**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q**

 

**ý****        QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly PeriodEnded June 30, 2005**

 

**OR**

 

**o****        TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the transitionperiod**               **to**               

 

**Commission File Number 1-14472**

 

**CORNELL COMPANIES, INC.**

(Exact name ofregistrant 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 area code: **(713)  623-0790** |

 

Indicateby a check mark whether Registrant (1) has filed all reports required tobe filed by Sections 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months, and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes ý  No o

 

Indicateby a check mark whether Registrant is an accelerated filer (as defined inExchange Act Rule 12b-2).

 

Yes ý  No o

 

At July 31, 2005 Registranthad outstanding 13,626,821 shares of its Common Stock.

 

 

----

 

**PART I          FINANCIAL INFORMATION**

 

**ITEM 1.          Financial Statements**

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCESHEETS**

**(Unaudited)**

**(in thousands, exceptshare data)**

 
| ** **                                                                                                                                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                            | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                                                            |       |              |       |                  |       |
|                                                                                                                                                                  |       |              |       |                  |       |
| **CURRENT  ASSETS:**                                                                                                                                                  |       |              |       |                  |       |
| Cash and cash  equivalents                                                                                                                                            |       | $                 | 12,947     |                  | $          | 9,895 |   |
| Investment securities  available for sale                                                                                                                             |       | 39,450            |       | 51,740                |       |
| Accounts receivable -  trade (net of allowance for doubtful accounts of $2,306 and $3,544,  respectively)                                                             |       | 51,245            |       | 60,174                |       |
| Other receivables (net  of allowance for doubtful accounts of $5,040)                                                                                                 |       | 3,214             |       | 4,691                 |       |
| Debt service fund and other  restricted assets                                                                                                                        |       | 25,390            |       | 19,713                |       |
| Deferred tax assets                                                                                                                                                   |       | 10,246            |       | 8,520                 |       |
| Prepaid expenses and  other                                                                                                                                           |       | 9,103             |       | 9,106                 |       |
| Total current assets                                                                                                                                                  |       | 151,595           |       | 163,839               |       |
| **PROPERTY  AND EQUIPMENT, net**                                                                                                                                      |       | 292,190           |       | 282,255               |       |
| **OTHER  ASSETS:**                                                                                                                                                    |       |              |       |                  |       |
| Debt service reserve  fund                                                                                                                                            |       | 23,800            |       | 23,801                |       |
| Goodwill, net                                                                                                                                                         |       | 10,588            |       | 7,721                 |       |
| Intangible assets, net                                                                                                                                                |       | 10,136            |       | 7,026                 |       |
| Deferred costs and  other                                                                                                                                             |       | 22,938            |       | 22,989                |       |
| **Total  assets**                                                                                                                                                     |       | $                 | 511,247    |                  | $          | 507,631 |   |
| ** **                                                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                         |       |              |       |                  |       |
| ** **                                                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| **CURRENT  LIABILITIES:**                                                                                                                                             |       |              |       |                  |       |
| Accounts payable and  accrued liabilities                                                                                                                             |       | $                 | 53,044     |                  | $          | 47,237 |   |
| Current portion of  long-term debt                                                                                                                                    |       | 9,001             |       | 9,005                 |       |
| **Total  current liabilities**                                                                                                                                        |       | 62,045            |       | 56,242                |       |
| LONG-TERM DEBT, net of  current portion                                                                                                                               |       | 279,752           |       | 279,528               |       |
| DEFERRED TAX  LIABILITIES                                                                                                                                             |       | 7,534             |       | 8,088                 |       |
| OTHER LONG-TERM  LIABILITIES                                                                                                                                          |       | 2,294             |       | 2,461                 |       |
| **Total  liabilities**                                                                                                                                                |       | 351,625           |       | 346,319               |       |
| **COMMITMENTS  AND CONTINGENCIES**                                                                                                                                    |       |              |       |                  |       |
| ** **                                                                                                                                                            | ** ** | ** **        | ** ** | ** **            | ** ** |
| **STOCKHOLDERS’  EQUITY:**                                                                                                                                       |       |              |       |                  |       |
| Preferred stock, $.001  par value, 10,000,000 shares authorized, none issued                                                                                          |       | —            |       | —                |       |
| Common stock, $.001 par  value, 30,000,000 shares authorized, 15,078,939 and 14,845,107 shares issued  and 13,605,265 and 13,297,524 shares outstanding, respectively |       | 15                |       | 15                    |       |
| Additional paid-in  capital                                                                                                                                           |       | 147,871           |       | 145,825               |       |
| Retained earnings                                                                                                                                                     |       | 24,201            |       | 26,785                |       |
| Treasury stock  (1,547,583 shares of common stock, at cost)                                                                                                           |       | (12,573           | )          | (12,573               | )          |
| Deferred compensation                                                                                                                                                 |       | (1,048            | )          | (432                  | )          |
| Accumulated other  comprehensive income                                                                                                                               |       | 1,156             |       | 1,692                 |       |
| **Total  stockholders’ equity**                                                                                                                                  |       | 159,622           |       | 161,312               |       |
| **Total  liabilities and stockholders’ equity**                                                                                                                  |       | $                 | 511,247    |                  | $          | 507,631 |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

2

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTSOF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)**

**(Unaudited)**

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

 
| ** **                                                                                                                           | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                           | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                                           | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| REVENUES                                                                                                                             |       | $                      | 78,502     |                 | $          | 66,377 |   | $ | 152,142 |   | $ | 131,952 |   |
| OPERATING EXPENSES                                                                                                                   |       | 59,508                 |       | 51,280               |       | 114,039 |   | 102,953 |   |
| PRE-OPENING AND  START-UP EXPENSES                                                                                                   |       | 2,152                  |       | 990                  |       | 6,846 |   | 1,268 |   |
| DEPRECIATION AND AMORTIZATION                                                                                                        |       | 3,816                  |       | 3,093                |       | 7,545 |   | 6,169 |   |
| GENERAL AND  ADMINISTRATIVE EXPENSES                                                                                                 |       | 4,899                  |       | 5,605                |       | 11,237 |   | 9,765 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| INCOME FROM OPERATIONS                                                                                                               |       | 8,127                  |       | 5,409                |       | 12,475 |   | 11,797 |   |
| INTEREST EXPENSE                                                                                                                     |       | 6,244                  |       | 4,663                |       | 12,584 |   | 9,681 |   |
| INTEREST INCOME                                                                                                                      |       | (664                   | )          | (447                 | )          | (1,260 | ) | (817 | ) |
| LOSS ON EXTINGUISHMENT  OF DEBT                                                                                                      |       | 3⁄4                 |       | 2,357                |       | 3⁄4 |   | 2,357 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| INCOME (LOSS) FROM  CONTINUING OPERATIONS BEFORE PROVISION (BENEFIT) FOR INCOME TAXES                                                |       | 2,547                  |       | (1,164               | )          | 1,151 |   | 576 |   |
| PROVISION (BENEFIT) FOR  INCOME TAXES                                                                                                |       | 1,176                  |       | (477                 | )          | 620 |   | 236 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| INCOME (LOSS) FROM  CONTINUING OPERATIONS                                                                                            |       | 1,371                  |       | (687                 | )          | 531 |   | 340 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| DISCONTINUED  OPERATIONS, NET OF TAX BENEFIT OF $904 AND $1,677 IN 2005 AND $286 AND $509  IN 2004                                   |       | (1,682                 | )          | (412                 | )          | (3,115 | ) | (733 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| NET LOSS                                                                                                                             |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| EARNINGS (LOSS) PER  SHARE:                                                                                                          |       |                   |       |                 |       |   |   |   |   |
| BASIC                                                                                                                                |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                                                                            |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                                                                                       |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                                                                             |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| DILUTED                                                                                                                              |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                                                                            |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                                                                                       |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                                                                             |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| NUMBER OF SHARES USED  IN PER SHARE COMPUTATION:                                                                                     |       |                   |       |                 |       |   |   |   |   |
| BASIC                                                                                                                                |       | 13,474                 |       | 13,146               |       | 13,451 |   | 13,114 |   |
| DILUTED                                                                                                                              |       | 13,600                 |       | 13,146               |       | 13,686 |   | 13,330 |   |
|                                                                                                                                 |       |                   |       |                 |       |   |   |   |   |
| COMPREHENSIVE INCOME  (LOSS):                                                                                                        |       |                   |       |                 |       |   |   |   |   |
| Net loss                                                                                                                             |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
| Unrealized gain (loss)  on derivative instruments, net of tax (benefit) provision of $239 and $53 in  2005 and $754 and $435 in 2004 |       | 344                    |       | (1,085               | )          | 77 |   | (627 | ) |
| Comprehensive income  (loss)                                                                                                         |       | $                      | 33         |                 | $          | (2,184 | ) | $ | 2,507 |   | $ | (1,020 | ) |
|                                                                                                                                      |            |                        |            |                      |            |  |  |  |  |  |  |  |  |  |  |  |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

3

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**CORNELL COMPANIES, INC.**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                        | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                        | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                        | ** ** | **2005**             | ** ** | **2004** | ** ** |
| CASH FLOWS FROM  OPERATING ACTIVITIES:                                                                            |       |                 |       |   |   |
| Net loss                                                                                                          |       | $                    | (2,584     | ) | $ | (393 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities -  Loss on extinguishment of debt |       | —               |       | 2,357 |   |
| Depreciation                                                                                                      |       | 6,722                |       | 5,799 |   |
| Amortization of  intangibles and other assets                                                                     |       | 973                  |       | 539 |   |
| Amortization of  deferred compensation                                                                            |       | (401                 | )          | 127 |   |
| Amortization of  deferred financing costs                                                                         |       | 886                  |       | 578 |   |
| Amortization of Senior  Notes discount                                                                            |       | 92                   |       | — |   |
| Provision for bad debts                                                                                           |       | 1,958                |       | 343 |   |
| Gain on sale of  property and equipment                                                                           |       | (7                   | )          | (10 | ) |
| Deferred income taxes                                                                                             |       | (2,955               | )          | 296 |   |
| Change in assets and  liabilities:                                                                                |       |                 |       |   |   |
| Accounts receivable                                                                                               |       | 8,205                |       | 1,265 |   |
| Debt service fund and  other restricted assets                                                                    |       | 119                  |       | (418 | ) |
| Other assets                                                                                                      |       | 2,812                |       | 2,180 |   |
| Accounts payable and  accrued liabilities                                                                         |       | 4,817                |       | (4,680 | ) |
| Deferred revenues and  other liabilities                                                                          |       | (109                 | )          | (41 | ) |
| Net cash provided by  operating activities                                                                        |       | 20,528               |       | 7,942 |   |
|                                                                                                              |       |                 |       |   |   |
| CASH FLOWS FROM  INVESTING ACTIVITIES:                                                                            |       |                 |       |   |   |
| Capital expenditures                                                                                              |       | (14,552              | )          | (20,559 | ) |
| Purchases of investment  securities                                                                               |       | (665,845             | )          | — |   |
| Sales of investment  securities                                                                                   |       | 678,135              |       | — |   |
| Acquisition of a  business                                                                                        |       | (9,064               | )          | — |   |
| Receipt from restricted  escrow arrangement                                                                       |       | —               |       | 5,000 |   |
| Purchase of facility  management contract                                                                         |       | —               |       | (2,900 | ) |
| Return of restricted  assets from deferred bonus plan                                                             |       | —               |       | 86 |   |
| Payments to restricted  debt payment account, net                                                                 |       | (5,795               | )          | (5,523 | ) |
| Proceeds from sale of fixed  assets                                                                               |       | —               |       | 163 |   |
| Net cash used in  investing activities                                                                            |       | (17,121              | )          | (23,733 | ) |
|                                                                                                              |       |                 |       |   |   |
| CASH FLOWS FROM  FINANCING ACTIVITIES:                                                                            |       |                 |       |   |   |
| Proceeds from long-term  debt and line of credit                                                                  |       | —               |       | 69,000 |   |
| Payments on line of  credit                                                                                       |       | —               |       | (71,000 | ) |
| Payments on acquired  debt                                                                                        |       | (1,905               | )          | — |   |
| Payments on synthetic  lease                                                                                      |       | —               |       | (52,495 | ) |
| Proceeds from Senior  Notes, net of discount                                                                      |       | —               |       | 110,527 |   |
| Payments for debt  issuance and other financing costs                                                             |       | —               |       | (5,033 | ) |
| Payments on capital  lease obligations                                                                            |       | (170                 | )          | (6 | ) |
| Proceeds from exercise  of stock options                                                                          |       | 1,720                |       | 1,040 |   |
| Purchases of treasury  stock                                                                                      |       | —               |       | (116 | ) |
| Net cash (used in) provided  by financing activities                                                              |       | (355                 | )          | 51,917 |   |
|                                                                                                              |       |                 |       |   |   |
| NET INCREASE IN CASH  AND CASH EQUIVALENTS                                                                        |       | 3,052                |       | 36,126 |   |
| CASH AND CASH  EQUIVALENTS AT BEGINNING OF PERIOD                                                                 |       | 9,895                |       | 40,171 |   |
| CASH AND CASH EQUIVALENTS  AT END OF PERIOD                                                                       |       | $                    | 12,947     |   | $ | 76,297 |   |
|                                                                                                              |       |                 |       |   |   |
| OTHER NON-CASH  INVESTING AND FINANCING ACTIVITIES:                                                               |       |                 |       |   |   |
| Increase in fair value  of interest rate swap                                                                     |       | $                    | 38         |   | $ | — |   |
| Other comprehensive  income (loss), net of tax                                                                    |       | 77                   |       | (627 | ) |
| Common stock issued for  board of directors fees                                                                  |       | 111                  |       | — |   |

 

The accompanying notes are an integralpart of these consolidated financial statements.

 

4

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

 

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

 

The accompanying unauditedconsolidated financial statements have been prepared by Cornell Companies, Inc.(the “Company”) pursuant to the rules and regulations of the Securitiesand Exchange Commission.  Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles in theUnited States (GAAP) have been condensed or omitted pursuant to such rules andregulations.  In the opinion ofmanagement, adjustments and disclosures necessary for a fair presentation ofthese financial statements have been included. Estimates were used in the preparation of these financialstatements.  Actual results could differfrom those estimates.  These financialstatements should be read in conjunction with the financial statements andnotes thereto included in our 2004 Annual Report on Form 10-K, as amended,as filed with the Securities and Exchange Commission.

 

**2.     Accounting Policies**

 

Seea description of our accounting policies in our 2004 Annual Report on Form 10-K,as amended.

 

***AccountingFor Stock-Based Compensation***

 

Inaccordance with the provisions of Statement of Financial Accounting Standard(SFAS) No. 123, “Accounting for Stock-Based Compensation,” we have electedto account for our stock-based compensation plans under the intrinsic valuemethod established by Accounting Principles Board Opinion (APB) No. 25, “Accountingfor Stock Issued to Employees.”  Inaccordance with the provisions of APB No. 25, the fair value of fixedstock options granted to employees is not reflected in net income, as alloptions granted under those plans had an exercise price equal to or in excessof the market value of the underlying common stock on the date of grant.  The following table illustrates, inaccordance with SFAS No. 148, “Accounting for Stock-Based Compensation –Transition and Disclosure, an Amendment of SFAS No. 123,” the effect onour net loss and loss per share as if we had applied the fair value recognitionprovisions of SFAS No. 123 to stock-based employee compensation (inthousands, expect per share amounts):

 

| ** **                                                                                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                                                                                                  | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                                                  | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                                                                        |       |                   |       |                 |       |   |   |   |   |
| Net loss, as reported                                                                                                                       |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
| Add: total stock-based  compensation recorded, net of tax                                                                                   |       | 31                     |       | 32                   |       | 65 |   | 32 |   |
| Less: total stock-based  employee compensation expense determined under fair value based method for  all awards, net of related tax effects |       | (405                   | )          | (343                 | )          | (796 | ) | (499 | ) |
| Pro forma net loss                                                                                                                          |       | $                      | (685       | )                    | $          | (1,410 | ) | $ | (3,315 | ) | $ | (860 | ) |
| Loss per share:                                                                                                                             |       |                   |       |                 |       |   |   |   |   |
| Basic, as reported                                                                                                                          |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
| Basic, pro forma                                                                                                                            |       | (.05                   | )          | (.11                 | )          | (.25 | ) | (.07 | ) |
| Diluted, as reported                                                                                                                        |       | (.02                   | )          | (.08                 | )          | (.19 | ) | (.03 | ) |
| Diluted, pro forma                                                                                                                          |       | (.05                   | )          | (.11                 | )          | (.25 | ) | (.07 | ) |

 

5

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***New AccountingPronouncements***

*** ***

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFASNo. 123R, “Share Based Payment,” that requires companies to expense thevalue of employee stock options and other types of equity-based compensationbased on the fair value of the options at the award’s grant date based on theestimated number of awards that are expected to vest.  Compensation cost for awards that vest wouldnot be reversed if the awards expired without being exercised.  When measuring fair value, companies canchoose an option-pricing model (e.g., Black-Sholes or binominal models) thatapproximately reflects their specific circumstances and the economics of theirtransactions.  Companies will recognizecompensation cost for share-based payment awards as they vest, including therelated tax effects.  The effective dateof SFAS No. 123R, as amended, applies to annual periods beginning after June 15,2005, and applies to all outstanding and unvested share based payment awards atthe company’s adoption date.  We arecurrently evaluating the alternative transition methods permitted by SFAS No. 123R.

