CorrectionalCenter to occur in the third and fourth quarters of 2006. A decline inoccupancy of certain juvenile justice, educational and treatment facilities canhave a more significant impact on operating results than the adult secureinstitutional services division due to higher per diem rates at certainjuvenile facilities.

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

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We are responsible for allfacility operating costs, except for certain debt service and interest or leasepayments for facilities where we have a management contract only. At thesefacilities, the facility owner is responsible for all debt service and interestor lease payments related to the facility. We are responsible for all otheroperating expenses at these facilities. We operated 21 facilities undermanagement contracts at June 30, 2006 and 2005.

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

We incur pre-opening andstart-up expenses including payroll, benefits, training and other operatingcosts prior to opening a new or expanded facility and during the period ofoperation while occupancy is ramping up. These costs vary by contract. Sincepre-opening and start-up costs are generally factored into the revenue per diemrate that is charged to the contracting agency, we typically expect to recoverthese upfront costs over the life of the contract. Because occupancy ratesduring a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, we may incur additionalpost-opening start-up costs. We do not anticipate post-opening start-up costsat any adult secure facilities operated under any future contracts with the BOPbecause these contracts are currently expected to continue to be take-or-paycontracts, meaning that the BOP will pay at least 80.0% of the contractualmonthly revenue once the facility opens, regardless of actual occupancy.

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

Workingcapital requirements generally increase immediately prior to commencingmanagement of a new or expanded facility as we incur start-up costs andpurchase necessary equipment and supplies before facility management revenue isrealized.

General and administrativeexpenses consist primarily of costs for corporate and administrative personnelwho provide senior management, legal, finance, accounting, human resources,payroll and information systems, costs of business development and outsideprofessional and consulting fees.

#### **Recent Developments**

***Moshannon ValleyCorrectional Center***

In April 2006 we began operations at the Moshannon ValleyCorrectional Center in Pennsylvania.

### ***Accounting For Stock-Based Compensation***

On January 1, 2006, we adopted theprovisions of the Financial Accounting Standards Board (“FASB”) Statement ofFinancial Accounting Standard (“SFAS”) No. 123R, “Share Based Payment” andelected to use the modified prospective transition method. The modifiedprospective transition method requires that compensation cost be recognized inthe financial statements for all awards granted after the date of adoption aswell as for existing awards for which the requisite service has not been renderedas of the date of adoption and requires that prior periods not be restated. Ourstock incentive plans provide for the granting of incentive options andnonqualified options to officers, directors and key employees of the Company.Outstanding options vest over periods up to seven years after the date of grantand expire no more than 10 years after grant. Prior to the adoption of SFASNo. 123R, we used the intrinsic-value based method to account for stockoptions and recorded no charges against earnings with respect to optionsgranted. We have elected to use the “short-cut method” to calculate thehistorical pool of windfall tax benefits upon adoption of SFAS 123R. Theelection to use the “short-cut method” had no effect on our consolidatedfinancial statements.

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The adoption of SFAS No. 123R reducedincome from continuing operations before income taxes for the three and sixmonths ended June 30, 2006 by approximately $0.5 million and $1.2 million,respectively, and reduced net income for the three and six months endedJune 30, 2006 by approximately $0.3 million ($0.02 per basic and dilutedshare) and $0.7 million ($0.05 per basic and diluted share), respectively. Theadoption of SFAS No. 123R had an immaterial effect on our ConsolidatedStatement of Cash Flows for the six months ended June 30, 2006. Refer toPart I, Item 1, Footnote 2 to the consolidated financial statements for furtherinformation concerning the adoption of SFAS No. 123R.

***Employee-Stock Purchase Plan***

We have an employee stockpurchase plan under which employees can make contributions to purchase ourcommon stock. Participation in the plan is elected annually by employees. Theplan year begins each January 1st (the “Grant Date”) and ends onDecember 31st (the “ExerciseDate”). Purchases of common stock are made at the end of the year using thelower of the fair market value on either the Grant Date or Exercise Date, lessa 15% discount. Under SFAS No. 123R, compensatory employee stock purchaseplans (“ESPP”) are required to recognize compensation cost over the requisiteservice period for grants made under the ESPP. We recognized approximately$0.02 million and $0.04 milion of expense related to this plan in the three andsix months ended June 30, 2006.

***Financial Accounting Standards Board Interpretation No. 48***

InJune 2006, the Financial Accounting Standards Board (“FASB”) issued FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes” (“FIN 48”),to clarify the accounting for uncertainty in income taxes recognized in anentity’s financial statements in accordance with SFAS No. 109, “Accounting forIncome Taxes.”  FIN 48 is effective forfiscal years beginning after December 15, 2006. We are currently reviewing this new guidance to determine the expectedimpact on our financial statements.

**Results of Operations**

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

|                                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                          | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| ** **                                                          | ** ** | **2006**                         | ** ** | **2005**                       | ** ** | **2006** | ** ** | **2005** | ** ** |
|                                                                |       |                             |       |                           |       |   |   |   |   |
| Revenues                                                            |       | 100.0                            | %          | 100.0                          | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                  |       | 74.2                             |       | 75.8                           |       | 75.8 |   | 75.0 |   |
| Pre-opening and start-up expenses                                   |       | —                           |       | 2.7                            |       | 1.5 |   | 4.5 |   |
| Depreciation and amortization                                       |       | 4.7                              |       | 4.9                            |       | 4.6 |   | 5.0 |   |
| General and administrative expenses                                 |       | 6.0                              |       | 6.2                            |       | 6.1 |   | 7.4 |   |
| Income from operations                                              |       | 15.1                             |       | 10.4                           |       | 12.0 |   | 8.1 |   |
| Interest expense, net                                               |       | 7.3                              |       | 7.1                            |       | 6.7 |   | 7.4 |   |
| Income from continuing operations before provision for income taxes |       | 7.8                              |       | 3.3                            |       | 5.3 |   | 0.7 |   |
| Provision for income taxes                                          |       | 3.4                              |       | 1.5                            |       | 2.3 |   | 0.4 |   |
| Income from continuing operations                                   |       | 4.4                              |       | 1.8                            |       | 3.0 |   | 0.3 |   |
| Discontinued operations, net of tax                                 |       | (0.2                             | )          | (2.1                           | )          | (0.4 | ) | (2.0 | ) |
| Net income (loss)                                                   |       | 4.2                              | %          | (0.3                           | )%         | 2.6 | % | (1.7 | )% |

 

***ThreeMonths Ended June 30, 2006 Compared to Three Months Ended June 30,2005***

Certain comparisons ofrevenues, expenses and average contract capacity contained herein have beenmade excluding the effect of pre-opening and start-up expenses and revenues.  Disclosures excluding the effect ofpre-opening and start-up expenses and revenues represent measures calculated ina manner that is not consistent with U.S. generally accepted accountingprinciples (GAAP).  We believe theexclusion of the non-recurring effect of pre-opening and start-up expenses andrevenues increases the reader’s understanding of our operating trends.

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***Revenues*****.** Revenues increased approximately $12.0 million, or 15.3%, to $90.5million for the three months ended June 30, 2006 from $78.5 million forthe three months ended June 30, 2005.

***Adult Secure.***Adultsecure institutional services division revenues increased approximately $14.6million, or 46.1%, to $46.3 million for the three months ended June 30,2006 from $31.7 million for the three months ended June 30, 2005 due primarilyto (1) revenues of approximately $8.9 million at the MoshannonValley Correctional Center which opened in April 2006, (2) an increase inrevenues of approximately $2.1 million at the Regional Correctional Center dueto increased occupancy, (3) revenues of approximately $1.9 million at the MesaVerde Community Correctional Center and (4) an increase in revenues ofapproximately $0.8 million at the D. Ray James Prison due to increasedoccupancy and a per diem rate increase in mid-year 2005. The remaining netincrease in revenues of approximately $0.9 million was due to variousinsignificant fluctuations in revenues at our other adult secure facilities.

Ouradult secure institutional services division revenues are primarily generatedfrom contracts with federal and state government agencies.  At June 30, 2006 we operated 11 adultsecure institutional facilities with an aggregate service capacity of 9,586.

Averagecontract occupancy was 93.0% for the three months ended June 30, 2006compared to 94.9% for the three months ended June 30, 2005.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Regional Correctional Center in 2005,average contract occupancy was 105.1% for the three months ended June 30,2005.  The average per diem rate for ouradult secure facilities was approximately $58.45 and $48.22 for the threemonths ended June 30, 2006 and 2005, respectively.  The increase in the per diem rate for 2006was due to the opening of the Moshannon Valley Correctional Center in April2006.  There were no revenuesattributable to start-up operations in the three months ended June 30,2006.  Revenues attributable to start-upoperations were approximately $1.0 million in the three months endedJune 30, 2005 and were attributable to the Regional Correctional Center inNew Mexico.

***Juvenile.***Juvenile justice, educational andtreatment services division revenues decreased approximately $1.6 million, or5.3%, to $28.7 million for the three months ended June 30, 2006 from $30.3million for the three months ended June 30, 2005 due primarily to adecrease in revenues of approximately $1.3 million due to the temporary closureof the Campbell Griffin Treatment Center in October 2005 and a decrease inrevenues of approximately $1.0 million at the Danville Center for AdolescentFemales due to reduced occupancy preceeding the effective conclusion of ourmanagement contract in March 2006.  Theremaining net increase in revenues of approximately $0.7 million was due tovarious insignificant fluctuation in revenues at our other juvenile facilitiesand programs. We currently plan to reactivate the Campbell Griffin TreatmentCenter in the fourth quarter of 2006.

AtJune 30, 2006, we operated 18 residential juvenile facilities and 15non-residential juvenile community-based programs with an aggregate servicecapacity of 4,165.  Our contracts forthese facilities and programs are generally with state and local governmentagencies and generally renew annually.

Average contractoccupancy for the three months ended June 30, 2006 was 92.1% compared to91.6% for the three months ended June 30, 2005.

Theaverage per diem rate for our residential juvenile facilities was approximately$164.28 for the three months ended June 30, 2006 compared to $161.61 forthe three months ended June 30, 2005. Our average fee-for-service rate for our non-residential juvenilecommunity-based facilities and programs was approximately $36.33 for the threemonths ended June 30, 2006 compared to $32.00 for the three months endedJune 30, 2005. The increase in average fee-for-service rate in 2006 is dueto changes in the mix of services provided at our non-residential juvenilefacilities and programs, as well as the addition of several new alternativeeducation programs in 2005. There were no revenues attributable to start-upoperations for the three months ended June 30, 2006 and 2005.

***Adult Community-Based.*****Adult community-based corrections andtreatment services division revenues decreased approximately $1.0 million, or6.1%, to $15.5 million for the three months ended June 30, 2006 from $16.5million for the three months ended June 30, 2005 due primarily to adecrease in revenues of approximately $0.6 million at our Southwood  programs due to reduced participation inthese programs and a decrease in revenues of approximately $0.3 million due tothe termination of our management contract for the SMART program in September2005. The remaining net decrease in revenues of $0.1 million was due to variousfluctuations in revenues at our other adult community-based facilities andprograms.

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At June 30,2006, we operated 26 residential adult community-based facilities and 10non-residential adult community-based programs with an aggregate servicecapacity of 5,389.  Average contractoccupancy was 97.1% for the three months ended June 30, 2006 compared to 105.0%for the three months ended June 30, 2005. The average per diem rate for our residential adult community-basedfacilities was approximately $60.33 for the three months ended June 30, 2006compared to $61.16 for the three months ended June 30, 2005.  The average fee-for-service rate for ournon-residential adult community-based programs was approximately $10.16 for thethree months ended June 30, 2006 compared to $9.55 for the three months endedJune 30, 2005.  There were no revenuesattributable to start-up operations for the three months ended June 30, 2006and 2005.

***Operating Expenses****.*Operating expenses increasedapproximately $7.6 million, or 12.8%, to $67.1 million for the three monthsended June 30, 2006 from $59.5 million for the three months ended June 30,2005.