 

Under SFAS No. 123R,compensatory employee stock purchase plans (ESPP) are required to recognizecompensation cost over the requisite service period for grants made under theESPP.  The criteria that an ESPP mustmeet to be considered non-compensatory are more restrictive under SFAS No. 123Rthan they were under APB No. 25.  Weare currently evaluating the impact on our ESPP by SFAS No. 123R.

 

The FASB issued SFAS No. 154, “Accounting Changes and ErrorCorrections – a replacement of APB Opinion No. 20 and FASB Statement No. 3.”  SFAS No. 154 is effective, and will beadopted, for accounting changes made in fiscal years beginning after December 15,2005 and is to be applied retrospectively. SFAS No. 154 requires that retroactive application of a change inaccounting principle be limited to the direct effects of the change.  Our adoption of SFAS No. 154 is notexpected to have a material effect on our financial position or results ofoperations.

 

***Reclassifications***

 

Certain reclassificationshave been made to the prior year financial statements contained herein toconform to current year presentation.

 

**3.****             ****Discontinued Operations andManagement Restructuring**

 

We classify as discontinued operations those components of our businessthat we hold for sale or disposition that have been disposed and cash flowsthat are clearly distinguishable operationally and for financial reportingpurposes from the rest of our operations. For those components, we have nosignificant continuing involvement after disposal and their operations areeliminated from our ongoing operations. During the three and six months ended June 30, 2005, we classifiedcertain components as discontinued operations. This was the result of amanagement decision to initiate the shut down of operations at certainfacilities in the first quarter of 2005. These facilities and programs include the Residential School, the MapleCreek Home and our mental health wrap programs in Pennsylvania in the firstquarter of 2005.  In the second quarterof 2005, we shut down the operations of the Northside Clinic and the Jos-ArzAcademy.  Notifications have been made tothe required contracting entities regarding the termination of the relatedprograms.  At June 30, 2005, we hadnet property and equipment of approximately $0.7 million pertaining to theseoperations.   These discontinuedoperations generated revenues of approximately $0.7 million and $3.6 millionfor the three months ended June 30, 2005 and 2004, respectively, andrevenues of approximately $2.6 million and $7.4 million for the six monthsended June 30, 2005 and 2004, respectively.

 

During the first quarter of 2005, a review was performed of ourmanagement structure and, as a result, approximately 14 positions wereeliminated.  In conjunction with thisaction, a charge of approximately $2.1 million was recorded in the firstquarter of 2005.  Approximately $1.0million of this charge was reflected in operating expenses and $1.1 million ingeneral and administrative expenses.  Theaccrued liability pertaining to this charge was approximately $1.5 million at June 30,2005.  There are no significantadditional costs expected to be incurred in conjunction with this activity infuture periods.

 

6

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**4.     Acquisitionof Correctional Systems, Inc.**

 

In April 2005, wecompleted our acquisition of Correctional Systems, Inc. (CSI), a SanDiego-based provider of privatized jail, community corrections and alternativesentencing services.  The transaction wasconsumated in cash of approximately $ 9.1 million, net of cash acquired,all of which was paid April 1, 2005.  Theacquisition included the operations of eight jails, six adult community-basedcorrection facilities and five alternative sentencing programs located inCalifornia, New Mexico, Texas and Kansas. The acquisition added approximately 986 corrections beds, as well asalternatives to incarceration services. The results of operations for CSI subsequent to the date of acquisitionare included in our consolidated financial statements.

 

We acquired substantially allof CSI’s assets and assumed all of their liabilities.  The excess of the purchase price over thefair value of the assets acquired and liabilities assumed was allocated togoodwill.  The following table summarizesthe estimated fair values of the assets acquired and liabilities assumed as ofthe acquisition date (in thousands).  Ourpurchase price allocations are preliminary and have not been finalized as weare awaiting the completion by an outside appraiser of the valuations of certainproperty and equipment acquired.  We donot anticipate any significant differences between current book values and thefair values upon the completion of the asset valuations.  The initial purchase price allocations may beadjusted within one year of the purchase date for changes in the estimates ofthe fair values of assets acquired and liabilities assumed.

 
| ** **                                | ** ** | **April 1,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2005**          | ** ** |
|                                      |       |              |       |
| Receivables                               |       | $                 | 1,769      |   |
| Deferred Tax Asset                        |       | 49                |       |
| Prepaid assets                            |       | 256               |       |
| Property and equipment                    |       | 2,097             |       |
| Contract value                            |       | 4,121             |       |
| Other assets                              |       | 1,351             |       |
| Goodwill                                  |       | 2,866             |       |
| Assets acquired                           |       | 12,509            |       |
|                                      |       |              |       |
| Accounts payable and  accrued liabilities |       | $                 | 1,076      |   |
| Long-term debt                            |       | 2,239             |       |
| Other long-term  liabilities              |       | 130               |       |
| Liabilities assumed                       |       | 3,445             |       |
| Net assets acquired                       |       | $                 | 9,064      |   |

 

We believe that the CSI acquisitionresulted in the recognition of goodwill because of its industry position,operational strength and potential to provide additional growth opportunitiesfor us.

 

Our amortization period foracquired contracts is the greater of the acquired contract life or seven years.

 

On unaudited pro-forma basis, the effects of the CSI acquisitionwere not significant to our results of operations.

 

**5.     IntangibleAssets**

 

Intangibleassets at June 30, 2005 and December 31, 2004 consisted of thefollowing (in thousands):

 
| ** **                   | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                   | ** ** | **2005**          | ** ** | **2004**              | ** ** |
|                         |       |              |       |                  |       |
| Non-compete agreements       |       | $                 | 9,900      |                  | $          | 9,840 |   |
| Acquired contract value      |       | 6,428             |       | 2,405                 |       |
| Accumulated  amortization    |       | (6,192            | )          | (5,219                | )          |
| Identified intangibles,  net |       | 10,136            |       | 7,026                 |       |
| Goodwill, net                |       | 10,588            |       | 7,721                 |       |
| Total intangibles, net       |       | $                 | 20,724     |                  | $          | 14,747 |   |

 

Amortization expense for our non-competeagreements was approximately $0.3 million for the three months ended June 30,2005 and 2004 and approximately $0.6 million and $0.5 million for the sixmonths ended June 30, 2005 and 2004, respectively.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the next fouryears ended December 31 and approximately $0.7 million for the fifth year.

 

Amortization expense for our acquiredcontract value was approximately $0.3 million and $0.4 million for the threeand six months ended June 30, 2005. Amortization expense for our acquired contract value is expected to beapproximately $1.1 million for each of the next four years ended December 31and approximately $0.6 million for the fifth year.

 

7

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

 

Ourlong-term debt at June 30, 2005 and December 31, 2004 consisted ofthe following (in thousands):

 

| ** **                                                                                                                                                          | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                          | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| **Debt  of Cornell Companies, Inc.:**                                                                                                                          |       |              |       |                  |       |
| Senior Notes,  unsecured, due July 2012 with an interest rate of 10.75%, net of  discount                                                                      |       | $                 | 110,711    |                  | $          | 110,619 |   |
| Fair-value adjustment  of Senior Notes as a result of interest rate swap                                                                                            |       | 3,170             |       | 3,208                 |       |
| 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 “2004 Credit Facility”) |       | —            |       | 3⁄4                |       |
| Capital lease  obligations                                                                                                                                          |       | 172               |       | 6                     |       |
| Subtotal                                                                                                                                                            |       | 114,053           |       | 113,833               |       |
| ** **                                                                                                                                                          | ** ** | ** **        | ** ** | ** **            | ** ** |
| **Debt  of Special Purpose Entity:**                                                                                                                                |       |              |       |                  |       |
| 8.47% Bonds due 2016                                                                                                                                                |       | 174,700           |       | 174,700               |       |
|                                                                                                                                                                |       |              |       |                  |       |
| Total consolidated debt                                                                                                                                             |       | 288,753           |       | 288,533               |       |
|                                                                                                                                                                |       |              |       |                  |       |
| Less: current  maturities                                                                                                                                           |       | (9,001            | )          | (9,005                | )          |
|                                                                                                                                                                |       |              |       |                  |       |
| Consolidated long-term  debt                                                                                                                                        |       | $                 | 279,752    |                  | $          | 279,528 |   |

 

***Long-Term Credit Facilities.***  The2004 Credit 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 the 2004Credit Facility was approximately $51.4 million at June 30, 2005.  We had no outstanding borrowings on the 2004Credit Facility at June 30, 2005, but we had outstanding letters of creditof approximately $8.6 million.  Subjectto certain requirements, we have the right to increase the aggregatecommitments under the 2004 Credit Facility up to an aggregate amount of $100.0million.  The 2004 Credit Facilitymatures in June 2008 and bears interest, at our election, depending on ourtotal leverage ratio, at either the prime rate plus a margin ranging from 0.75%to 2.00%, or a rate which ranges from 2.25% to 3.50% above the applicable LIBORrate. The 2004 Credit Facility is collateralized by substantially allof our assets, including the assets and stock of all of our subsidiaries.  The 2004 Credit Facility is not secured bythe assets of MCF.  The 2004 CreditFacility contains standard covenants including compliance with laws,limitations on capital expenditures, restrictions on dividend payments,limitations on mergers and compliance with financial covenants.

 

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

 

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

 

8

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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 theoriginal aggregate principal amount of the Senior Notes at a redemption priceof 110.75% of the principal amount thereof with the net cash of publicofferings of equity, provided that at least 65% of the original aggregateprincipal amount of the Notes remains outstanding after the redemption and otherconditions are met.  Upon the occurrenceof specified change of control events, unless we have exercised our option toredeem all the Senior Notes as described above, each holder will have the rightto require us to repurchase all or a portion of such holder’s Senior Notes at apurchase price in cash equal to 101% of the aggregate principal amount of thenotes repurchased 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”) which 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 floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, andreceive a fixed-rate interest of 10.75%. For the three and six months ended June 30, 2005, we recordedinterest savings related to this interest rate swap of approximately $0.3million and $0.8 million, respectively, which is reflected as a reduction tointerest expense in the accompanying financial statements.  The swap agreements are marked to market eachquarter with a corresponding mark-to-market adjustment reflected as either adiscount or premium on the Senior Notes. At June 30, 2005 and December 31, 2004, the fair value of thisderivative instrument was approximately $3.2 million, and is included in otherassets in our Consolidated Balance Sheets. The carrying value of the Senior Notes as of these dates was increasedby the same amount. Because the swap agreement is considered an effectivefair-value hedge, there will be no effect on our results of operations from themark-to-market adjustment as long as the swap is in effect.

 

**7.     Projects Under Development, Construction orRenovation**

 

***Moshannon Valley Correctional Center***

** **

InMarch 2003, we reached an agreement with the Commonwealth of Pennsylvaniathat resolved all outstanding administrative issues relative to the contractawarded by the Bureau of Prisons (BOP) to operate the Moshannon ValleyCorrectional Center. In October 2004, we received the signed Finding of NoSignificant Impact for the facility. Construction of the facility, which will house 1,300 male federalinmates, began immediately.  We have athree-year contract with the BOP to operate the facility and the BOP has theoption to grant seven one-year extensions. The facility is scheduled to begin operations in early 2006.

 

InSeptember 2004, we resolved our claim with the BOP for the reimbursementof a portion of the expenses we incurred in connection with the issuance of theStop-Work Order and the delay of the project (included among these expenses wasapproximately $1.4 million in accounts receivable for expenses incurred by usafter the September 1999 issuance of the Stop-Work Order).  We settled the claim, as well as the claimfor the reimbursement of costs related to the original construction effortsincurred beginning in 1999, with the BOP and were reimbursed approximately $7.0million in September 2004.  Theexcess reimbursement of approximately $5.6 million over the $1.4 million inaccounts receivable was credited against the carrying cost of the facility.

 

9

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As of June 30, 2005, we had incurred (net of the BOPreimbursement) approximately $31.1 million for the design,construction and development costs and capitalized interest related to theMoshannon Valley Correctional Center facility. We believe that our existing cash and credit facilities will provideadequate funding to complete the construction of the facility.

 

***New Morgan Academy***

** **

Weclosed the New Morgan Academy in the fourth quarter of 2002 and arecurrently considering several options ranging from the utilization of thefacility for another type of program or the sale or lease of the facility. Asof June 30, 2005, we are principally focusing our efforts on the potentialinsertion of a program.  In addition, weare considering the possible sale or lease of the facility.  We are maintaining a small staff to secure and maintain the facility.  We have recognized pre-tax costs ofapproximately $0.9 million and $1.8 million in our Consolidated Statements ofOperations and Comprehensive Income (Loss) for the three and six months ended June 30,2005 and pre-tax costs of $0.8 million and $1.6 million for the three and sixmonths ended June 30, 2004, for related holding costs (depreciation,interest, property, taxes and other maintenance costs).

 

The developing inability during late 2004 of various governmentalagencies with whom we had been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy indicated anexpectation of continuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the requirements of SFAS No. 144, at December 31,2004.  As of June 30, 2005, webelieve that, pursuant to the provisions of SFAS No. 144, no additionalimpairment allowance is necessary. The carrying value of the property andequipment for the New Morgan Academy, after the impairment charge, wasapproximately $20.1 million and $20.4 million at June 30, 2005 and December 31,2004, respectively.

 

***CentralCalifornia Treatment Center***

** **

In January 2004, wepurchased a building in Los Angeles, California for which our carrying value wasapproximately $2.7 million at June 30, 2005. This new facility could provide service to 220 inmates in awork-furlough type program.  Although wedo not currently have a contract for this facility, the facility has been submittedand is under consideration in several recent proposals.  We believe that due to the growth of theinmate population, severe budget crisis and recent legal settlements requiringadditional community services, this facility will fill a small part of theoverall demand in California.  Thepotential uses for the facility range from a “halfway back” program to acomprehensive drug and alcohol treatment program.

 

**8.     Earnings Per Share**

 

Basicearnings per share (EPS) is computed by dividing net income by the weightedaverage number 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, 2005and 2004, there were 317,546 shares ($12.63 average price) and 423,229 shares($13.61 average price), respectively, of stock options that were not includedin the computation of diluted EPS because to do so would have beenanti-dilutive.  For the six months ended June 30,2005 and 2004 there were 203,207 shares ($16.83 average price) and 415,956shares ($14.64 average price), respectively, of stock options that were notincluded in the computation of diluted EPS because to do so would have beenanti-dilutive.

 

10

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The following table summarizes the calculation of net earnings (loss) andweighted 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,**    | ** ** |
| ** **                                                               | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Income (loss) from  continuing operations                                |       | $                      | 1,371      |                 | $          | (687 | ) | $ | 531 |   | $ | 340 |   |
| Loss from discontinued  operations, net of taxes                         |       | (1,682                 | )          | (412                 | )          | (3,115 | ) | (733 | ) |
| Net loss                                                                 |       | $                      | (311       | )                    | $          | (1,099 | ) | $ | (2,584 | ) | $ | (393 | ) |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Weighted average common  shares outstanding                              |       | 13,474                 |       | 13,146               |       | 13,451 |   | 13,114 |   |
| Weighted average common  share equivalents outstanding                   |       | 126                    |       | 3⁄4               |       | 235 |   | 216 |   |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Weighted average common  shares and common share equivalents outstanding |       | 13,600                 |       | 13,146               |       | 13,686 |   | 13,330 |   |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Basic earnings (loss)  per share:                                        |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                           |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                 |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |
|                                                                     |       |                   |       |                 |       |   |   |   |   |
| Diluted earnings (loss)  per share:                                      |       |                   |       |                 |       |   |   |   |   |
| Income (loss) from  continuing operations                                |       | $                      | .10        |                 | $          | (.05 | ) | $ | .04 |   | $ | .03 |   |
| Loss from discontinued  operations, net of tax                           |       | (.12                   | )          | (.03                 | )          | (.23 | ) | (.06 | ) |
| Net loss                                                                 |       | $                      | (.02       | )                    | $          | (.08 | ) | $ | (.19 | ) | $ | (.03 | ) |

 

**9.     Commitments and Contingencies**

 

## **LegalProceedings**

## ** **

##### ***SouthernPeaks Regional Treatment Center***

##### * *

OnJanuary 5, 2004, we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v.Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in theSuperior Court of Fulton County, Georgia under theories of fraud, conversion,breach of contract and other theories to determine the location of and torecover funds previously deposited by us into what we believed to be an escrowaccount in connection with the development and construction of the SouthernPeaks Regional Treatment Center.  Of thefunds previously deposited, approximately $5.3 million remains to be recoveredat June 30, 2005.  In December 2004,the case was tried before a jury and the jury verdict awarded approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, 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 judgement has yetbeen entered on this verdict.  The awardfor compensatory damages accrues pre-judgment interest at a rate of 7 percentfrom the date of loss through the date of judgment. Following the jury verdicts, we collected approximately $0.4 million in January 2005in funds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Currently, certain of the defendants havefiled motions to move for a new trial. No judgment will be entered on theverdict until after these motions for a new trial have been heard and ruled onby the court.  Due to the continueduncertainty surrounding the ultimate recovery of the funds previouslydeposited, we will continue to maintain our existing reserve of approximately$5.0 million in an allowance for doubtful accounts.

 

11

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**ShareholderLawsuits**

 

In March andApril 2002, the Company, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*, No. H-02-1075,in the United States District Court for the Southern District of Texas, HoustonDivision; (3) *Louis A. Daly, On Behalfof Himself and All Others Similarly Situated v. Cornell Companies, Inc.,et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No. H-02-1567,in the United States District Court for the Southern District of Texas, HoustonDivision.  The aforementioned lawsuitswere putative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 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 four lawsuits were consolidated intothe *Graydon Williams* action andFlyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint wasfiled by Flyline Partners, LP.  RichardPicard and Anthony Scolaro were also named as plaintiffs.  Since then, the court allowed plaintiffs tofile an amended consolidated complaint. The amended consolidated complaintalleges that the defendants violated Section 10(b) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b) ofthe Exchange Act, Section 20(a) of the Exchange Act, Section 11of the Securities Act of 1933 (the “Securities Act”) and/or Section 15 ofthe Securities Act.  The amendedconsolidated complaint seeks, among other things, restitution damages,compensatory damages, rescission or a rescissory measure of damages, costs,expenses, attorneys’ fees and expert fees. The Company filed a motion to dismiss the lawsuit.  In an order entered April 1, 2005, thecourt granted the motion to dismiss with respect to the plaintiffs’ securitiesfraud claims pursuant to Sections 10(b) and 20(a) of the Exchange Actand Rule 10b-5.  The court deniedthe motion to dismiss as to the remaining claims covering the Company’ssecondary offering in 2001.  Subject tocourt approval and documentation, the parties have agreed to settle thismatter.  Under the proposed agreement,the Company has not admitted any wrongdoing. Settlement in the amount of $7 million will be funded through theCompany’s Directors’ and Officers’ liability insurance.  The Company has not reached settlement in thepending derivative litigation discussed below.

 

In March 2002,the Company, our directors, and our former independent auditor Arthur AndersenLLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf of Nominal DefendantCornell 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 in2002 of certain financial statements. The lawsuit alleged breaches of fiduciary duty by all of the individualdefendants and asserted breach of contract and professional negligence claimsonly against Arthur Andersen LLP.  Thislawsuit has been dismissed without prejudice by agreement.

 

On January 27,2004, we received a letter from William Williams, the plaintiff in the *William Williams* action discussed above,demanding that we pursue breach of fiduciary duty claims against variousofficers and directors based on the August 2001 sale leaseback transactionand the subsequent restatement.  We haveissued a preliminary response to the letter indicating that the Board willconsider the request and inform Mr. Williams of its decision.

 

In May andSeptember 2002, the Company and our directors were sued in three otherderivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of Cornell Companies, Inc.v. Steven W. Logan, et. al.,* No. H-02-1812, in the UnitedStated District Court for the Southern District of Texas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896,in the United Stated District Court for the Southern District of Texas, HoustonDivision; and (3) *Jesse Menning,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et.al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits relate to our restatement in 2002 of certain financialstatements.  These lawsuits all allegebreaches of fiduciary duty and waste of corporate assets by all of the defendants.  A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action.  The motion to dismiss the *Guitierrez* action is still pending.  The *Menning*action has been dismissed, but with an agreement that the

 

12

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plaintiff’s claims as to Cornell are tolled until 30 days following thefinal resolution of the *Guitierrez*case, including any appeals.

 

The plaintiffs in these caseshave not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, we believe we have good defenses andintend to vigorously defend against the claims asserted in these actions.  We have not recorded any loss accrualsrelated 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 decision in these matters exceeds the insurancecoverage or if the insurance coverage is deemed not to apply to these matters,an adverse decision to us in these matters could have a material adverse effecton us, our financial condition, results of operations and future prospects.

 

***Other***

 

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto apply to these matters, or if the underlying insurance carrier were unableto fulfill their obligation under the insurance coverage provided, it couldhave a material adverse effect on our financial position, results of operationsor cash flows.

 

During theperiod of August 2000 through May 2003, our general liability andprofessional liability coverage was provided by Specialty Surplus InsuranceCompany, a Kemper Insurance Company (“Kemper”) group member.  In June 2004, the Illinois Department ofInsurance gave Kemper permission to proceed with a run-off plan it hadpreviously submitted.  The three-yearplan is designed to help Kemper meet its goal of resolving, to the maximumextent possible, all valid policyholder claims. In view of the risks and uncertainties involved in implementing theplan, including the need to achieve significant policy buybacks, commutation ofreinsurance agreements, and further agreements with regulators, no assurancecan be given that the plan will be successfully implemented by Kemper.  In the year ended December 31, 2004, werecorded a reserve of $0.6 million, and estimated our range of additionalexposure to be approximately $0.5 million with respect to outstanding claimsincurred during this policy period with Kemper which would become ourobligation to resolve if not settled through Kemper.

 

During the six months ended June 30, 2005, Kemper continued toimplement its run-off plan.  As a result,several of our significant claims were settled by Kemper in the second quarterof 2005. In conjunction with these settlements, we booked a charge against ourexisting reserve in the amount of $0.3 million. While we believe that the uncertainty surrounding the ability of Kemperto settle our remaining outstanding claims still exists, we feel no additionalreserve is necessary at June 30, 2005. We believe our estimated range of exposure, above our existing $0.3million reserve, to be approximately $0.3 million related to the outstandingclaims which could become our obligation to resolve if not settled throughKemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialposition, operating results or cash flow.

 

**10.  DerivativeFinancial Instruments and Guarantees**

 

***Debt Service Reserve Fund and Debt ServiceFund***

 

In August 2001, MCFcompleted a bond offering to finance the 2001 Sale and LeasebackTransaction.  In connection with thisbond offering, two reserve fund accounts were established by MCF pursuant tothe terms of the indenture: (1) MCF’s Debt Service Reserve Fund,aggregating $23.8 million at June 30, 2005, was established to make

 

13

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paymentson MCF’s outstanding bonds in the event we (as lessee) should fail to make thescheduled rental payments to MCF and (2) MCF’s Debt Service Fund,aggregating $22.9 million and $17.1 million at June 30, 2005 and December 31,2004, respectively, used to accumulate the monthly lease payments that MCFreceives from us until such funds are used to pay MCF’s semi-annual bondinterest and annual bond principal payments. Both reserve fund accounts are subject to the agreements with the MCFEquity Investors whereby guaranteed rates of return of 3.0% and 5.08%,respectively, are provided for in the balance of the Debt Service Reserve Fundand the Debt Service Fund.  Theguaranteed rates of return are characterized as cash flow hedge derivativeinstruments.  At inception, thederivatives had an aggregate fair value of $4.0 million, which has beenrecorded as a decrease to the equity investment in MCF made by the MCF EquityInvestors (MCF minority interest) and as a deferred liability in ourConsolidated Balance Sheets. Changes in the fair value of the derivativeinstruments are recorded as an adjustment to other long-term liabilities andreported as other comprehensive income (loss) in our Consolidated Statements ofOperations and Comprehensive Income (Loss). At June 30, 2005 and December 31, 2004, the fair value ofthese derivative instruments was approximately $2.0 million and $2.2 million,respectively.  As a result, ourConsolidated Statements of Operations and Comprehensive Income (Loss) includeother comprehensive income (loss) of approximately $0.3 million and ($1.1)million for the three months ended June 30, 2005 and 2004, respectively,and $0.1 million and ($0.6) million for the six months ended June 30, 2005and 2004, respectively.  The $0.1 millionunrealized gain reported in comprehensive income (loss) for the six monthsended June 30, 2005 includes an adjustment of $0.6 million for the taxeffect of changes in fair value during the years ended December 31, 2002and 2003. This adjustment decreased accumulated other comprehensive income andincreased deferred tax liabilities in our Consolidated Balance Sheet as of June 30,2005.

 

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

 

**11.****      ****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-residential community-basedprograms to juveniles between the ages of 10 and 17 who have either beenadjudicated or suffer from behavioral problems. The adult community-based corrections and treatment services segmentconsists of providing pre-release and halfway house programs for adultoffenders who are either on probation or serving the last three to six-monthsof their sentences on parole and preparing for re-entry into society at largeas well as community-based treatment and education programs as an alternativeto incarceration.  All of our customersand long-lived assets are located in the United States of America.  The accounting policies of our reportablesegments are the same as those described in the summary of significantaccounting policies in our 2004 Annual Report on Form 10-K, asamended.  Intangible assets are notincluded in each segment’s reportable assets, and the amortization ofintangible assets is not included in the determination of a segment’s operatingincome.  We evaluate performance based onincome or loss from operations before general and administrative expenses,incentive bonuses, amortization of intangibles, impairment charges onlong-lived assets, interest and income taxes. Corporate and other assets are comprised primarily of cash, investmentsecurities available for sale, accounts receivable, debt service fund,deposits, property and equipment, deferred taxes, deferred costs and otherassets.  Corporate and other income fromoperations primarily consists of depreciation and amortization on the corporateoffice facilities and equipment, and is presented separately as such chargescannot be readily identified for allocation to a particular segment.

 

14

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The following table excludes the resultsof discontinued operations for the revenue, pre-opening and start-up expensesand income from operations categories for all periods presented.  The only significant non-cash item reportedin the respective segment’s income from operations is depreciation andamortization (excluding intangibles) (in thousands).

 
| ** **                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                         | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                         | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Revenues                                           |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | 32,295     |                 | $          | 26,681 |   | $ | 63,154 |   | $ | 52,465 |   |
| Juvenile                                           |       | 30,319                 |       | 27,796               |       | 60,454 |   | 55,403 |   |
| Adult community-based                              |       | 15,888                 |       | 11,900               |       | 28,534 |   | 24,084 |   |
| Total revenues                                     |       | $                      | 78,502     |                 | $          | 66,377 |   | $ | 152,142 |   | $ | 131,952 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Pre-opening and  start-up expenses                 |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | 2,152      |                 | $          | 514 |   | $ | 5,042 |   | $ | 670 |   |
| Juvenile                                           |       | —                 |       | 476                  |       | 1,804 |   | 598 |   |
| Adult community-based                              |       | —                 |       | —               |       | — |   | — |   |
| Total pre-opening and  start-up expenses           |       | $                      | 2,152      |                 | $          | 990 |   | $ | 6,846 |   | $ | 1,268 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Income from operations                             |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | 6,315      |                 | $          | 5,972 |   | $ | 12,424 |   | $ | 11,859 |   |
| Juvenile                                           |       | 4,468                  |       | 3,602                |       | 7,693 |   | 6,939 |   |
| Adult community-based                              |       | 3,125                  |       | 2,145                |       | 5,313 |   | 4,223 |   |
| Subtotal                                           |       | 13,908                 |       | 11,719               |       | 25,430 |   | 23,021 |   |
| General and  administrative expense                |       | (4,899                 | )          | (5,605               | )          | (11,237 | ) | (9,765 | ) |
| Amortization of  intangibles                       |       | (545                   | )          | (270                 | )          | (973 | ) | (539 | ) |
| Corporate and other                                |       | (337                   | )          | (435                 | )          | (745 | ) | (920 | ) |
| Total income from  operations                      |       | $                      | 8,127      |                 | $          | 5,409 |   | $ | 12,475 |   | $ | 11,797 |   |
|                                               |       |                   |       |                 |       |   |   |   |   |
| Loss on discontinued  operations, net of tax       |       |                   |       |                 |       |   |   |   |   |
| Adult secure  institutional                        |       | $                      | —     |                 | $          | — |   | $ | — |   | $ | — |   |
| Juvenile                                           |       | (1,639                 | )          | (442                 | )          | (3,087 | ) | (789 | ) |
| Adult community-based                              |       | (43                    | )          | 30                   |       | (28 | ) | 56 |   |
| Total loss on  discontinued operations, net of tax |       | $                      | (1,682     | )                    | $          | (412 | ) | $ | (3,115 | ) | $ | (733 | ) |

 
| ** **                  | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **2005**          | ** ** | **2004**              | ** ** |
| Assets                      |       |              |       |                  |       |
| Adult secure  institutional |       | $                 | 178,122    |                  | $          | 172,793 |   |
| Juvenile                    |       | 106,880           |       | 123,890               |       |
| Adult community-based       |       | 68,031            |       | 62,984                |       |
| Intangible assets, net      |       | 20,724            |       | 14,747                |       |
| Corporate and other         |       | 137,490           |       | 133,217               |       |
| Total assets                |       | $                 | 511,247    |                  | $          | 507,631 |   |

 

**12.  Guarantor Disclosures**

 

Wecompleted an offering of $112.0 million of Senior Notes in June 2004.  The Senior Notes are guaranteed by each ofour subsidiaries (Guarantor Subsidiaries). 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.

 

15

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**Condensed Consolidating Balance Sheet as of June 30,2005 (in thousands) (unaudited)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |              |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash equivalents                        |       | $          | 11,695     |             | $          | 1,171             |       | $                | 81         |             | $          | — |   | $ | 12,947 |   |
| Investment securities                            |       | 39,450     |       | —           |       | —            |       | —           |       | 39,450           |       |
| Accounts receivable                              |       | 1,813      |       | 52,288           |       | 358               |       | —           |       | 54,459           |       |
| Debt service fund and other  restricted assets   |       | 1          |       | 2,453            |       | 22,936            |       | —           |       | 25,390           |       |
| Prepaids and other                               |       | 15,731     |       | 3,618            |       | —            |       | —           |       | 19,349           |       |
| Total current assets                             |       | 68,690     |       | 59,530           |       | 23,375            |       | —           |       | 151,595          |       |
| Property and equipment,  net                     |       | 608        |       | 140,874          |       | 156,753           |       | (6,045           | )          | 292,190          |       |
| Other assets:                                    |       |       |       |             |       |              |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —           |       | 23,800            |       | —           |       | 23,800           |       |
| Deferred costs and  other                        |       | 42,240     |       | 26,236           |       | 9,067             |       | (33,881          | )          | 43,662           |       |
| Investment in  subsidiaries                      |       | 15,304     |       | 1,856            |       | —            |       | (17,160          | )          | —           |       |
| Total assets                                     |       | $          | 126,842    |             | $          | 228,496           |       | $                | 212,995    |             | $          | (57,086 | ) | $ | 511,247 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and stockholders’ equity**    |       |       |       |             |       |              |       |             |       |             |       |
|                                             |       |       |       |             |       |              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 41,165     |             | $          | 8,284             |       | $                | 6,191      |             | $          | (2,596 | ) | $ | 53,044 |   |
| Current portion of  long-term debt               |       | —     |       | 1                |       | 9,000             |       | —           |       | 9,001            |       |
| Total current  liabilities                       |       | 41,165     |       | 8,285            |       | 15,191            |       | (2,596           | )          | 62,045           |       |
| Long-term debt, net of  current portion          |       | 113,881    |       | 171              |       | 165,700           |       | —           |       | 279,752          |       |
| Deferred tax  liabilities                        |       | 8,516      |       | (1,763           | )          | —            |       | 781              |       | 7,354            |       |
| Other long-term  liabilities                     |       | 5,530      |       | 189              |       | 32,156            |       | (35,581          | )          | 2,294            |       |
| Intercompany                                     |       | (201,872   | )          | 201,872          |       | —            |       | —           |       | —           |       |
| Total liabilities                                |       | (32,780    | )          | 208,754          |       | 213,047           |       | (37,396          | )          | 351,625          |       |
| Stockholders’ equity                        |       | 159,622    |       | 19,742           |       | (52               | )          | (19,690          | )          | 159,622          |       |
| Total liabilities and  stockholders’ equity |       | $          | 126,842    |             | $          | 228,496           |       | $                | 212,995    |             | $          | (57,086 | ) | $ | 511,247 |   |

 