***Adult Secure.***Adultsecure institutional services division operating expenses increased approximately$9.1 million, or 41.7%, to $30.9 million for the three months ended June 30,2006 from $21.8 million for the three months ended June 30, 2005 due primarilyto (1) operating expenses of approximately $4.4 million at the MoshannonValley Correctional Center which opened in April 2006, (2) an increase inoperating expenses of approximately $2.8 million at the Regional CorrectionalCenter as the operating expenses for the three months ended June 30, 2005 werereported as pre-opening and start-up expenses and (3) operating expenses ofapproximately $1.2 million at the Mesa Verde Community CorrectionalCenter.  The remaining net increase inoperating expenses of approximately $0.7 million was due to variousfluctuations in operating expenses at our other adult secure facilities.

As a percentage of segment revenues, adult secureinstitutional services division operating expenses were 66.8% for the threemonths ended June 30, 2006 compared to 68.7% for the three months endedJune 30, 2005.  As Moshannon ValleyCorrectional Center continues to ramp its population, we anticipate some margindecreases as certain variable costs increase. Excluding approximately $1.0 million of revenues attributable to thestart-up operations of the Regional Correctional Center for the three monthsended June 30, 2005, adult secure institutional services division operatingexpenses, as a percentage of segment revenues, were 71.0%.

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses decreased approximately $1.2million, or 4.8%, to $23.8 million for the three months ended June 30, 2006from $25.0 million for the three months ended June 30, 2005 due primarilyto a decrease in operating expenses of approximately $1.0 million due tothe temporary closure of the Campbell Griffin Treatment Center in October 2005and a decrease in operating expenses of approximately $1.0 million at theDanville Center for Adolescent Females (due to reduced occupancy as notedabove).  The remaining net increase inoperating expenses of approximately $0.8 million was due to variousinsignificant fluctuations in operating expenses at our other juvenilefacilities and programs.

As a percentageof segment revenues, juvenile services division operating expenses were 83.0%for the three months ended June 30, 2006 compared to 82.6% for threemonths ended June 30, 2005.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division operating expenses decreasedapproximately $0.3 million, or 2.4%, to $12.4 million for the three months endedJune 30, 2006 from $12.7 million for the three months ended June 30,2005 due to a decrease in operating expenses of approximately $ 0.2million due to the termination of our management contract for the SMART programin September 2005 and a decrease in operating expenses of $0.1 million at theSouthwood programs.

As a percentageof segment revenues, adult community-based division operating expenses were79.8% for the three months ended June 30, 2006 compared to 77.1% for the threemonths ended June 30, 2005.

***Pre-Opening and Start-up Expenses.*** Therewere no pre-opening and start-up expenses for the three months ended June 30,2006.  Pre-opening and start-up expensesfor the three months ended June 30, 2005 were approximately $2.2 millionand were attributable to the pre-opening and start-up activities of theRegional Correctional Center and the Moshannon Valley Correctional Center.

***Depreciation and Amortization*****. **Depreciationand amortization increased approximately $0.4 million, or 10.5%, to $4.2 millionfor the three months ended June 30, 2006 from $3.8 million for the threemonths ended June 30, 2005 due primarily to depreciation of the buildingand related furniture and equipment at the Moshannon Valley Correctional Centerwhich opened in April 2006.  Amortizationof intangibles was approximately $0.6 million and $0.5 million for the threemonths ended June 30, 2006 and 2005, respectively.

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***General and Administrative Expenses.*** Generaland administrative expenses increased approximately $0.5 million, or 10.2%, to$5.4 million for the three months ended June 30, 2006 from $4.9 millionfor the three months ended June 30, 2005 due primarily tocompensation expense of approximately $0.5 million recognized under theprovisions of FAS 123R which we adopted effective January 1, 2006. See note 2to the accompanying financial statements for further discussion concerning ouradoption of FAS 123R.

***Interest.*** Interest expense, net of interestincome, increased to approximately $6.6 million for the three months ended June 30,2006 from $5.6 million for the three months ended June 30, 2005.  In the three months ended June 30,2006 we recognized interest expense related to the interest rate swap of $0.1million compared to interest income of $0.3 million in the three months endedJune 30, 2005.  At current interest ratelevels, we would expect to continue to incur additional interest expense underour interest rate swap.  Any additional risein interest rates would increase our interest expense.  Moreover, we did not capitalize interest inthe three months ended June 30, 2006.  Capitalizedinterest for the three months ended June 30, 2005 was approximately $0.6million and related to development and construction costs for the MoshannonValley Correctional Center.

***Income Taxes.*** For thethree months ended June 30, 2006, we recognized a provision for incometaxes on our income from operations at an estimated effective rate of42.9%.  For the three months endedJune 30, 2005, we recognized a provision for income taxes on income fromcontinuing operations at an estimated effective rate of 46.2%.  The change in our estimated effective taxrate in 2006 was related to an increase in operating income across certain ofour business segments and the impact of certain non-deductible expenses such aslobbying and tax-exempt income.

***SixMonths Ended June 30, 2006 Compared to Six Months Ended June 30, 2005***

***Revenues*****.** Revenues increased approximately $22.2million, or 14.6%, to $174.3 million for the six months ended June 30, 2006from $152.1 million for the six months ended June 30, 2005.

***Adult Secure.***Adultsecure institutional services division revenues increased approximately $22.0million, or 35.1%, to $84.6 million for the six months ended June 30, 2006from $62.6 million for the six months ended June 30, 2005 due primarily to(1) revenues of approximately $8.9 million at the Moshannon ValleyCorrectional Center which opened in April 2006, (2) an increase in revenues ofapproximately $6.0 million at the Regional Correctional Center due to increasedoccupancy, (3) revenues of approximately $3.4 million at the Mesa VerdeCommunity Correctional Facility which we began managing in January 2006, (4) anincrease in revenues of approximately $1.6 million at the D. Ray James Prisondue to increased occupancy coupled with a per diem rate increase in 2005, (5)an increase in revenues of approximately $0.9 million at our two securefacilities in California and (6) an increase in revenues of approximately $0.5million at the Lincoln County Detention Center acquired from CSI in April2005.  The remaining net increase inrevenues of approximately $0.7 million was due to various fluctuations inrevenues at our other adult secure facilities.

Average contract occupancy for the six months endedJune 30, 2006 was 95.6% compared to 93.9% for the six months endedJune 30, 2005.  Excluding the actualoccupancy and contract capacity for the start-up operations of the RegionalCorrectional Center in the six months ended June 30, 2005, averagecontract occupancy was 104.1% for the six months ended June 30, 2005.