16

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**Condensed Consolidating Balance Sheet as of December 31,2004 (in thousands)**

 
| ** **                                       | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|--------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                       | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Assets**                                       |       |       |       |             |       |              |       |             |       |             |       |
| Current assets:                                  |       |       |       |             |       |              |       |             |       |             |       |
| Cash and cash  equivalents                       |       | $          | 9,559      |             | $          | 296               |       | $                | 40         |             | $          | — |   | $ | 9,895 |   |
| Investment securities                            |       | 51,740     |       | —           |       | —            |       | —           |       | 51,740           |       |
| Accounts receivable                              |       | 3,298      |       | 61,189           |       | 378               |       | —           |       | 64,865           |       |
| Restricted assets                                |       | 121        |       | 2,451            |       | 17,141            |       | —           |       | 19,713           |       |
| Prepaids and other                               |       | 15,664     |       | 1,962            |       | —            |       | —           |       | 17,626           |       |
| Total current assets                             |       | 80,382     |       | 65,898           |       | 17,559            |       | —           |       | 163,839          |       |
| Property and equipment,  net                     |       | 672        |       | 128,965          |       | 158,863           |       | (6,245           | )          | 282,255          |       |
| Other assets:                                    |       |       |       |             |       |              |       |             |       |             |       |
| Debt service reserve  fund                       |       | —     |       | —           |       | 23,801            |       | —           |       | 23,801           |       |
| Deferred costs and  other                        |       | 39,392     |       | 19,225           |       | 9,362             |       | (30,243          | )          | 37,736           |       |
| Investment in  subsidiaries                      |       | 20,613     |       | 1,856            |       | —            |       | (22,469          | )          | —           |       |
| Total assets                                     |       | $          | 141,059    |             | $          | 215,944           |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |
| ** **                                       | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Liabilities and stockholders’ equity**    |       |       |       |             |       |              |       |             |       |             |       |
| Current liabilities:                             |       |       |       |             |       |              |       |             |       |             |       |
| Accounts payable and  accrued liabilities        |       | $          | 36,191     |             | $          | 7,369             |       | $                | 6,197      |             | $          | (2,520 | ) | $ | 47,237 |   |
| Current portion of  long-term debt               |       | —     |       | 5                |       | 9,000             |       | —           |       | 9,005            |       |
| Total current  liabilities                       |       | 36,191     |       | 7,374            |       | 15,197            |       | (2,520           | )          | 56,242           |       |
| Long-term debt, net of  current portion          |       | 113,827    |       | 1                |       | 165,700           |       | —           |       | 279,528          |       |
| Deferred tax liabilities                         |       | 7,966      |       | —           |       | —            |       | 122              |       | 8,088            |       |
| Other long-term  liabilities                     |       | 5,846      |       | 80               |       | 28,546            |       | (32,011          | )          | 2,461            |       |
| Intercompany                                     |       | (184,083   | )          | 184,083          |       | —            |       | —           |       | —           |       |
| Total liabilities                                |       | (20,253    | )          | 191,538          |       | 209,443           |       | (34,409          | )          | 346,319          |       |
| Stockholders’ equity                        |       | 161,312    |       | 24,406           |       | 142               |       | (24,548          | )          | 161,312          |       |
| Total liabilities and  stockholders’ equity |       | $          | 141,059    |             | $          | 215,944           |       | $                | 209,585    |             | $          | (58,957 | ) | $ | 507,631 |   |

 

17

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**Condensed Consolidating Statement ofOperations for the three months ended June 30, 2005****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **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 | ) |

 

18

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**Condensed Consolidating Statement ofOperations for the three months ended June 30, 2004****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 4,531      |             | $          | 74,601            |       | $                | 4,502      |             | $          | (17,257 | ) | $ | 66,377 |   |
| Operating expenses                                                                    |       | 5,900      |       | 62,354           |       | 23                |       | (16,997          | )          | 51,280           |       |
| Pre-opening and  start-up expenses                                                    |       | —     |       | 990              |       | —            |       | —           |       | 990              |       |
| Depreciation and  amortization                                                        |       | (20        | )          | 2,134            |       | 1,055             |       | (76              | )          | 3,093            |       |
| General and  administrative expenses                                                  |       | 5,574      |       | —           |       | 19                |       | 12               |       | 5,605            |       |
| Income (loss) from  operations                                                        |       | (6,923     | )          | 9,123            |       | 3,405             |       | (196             | )          | 5,409            |       |
| Overhead allocations                                                                  |       | (8,604     | )          | 8,604            |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | (1,117     | )          | 1,689            |       | 3,633             |       | 11               |       | 4,216            |       |
| Loss on extinguishment  of debt                                                       |       | —     |       | 2,357            |       | —            |       | —           |       | 2,357            |       |
| Equity earnings in  subsidiaries                                                      |       | (3,475     | )          | —           |       | —            |       | 3,475            |       | —           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | (677       | )          | (3,527           | )          | (228              | )          | 3,268            |       | (1,164           | )          |
| Provision (benefit) for  income taxes                                                 |       | 422        |       | (794             | )          | —            |       | (105             | )          | (477             | )          |
| Income (loss) from  continuing operations                                             |       | (1,099     | )          | (2,733           | )          | (228              | )          | 3,373            |       | (687             | )          |
| Discontinued  operations, net of income tax benefit of $286                           |       | —     |       | (412             | )          | —            |       | —           |       | (412             | )          |
| Net income (loss)                                                                     |       | $          | (1,099     | )                | $          | (3,145            | )          | $                | (228       | )                | $          | 3,373 |   | $ | (1,099 | ) |

 

19

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**Condensed Consolidating Statement ofOperations for the six months ended June 30, 2005****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **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 | ) |

 

20

----

 

**Condensed Consolidating Statement ofOperations for the six months ended June 30, 2004****(in thousands) (unaudited)**

 
| ** **                                                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|---------------------------------------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| ** **                                                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| Revenues                                                                              |       | $          | 9,088      |             | $          | 148,926           |       | $                | 9,004      |             | $          | (35,066 | ) | $ | 131,952 |   |
| Operating expenses                                                                    |       | 11,723     |       | 125,954          |       | 23                |       | (34,747          | )          | 102,953          |       |
| Pre-opening and  start-up expenses                                                    |       | —     |       | 1,268            |       | —            |       | —           |       | 1,268            |       |
| Depreciation and  amortization                                                        |       | —     |       | 4,205            |       | 2,111             |       | (147             | )          | 6,169            |       |
| General and administrative  expenses                                                  |       | 9,715      |       | —           |       | 38                |       | 12               |       | 9,765            |       |
| Income (loss) from  operations                                                        |       | (12,350    | )          | 17,499           |       | 6,832             |       | (184             | )          | 11,797           |       |
| Overhead allocations                                                                  |       | (15,834    | )          | 15,834           |       | —            |       | —           |       | —           |       |
| Interest, net                                                                         |       | (1,970     | )          | 3,427            |       | 7,386             |       | 21               |       | 8,864            |       |
| Loss on extinguishment  of debt                                                       |       | —     |       | 2,357            |       | —            |       | —           |       | 2,357            |       |
| Equity earnings in  subsidiaries                                                      |       | (4,706     | )          | —           |       | —            |       | 4,706            |       | —           |       |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | 748        |       | (4,119           | )          | (554              | )          | 4,501            |       | 576              |       |
| Provision (benefit) for  income taxes                                                 |       | 1,141      |       | (654             | )          | —            |       | (251             | )          | 236              |       |
| Income (loss) from  continuing operations                                             |       | (393       | )          | (3,465           | )          | (554              | )          | 4,752            |       | 340              |       |
| Discontinued  operations, net of income tax benefit of $509                           |       | —     |       | (733             | )          | —            |       | —           |       | (733             | )          |
| Net income (loss)                                                                     |       | $          | (393       | )                | $          | (4,198            | )          | $                | (554       | )                | $          | 4,752 |   | $ | (393 | ) |

 

21

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**CondensedConsolidating Statement of Cash Flows for the six months ended June 30,2005 (in thousands) (unaudited)**

 
| ** **                                            | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                            | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **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          | )          |              |       |             |       |             |       |
| 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            | )          | —           |       | (5,798           | )          |
| Net cash provided by (used)  in investing activities  |       | $          | 3,226      |             | $          | (14,552           | )          | $                | (5,795     | )                | $          | — |   | $ | (335 | ) |
| ** **                                            | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **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 provided by (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 |   |

 

22

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**CondensedConsolidating Statement of Cash Flows for the six months ended June 30,2004 (in thousands) (unaudited)**

 
| ** **                                                | ** ** | ** ** | ** ** | **Guarantor**    | ** ** | **Non-Guarantor** | ** ** | ** **       | ** ** | ** **       | ** ** |
|-----------------------------------------------------------|------------|------------|------------|------------------|------------|-------------------|------------|------------------|------------|------------------|------------|
| ** **                                                | ** ** | **Parent** | ** ** | **Subsidiaries** | ** ** | **Subsidiary**    | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
| **Cash  flows from operating activities:**                |       |       |       |             |       |              |       |             |       |             |       |
| Net cash provided by  (used in) operating activities      |       | $          | (20,656    | )                | $          | 23,080            |       | $                | 5,518      |             | $          | — |   | $ | 7,942 |   |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  flows from investing activities:**                |       |       |       |             |       |              |       |             |       |             |       |
| Capital expenditures                                      |       | —     |       | (20,559          | )          | —            |       | —           |       | (20,559          | )          |
| Purchase of facility  management contract                 |       | —     |       | (2,900           | )          | —            |       | —           |       | (2,900           | )          |
| Refund from restricted  escrow arrangement                |       | 5,000      |       | —           |       | —            |       | —           |       | 5,000            |       |
| Payments to restricted  debt payment account, net         |       | —     |       | —           |       | (5,523            | )          | —           |       | (5,523           | )          |
| Return of restricted  assets from deferred bonus plan     |       | 86         |       | —           |       | —            |       | —           |       | 86               |       |
| Proceeds from sale of fixed  assets                       |       | —     |       | 163              |       | —            |       | —           |       | 163              |       |
| Net cash provided by  (used in) investing activities      |       | $          | 5,086      |             | $          | (23,296           | )          | $                | (5,523     | )                | $          | — |   | $ | (23,733 | ) |
|                                                      |       |       |       |             |       |              |       |             |       |             |       |
| **Cash  flows from financing activities:**                |       |       |       |             |       |              |       |             |       |             |       |
| Proceeds from long-term  debt and line of credit          |       | 69,000     |       | —           |       | —            |       | —           |       | 69,000           |       |
| Payments on line of  credit                               |       | (71,000    | )          | —           |       | —            |       | —           |       | (71,000          | )          |
| Payments on synthetic lease                               |       | —     |       | (52,495          | )          | —            |       | —           |       | (52,495          | )          |
| Intercompany transfers                                    |       | (52,495    | )          | 52,495           |       | —            |       | —           |       | —           |       |
| Proceeds from Senior  Notes, net of discount              |       | 110,527    |       | —           |       | —            |       | —           |       | 110,527          |       |
| Payments for debt  issuance and other financing costs     |       | (5,033     | )          | —           |       | —            |       | —           |       | (5,033           | )          |
| Payments on capital  lease obligations                    |       | (6         | )          | —           |       | —            |       | —           |       | (6               | )          |
| Proceeds from exercise  of stock options                  |       | 1,040      |       | —           |       | —            |       | —           |       | 1,040            |       |
| Purchases of treasury  stock                              |       | (116       | )          | —           |       | —            |       | —           |       | (116             | )          |
| Net cash provided by  financing activities                |       | 51,917     |       | —           |       | —            |       | —           |       | 51,917           |       |
|                                                      |       |       |       |             |       |              |       |             |       |             |       |
| **Net  increase (decrease) in cash and cash equivalents** |       | 36,347     |       | (216             | )          | (5                | )          | —           |       | 36,126           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at beginning of period**     |       | 39,827     |       | 289              |       | 55                |       | —           |       | 40,171           |       |
| ** **                                                | ** ** | ** ** | ** ** | ** **       | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** |
| **Cash  and cash equivalents at end of period**           |       | $          | 76,174     |             | $          | 73                |       | $                | 50         |             | $          | — |   | $ | 76,297 |   |
|                                                           |            |            |            |                  |            |                   |            |                  |            |                  |            |  |  |  |  |  |  |

 

23

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

 

**Forward Looking Statement Disclaimer**

 

This report contains orincorporates by reference forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995.  These statements are based on current plans and actual futureactivities and results of operations may be materially different from those setforth in the forward-looking statements. Important factors that could causeactual results to differ include, among others, (1) the outcomes ofpending putative class action shareholder and derivative lawsuits, and relatedinsurance coverage, (2) our ability to win new contracts and to executeour growth strategy, (3) risks associated with acquisitions and theintegration thereof (including the ability to achieve administrative andoperating cost savings and anticipated synergies), (4) the timing andcosts of the opening of new programs and facilities, including Southern PeaksRegional Treatment Center and Regional Correction Center, or the expansions ofexisting facilities and the related ramp-up of expected occupancy, (5) theresumption of admissions at the Campbell Griffin Treatment Center (6) ourability to negotiate contracts at those facilities for which we currently donot have an operating contract, (7) significant charges to expense ofdeferred costs associated with financing and other projects in development ifwe determine that one or more of such projects is unlikely to be successfullyconcluded, (8) results from alternative deployment or sale of facilitiessuch as the New Morgan Academy or the inability to do so, (9) our abilityto complete the construction of the Moshannon Valley Correctional Center asanticipated, (10) changes in governmental policy and/or funding todiscontinue or not renew existing arrangements, to eliminate or discourage theprivatization of correctional, detention and pre-release services in the UnitedStates, or to eliminate rate increase, (11) the availability of financing onterms that are favorable to us and (12) fluctuations in operating resultsbecause of occupancy levels and/or mix, competition (including competition fromtwo competitors that are substantially larger than us), increases in cost of operations,fluctuations in interest rates and risks of operations.

 

**General**

 

We are a leading provider ofcorrectional, treatment and educational services outsourced by federal, stateand local government agencies.  Weprovide a diversified portfolio of services for adults and juveniles throughour three operating divisions: (1) adult secure institutional services; (2) juvenilejustice, educational and treatment services and (3) adult community-basedcorrections and treatment services.

 

We classify as discontinuedoperations those components of our business that we hold for sale or have beendisposed that have operations and cash flows that are clearly distinguishableoperationally and for financial reporting purposes from the rest of ouroperations.  For the six months ended June 30,2005, we classified the operating results of certain facilities and programs asdiscontinued operations.  This was theresult of management’s decision to initiate the shut down of operations atcertain facilities.  In the first quarterof 2005, these facilities and programs included the Residential School, theMaple Creek Home and our mental health wrap programs in Pennsylvania.  During the second quarter of 2005, weinitiated the shut down of the Northside Clinic and the Jos-Arz Academy.  Notifications have been made to the requiredcontracting entities regarding the termination of the related programs.  Accordingly, these facilities and programs havebeen excluded from such statistics and information as to the number offacilities in operation, service capacity, contracted beds in operation andaverage contract occupancy percentages, as well as management’s discussionsregarding revenues and expenses. Discontinued operations have been presented separately in our ConsolidatedStatements of Operations and Comprehensive Income (Loss) for the three and sixmonths ended June 30, 2005 and 2004.

 

At June 30, 2005, weoperated 79 facilities with a total service capacity of 17,752 and had 2facilities under development or construction with an aggregate service capacityof 1,514 upon completion. Our facilities are located in 17 states and theDistrict of Columbia.

 

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The following table setsforth for the periods indicated total residential service capacity andcontracted beds in operation at the end of the periods shown, average contract occupancypercentages and total non-residential service capacity, excluding in bothperiods those facilities and programs which were classified as discontinuedoperations.

 

| ** **                                                                     | ** ** | **June 30,** | ** ** | **June 30,** | ** ** |
|--------------------------------------------------------------------------------|------------|-------------------|------------|-------------------|------------|
| ** **                                                                     | ** ** | **2005**          | ** ** | **2004**          | ** ** |
| **Residential**                                                                | ** ** | ** **        | ** ** | ** **        | ** ** |
| Service capacity (1)                                                           |       | 14,324            |       | 13,436            |       |
| Contracted beds in  operation (end of period) (2)                              |       | 11,761            |       | 10,316            |       |
| Average contract  occupancy based on contracted beds in operation (3) (4) |       | 96.4              | %          | 101.4             | %          |
| Average contract  occupancy excluding start-up operations (3) (4)         |       | 103.4             | %          | 101.5             | %          |
| **Non-Residential**                                                            | ** ** | ** **        | ** ** | ** **        | ** ** |
| Service capacity (5)                                                           |       | 4,942             |       | 3,628             |       |

 

----

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

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

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

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

(5)   Servicecapacity for non-residential programs is based on either contractual terms oran estimate of the number of clients to be served.  We update these estimates at least annuallybased 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 thethree months ended June 30, 2005, our revenue base consisted of 76.7% forservices provided under per diem contracts, 9.6% for services provided undertake-or-pay and management contracts, 9.3% for services provided undercost-plus reimbursement contracts, 3.0% for services provided underfee-for-service contracts and 1.5% from other miscellaneous sources.   For the six months ended June 30, 2005,our revenue base consisted of 76.3% for services provided under per diemcontracts, 9.9% for services provided under take-or-pay and managementcontracts, 9.4% for services provided under cost-plus reimbursement contracts,3.0% for services provided under fee-for-service contracts and 1.4% from othermiscellaneous sources.  There has been anincrease in the percentage of revenues for services provided under per diemcontracts and a decrease in the percentage of revenues provided under fee-for-servicecontracts between the comparable periods for 2005 and 2004.  These percentages reflect the acquisition ofCSI in April 2005.  Revenues can fluctuate from period to perioddue to changes in government funding policies, changes in the number of clientsreferred to our facilities by governmental agencies, the opening of newfacilities or the expansion of existing facilities and the termination ofcontracts for a facility or the closure of a facility.

 

Revenuesfor our adult secure institutional services division are primarily generatedfrom per diem, take-or-pay and management contracts.  For the three months ended June 30, 2005and 2004, we realized average per diem rates on our adult secure institutional facilitiesof approximately $49.13 and $49.37, respectively.   For the six months ended June 30, 2005and 2004, we realized average per diem rates of approximately $48.81 and$48.70, respectively.