 The averageper diem rate for our adult secure facilities was approximately $56.18 and$48.35 for the six months ended June 30, 2006 and 2005, respectively.  The increase in the per diem rate in 2006 isdue to the opening of the Moshannon Valley Correctional Center in April2006.  There were no revenuesattributable to start-up operations for the six months ended June 30,2006.  Revenues attributable to start-upoperations for the six months ended June 30, 2005 were approximately $2.5million and were attributable to the start-up operations of the RegionalCorrectional Center in New Mexico.

***Juvenile.***Juvenile justice, educational and treatment services divisionrevenues decreased approximately $2.5 million, or 4.1%, to $58.0 million forthe six months ended June 30, 2006 from $60.5 million for the six monthsended June 30, 2005 due primarily to a decrease in revenues ofapproximately $2.8 million as a result of the temporary closure of the CampbellGriffin Treatment Center in October 2005 and a decrease in revenues ofapproximately $1.1 million at the Danville Center for Adolescent Females due toreduced occupancy preceeding the effective conclusion of our managementcontract in March 2006. The decrease in revenues due to the above was offset,in part, by an increase of approximately $1.1 million at the Southern PeaksRegional Treatment Center due to increased occupancy and an increase inrevenues of approximately $1.2 million from the commencement of our managementcontract for the Reading Alternative Education Program in July 2005. Theremaining net decrease in revenues of approximately $0.9 million was duevarious fluctuations in revenues at our other juvenile facilities and programs.

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Average contract occupancy was 91.8% for the sixmonths ended June 30, 2006 and 2005. Excluding the actual occupancy andcontract capacity for the start-up activities of the Southern Peaks RegionalTreatment Center in 2005, average contract occupancy was 93.5% for the sixmonths ended June 30, 2005.  Theaverage per diem rate for our residential juvenile facilities was approximately$168.89 and $162.95 for the six months ended June 30, 2006 and 2005,respectively.  Our averagefee-for-service rate for our non-residential juvenile community-basedfacilities and programs was approximately $35.63 and $31.57 for the six monthsended June 30, 2006 and 2005, respectively.  The increase in average fee-for-service ratein 2006 is due to changes in the mix of services provided, as well as theaddition of several new alternative education programs in 2005.

There were norevenues attributable to start-up operations for the six months ended June 30,2006.  Revenues attributable to start-upoperations were approximately $1.5 million for the six months endedJune 30, 2005 and were attributable to the start-up operations of theSouthern Peaks Regional Treatment Center.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division revenues increased approximately$2.7 million, or 9.3%, to $31.8 million for the six months ended June 30,2006 from $29.1 million for the six months ended June 30, 2005 dueprimarily to revenues ofapproximately $2.8 million generated from the facilities and programs acquiredfrom Correctional Systems, Inc. (“CSI”) in April 2005.  The remaining net decrease in revenues ofapproximately $0.1 million was due to various insignificant fluctuations inrevenues at our other adult community-based facilities and programs.

Average contract occupancy for the six months endedJune 30, 2006 was  98.4% compared to103.2% for the six months ended June 30, 2005.  The average per diem rate for our residentialadult community-based facilities was $62.62 and $61.36 for the six months endedJune 30, 2006 and 2005, respectively.  The average fee-for-service rate for our non-residential adultcommunity-based programs was $8.75 and $8.54 for the six months endedJune 30, 2006 and 2005, respectively.  There were no revenues attributable to start-up operations for the sixmonths ended June 30, 2006 and 2005.

***Operating Expenses.***Operating expenses increased approximately $18.3 million, or 16.1%, to $132.3 millionfor the six months ended June 30, 2006 from $114.0 million for the sixmonths ended June 30, 2005.

***Adult Secure.***Adultsecure institutional services division operating expenses increasedapproximately $15.3 million, or 36.3%, to $57.4 million for the six monthsended June 30, 2006 from $42.1 million for the six months ended June 30,2005 due primarily to (1) an increase in operating expenses ofapproximately $4.4 million at the Moshannon Valley Correctional Center whichopened in April 2006 (operating expenses of approximately $0.1 million incurredduring the same period of 2005 were reported as pre-opening and start-upexpenses), (2) operating expenses of approximately $2.4 million at the MesaVerde Community Correctional Center we began operating in January 2006, (3) anincrease in operating expenses of approximately $6.3 million at the RegionalCorrectional Center (as the expenses incurred in the same period of 2005 werereported as pre-opening and start-up expenses), (4) an increase in operatingexpenses of approximately $0.6 million at our two secure facilities inCalifornia due to increased occupancy and (5) an increase in operating expensesof approximately $0.4 million at the Lincoln County Detention Center acquiredfrom CSI in April 2005. The remaining net increase in operating expenses of$1.2 million was due to various fluctuations in operating expenses at our otheradult secure facilities.

As a percentageof segment revenues, adult secure institutional services division operatingexpenses were 67.9% for the six months ended June 30, 2006 compared to 67.2%for the six months ended June 30, 2005. Excluding approximately $2.5 million of revenues attributable to thestart-up operations of the Regional Correctional Center in the six months endedJune 30, 2005, adult secure institutional services division operatingexpenses, as a percentage of segment revenues, were 70.1% for the six monthsended June 30, 2005.

***Juvenile.***Juvenile justice, educational andtreatment services division operating expenses increased approximately $0.5million, or 1.0%, to $49.8 million for the six months ended June 30, 2006from $49.3 million for the six months ended June 30, 2005 due primarily to(1) a decrease in operating expenses of approximately $1.9 milliondue to the temporary closure of the Campbell Griffin Treatment Center inOctober 2005, (2) a decrease in operating expenses of approximately $1.2million at the Danville Center for Adolescent Females due to reduced occupancyas our management contract for this facility effectively concluded in March2006 and (3) a decrease in operating expenses of approximately $1.0 million dueto personnel costs recognized in the six months ended June 30, 2005 associatedwith management streamlining initiatives

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implemented in the first quarter of 2005.  The decrease in operating expenses due to theabove was offset, in part, by (1) an increase in operating expenses ofapproximately $2.6 million at the Southern Peaks Regional Treatment Center (asoperating expenses of $1.8 in the six months ended June 30, 2005 were reportedas pre-opening and start-up expenses) and (2) an increase in operating expensesof approximately $0.9 million due to the commencement of our managementcontract for the Reading Alternative Education Program in July 2005.  The remaining net increase in operatingexpenses of approximately $1.2 million was due to various insignificantfluctuations in operating expenses at our other juvenile facilities/programs.

As a percentageof segment revenues, juvenile services division operating expenses were 85.9%for the six months ended June 30, 2006 compared to 81.6% for the sixmonths ended June 30, 2005.  Excluding approximately $1.5 million ofrevenues attributable to the start-up operations of the Southern Peaks RegionalTreatment Center in the six months ended June 30, 2005, juvenile servicesdivision operating expenses, as a percentage of segment revenues, were 83.7%.

***Adult Community-Based.*** Adultcommunity-based corrections and treatment services division operating expenses increasedapproximately $2.4 million, or 10.6%, to $25.1 million for the six months endedJune 30, 2006 from $22.7 million for the six months ended June 30,2005 due primarily to operating expenses of approximately $2.7 millionfrom the facilities and programs acquired from CSI in April 2005.  The remaining net decrease in operatingexpenses of approximately $0.3 million was due various insignificant fluctuationsin operating expenses at our other adult community-based facilities andprograms.

As a percentage of segment revenues, adultcommunity-based corrections and treatment services division operating expenseswere 79.0% for the six months ended June 30, 2006 compared to 77.8% forthe six months ended June 30, 2005.

***Pre-Opening and Start-up Expenses.*** Pre-openingand start-up expenses for the six months ended June 30, 2006 wereapproximately $2.7 million and were attributable to the pre-opening activitiesof the Moshannon Valley Correctional Center. Pre-opening and start-up expenses for the six months ended June 30,2005 were approximately $6.8 million and were attributable to the pre-openingand start-up activities of the Regional Correctional Center, the Southern PeaksRegional Treatment Center and the Moshannon Valley Correctional Center.

***Depreciation and Amortization*****.** Depreciation and amortization increasedapproximately $0.4 million, or 5.3%, to $7.9 million for the six months endedJune 30, 2006 compared to $7.5 million for the six months ended June 30,2005 due primarily to depreciation of the building and related furniture andequipment at the Moshannon Valley Correctional Center which opened in April2006.  Amortization of intangibles wasapproximately $1.1 million and $1.0 million for the six months ended June 30,2006 and 2005, respectively.

***General and Administrative Expenses.*** Generaland administrative expenses decreased approximately $0.6 million, or 5.4%, to $10.6million for the six months ended June 30, 2006 from $11.2 million for thesix months ended June 30, 2005 due primarily to (1) a restructuringcharge of approximately $1.1 million in the six months ended June 30, 2005 forpersonnel costs associated with management’s streamlining initiativesimplemented in the first quarter of 2005 and (2) professional and consultingexpenses of approximately $0.5 million in 2005. The decreases above were offset by an increase in compensation expenseof approximately $1.1 million resulting from adoption of FAS 123R.

***Interest.*** Interest expense, net of interestincome, increased to $11.6 million for the six months ended June 30, 2006from $11.3 million for the six months ended June 30, 2005.  For the six months ended June 30, 2006, werecognized interest expense related to the interest rate swap of approximately$0.04 million compared to interest rate savings of approximately $0.8 millionin the six months ended June 30, 2005. At current interest rate levels, we would expect to incur additionalinterest expense under our interest rate swap. Any additional rise in interest rates would increase our interestexpense.  Furthermore, interest expensedecreased approximately $0.4 million due to an increase in capitalized interestduring 2006.  For six months ended June30, 2006, we capitalized interest of approximately $1.5 million related to theconstruction of the Moshannon Valley Correctional Center compared toapproximately $1.1 million in the six months ended June 30, 2005.

***Income Taxes.*** For thesix months ended June 30, 2006, we recognized a provision for income taxeson our income from continuing operations at an estimated effective rate of43.2%.  For the six months endedJune 30, 2005, we recognized a provision for income taxes on our incomefrom continuing operations at an estimated effective rate of 53.9%.  The change in our estimated effective rate in2006 was related to an increase in operating income across certain of ourbusiness segments.

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**Liquidity andCapital Resources**

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

***Cash Flows From Operating Activities.***  Cash provided by operations was approximately$10.8 million for the six months ended June 30, 2006 compared to $20.5million for the six months ended June 30, 2005.  The decrease in 2006 is due to an increase inaccounts receivable (due to the activation of Moshannon Valley CorrectionalCenter in April 2006) as well as the related timing of collections on accountsreceivable in 2006 and 2005.

***Cash Flows From Investing Activities*****. **Cash usedin investing activities was approximately $17.1 million for the six monthsended June 30, 2006 due to net purchases of investment securities of $1.7million, capital expenditures of approximately $9.1 million and net payments tothe restricted debt payment account of approximately $6.3 million. Cashused in investing activities was approximately $17.1 million for the six monthsended June 30, 2005 due to net sales of investment securities of $12.3million offset by capital expenditures of $23.7 million comprised ofapproximately $14.6 million for the development of Moshannon ValleyCorrectional Center and approximately $9.1 million (net) for the acquisition ofCSI.  Additionally, there were netpayments to the restricted debt payment account of approximately $5.8 million.

***Cash Flows From Financing Activities*****. **Cashprovided by financing activities was approximately $1.7 million due primarilyto proceeds from the exercise of stock options.** **Cash used by financing activitieswas approximately $0.4 million for the six months ended June 30, 2005 dueprimarily to repayments of approximately $1.9 million in debt acquired from CSIoffset by stock option proceeds received of $1.7 million.

***Treasury Stock/Repurchases.***  There were no purchases of our common stockin the six months ended June 30, 2006 and 2005.

***Long-Term Credit Facilities.***  OurCredit Facility provides for borrowings of up to $60.0 million under arevolving line of credit, and is reduced by outstanding letters of credit.  The available commitment under our CreditFacility was approximately $49.8 million at June 30, 2006.  We had no outstanding borrowings on ourCredit Facility at June 30, 2006, but we had outstanding letters of credit ofapproximately $10.2 million.  Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder our Credit Facility up to an aggregate amount of $100.0 million.  Our Credit Facility matures in June 2008 andbears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. Our CreditFacility is collateralized by substantially all of our assets, including theassets and stock of all of our subsidiaries. Our Credit Facility is not securedby the assets of Municipal Corrections Finance, LP (“MCF”).  Our Credit Facility contains standard covenantsincluding compliance with laws, limitations on capital expenditures,restrictions on dividend payments, limitations on mergers and compliance withfinancial covenants.