 

25

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Revenues for our juvenile justice, educational and treatment servicesdivision are primarily generated from per diem, fee-for-service and cost-plusreimbursement contracts.  For the threemonths ended June 30, 2005 and 2004, we realized average per diem rates onour residential juvenile facilities of approximately $161.61 and $157.69,respectively.  For the six months ended June 30,2005 and 2004, we realized average per diem rates of approximately $162.95 and$159.11, respectively.  The increase inthe average per diem rate for 2005 as compared to 2004 was due primarily to theopening of the Southern Peaks Regional Treatment Center in August 2004 andper diem rate increases at our Pennsylvania programs and facilities in July 2004.  Forthe three months ended June 30, 2005 and 2004, we realized averagefee-for-service rates for our non-residential community-based juvenile facilitiesand programs, including rates that are limited by Medicaid and other privateinsurance providers, of approximately $32.00 and $24.11, respectively.  For the six months ended June 30, 2005and 2004, we realized average fee-for-service rates of approximately $31.57 and$23.85, respectively.  The increase inthe average fee-for-service rate for 2005 as compared to 2004 is due to changesin the mix of services provided by our various non-residential juvenileprograms and facilities. The majority of our juvenile services contracts renewannually.

 

Revenues for our adult community-based corrections and treatmentservices division are primarily generated from per diem and fee-for-servicecontracts.  For the three months ended June 30,2005 and 2004, we realized average per diem rates on our residential adultcommunity-based facilities of approximately $58.76 and $62.36,respectively.  The decrease in theaverage per diem in the three months ended June 30, 2005 as compared to thesame period of 2004 was due to lower per diem rates at the facilities andprograms acquired from CSI in April 2005. For the six months ended June 30, 2005 and 2004, we realizedaverage per diem rates of $60.00 and $60.93, respectively.  For the three months ended June 30, 2005and 2004, we realized average fee-for-service rates on our non-residentialadult community-based programs of approximately $9.55 and $8.54,respectively.  The increase in theaverage fee-for-service rate in the three months ended June 30, 2005 ascompared to the same period of 2004 was due to changes in the mix of servicesprovided by our various adult community-based programs and facilities.  For the six months ended June 30, 2005and 2004, we realized average fee-for-service rates of approximately $8.54 and$8.70, respectively.

 

Factorsconsidered in determining billing rates to charge include:  (1) the programs specified by thecontract and the related staffing levels, (2) wage levels customary in therespective geographic areas, (3) whether the proposed facility is to beleased or purchased and (4) the anticipated average occupancy levels thatcould reasonably be maintained.

 

Wehave historically experienced higher operating margins in our adult secureinstitutional services and adult community-based corrections and treatmentservices divisions as compared to the juvenile justice, educational andtreatment services division. Additionally, our operating margins within a division can vary fromfacility to facility based on whether a facility is owned or leased, the levelof competition for the contract award, the proposed length of the contract, theoccupancy levels for a facility, the level of capital commitment required withrespect to a facility, the anticipated changes in operating costs over the termof the contract, and our ability to increase a facility’s contractrevenue.  A decline in occupancy ofcertain juvenile justice, educational and treatment facilities can have a moresignificant impact on operating results than the adult secure institutionalservices division due to higher per diem rates at certain juvenilefacilities.  We have experiencedand expect to continue to experience interim period operating marginfluctuations due to the number of calendar days in the period, higher payrolltaxes in the first half of the year, and salary and wage increases andinsurance cost increases that are incurred prior to certain contract rateincreases.  Moreover, many of thegovernmental agencies with whom we contract are experiencing budget pressuresand may approach us to limit or reduce per diem rates.  Decreases in, or the lack of anticipatedincreases in, per diem rates could adversely impact our operating margin.  Additionally, a decrease in per diem rateswithout a corresponding decrease in operating expenses could also adverselyaffect our operating margin.

 

We are responsible for all facility operating costs, except for certaindebt service and interest or lease payments for facilities where we have amanagement contract only.  At thesefacilities, the facility owner is responsible for all debt service and interestand lease payments related to the facility. We are responsible for all other operating expenses at thesefacilities.  We operated 21 and 11facilities under management contracts at June 30, 2005 and 2004,respectively.

 

Amajority of our facility operating costs consists of fixed costs.  These fixed costs include lease and rentalexpense, insurance, utilities and depreciation. As a result, when we commence operation of new or expanded facilities,fixed operating costs increase.  Theamount of our variable operating costs, including food, medical services,supplies and clothing, depend on occupancy levels at the facilities we operate.  Our largest single operating cost, facilitypayroll expense and related employment taxes and expenses, has both a fixed anda variable component.  We can adjust a

 

26

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facility’sstaffing levels and the related payroll expense to a certain extent based onoccupancy at a facility, however a minimum fixed number of employees isrequired to operate and maintain any facility regardless of occupancylevels.  Personnel costs are subject toincreases in tightening labor markets based on local economic and otherconditions.

 

Weincur pre-opening and start-up expenses including payroll, benefits, trainingand other operating costs prior to opening a new or expanded facility andduring the period of operation while occupancy is ramping up.  These costs vary by contract.  Since pre-opening and start-up costs aregenerally factored into the revenue per diem rate that is charged to acontracting agency, we typically expect to recover these upfront costs over thelife of a contract.  Because occupancyrates during a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, we may incur additionalpost-opening start-up costs.  We do notanticipate post-opening start-up costs at adult secure facilities operatedunder any future contracts with the Bureau of Prisons (BOP) because thesecontracts are currently expected to continue to be take-or-pay contracts,meaning that the BOP will pay at least 80.0% of the contractual monthly revenueonce the facility opens, regardless of actual occupancy.

 

Newly opened facilities are staffed according to applicable regulatoryor contractual requirements when we begin receiving offenders or clients.  Offenders or clients are typically assignedto a newly opened facility on a phased-in basis over a one- to six-month period.  Our start-up period for new juvenileoperations is 12 months from the date we begin recognizing revenue unlessbreak-even occupancy levels are achieved before then.  Our start-up period for new adult operationsis nine months from the date we begin recognizing revenue unless break-evenoccupancy levels are achieved before then. Although we typically recover these upfront costs over the life of thecontract, quarterly results can be substantially affected by the timing of thecommencement of operations as well as the development and construction of newfacilities.

 

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

 

Generaland administrative expenses consist primarily of costs for corporate andadministrative personnel who provide senior management, legal, finance,accounting, human resources, payroll and information systems, costs of businessdevelopment and outside professional and consulting fees.

 

#### **RecentDevelopments**

#### ** **

***Correctional SystemsInc. Acquisition***

 

In April 2005, wecompleted our acquisition of Correctional Systems, Inc. (CSI), a SanDiego-based provider of privatized jail, community corrections and alternativesentencing services.  The transaction wasconsumated in cash of approximately $9.1 million, net of cash acquired,all of which was paid on April 1, 2005.  The acquisition included the operations of eight jails, six adultcommunity-based correction facilities and five alternative sentencing programslocated in California, New Mexico, Texas and Kansas.  The acquisition added approximately 986corrections beds, as well as alternatives to incarceration services.  The results of operations for CSI subsequentto the date of acquisition are included in our consolidated financialstatements.

 

We acquired substantially allof CSI’s assets and assumed all of their liabilities.  The excess of the purchase price over thefair value of the assets acquired and liabilities assumed was allocated togoodwill.  The following table summarizesthe estimated fair values of the assets acquired and liabilities assumed as ofthe date of acquisition (in thousands).  Ourpurchase price allocations are preliminary and have not been finalized as weare awaiting the completion by an outside appraiser the valuations of certainproperty and equipment acquired.  Theinitial purchase price allocations may be adjusted within one year of thepurchase date for changes in estimates of the fair value of assets acquired andliabilities assumed.  We do notanticipate any significant differences between current book values and the fairvalues upon the completion of the asset valuations.

 

27

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| ** **                                | ** ** | **April 1,** | ** ** |
|-------------------------------------------|------------|-------------------|------------|
| ** **                                | ** ** | **2005**          | ** ** |
|                                      |       |              |       |
| Receivables                               |       | $                 | 1,769      |   |
| Deferred tax asset                        |       | 49                |       |
| Prepaid assets                            |       | 256               |       |
| Property and equipment                    |       | 2,097             |       |
| Contract value                            |       | 4,121             |       |
| Other assets                              |       | 1,351             |       |
| Goodwill                                  |       | 2,866             |       |
| Assets acquired                           |       | 12,509            |       |
|                                      |       |              |       |
| Accounts payable and  accrued liabilities |       | $                 | 1,076      |   |
| Long-term debt                            |       | 2,239             |       |
| Other long-term  liabilities              |       | 130               |       |
| Liabilities assumed                       |       | 3,445             |       |
| Net assets acquired                       |       | $                 | 9,064      |   |

 

We believe the CSI acquisitionresulted in the recognition of goodwill because of its industry position,operational strength and potential to provide additional growth opportunitiesfor us.

 

Our amortization period for acquiredcontracts is the greater of the acquired contract life or seven years.

 

On an unaudited pro-forma basis, the effects of the CSIacquisition were not significant to our results of operations.

 

### ***Facility Closures***

### * *

During the six months ended June 30,2005, we elected to close certain facilities and programs based on an internalanalysis of various factors including risk adjusted return on capital employed,cash flow, operational intensity and personnel requirements.  These facilities and programs included theResidential School and the Maple Creek Home facilities, as well as certain mentalhealth wrap programs in Pennsylvania in the first quarter of 2005.  During the second quarter of 2005, we closedthe Northside Clinic and the Jos-Arz Academy. For the three months ended June 30, 2005 and 2004, thesediscontinued operations generated net losses of approximately $1.7 million and$0.4 million, respectively.  The increasein the 2005 net loss reflects reduced revenues as the programs were shut down,a $0.9 million charge for certain accounts receivable and closure costs.  Revenues for these discontinued operationswere approximately $0.7 million and $3.6 million for the three months ended June 30,2005 and 2004.  For the six months ended June 30,2005 and 2004, these discontinued operations generated net losses ofapproximately $3.1 million and $0.7 million, respectively.  Revenues for these discontinued operationswere approximately $2.6 million and $7.4 million for the six months ended June 30,2005 and 2004.

 

**NewAccounting Pronouncements**

 

In December 2004, theFASB issued SFAS No. 123R, “Share Based Payment,” that requires companiesto expense the value of employee stock options and other types of equity-basedcompensation based on the fair value of the options at the award’s grant datebased on the estimated number of awards that are expected to vest. Compensationcost for awards that vest would not be reversed if the awards expire withoutbeing exercised. When measuring fair value, companies can choose anoption-pricing model (e.g., Black-Sholes or binominal models) that approximatelyreflects their specific circumstances and the economics of their transactions.Companies will recognize compensation cost per share based paymentawards as they vest, including the related tax effects.  The effective date of SFAS No. 123R, asamended, applies to annual periods beginning after June 15, 2005, andapplies to all outstanding and unvested share based payment awards at thecompany’s adoption date.  In April 2005,the Securities and Exchange Commission adopted a rule that amends theadoption date of SFAS No. 123R to January 1, 2006.  We are currently evaluating the alternativetransition methods permitted by SFAS No. 123R.

 

Under SFAS No. 123R,compensatory employee stock purchase plans (ESPP) are required to recognizecompensation cost over the requisite service period for grants made under theESPP.  The criteria that an ESPP mustmeet to be considered non-compensatory are more restrictive under SFAS No. 123Rthan they are under APB No. 25.  Weare currently evaluating the impact on our ESPP by SFAS No. 123R.

 

The FASB issued SFAS No. 154,“Accounting Changes and Error Corrections – a replacement of APB Opinion No. 20and FASB Statement No. 3.”  SFAS No. 154 is effective, and will beadopted, for accounting changes made in fiscal years beginning after December 15,2005 and is to be applied retrospectively. SFAS No. 154 requires that retroactive application of a change inaccounting principle be limited to the direct effects of the change.  Our adoption of SFAS No. 154 is notexpected to have a material effect on our financial position or results ofoperations.

 

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**Results of Operations**

 

Thefollowing table 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,**    | ** ** |
| ** **                                                                            | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                                  |       |                   |       |                 |       |   |   |   |   |
| Revenues                                                                              |       | 100.0                  | %          | 100.0                | %          | 100.0 | % | 100.0 | % |
| Operating expenses                                                                    |       | 75.8                   |       | 77.3                 |       | 75.0 |   | 78.0 |   |
| Pre-opening and  start-up expenses                                                    |       | 2.7                    |       | 1.5                  |       | 4.5 |   | 1.0 |   |
| Depreciation and  amortization                                                        |       | 4.9                    |       | 4.7                  |       | 5.0 |   | 4.7 |   |
| General and  administrative expenses                                                  |       | 6.2                    |       | 8.4                  |       | 7.4 |   | 7.4 |   |
| Income from operations                                                                |       | 10.4                   |       | 8.1                  |       | 8.1 |   | 8.9 |   |
| Interest expense, net                                                                 |       | 7.1                    |       | 6.4                  |       | 7.4 |   | 6.7 |   |
| Loss on extinguishment  of debt                                                       |       | —                 |       | 3.5                  |       | — |   | 1.8 |   |
| Income (loss) from  continuing operations before provision (benefit) for income taxes |       | 3.3                    |       | (1.8                 | )          | 0.7 |   | 0.4 |   |
| Provision (benefit) for  income taxes                                                 |       | 1.5                    |       | (0.7                 | )          | 0.4 |   | 0.2 |   |
| Income (loss) from  continuing operations                                             |       | 1.8                    |       | (1.1                 | )          | 0.3 |   | 0.2 |   |
| Discontinued  operations, net of taxes                                                |       | (2.1                   | )          | (0.6                 | )          | (2.0 | ) | (0.5 | ) |
| Net loss                                                                              |       | (0.3                   | )%         | (1.7                 | )%         | (1.7 | )% | (0.3 | )% |

 

***Three Months Ended June 30, 2005Compared to Three Months Ended June 30, 2004***

 

Certaincomparisons of revenue, expenses and average contract capacity contained hereinhave been made excluding the effect of pre-opening and start-up expenses andrevenues.  Disclosures excluding theeffect of pre-opening and start-up expenses and revenues represent non-GAAPmeasures calculated in a manner that is not consistent with U.S. generallyaccepted accounting principles (GAAP). We believe exclusion of the non-recurring effect of pre-opening andstart-up expenses and revenues increases the reader’s understanding of ouroperating trends.

 

***Revenues*****.** Revenues increased approximately $12.1 million, or 18.2%, to $78.5million for the three months ended June 30, 2005 from $66.4 million forthe three months ended June 30, 2004.

 

***AdultSecure.***Adult secure institutional services divisionrevenues increased approximately $5.6 million, or 21.0%, to $32.3 million forthe three months ended June 30, 2005 from $26.7 million for the threemonths ended June 30, 2004 due primarily to (1) theacquisition of the Walnut Grove Youth Correctional Facility management contractin June 2004 which contributed revenues of approximately $2.7 million inthe second quarter of 2005, (2) the opening of the two tower RegionalCorrectional Center in July and December 2004 which contributedrevenues of approximately $1.3 million in the second quarter of 2005, (3) revenuesof approximately $1.0 million generated by the eight adult secure facilitiesacquired from CSI in April 2005,(4) an increase in revenues in the second quarter of 2005 of approximately$0.8 million at the Big Spring Correctional Center due to increased occupancy, (5) aper diem rate increase in the latter half of 2004 at the D. Ray James Prisonwhich increased second quarter 2005 revenues by approximately $0.3 million and (6) anincrease in revenues of approximately $0.2 million at the Donald W. WyattDetention Center due to increased occupancy.  The increase in adult secure revenues due to the above was offset, inpart, by a decrease in revenues of approximately $0.8 million due to thenon-renewal of the Valencia County Detention Center contract as of December 31,2004.  The remaining net increase inrevenues of approximately $0.1 million was due to various insignificantfluctuations in revenues at our other adult secure facilities.

 

Our adultsecure institutional services division revenues are primarily generated fromcontracts with federal and state government agencies.  At June 30, 2005, we operated 16 adultsecure institutional facilities with an aggregate service capacity of 8,114.

 

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Averagecontract occupancy was 94.9% for the three months ended June 30, 2005compared to 101.6% for the three months ended June 30, 2004.  The decline in the average contract occupancypercentage in 2005 was due to the two tower Regional Correctional Center whichopened in July and December 2004 and did not operate at full capacityduring the three months ended June 30, 2005.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Regional Correctional Center in2005, average contract capacity was 105.1% for the three months ended June 30,2005.  The average per diem rate for ouradult secure facilities was approximately $49.13 and $49.37 for the threemonths ended June 30, 2005 and 2004, respectively.  Revenues attributable to start-up operationswere approximately $1.0 million for the three months ended June 30, 2005and were attributable to the Regional Correctional Center.  There were no revenues attributable tostart-up operations for the three months ended June 30, 2004.

 

***Juvenile.***Juvenile justice, educational and treatment services divisionrevenues increased approximately $2.5 million, or 9.0%, to $30.3 million forthe three months ended June 30, 2005 from $27.8 million for the threemonths ended June 30, 2004 due primarily to (1) the opening ofthe Southern Peaks Regional Treatment Center in August 2004 whichcontributed revenues of approximately $1.9 million in the second quarter of2005 and (2) the commencement of our management contract for the LebanonAlternative Education Program in September 2004 and for the PhiladelphiaAlternative Education Program in August 2004 which contributed combinedrevenues of approximately $0.9 million in the second quarter of 2005.  The remaining net decrease in revenues ofapproximately $0.3 million was due to various insignificant fluctuations inrevenue at our other juvenile justice, educational and treatment programs andfacilities.