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

InJune 2004, we issued $112.0 million in principal of 10.75% Senior Notes (the “SeniorNotes”) due July 1, 2012.  The SeniorNotes are unsecured senior indebtedness and are guaranteed by all of ourexisting and future subsidiaries (collectively, the “Guarantors”).  The Senior Notes are not guaranteed by MCF(the “Non-Guarantor”).  Interest on theSenior Notes is payable semi-annually on January 1 and July 1 of each year, commencingJanuary 1, 2005.  On or after July 1,2008, we may redeem all or a portion of the Senior Notes at the redemptionprices (expressed as a percentage of the principal amount) listed below, plusaccrued and unpaid interest, if any, on the Senior Notes redeemed, to theapplicable date of redemption, if redeemed during the 12-month periodcommencing on July 1 of the years indicated below:

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

 

Any time prior to July 1, 2007, we may redeem up to 35% of the originalaggregate principal amount of the Senior Notes at a redemption price of 110.75%of the principal amount thereof with the net cash of public offerings ofequity, provided that at least 65% of the original aggregate principal amountof the Notes remains outstanding after the redemption and other conditions aremet.  Upon the occurrence of specifiedchange of control events, unless we have exercised our option to redeem all theSenior Notes as described above, each holder will have the right to require usto repurchase all or a portion of such holder’s Senior Notes at a purchaseprice in cash equal to 101% of the aggregate principal amount of the notesrepurchased plus accrued and unpaid interest, if any, on the Senior Notesrepurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) that limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to paydividends or other payments to us, enter into transactions with affiliates, andengage in mergers, consolidations and certain sales of assets.

In conjunction with the issuance of the Senior Notes, we entered intoan interest rate swap transaction with a financial institution to hedge ourexposure to changes in the fair value on $84.0 million of our SeniorNotes.  The purpose of this transactionwas to convert future interest due on $84.0 million of the Senior Notes to avariable rate.  The terms of the interestrate swap contract and the underlying debt instrument are identical.  We have designated the swap agreement as afair value hedge.  The swap has anotional amount of $84.0 million and matures in July 2012 to mirror thematurity of the Senior Notes.  Under theagreement, we pay on a semi-annual basis (each January 1 and July 1) a floatingrate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive afixed-rate interest of 10.75%.  For thethree and six months ended June 30, 2006, we recorded interest expense relatedto this interest rate swap of approximately $0.1 million and $0.04 million,respectively, which is reflected as interest expense in the accompanyingfinancial statements.  For the three andsix months ended June 30, 2005, we recorded interest savings related to thisinterest rate swap of approximately $0.3 million and $0.8 million,respectively, which is reflected as a reduction to interest expense in theaccompanying financial statements.  Theswap agreements are marked to market each quarter with a corresponding mark-to-marketadjustment reflected as either a discount or premium on the Senior Notes.  At June 30, 2006 and December 31, 2005, thefair value of this derivative instrument was approximately ($3.1) million and($0.1) million, respectively, and is included in other liabilities.  The carrying value of the Senior Notes as ofthese dates was reduced by the same amount. Because the swap agreement is aneffective fair-value hedge, there is no effect on our results of operationsfrom the mark-to-market adjustment as long as the swap is in effect.

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

***Big Spring Correctional Center.***   TheFederal Bureau of Prisons (“BOP”) is soliciting a Request for Proposals (“RFP”)for services to house approximately 7,000 low security non-United Statescitizen sentenced males in an existing secure correctional institution procuredfrom private sources or state and local governments, with excess capacity,located in Arizona, California, Louisiana, New Mexico, Oklahoma or Texas toreplace several existing intergovernmental agreements (“IGA”) for suchservices, including the IGA relating to our Big Spring CorrectionalCenter.  We submitted a response to theRFP on August 8, 2006.  Our failure tosuccessfully respond to this RFP would materially adversely affect ourfinancial condition, results of operations and liquidity.

***New Morgan Academy.***We closed theNew Morgan Academy in the fourth quarter of 2002 and have considered severaloptions ranging from the utilization of the facility for another type ofprogram or the sale or lease of the facility. As of June 30, 2006, we arefocusing our efforts on the reopening of the facility by the fourth quarter of2006. Once reopened, the facility will operate as a residential treatmentfacility for youth sex offenders. We are maintaining a small staff to secureand maintain the facility during the finalization of the reactivationplans.  We recognized pre-tax costs of$1.0 million and $1.9 million in our Consolidated Statements of Operations andComprehensive Income (Loss) for the three and six months ended June 30, 2006,respectively, for related holding costs (depreciation, interest, property,taxes and other maintenance costs). We recognized pre-tax costs of $0.9 millionand $1.8 million in the three and six months ended June 30, 2005, respectively,related to these costs.

As of June 30, 2006, we believe that, pursuant to the provisions ofSFAS No. 144, no impairment allowance is necessary. The carrying value ofthe property and equipment for the New Morgan Academy was approximately $19.6 millionand $19.9 million at June 30, 2006 and December 31, 2005, respectively.

***Regional Correctional Center.***InJanuary 2003, we executed a five-year lease for the Regional CorrectionalCenter in Albuquerque, New Mexico. This 970 bed facility consists of two units,the 528 South Tower and the 442 bed North Tower. As of June 30, 2006, we hadinvested approximately $9.8 million on renovations and furniture and equipmentfor both towers. While we currently anticipate that there will be periods thatthe facility will reach substantial capacity during 2006, there can be noassurance that we will develop (maintain) enough volume at the facility toassure its profitability. The lease

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for the facility requires monthly rental payments ofapproximately $113,000 for the first two years and $130,000 for the last threeyears of the lease.