 

At June 30,2005, we operated 19 residential juvenile facilities and 13 non-residentialcommunity-based programs with an aggregate service capacity of 4,247.  Our contracts for these facilities andprograms are generally with state and local government agencies and generallyrenew annually.

 

Average contract occupancy for the three months ended June 30,2005 was 91.6% compared to 97.9% for the three months ended June 30,2004.  Excluding the actual occupancy andcontract capacity for the start-up activities of the Plankinton Regional DetentionCenter in 2004, average contract occupancy was 99.3% for the three months endedJune 30, 2004.

 

The average per diem rate for our residential juvenile facilities wasapproximately $161.61 for the three months ended June 30, 2005 compared to$157.69 for the three months ended June 30, 2004.  The increase in the average per diem rate in2005 as compared to 2004 was due to the opening of the Southern Peaks RegionalTreatment Center in August 2004 and per diem rate increases at ourPennsylvania programs and facilities in July 2004. Our average fee-for-service rate for ournon-residential juvenile community-based facilities and programs wasapproximately $32.00 for the three months ended June 30, 2005 compared to$24.11 for the three months ended June 30, 2004.  The increase in the average fee-for-servicerate in 2005 as compared to 2004 was due to changes in the mix of servicesprovided by our various non-residential juvenile facilities and programs.

 

There were norevenues attributable to start-up operations for the three months ended June 30,2005.  Revenues attributable to start-upoperations were approximately $30,000 for the three months ended June 30,2004 and were attributable to the start-up operations of the PlankintonRegional Detention Center.

 

***AdultCommunity-Based.*****Adultcommunity-based corrections and treatment services division revenues increasedapproximately $4.0 million, or 33.6%, to $15.9 million for the three monthsended June 30, 2005 from $11.9 million for the three months ended June 30,2004 due primarily to (1) revenues of approximately $2.8 million generatedby the eleven adult community-based facilities and programs acquired from CSIin April 2005, (2) the opening of the Las Vegas Center in December 2004which contributed revenues of approximately $0.4 million in the second quarterof 2005 and (3) an increase in revenues of approximately $0.3 million inthe second quarter of 2005 at the Dallas County Judicial Treatment Center dueto increased occupancy.  The remainingnet increase in revenues of approximately $0.5 million was due to variousinsignificant fluctuations in revenues at our other adult community-basedcorrections and treatment facilities and programs.

 

AtJune 30, 2005, we operated 21 residential adult community-based facilitiesand 10 non-residential adult community-based programs with an aggregate servicecapacity of 5,391.  Average contract occupancywas 115.6% for the three months ended June 30, 2005 compared to 103.3% forthe three months ended June 30, 2004. The average per

 

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diem rate for our residential adult community-based facilities wasapproximately $58.76 for the three months ended June 30, 2005 compared to$62.36 for the three months ended June 30, 2004.  The decrease in the average per diem rate for2005 as compared to 2004 was due to lower per diem rates at the facilities andprograms acquired from CSI in April 2005. The average fee-for-service rate for our non-residential adultcommunity-based programs was approximately $9.55 for the three months ended June 30,2005 compared to $8.54 for the three months ended June 30, 2004.  The increase in the average fee-for-servicerate for 2005 as compared to 2004 was due to changes in the mix of servicesprovided by our various non-residential adult community-based programs andfacilities.  There were no revenuesattributable to start-up operations for the three months ended June 30,2005 and 2004.

 

***OperatingExpenses****.*Operatingexpenses increased approximately $8.2 million, or 16.0%, to $59.5 million forthe three months ended June 30, 2005 from $51.3 million for the threemonths ended June 30, 2004.

 

***AdultSecure.***Adult secure institutional services divisionoperating expenses increased approximately $3.2 million, or 16.8%, to $22.3million for the three months ended June 30, 2005 from $19.1 million forthe three months ended June 30, 2004 due primarily to (1) theacquisition of the Walnut Grove Youth Correctional Facility management contractin June 2004 which increased second quarter 2005 operating expenses byapproximately $2.0 million, (2) operating expenses of approximately $0.8million attributable to the eight adult secure facilities acquired from CSI in April 2005and (3) an increase in operating expenses of approximately $0.7 million inthe second quarter of 2005 due to increased occupancy at the Big SpringCorrectional Center.  The increase inoperating expenses due to the above was offset, in part, by a decrease inoperating expenses of approximately $0.6 million due to the non-renewal of theValencia County Detention Center contract as of December 31, 2004.  The remaining net decrease of approximately$0.3 million was due to various insignificant fluctuations in operatingexpenses at our other adult secure facilities.

 

As a percentage of segmentrevenues, adult secure institutional services division operating expenses were68.9% for the three months ended June 30, 2005 compared to 71.6% for thethree months ended June 30, 2004. Excluding approximately $1.0 million of revenues attributable to thestart-up operations of the Regional Correctional Center in the second quarterof 2005, adult secure institutional services division operating expenses, as apercentage of segment revenues, were 71.2%.

 

***Juvenile.***Juvenile justice, educational and treatment services division operatingexpenses increased approximately $2.1 million, or 9.2%, to $25.0 million forthe three months ended June 30, 2005 from $22.9 million for the threemonths ended June 30, 2004 due primarily to (1) the opening of theSouthern Peaks Regional Treatment Center in August 2004 which increasedsecond quarter 2005 operating expenses by approximately $1.7 million, (2) thecommencement of our management contract for the Lebanon Alternative EducationProgram in September 2004 which increased second quarter 2005 operatingexpenses by approximately $0.3 million and (3) the commencement of ourmanagement contract for the Philadelphia Alternative Education Program in August 2004which increased second quarter 2005 operating expenses by approximately $0.4million.  The remaining net decrease inoperating expenses of approximately $0.3 million was due to variousinsignificant fluctuations in operating expenses at our other juvenilefacilities and programs.

 

Asa percentage of segment revenues, juvenile services division operating expenseswere 82.6% for the three months ended June 30, 2005 compared to 82.4% forthree months ended June 30, 2004.

 

***AdultCommunity-Based.*** Adult community-based corrections andtreatment services division operating expenses increased approximately $2.9million, or 31.2%, to $12.2 million for the three months ended June 30,2005 from $9.3 million for the three months ended June 30, 2004 dueprimarily to (1) operating expenses of approximately $2.1 millionattributable to the eleven adult community-based programs and facilitiesacquired from CSI in April 2005, (2) the opening of the Las VegasCenter in December 2004 which increased second quarter 2005 operatingexpenses by approximately $0.3 million and (3)  a charge of approximately$0.3 million in the second quarter of 2005 for terminated facility lease optioncosts.  As a percentage of segment revenues,adult community-based corrections and treatment services division operatingexpenses were 76.9% for the three months ended June 30, 2005 compared to 77.8%for the three months ended June 30, 2004.

 

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***Pre-Openingand Start-up Expenses.*** 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.  Pre-opening and start-up expenses for thethree months ended June 30, 2004 were approximately $1.0 million and wereattributable to the pre-opening and start-up activities of the RegionalCorrectional Center, the Southern Peaks Regional Treatment Center and thePlankinton Regional Detention Center.

 

***Depreciationand Amortization*****.**Depreciationand amortization increased approximately $0.7 million, or 22.6%, to $3.8million for the three months ended June 30, 2005 from $3.1 million for thethree months ended June 30, 2004.  Depreciationand amortization of property and equipment increased approximately $0.4 milliondue primarily to depreciation of the Southern Peaks Regional Treatment Centerand the Regional Correctional Center buildings which were not in operation andwere not being depreciated in the three months ended June 30, 2004.  Amortization of intangibles was approximately$0.5 million and $0.3 million for the three months ended June 30, 2005 and2004, respectively.  The increase inamortization expense for intangibles in the three months ended June 30,2005 as compared to 2004 was due to the amortization of the June 2004purchased contract value for the Walnut Grove Youth Correctional Facilitymanagement contract and the April 2005 purchased contract value for thefacilities and programs acquired from CSI.

 

***Generaland Administrative Expenses.*** General and administrativeexpenses decreased approximately $0.7 million, or 12.5%, to $4.9 million forthe three months ended June 30, 2005 from $5.6 million for the threemonths ended June 30, 2004.  The decrease in general and administrativeexpenses was primarily due to a decrease in personnel costs as a result ofmanagement streamlining initiatives implemented in the first quarter of 2005and a decrease in professional fees.

 

***Interest.***Interest expense, net of interest income, increased to approximately $5.6million for the three months ended June 30, 2005 from $4.2 million for thethree months ended June 30, 2004. Interest expense increased $1.6 million due primarily to interestexpense on the Senior Notes of $2.7 million (net of swap interest income of$0.3 million) in the three months ended June 30, 2005 compared to $0.2million in the three months ended June 30, 2004. The increase in interestexpense due to the Senior Notes was offset, in part, by a decrease in interestexpense of $0.6 million due to the pay-off of the Synthetic Lease InvestorNotes A and B in June 2004. Capitalized interest for the three months ended June 30, 2005 wasapproximately $0.6 million and was attributable to capitalized interest ondevelopment and construction costs for the Moshannon Valley CorrectionalCenter.  Capitalized interest for thethree months ended June 30, 2004 was approximately $0.5 million andrelated to development and construction costs for the Southern Peaks RegionalTreatment Center and the Moshannon Valley Correctional Center.  Additionally, interest income increasedapproximately $0.2 million in the three months ended June 30, 2005 ascompared to the same period of 2004 due to higher fund balances and higherinterest rates in the 2005 period.

 

***Loss on Extinguishment ofDebt.***In June 2004,we recognized a loss on the extinguishment of debt of approximately $2.4million related to the early retirement of the Synthetic Lease Investor Notes Aand B and our revolving line of credit under the Amended 2000 Credit Facility.

 

***IncomeTaxes.*** For the three months ended June 30, 2005, we recognized aprovision for income taxes on our income from operations at an estimatedeffective rate of 46.2%.  Additionally,we recognized an income tax benefit on our loss from discontinued operations atan estimated effective rate of 35.0%. For the three months ended June 30, 2004, we recognized an incometax benefit at an estimated effective 42.7%. The change in our estimated effective tax rate in 2005 was related to areduction in operating income across certain of our business segments and theimpact of certain non-deductible expenses such as lobbying.

 

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***Six Months Ended June 30, 2005Compared to Six Months Ended June 30, 2004***

 

***Revenues*****.** Revenues increased approximately $20.1million, or 15.2%, to $152.1 million for the six months ended June 30, 2005from $132.0 million for the six months ended June 30, 2004.

 

***AdultSecure.***Adult secure institutional services divisionrevenues increased approximately $10.7 million, or 20.4%, to $63.2 million forthe six months ended June 30, 2005 from $52.5 million for the six monthsended June 30, 2004 due primarily to (1) the acquisition of theWalnut Grove Youth Correctional Facility management contract in June 2004which increased revenues for the six months ended June 30, 2005 byapproximately $5.2 million, (2) the opening of the two tower RegionalCorrectional Center in July and December 2004 which contributed revenuesof approximately $2.8 million in 2005, (3) revenues of approximately $1.0million generated from the eight adult secure facilities acquired from CSI in April 2005,(4) an increase in revenues of approximately $2.2 million in the sixmonths ended June 30, 2005 at the Big Spring Correctional Center due toincreased occupancy, (5) an increase in revenues of approximately $0.5million in the six months ended June 30, 2005 at the D. Ray James Prisondue to a per diem rate increase received in the latter half of 2004 and (6) anincrease in revenues in the six months ended June 30, 2005 ofapproximately $0.5 million at the Donald W. Wyatt Detention Center due toincreased occupancy.  The increase inrevenues due to the above was offset, in part, by a decrease in revenues ofapproximately $1.7 million due to the non-renewal of the Valencia CountyDetention Center contract as of December 31, 2004. The remaining netincrease in revenue of approximately $0.2 million was due to variousinsignificant revenue fluctuations at our other adult secure institutionalfacilities.

 

Average contract occupancyfor the six months ended June 30, 2005 was 93.9% compared to 101.4% forthe six months ended June 30, 2004. The decline in the average contract occupancy percentage in the sixmonths ended June 30, 2005 was due to the two tower Regional CorrectionalCenter, which opened in July and December 2004, and did not operateat full capacity during the six months ended June 30, 2005.   Excluding the actual occupancy and contractcapacity for the start-up operations of the Regional Correctional Center in thesix months ended June 30, 2005, average contract occupancy was 104.1% forthe six months ended June 30, 2005.

 

 The average per diem rate for our adult securefacilities was approximately $48.81 and $48.70 for the six months ended June 30,2005 and 2004, respectively.  Revenuesattributable to start-up operations for the six months ended June 30, 2005were approximately $2.5 million and were attributable to the start-up operationsof the Regional Correctional Center. There were no revenues attributable to start-up operations for the sixmonths ended June 30, 2004.

 

***Juvenile.***Juvenile justice, educational and treatment services divisionrevenues increased approximately $5.1 million, or 9.2%, to $60.5 million forthe six months ended June 30, 2005 from $55.4 million for the six monthsended June 30, 2004 due primarily to (1) the opening of the Southern Peaks Regional Treatment Center inAugust 2004 which contributed revenues of approximately $3.4 million inthe six months ended June 30, 2005, (2) the commencement of ourmanagement contract for the Lebanon Alternative Education Program in September 2004which contributed revenues of approximately $0.8 million in the six months endedJune 30, 2005 and (3) the commencement of our management contract forthe Philadelphia Alternative Education Program in August 2004 whichcontributed revenues of approximately $1.0 million in the six months ended June 30,2005.  The remaining net decrease inrevenues of $0.1 million was due to various insignificant fluctuations inrevenues at our other juvenile facilities and programs.

 

Average contract occupancyfor the six months ended June 30, 2005 was 91.8% compared to 96.2% for thesix months ended June 30, 2004. Excluding the actual occupancy and contract capacity for the start-upactivities of the Southern Peaks Regional Treatment Center in 2005 and thestart-up activities of the Plankinton Regional Detention Center in 2004,average contract occupancy was 93.5% for the six months ended June 30,2005 compared to 96.9% for the six months ended June 30, 2004.  The average per diem rate for our residentialjuvenile facilities was approximately $162.95 and $159.11 for the six monthsended June 30, 2005 and 2004, respectively.  The increase in the average per diem rate for2005 as compared to 2004 was due to the opening of the Southern Peaks RegionalTreatment Center and per diem rate increases at our Pennsylvania programs andfacilities in July 2004.  Our averagefee-for-service rate for our non-residential juvenile community-basedfacilities and programs was approximately $31.57 and $23.85 for the six monthsended June 30, 2005 and 2004, respectively.  The increase in the average fee-for-servicerate for 2005 as compared to 2004 was due to changes in the mix of servicesprovided by our various non-residential juvenile facilities and programs.

 

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Revenuesattributable to start-up operations were approximately $1.5 million for the sixmonths ended June 30, 2005 and were attributable to the start-upoperations of the Southern Peaks Regional Treatment Center.  Revenues attributable to start-up operationswere approximately $30,000 for the six months ended June 30, 2004 and wereattributable to the start-up operations of the Plankinton Regional DetentionCenter.

 

***AdultCommunity-Based.*** Adult community-based corrections andtreatment services division revenues increased approximately $4.4 million, or18.3%, to $28.5 million for the six months ended June 30, 2005 from $24.1million for the six months ended June 30, 2004 due primarily to (1) revenues of approximately $2.8million in the six months ended June 30, 2005 from the eleven adultcommunity-based programs and facilities acquired from CSI in April 2005and (2) the opening of the Las Vegas Center in December 2004 whichcontributed revenues of approximately $0.9 million in the six months ended June 30,2005.  The remaining net increase inrevenue of approximately $0.7 million was due to various insignificantfluctuations in revenues at our other adult community-based facilities andprograms.

 

Average contract occupancyfor the six months ended June 30, 2005 was 108.7% compared to 105.9% forthe six months ended June 30, 2004. The average per diem rate for our residential adult community-basedfacilities was $60.00 and $60.93 for the six months ended June 30, 2005and 2004, respectively.   The averagefee-for-service rate for our non-residential adult community-based programs was$8.54 and $8.70 for the six months ended June 30, 2005 and 2004,respectively.   There were no revenuesattributable to start-up operations for the six months ended June 30, 2005and 2004.

 

***OperatingExpenses.*** Operating expenses increased approximately$11.0 million, or 10.7%, to $114.0 million for the six months ended June 30,2005 from $103.0 million for the six months ended June 30, 2004.

 

***AdultSecure.***Adult secure institutional servicesdivision operating expenses increased approximately $4.7 million, or 12.4%, to$42.5 million for the six months ended June 30, 2005 from $37.8 millionfor the six months ended June 30, 2004 due primarily to (1) anincrease in operating expenses in the six months ended June 30, 2005 ofapproximately $3.9 million due to the acquisition of the Walnut Grove YouthCorrectional Facility management contract in June 2004, (2) anincrease in operating expenses in the six months ended June 30, 2005 ofapproximately $2.0 million at the Big Spring Correctional Center due toincreased occupancy and (3) operating expenses of $0.8 million from theeight adult secure facilities purchased from CSI in April 2005.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses in the sixmonths ended June 30, 2005 of approximately $1.4 million due to thenon-renewal of the Valencia County Detention Center contract as of December 31,2004.  The remaining net decrease inoperating expenses of approximately $0.6 million was due to variousinsignificant fluctuations in operating expenses at our other adult securefacilities.

 

Asa percentage of segment revenues, adult secure institutional services division operatingexpenses were 67.3% for the six months ended June 30, 2005 compared to 72.0%for the six months ended June 30, 2004. 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 were 70.1%.  The improvement inthe 2005 operating margin was due to the positive margin impact of the WalnutGrove Youth Correctional, Facility and the eight facilities acquired from CSIin April 2005.

 

***Juvenile.***Juvenile justice, educational and treatment services division operatingexpenses increased approximately $3.0 million, or 6.5%, to $49.3 million forthe six months ended June 30, 2005 from $46.3 million for the six monthsended June 30, 2004 due primarily to (1) the opening of the Southern Peaks RegionalTreatment Center in August 2004 which increased operating expenses for thesix months ended June 30, 2005 by approximately $1.6 million, (2) thecommencement of our management contract for the Philadelphia AlternativeEducation Program in August 2004 which increased operating expenses forthe six months ended June 30, 2005 by approximately $0.8 million and (3) thecommencement of our management contract for the Lebanon Alternative EducationProgram in September 2004 which increased operating expenses for the sixmonths ended June 30, 2005 by approximately $0.6 million.   Additionally, in the six months ended June 30,2005, we recorded a restructuring charge of approximately $1.0 million forpersonnel costs

 

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associatedwith management streamlining initiatives implemented in the first quarter of2005.  The increase in operating expensesdue to the above was offset, in part, by a decrease in operating expenses inthe six months ended June 30, 2005 of approximately $0.6 million due tothe termination of the Santa Fe County Youth Development Program in January 2004.  The remaining net decrease in operatingexpenses of approximately $0.4 million for the six months ended June 30,2005 was due to various insignificant fluctuations in operating expenses at ourother juvenile facilities and programs.

 

Asa percentage of segment revenues, juvenile services division operating expenseswere 81.6% for the six months ended June 30, 2005 compared to 83.6% for thesix months ended June 30, 2004.  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 were 83.7%.

 

***AdultCommunity-Based.*** Adult community-based corrections andtreatment services division operating expenses increased approximately $3.4million, or 18.1%, to $22.2 million for the six months ended June 30, 2005from $18.8 million for the six months ended June 30, 2004 due to (1) operatingexpenses of approximately $2.2 million attributable to the eleven adultcommunity-based programs and facilities acquired from CSI in April 2005, (2) theopening of the Las Vegas Center in December 2004 which increased operatingexpenses in the six months ended June 30, 2005 by approximately $0.6million and (3) a charge of approximately $0.3 million in the six monthsended June 30, 2005 for terminated facility lease option costs.  The remaining net increase in operatingexpenses for the six months ended June 30, 2005 of approximately $0.3million was due to various insignificant fluctuations in operating expenses atour other adult community-based programs and facilities.

 

As a percentage of segmentrevenues, adult community-based corrections and treatment services divisionoperating expenses were 77.7% for the six months ended June 30, 2005compared to 78.2% for the six months ended June 30, 2004.

 

***Pre-Openingand Start-up Expenses.*** Pre-opening and start-up expensesfor the six months ended June 30, 2005 were approximately $6.8 million andwere attributable to the pre-opening and start-up activities of the RegionalCorrectional Center, the Southern Peaks Regional Treatment Center and theMoshannon Valley Correctional Center. Pre-opening and start-up expenses for thesix months ended June 30, 2004 were approximately $1.3 million and wereattributable to the pre-opening and start-up activities of the RegionalCorrectional Center, the Southern Peaks Regional Treatment Center and thePlankinton Regional Detention Center.

 

***Depreciationand Amortization*****.** Depreciation and amortization increasedapproximately $1.3 million, or 21.0%, to $7.5 million for the six months ended June 30,2005 compared to $6.2 million for the six months ended June 30, 2004.  Depreciation and amortization of property andequipment increased approximately $0.9 million due primarily to depreciation ofthe Southern Peaks Regional Treatment Center and the Regional CorrectionalCenter buildings that were not in operation and were not being depreciated inthe six months ended June 30, 2004. Amortization of intangibles was approximately $1.0 million and $0.5million for the six months ended June 30, 2005 and 2004,respectively.  The increase inamortization expense for intangibles in the six months ended June 30, 2005as compared to 2004 was due to amortization of the June 2004 purchasedcontract value for the Walnut Grove Youth Correctional Facility managementcontract and the April 2005 purchased contract value for the facilitiesand programs acquired from CSI.

 

***Generaland Administrative Expenses.*** General and administrativeexpenses increased approximately $1.4 million, or 14.3%, to $11.2 million forthe six months ended June 30, 2005 from $9.8 million for the six monthsended June 30, 2004.  This was dueprimarily to a restructuring charge of approximately $1.1 million in the sixmonths ended June 30, 2005 for personnel costs associated with managementstreamlining initiatives implemented in the first quarter of 2005.  Additionally, professional fees, principallyassociated with certain accounting services (including Sarbanes-Oxleycompliance), executive recruitment services, and business development increasedby approximately $0.6 million.

 

***Interest.***Interest expense, net of interest income, increased to $11.3 million for thesix months ended June 30, 2005 from $8.9 million for the six months ended June 30,2004.  Interest expense increasedapproximately $2.9 million primarily due to interest on the Senior Notes ofapproximately $5.2 million (net of swap interest income of $0.8 million) in thesix months ended June 30, 2005 compared to $0.2 million in the six monthsended June 30, 2004.  The increasein interest expense attributable to the Senior Notes was offset, in part, by adecrease in interest expense of $1.2 million due

 

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to the pay-off of the Synthetic LeaseInvestor Notes A and B in June 2004. Capitalized interest for the six months ended June 30, 2005 wasapproximately $1.1 million and related to development and construction costsfor the Moshannon Valley Correctional Center. Capitalized interest for the six months ended June 30, 2004 wasapproximately $0.7 million and related to development and construction costsfor the Moshannon Valley Correctional Center and the Southern Peaks RegionalTreatment Center.  Additionally, interestincome increased approximately $0.5 million for the six months ended June 30,2005 as compared to the same period in 2004 due to higher fund balances andhigher interest rates in the 2005 period.

 

***Loss on Extinguishment ofDebt.***In June 2004,we recognized a loss on the extinguishment of debt of approximately $2.4million related to the early retirement of the Synthetic Lease Investor Notes Aand B and our revolving line of credit under the Amended 2000 Credit Facility.

 

***IncomeTaxes.*** For the six months ended June 30, 2005, we recognized aprovision for income taxes on our income from continuing operations at anestimated effective rate of 53.9%. Additionally, we recorded an income tax benefit on our loss fromdiscontinued operations at an estimated effective rate of 35.0%.  For the six months ended June 30, 2004,we recognized an income tax benefit at an estimated effective rate of41.0%.  The change in our estimatedeffective rate in 2005 was related to a reduction in operating income acrosscertain of our business segments.

 

**Liquidity and Capital Resources**

 

***General*****.**Our primary capital requirements for (1) purchases,construction or renovation of new facilities, (2) expansions of existingfacilities, (3) working capital, (4) pre-opening and start-up costsrelated to new operating contracts, (5) acquisitions, (6) informationsystems hardware and software, and (7) furniture, fixtures andequipment.  Working capital requirementsgenerally increase immediately prior to commencing management of a new facilityas we incur start-up costs and purchase necessary equipment and supplies beforefacility management revenue is realized.

 

***CashFlows From Operating Activities.***  Cash provided by operations was approximately$20.5 million for the six months ended June 30, 2005 compared to $7.9million for the six months ended June 30, 2004.  The increase was principally due to anincrease in accounts payable and accrued liabilities due to higher accruedinterest (pertaining to the Senior Notes issued in June 2004) and a decrease inaccounts receivable due to increased collections during 2005.

 

***CashFlows From Investing Activities*****.**  Cash used in investing activities wasapproximately $17.1 million for the six months ended June 30, 2005 due tonet sales of investment securities of $12.3 million offset by capitalexpenditures of $23.7 million comprised of approximately $14.6 million for thedevelopment of Moshannon Valley Correctional Center and approximately $9.1million (net) for the acquisition of CSI. Additionally, there were net payments to the restricted debt paymentaccount of approximately $5.8 million.  Cash used in investing activities wasapproximately $23.7 million for the six months ended June 30, 2004 dueprimarily to capital expenditures of $20.6 million for the purchase anddevelopment of the Southern Peaks Regional Treatment Center, the Las VegasCenter and the Central California Treatment Center buildings, renovation of theRegional Correctional Center, renovations to the Plankinton Regional DetentionCenter, capitalized interest on the Moshannon Valley CorrectionalCenter and the Southern PeaksRegional Treatment Center and various other facility improvements and/orexpansions and information technology and software development costs.  Additionally, there were net payments to therestricted debt payment account of approximately $5.5 million.  Additionally, we received $5.0 million from ourrestricted escrow arrangement related to the Southern Peaks Regional TreatmentCenter.

 

***CashFlows From Financing Activities*****.**  Cash used by financing activities wasapproximately $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.  Cashprovided by financing activities was approximately $51.9 million for the sixmonths ended June 30, 2004 due primarily to cash proceeds of $110.5million from the issuance of the Senior Notes in June 2004 offset by netrepayments on our revolving line of credit of $2.0 million and the repayment ofthe Synthetic Lease Investor Notes A and B of $52.5 million.  Additionally, we made payments of approximately$5.0 million related to the issuance of the Senior Notes and our new revolvingline of credit.

 

***TreasuryStock/Repurchases.***  There were no purchases of our common stock in the six months ended June 30,2005.  We repurchased in the open market 10,000 shares of our common stock forapproximately $0.1 million in the six months ended June 30, 2004.

 

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***Long-Term Credit Facilities.*** The 2004 Credit Facility provides for borrowingsof up to $60.0 million under a revolving line of credit, and is reduced byoutstanding letters of credit.  Theavailable commitment under the 2004 Credit Facility was approximately $51.4million at June 30, 2005.  We had nooutstanding borrowings on the 2004 Credit Facility at June 30, 2005, butwe had outstanding letters of credit of approximately $8.6 million.  Subject to certain requirements, we have theright to increase the aggregate commitments under the 2004 Credit Facility upto an aggregate amount of $100.0 million. The 2004 Credit Facility matures in June 2008 and bears interest,at our election, depending on our total leverage ratio, at either the primerate plus a margin ranging from 0.75% to 2.00%, or a rate which ranges from2.25% to 3.50% above the applicable LIBOR rate. The 2004 Credit Facility iscollateralized by substantially all of our assets, including the assets andstock of all of our subsidiaries.  The2004 Credit Facility is not secured by the assets of MCF.  The 2004 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 at a rate of 8.47%per annum and are payable in semi-annual installments of interest and annualinstallments of principal.  All unpaidprincipal and accrued interest on the bonds is due on the earlier of August 1,2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by us.

 

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

 

| **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 theoriginal aggregate principal amount of the Senior Notes at a redemption priceof 110.75% of the principal amount thereof with the net cash of publicofferings of equity, provided that at least 65% of the original aggregateprincipal amount of the Notes remains outstanding after the redemption andother conditions are met.  Upon theoccurrence of specified change of control events, unless we have exercised ouroption to redeem all the Senior Notes as described above, each holder will havethe right to require us to repurchase all or a portion of such holder’s SeniorNotes at a purchase price in cash equal to 101% of the aggregate principalamount of the notes repurchased plus accrued and unpaid interest, if any, onthe Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) which 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

 

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agreement as a fair valuehedge.  The swap has a notional amount of$84.0 million and matures in July 2012 to mirror the maturity of theSenior Notes.  Under the agreement, we payon a semi-annual basis (each January 1 and July 1) a floating ratebased 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, 2005, we recorded interest savings relatedto this interest 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, 2005 and December 31,2004, the fair value of this derivative instrument was approximately $3.2million, and is included in other assets in our Consolidated Balance Sheets asof these dates.  The carrying value ofthe Senior Notes as of these dates was increased by the same amount. Becausethe swap agreement is considered an effective fair-value hedge, there will beno effect on our results of operations from the mark-to-market adjustment aslong as the swap is in effect.

 

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

 

***Regional Correctional Center.***  In January 2003, we executed a five-yearlease for the Regional Correctional Center in Albuquerque, New Mexico. This 970bed facility consists of two units, the 528 South Tower and the 442 bed NorthTower. We renovated the South Tower and opened the unit in July 2004.  We renovated the North Tower and opened theunit in December 2004.  As of June 30,2005, we had invested approximately $9.7 million on renovations and furnitureand equipment for both the Towers.  Forthe three and six months ended June 30, 2005, we incurred pre-opening andstart-up expenses of approximately $2.1 million and $4.9 million, respectively,and recognized revenue of approximately $1.0 million and $2.5 million,respectively related to this facility. We currently anticipate that the facility will reach substantialcapacity during the second half of 2005. However, there can be no assurance that we will develop enough volume atthe facility to assure its profitability. The lease 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.

 

***New Morgan Academy. ***We closed the New MorganAcademy in the fourth quarter of 2002 and are currently considering severaloptions ranging from the utilization of the facility for another type ofprogram or the sale or lease of the facility. As of June 30, 2005, we are principally focusing our efforts on thepotential insertion of a program.  Inaddition, we are considering the possible sale or lease of the facility.  We are maintaining a small staff to secureand maintain the facility.  We have recognizedpre-tax costs of $0.9 million and $1.8 million in our Consolidated Statementsof Operations and Comprehensive Income (Loss) for the three and six monthsended June 30, 2005, respectively, and pre-tax costs of $0.8 million and$1.6 million for the three and six months ended June 30, 2004,respectively, for related holding costs (depreciation, interest, property,taxes and other maintenance costs).

 

The developing inability during late 2004 of various governmentalagencies with whom we had been in negotiations to obtain the level of fundingto contract with us for the use of the New Morgan Academy indicated anexpectation of continuing losses associated with this facility.  As a result, we recorded an impairment chargeof $9.3 million, pursuant to the requirements of Statement of FinancialAccounting Standards (“SFAS”) No. 144, in the year ended December 31,2004.  As of June 30, 2005, webelieve that, pursuant to the provisions of SFAS No. 144, no additionalimpairment allowance is necessary.  The carryingvalue of the property and equipment for the New Morgan Academy, after theimpairment charge, was approximately $20.1 million and $20.4 million at June 30,  2005 and December 31, 2004,respectively.

 

***Central California Treatment Center***.  In January 2004,we purchased a building in Los Angeles, California for which our carrying valuewas approximately $2.7 million at June 30, 2005.   This new facility could provide service to220 inmates in a work-furlough type program. Although we do not currently have a contract for this facility, thefacility has been submitted and is under consideration in several recentproposals.  We believed that due to thegrowth of the inmate population, severe budget crisis and recent legalsettlements requiring additional community services, this facility would fill asmall part of the overall demand in California. The potential uses for the facility range from a “halfway back” programto a comprehensive drug and alcohol treatment program.

 

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***FutureLiquidity*****.  **We believe that the existing cashand the cash flows generated from operations, together with the creditavailable under the 2004 Credit Facility, will provide sufficient liquidity tomeet our committed capital and working capital requirements for currentlyawarded and certain potential future development contracts, including theconstruction of the Moshannon Valley Correctional Center. To the extent our cashand current financing arrangements do not provide sufficient financing to fundconstruction costs related to future adult secure institutional contract awardsor significant facility expansions, we anticipate obtaining additional sourcesof financing to fund such activities. However, there can be no assurance that such financing will be availableor will be available on terms favorable to us.

 

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

 

Wemaintain operating leases in the ordinary course of our businessactivities.  These leases include thosefor operating facilities, office space and office and operating equipment, andthe terms of these agreements range from 2005 until 2075.  As of June 30, 2005, our totalcommitment under these operating leases was approximately $36.5 million.