***Central California Treatment Center.***InJanuary 2004, we purchased a building in Los Angeles, California for whichour carrying value was approximately $2.7 million at December 31, 2005. In2005, we received notice from a local governmental agency indicating a desireto acquire the facility. In early 2006, the governmental agency initiatedcondemnation proceedings relating to the facility and deposited approximately$2.9 million of condemnation proceeds with the court, which we received in July2006. We also have commenced litigation contesting the valuation of thefacility submitted by the governmental agency.

***Campbell GriffinTreatment Center.***In October 2005, we initiated thetemporary closure of this leased facility in San Antonio, Texas. It is ourintent to reactivate this facility during the fourth quarter of 2006.Accordingly, it has not been included in discontinued operations.

***Future Liquidity*****.**Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future developmentcontracts. To the extent our cash and current financing arrangements do notprovide sufficient financing to fund construction costs related to future adultsecure institutional contract awards or significant facility expansions, weanticipate obtaining additional sources of financing to fund such activities.However, there can be no assurance that such financing will be available orwill be available on terms favorable to us.

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

We maintainoperating leases in the ordinary course of our business activities.  These leases include those for operatingfacilities, office space and office and operating equipment, and the terms ofthese agreements range from 2006 until 2075.  As of June 30, 2006, our total commitmentunder these operating leases was approximately $33.3 million.

The followingtable details our known future cash payments (on an undiscounted basis) relatedto various contractual obligations as of June 30, 2006 (in thousands):

|                                              | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                   | ** ** | ** **                                | ** ** | ** ** | ** ** | **2007 -** | ** ** | **2009 -** | ** ** | ** ** | ** ** |
| ** **                                   | ** ** | **Total**                                 | ** ** | **2006** | ** ** | **2008** | ** ** | **2010** | ** ** | **Thereafter** | ** ** |
|                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Contractual  Obligations:                    |       |                                      |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                   |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.     |       | $                                         | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| · Special Purpose Entities         |       | 165,700                                   |       | 9,700 |   | 21,900 |   | 25,800 |   | 108,300 |   |
| Long-term debt - interest (1)                |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.     |       | 75,140                                    |       | 6,296 |   | 25,055 |   | 25,029 |   | 18,760 |   |
| · Special Purpose Entities         |       | 89,490                                    |       | 7,017 |   | 25,537 |   | 22,666 |   | 34,270 |   |
| Capital lease  obligations                   |       |                                      |       |   |   |   |   |   |   |   |   |
| · Cornell Companies, Inc.     |       | 52                                        |       | 10 |   | 20 |   | 21 |   | 1 |   |
| Operating leases                             |       | 33,273                                    |       | 3,203 |   | 11,050 |   | 8,540 |   | 10,480 |   |
| Consultative and  non-competition agreements |       | 1,127                                     |       | 486 |   | 641 |   | — |   | — |   |
| Total contractual cash  obligations          |       | $                                         | 476,782    |   | $ | 26,712 |   | $ | 84,203 |   | $ | 82,056 |   | $ | 283,811 |   |

 

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(1)          We have an interest rateswap agreement under which we receive a fixed interest rate and pay a floatinginterest rate. The future cash payments on the Cornell Companies, Inc.long-term debt – interest assume an effective rate of 11.16% on the relatedinterest rate swap contract. An increase in the six-month U.S. dollar LIBORrate would increase future interest payments as required under thisarrangement.

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We enter intoletters of credit in the ordinary course of our operating and financingactivities.  As of June 30, 2006, wehad outstanding letters of credit of approximately $10.2 million related toinsurance and other operating activities. The following table details our letter of credit commitments as of June 30,2006 (in thousands):
|                           | ** ** | **Total**     | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|---------------------------|------------|---------------|------------|-------------------------------------------------------------------------|------------|
| ** **                | ** ** | **Amounts**   | ** ** | **Less than**                                                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Over** | ** ** |
| ** **                | ** ** | **Committed** | ** ** | **1 Year**                                                         | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **5 Years** | ** ** |
|                      |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Commercial Commitments:   |       |          |       |                                                                    |       |   |   |   |   |   |   |
| Standby letters of credit |       | $             | 10,182     |                                                                    | $          | 9,432 |   | $ | — |   | $ | 750 |   | $ | — |   |
|                           |            |               |            |                                                                         |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

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

**Interest RateExposure**

Our exposure tochanges in interest rates primarily results from our long-term debt with bothfixed and floating interest rates.  Thedebt on our consolidated financial statements with fixed interest ratesconsists of the 8.47% Bonds issued by MCF in August 2001 in connectionwith the 2001 Sale and Leaseback Transaction and approximately $28.0 million ofthe Senior Notes (not hedged by the interest rate swap entered into by theCompany).  At June 30, 2006, 30.7%($84.0 million of debt outstanding on the Senior Notes issued in June 2004)of our consolidated long-term debt was subject to variable interest rates.  The detrimental effect of a hypothetical 100basis point increase in interest rates would be to reduce income beforeprovision for income taxes by approximately $0.2 million and $0.4 million forthe three and six months ended June 30, 2006.  At June 30, 2006, the fair value of ourconsolidated fixed rate debt approximated carrying value based upon discountedfuture cash flows using current market prices.

**ITEM 4.          Controlsand Procedures**

We maintain disclosure controls and proceduresdesigned to ensure that information disclosed in our annual and periodicreports is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms. Inaddition, we designed these disclosure controls and procedures to ensure thatthis information is accumulated and communicated to management, including thechief executive officer (CEO) and chief financial officer (CFO), to allowtimely decisions regarding required disclosures. SEC rules require that wedisclose the conclusions of our CEO and CFO about the effectiveness of ourdisclosure controls and procedures.

We do not expect that our disclosure controls and procedures willprevent all errors or fraud. The design of disclosure controls and proceduresmust reflect the fact that there are resource constraints, and the benefits ofcontrols must be considered relative to their costs. Because of the inherentlimitation in a cost-effective control system, no evaluation of controls canprovide absolute assurance that all control issues and instances of fraud, ifany, within the Company have been detected.

Underthe supervision and with the participation of our management, including ourprincipal executive officer and principal financial officer, we have evaluatedthe effectiveness of the design and operation of our disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) of theSecurities Exchange Act of 1934, as amended (the Exchange Act) as of the end ofthe period required by this report. Based on that evaluation, our principalexecutive officer and principal financial officer have concluded that thesecontrols and procedures are effective as of that date.