 

Thefollowing table details our known future cash payments (on an undiscountedbasis) related to various contractual obligations as of June 30, 2005 (inthousands):

 
| ** **                                  | ** ** | **Payments Due by Period** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|
| ** **                                  | ** ** | ** **                 | ** ** | ** ** | ** ** | **2006 -** | ** ** | **2008 -** | ** ** | ** ** | ** ** |
| ** **                                  | ** ** | **Total**                  | ** ** | **2005** | ** ** | **2007** | ** ** | **2009** | ** ** | **Thereafter** | ** ** |
|                                        |       |                       |       |   |   |   |   |   |   |   |   |
| Contractual Obligations:                    |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term debt - principal                  |       |                       |       |   |   |   |   |   |   |   |   |
| • Cornell  Companies, Inc.        |       | $                          | 112,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 112,000 |   |
| • Special  Purpose Entities            |       | 174,700                    |       | 9,000 |   | 20,200 |   | 23,800 |   | 121,700 |   |
| Long-term debt - interest (1)               |       |                       |       |   |   |   |   |   |   |   |   |
| • Cornell  Companies, Inc.        |       | 76,466                     |       | 5,491 |   | 21,835 |   | 21,857 |   | 27,283 |   |
| • Special  Purpose Entities            |       | 102,907                    |       | 7,399 |   | 27,248 |   | 23,682 |   | 44,578 |   |
| Construction commitments                    |       | 35,408                     |       | 32,570 |   | 2,838 |   | 3⁄4 |   | — |   |
| Capital lease obligations                   |       |                       |       |   |   |   |   |   |   |   |   |
| • Cornell  Companies, Inc.        |       | 171                        |       | 1 |   | 170 |   | — |   | — |   |
| Operating leases                            |       | 36,476                     |       | 3,388 |   | 12,112 |   | 6,754 |   | 14,222 |   |
| Consultative and non-competition agreements |       | 1,536                      |       | 477 |   | 809 |   | 250 |   | — |   |
| Total contractual cash obligations          |       | $                          | 539,664    |   | $ | 58,326 |   | $ | 85,212 |   | $ | 76,343 |   | $ | 319,783 |   |

 

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(1)          Wehave an interest rate swap agreement under which we receive a fixed interestrate and pay a floating interest rate. The future cash payments on the CornellCompanies, Inc. long-term debt – interest assume an effective rate of9.29% on the related interest rate swap contract.

 

Weenter into letters of credit in the ordinary course of our operating andfinancing activities.  As of June 30,2005, we had outstanding letters of credit of approximately $8.6 millionrelated to insurance and other operating activities.  The following table details our letter ofcredit commitments as of June 30, 2005 (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 |       | $             | 8,628      |                                            | $          | 8,628 |   | $ | — |   | $ | — |   | $ | — |   |
|                            |            |               |            |                                                 |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

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

 

**Interest Rate Exposure**

 

Ourexposure to changes in interest rates primarily results from our long-term debtwith both fixed and floating interest rates. The debt on our consolidated financial statements with fixed interestrates consists of the 8.47% Bonds issued by MCF in August 2001 inconnection with the 2001 Sale and Leaseback Transaction and approximately $28.0million of the Senior Notes (not hedged by the interest rate swap entered intoby the Company).  At June 30, 2005,29.1% ($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, 2005.  At June 30, 2005, the fair value of ourconsolidated fixed rate debt approximated carrying value based upon discountedfuture cash flows using current market prices.

 

**ITEM 4.          Controls and Procedures**

 

We maintain disclosurecontrols and procedures designed to ensure that information disclosed in ourannual and periodic reports is recorded, processed, summarized and reportedwithin the time periods specified in the Securities and Exchange Commission’s rules andforms. In addition, we designed these disclosure controls and procedures toensure that this information is accumulated and communicated to management,including the chief executive officer (CEO) and chief financial officer (CFO),to allow timely decisions regarding required disclosures. SEC rules requirethat we disclose the conclusions of our CEO and CFO about the effectiveness ofour disclosure 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.

 

Under thesupervision 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 with the evaluation described above, there have been nochanges in our internal control over financial reporting (as such term isdefined in Rules 13a-15(f) and 15d-15(f) under Exchange Act)during our fiscal quarter ended June 30, 2005 that has materially affected,or is reasonably likely to materially affect, our internal control overfinancial reporting.

 

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**PART II         OTHER INFORMATION**

 

**ITEM 1.          Legal Proceedings**

 

***Southern Peaks Regional Treatment Center***

 

OnJanuary 5, 2004, we initiated legal proceedings in the lawsuit styled *Cornell Corrections of California, Inc. v.Longboat Global Advisors, LLC, et al*., No.2004 CV79761 in theSuperior Court of Fulton County, Georgia under theories of fraud, conversion,breach of contract and other theories to determine the location of and torecover funds previously deposited by us into what we believed to be an escrowaccount in connection with the development and construction of the SouthernPeaks Regional Treatment Center.  Of thefunds previously deposited, approximately $5.3 million remains to be recoveredat June 30, 2005.  In December 2004,the case was tried before a jury and the jury verdict awarded approximately$6.5 million in compensatory damages and approximately $1.4 million in punitivedamages, 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 judgement has yetbeen entered on this verdict.  The awardfor compensatory damages accrues pre-judgment interest at a rate of 7 percentfrom the date of loss through the date of judgment.  Followingthe jury verdicts, we collected approximately $0.4 million in January 2005in funds which had been previously frozen under a temporary restraining orderissued at the time that we commenced this litigation.  Currently, certain of the defendants have filedmotions for a new trial. No judgment will be entered on the verdict until afterthese motions for a new trial have been heard and ruled on by the court.  Due to the continued uncertainty surroundingthe ultimate recovery of the funds previously deposited, we will continue tomaintain our existing reserve of approximately $5.0 million in an allowance fordoubtful accounts.

 

**ShareholderLawsuits**

 

In March andApril 2002, the Company, Steven W. Logan (our former President and ChiefExecutive Officer), and John L. Hendrix (our former Chief Financial Officer),were named as defendants in four federal putative class action lawsuits styledas follows: (1) *Graydon Williams, OnBehalf of Himself and All Others Similarly Situated v. Cornell Companies, Inc,et al.*, No. H-02-0866, in the United States District Court forthe Southern District of Texas, Houston Division; (2) *Richard Picard, On Behalf of Himself and All OthersSimilarly Situated v. Cornell Companies, Inc., et al.*, No. H-02-1075,in the United States District Court for the Southern District of Texas, HoustonDivision; (3) *Louis A. Daly, On Behalfof Himself and All Others Similarly Situated v. Cornell Companies, Inc.,et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No. H-02-1567,in the United States District Court for the Southern District of Texas, HoustonDivision.  The aforementioned lawsuitswere putative class action lawsuits brought on behalf of all purchasers of ourcommon stock between March 6, 2001 and March 5, 2002 and relate toour restatement in 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 four lawsuits were consolidated intothe *Graydon Williams* action andFlyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint wasfiled by Flyline Partners, LP.  RichardPicard and Anthony Scolaro were also named as plaintiffs.  Since then, the court allowed plaintiffs tofile an amended consolidated complaint. The amended consolidated complaintalleges that the defendants violated Section 10(b) of the SecuritiesExchange Act of 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b) ofthe Exchange Act, Section 20(a) of the Exchange Act, Section 11of the Securities Act of 1933 (the “Securities Act”) and/or Section 15 ofthe Securities Act.  The amendedconsolidated complaint seeks, among other things, restitution damages,compensatory damages, rescission or a rescissory measure of damages, costs,expenses, attorneys’ fees and expert fees. The Company filed a motion to dismiss the lawsuit.  In an order entered April 1, 2005, thecourt granted the motion to dismiss with respect to the plaintiffs’ securitiesfraud claims pursuant to Sections 10(b) and 20(a) of the Exchange Actand Rule 10b-5.  The court deniedthe motion to dismiss as to the remaining claims covering the Company’ssecondary offering in 2001.  Subject tocourt approval and documentation, the parties have agreed to settle thismatter.  Under the proposed agreement,the Company has not admitted any wrongdoing. Settlement in the amount of $7 million will be funded through theCompany’s Directors’ and Officers’ liability insurance.  The Company has not reached settlement in thepending derivative litigation discussed below.

 

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In March 2002,the Company, our directors, and our former independent auditor Arthur AndersenLLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf of Nominal DefendantCornell 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 in2002 of certain financial statements. The lawsuit alleged breaches of fiduciary duty by all of the individualdefendants and asserted breach of contract and professional negligence claimsonly against Arthur Andersen LLP.  Thislawsuit has been dismissed without prejudice by agreement.

 

On January 27,2004, we received a letter from William Williams, the plaintiff in the *William Williams* action discussed above,demanding that we pursue breach of fiduciary duty claims against variousofficers and directors based on the August 2001 sale leaseback transactionand the subsequent restatement.  We haveissued a preliminary response to the letter indicating that the Board willconsider the request and inform Mr. Williams of its decision.

 

In May andSeptember 2002, the Company and our directors were sued in three otherderivative lawsuits styled as follows: (1) *Juan Guitierrez, Derivatively on Behalf of Cornell Companies, Inc.v. Steven W. Logan, et. al.,* No. H-02-1812, in the UnitedStated District Court for the Southern District of Texas, Houston Division; (2) *Thomas Pagano, Derivatively on Behalf of CornellCompanies, Inc. v. Steven W. Logan, et. al.*, No. H-02-1896,in the United Stated District Court for the Southern District of Texas, HoustonDivision; and (3) *Jesse Menning,Derivatively on Behalf of Cornell Companies, Inc. v. Steven W. Logan, et.al.,* No. 2002-28924, in the 164th Judicial DistrictCourt of Harris County, Texas.  Theselawsuits relate to our restatement in 2002 of certain financialstatements.  These lawsuits all allegebreaches of fiduciary duty and waste of corporate assets by all of thedefendants.  A motion to dismiss the *Guitierrez* and *Pagano* lawsuits was filed. The court dismissed the *Pagano*action as duplicative of the *Guitierrez*action.  The motion to dismiss the *Guitierrez* action is still pending.  The *Menning*action has been dismissed, but with an agreement that the plaintiff’s claims asto Cornell are tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

The plaintiffs in these caseshave not quantified their claim of damages and the outcome of the mattersdiscussed above cannot be predicted with certainty.  However, we believe we have good defenses andintend to vigorously defend against the claims asserted in these actions.  We have not recorded any loss accrualsrelated 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 decision in these matters exceeds the insurancecoverage or if the insurance coverage is deemed not to apply to these matters,an adverse decision to us in these matters could have a material adverse effecton us, our financial condition, results of operations and future prospects.

 

***Other***

 

Additionally, we currently and from time to time are subject to claimsand suits arising in the ordinary course of business, including claims fordamages for personal injuries or for wrongful restriction of or interferencewith offender privileges and employment matters. If an adverse decision inthese matters exceeds our insurance coverage, or if our coverage is deemed notto apply to these matters, or if the underlying insurance carrier were unableto fulfill their obligation under the insurance coverage provided, it couldhave a material adverse effect on our financial position, results of operationsor cash flows.

 

During the period of August 2000through May 2003, our general liability and professional liability coveragewas provided by Specialty Surplus Insurance Company, a Kemper Insurance Company(“Kemper”) group member.  In June 2004,the Illinois Department of Insurance gave Kemper permission to proceed with arun-off plan it had previously submitted. The three-year plan is designed to help Kemper meet its goal ofresolving, to the maximum extent possible, all valid policyholder claims.  In view of the risks and uncertaintiesinvolved in implementing the plan, including the need to achieve significantpolicy buybacks, commutation of reinsurance agreements, and further agreementswith regulators, no assurance can be given that the plan will be successfullyimplemented by Kemper.  In the year endedDecember 31, 2004, we recorded a reserve of $0.6 million, and estimatedour range of additional exposure to be approximately $0.5 million with respectto outstanding claims incurred during this policy period with Kemper whichwould become our obligation to resolve if not settled through Kemper.

 

42

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During the six months ended June 30, 2005, Kemper continued toimplement its run-off plan.  As a result,several of our significant claims were settled by Kemper in the second quarterof 2005. In conjunction with these settlements, we booked a charge against ourexisting reserve in the amount of $0.3 million. While we believe that the uncertainty surrounding the ability of Kemperto settle our remaining outstanding claims still exists, we feel no additionalreserve is necessary at June 30, 2005. We believe our estimated range of exposure, above our existing $0.3million reserve, to be approximately $0.3 million related to the outstandingclaims which could become our obligation to resolve if not settled throughKemper.

 

While the outcome of such matters cannot be predicated with certainty,based on the information known to date, we believe that the ultimate resolutionof these matters will not have a material adverse effect on our financialposition, operating results or cash flow.

 

**ITEM 2.          Unrestricted Salesof Equity Securities and Use of Proceeds**

 

None

 

**ITEM 3.          Defaults UponSenior Securities**

 

None

 

**ITEM 4.          Submission ofMatters to a Vote of Security Holders**

 

OnJune 30, 2005, the Company held its 2005 Annual Meeting of Stockholders.  The matters voted on at the meeting and theresults thereof are as follows:

 

Stockholderselected the persons listed below as directors whose terms expire at the 2006Annual Meeting of Stockholders.  Pleasesee the Company’s proxy statement for its 2005 Annual Meeting of Stockholdersfor a discussion of the Company’s settlement of its proxy contest with PirateCapital LLC, Jolly Roger Fund LP, Mint Master Fund LTD, Jolly Roger OffshoreFund LTD, Thomas R. Hudson, Jr. and Zachary R. George.  Results by nominee were:

 

| ** **                  | ** ** | ** **    | ** ** | **Authority** | ** ** |
|-----------------------------|------------|---------------|------------|---------------|------------|
| ** **                  | ** ** | **Voted For** | ** ** | **Withheld**  | ** ** |
|                        |       |          |       |          |       |
| Anthony R. Chase            |       | 11,607,274    |       | 339,842       |       |
| Leon Clements               |       | 11,855,954    |       | 91,162        |       |
| Richard Crane               |       | 11,860,454    |       | 86,662        |       |
| Zachary R. George           |       | 11,861,358    |       | 85,758        |       |
| Todd Goodwin                |       | 11,848,334    |       | 98,782        |       |
| Thomas R.  Hudson, Jr. |       | 11,866,254    |       | 80,862        |       |
| Alfred Jay  Moran, Jr. |       | 11,855,183    |       | 91,933        |       |
| D. Stephen Slack            |       | 11,609,108    |       | 338,008       |       |
| Sally Walker                |       | 11,855,954    |       | 91,162        |       |

 

Stockholdersratified the appointment of PricewaterhouseCoopers LLP as the Company’sindependent registered public accounting firm for the fiscal year ending December 31,2005, with 11,859,824 shares voted for, 1,961 shares voted against and 85,331abstained.

 

43

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**ITEM 5.          Other Information**

 

None

 

**ITEM 6.****                            ****Exhibits**

 
| **Exhibit No.** | ** ** | **Description**                                                                                                                                                    | ** ** | **Incorporated by  Reference** |
|----------------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------|
| 4.1                  |       | Amendment  No. 1 to Rights Agreement, dated as of July 1, 2005, between the  Company and Computershare Trust Company, Inc.                          |       | (1)                            |
| 4.2                  |       | Certification  of Elimination with respect to Preferred Stock Purchase Rights                                                                                      |       | (1)                            |
| 10.1 (a)             |       | Release of  Claims and Covenant not to Sue, dated as of April 12, 2005, between  Cornell Companies, Inc. and Luis A. Collazo                             |       | (2)                            |
| 10.2 (a)             |       | Independent  Contractor Agreement effective as of June 6, 2005, between Cornell Companies, Inc.  and Luis A. Collazo                                     |       | (2)                            |
| 10.3 (a)             |       | Release of  Claims, Covenant not to Sue and Older Workers Act Waiver, dated as of  April 25, 2005, between Cornell Companies, Inc. and John C.  Godlesky |       | (3)                            |
| 10.4 (a)             |       | Independent  Contractor Agreement effective as of July 1, 2005, between Cornell Companies, Inc.  and John C. Godlesky                                    |       | (3)                            |
| 10.5                 |       | Letter  Agreement, dated May 17, 2005 (but effective as of May 18, 2005),  between Cornell Companies, Inc. and Pirate Capital LLC.                  |       | (4)                            |
| 11.1                 |       | Computation  of Per Share Earnings                                                                                                                                 |       |                           |
| 31.1                 |       | Section 302  Certification of Chief Executive Officer                                                                                                         |       |                           |
| 31.2                 |       | Section 302  Certification of Chief Financial Officer                                                                                                         |       |                           |
| 32.1                 |       | Section 906  Certification of Chief Executive Officer                                                                                                         |       |                           |
| 32.2                 |       | Section 906  Certification of Chief Financial Officer                                                                                                         |       |                           |

 

----

| (a) |   | Management compensatory plan or contract.                                  |
|-----|--------|----------------------------------------------------------------------------|
| (1) |   | Current Report on Form 8-K of the Company  filed July 6, 2005.   |
| (2) |   | Current Report on Form 8-K of the Company  filed April 18, 2005. |
| (3) |   | Current Report on Form 8-K of the Company  filed April 29, 2005. |
| (4) |   | Current Report on Form 8-K of the Company  filed May 19, 2005.   |

 

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**SIGNATURES**

 

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned,thereunto duly authorized.

 

 
|                                              |   | **CORNELL COMPANIES, INC.**           |   |
|---------------------------------------------------|--------|---------------------------------------|--------|
|                                              |   |                                  |   |
|                                              |   |                                  |   |
| Date:    August 9, 2005  | By:    | /s/ James E. Hyman                    |   |
|                                              |   | JAMES E. HYMAN                        |   |
|                                              |   | Chief Executive Officer  and          |   |
|                                              |   | Chairman of the Board                 |   |
|                                              |   | (Principal Executive  Officer)        |   |
|                                              |   |                                  |   |
|                                              |   |                                  |   |
| Date:    August 9,  2005 | By:    | /s/ John R. Nieser                    |   |
|                                              |   | JOHN R. NIESER                        |   |
|                                              |   | Chief Financial Officer and Treasurer |   |
|                                              |   | (Principal Financial Officer)         |   |
|                                                   |        |                                       |        |  |

 

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