In connection withthe evaluation described above, there have been no changes in our internalcontrol over financial reporting (as such term is defined inRules 13a-15(f) and 15d-15(f) under Exchange Act) during ourfiscal quarter ended June 30, 2006 that has materially affected, or isreasonably likely to materially affect, our internal control over financialreporting.

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**PART II****                          ****OTHER INFORMATION**
| **ITEM 1.**  | ** ** | **Legal Proceedings.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|--------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|         |       | See Part I, Item 1. Financial Statements, Note 7.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| **ITEM 1A.** | ** ** | **Risk Factors.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
| ** **   | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|         |       | The risk factors as previously discussed in our Form 10-K for  the fiscal year ended  December 31, 2005 are incorporated herein by this reference. There are  no material  changes to such risk factors.                                                                                                                                                                                                                                                                                                                                                                                                                  |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|         |       | On June 5, 2006, we announced that we had retained a financial advisor  to assist us in our analysis and consideration of a range of strategic  alternatives to maximize shareholder value.  We do not intend to make further  announcements on the status or results of the assessment process unless and  until we have made a definitive decision on our future strategic direction.  This  assessment process is ongoing  and is subject to a number of risks and uncertainties.  No assurance can be given that any  transaction will be pursued or, if a transaction is pursued, that it will be  consummated. |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| **ITEM 2.**  | ** ** | **Unregistered  Sales of Equity Securities and Use of Proceeds.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|         |       | None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| **ITEM 3.**  | ** ** | **Defaults Upon Senior Securities.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|         |       | None.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| **ITEM 4.**  | ** ** | **Submission of Matters to a Vote of Security Holders.**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|         |       | On June 29, 2006, the Company held  its 2006 Annual Meeting of Stockholders.   The matters voted on at the meeting and the results thereof are as  follows:                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
|         |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|         |       | Stockholders elected the persons listed  below as directors whose terms expire at the 2007 Annual Meeting of  Stockholders.  Results by nominee were:                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |

 

|                            | ** ** | ** **    | ** ** | **Authority** | ** ** |
|----------------------------|------------|---------------|------------|---------------|------------|
| ** **                 | ** ** | **Voted For** | ** ** | **Withheld**  | ** ** |
| ** **                 | ** ** | ** **    | ** ** | ** **    | ** ** |
| Anthony R. Chase           |       | 11,632,576    |       | 444,549       |       |
| Leon Clements              |       | 11,965,925    |       | 111,200       |       |
| Richard Crane              |       | 11,912,712    |       | 164,413       |       |
| Zachary R. George          |       | 11,630,103    |       | 447,022       |       |
| Todd Goodwin               |       | 11,966,260    |       | 110,865       |       |
| Thomas R. Hudson, Jr. |       | 11,912,463    |       | 164,662       |       |
| James E. Hyman             |       | 11,966,846    |       | 110,279       |       |
| Alfred Jay Moran, Jr. |       | 11,966,824    |       | 110,301       |       |
| D. Stephen Slack           |       | 11,633,075    |       | 444,050       |       |
| Sally L. Walker            |       | 11,912,813    |       | 164,312       |       |

 
|             |       | Stockholders ratified the appointment  of PricewaterhouseCoopers LLP as the Company’s independent registered public  accounting firm for the fiscal year ending December 31, 2006 with  12,050,838 shares voted for, 16,299 shares voted against and 9,988 shares  abstained. |
|-------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|        |       |                                                                                                                                                                                                                                                                                    |
|        |       | Stockholders  approved the Company’s 2006 Equity Incentive Plan with 9,829,265 shares voted  for, 230,282 shares voted against, 15,033 shares abstained and 2,002,545  shares not voted.                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                    |
| **ITEM 5.** | ** ** | **Other Information.**                                                                                                                                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                                    |
|        |       | None.                                                                                                                                                                                                                                                                                   |

 

39

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| **ITEM 6.** | ** ** | **Exhibits.** |
|-------------|------------|---------------|
| ** **  |       | 10.1(a)       | Terms  and conditions of incentive stock option grants under the Cornell Companies,  Inc. Amended and Restated 1996 Stock Option Plan to named executive officers  and form of stock option agreement (incorporated by reference to Item 1.01  and Exhibit 99.1 to the Registrant’s Current Report on Form 8-K, as filed on  April 13, 2006) |
| ** **  |       | 10.2  (a)     | Cornell  Companies, Inc. 2006 Equity Incentive Plan (incorporated by reference to  Annex A to the Registrant’s Schedule 14A, as filed on May 10, 2006) |
| ** **  |       | 10.3  (a)*    | Amendment  to Severence Agreement, dated August 9, 2006, between Cornell Companies, Inc.  and Mark S. Croft |
| ** **  |       | 31.1*         | Section 302  Certification of Chief Executive Officer |   |
| ** **  |       | 31.2*         | Section 302  Certification of Chief Financial Officer |   |
| ** **  |       | 32.1*         | Section 906  Certification of Chief Executive Officer |   |
| ** **  |       | 32.2*         | Section 906  Certification of Chief Financial Officer |   |

 

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| ** ** |   | (a) | Compensation plan or agreement in which directors or executive  officers are eligible to participate. |   |
|------------|--------|-----|-------------------------------------------------------------------------------------------------------|--------|
| ** ** |   | *   | Filed herewith.                                                                                       |   |

 

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**SIGNATURES**

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the Registrant has duly caused this reportto be signed on its behalf by the undersigned, thereunto duly authorized.
|                                                  | ** ** | **CORNELL COMPANIES,  INC.**           |
|--------------------------------------------------|------------|----------------------------------------|
|                                             |       |                                   |
|                                             |       |                                   |
| Date:    August 9, 2006 | By:        | /s/ James E. Hyman                     |   |
|                                             |       | JAMES E. HYMAN                         |
|                                             |       | Chief Executive Officer and            |
|                                             |       | Chairman of the Board                  |
|                                             |       | (Principal Executive Officer)          |
|                                             |       |                                   |
|                                             |       |                                   |
| Date:    August 9, 2006 | By:        | /s/ John R.  Nieser                    |   |
|                                             |       | JOHN R. NIESER                         |
|                                             |       | Chief Financial  Officer and Treasurer |
|                                             |       | (Principal  Financial Officer)         |

 

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