**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, DC 20549**

 

**FORM 10-Q**

 

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

 

**For the Quarterly Period Ended March 31, 2005**

 

**OR**

 

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

 

**For the transition period              to              **

 

**Commission File Number 1-14472**

 

**CORNELL COMPANIES, INC.**

(Exact name of registrant as specified in itscharter)

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

 

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

 

Yes  ý  No o

 

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

 

Yes  ý No o

 

At April 30, 2005 Registranthad outstanding 13,430,394 shares of its Common Stock.

 

 

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**PART I  FINANCIAL INFORMATION**

 

**ITEM 1.  Financial Statements**

 

**CORNELL COMPANIES, INC.**

**CONSOLIDATED BALANCE SHEETS**

**(Unaudited)**

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

 
| ** **                                                                                                                                                     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
| ASSETS                                                                                                                                                         |       |                |       |                   |       |
| CURRENT ASSETS:                                                                                                                                                |       |                |       |                   |       |
| Cash and cash equivalents                                                                                                                                      |       | $                   | 23,133     |                   | $          | 9,895 |   |
| Investment securities available for sale                                                                                                                       |       | 41,625              |       | 51,740                 |       |
| Accounts receivable – trade (net of  allowance for doubtful accounts of $4,577 and $3,198, respectively)                                                  |       | 52,554              |       | 60,174                 |       |
| Other receivables (net of allowance for  doubtful accounts of $5,040 and $5,039, respectively)                                                                 |       | 4,566               |       | 4,691                  |       |
| Other restricted assets                                                                                                                                        |       | 18,733              |       | 19,713                 |       |
| Deferred tax assets                                                                                                                                            |       | 9,923               |       | 8,520                  |       |
| Prepaids and other                                                                                                                                             |       | 8,648               |       | 9,106                  |       |
| Total current assets                                                                                                                                           |       | 159,182             |       | 163,839                |       |
| PROPERTY AND EQUIPMENT, net                                                                                                                                    |       | 284,463             |       | 282,255                |       |
| OTHER ASSETS:                                                                                                                                                  |       |                |       |                   |       |
| Debt service reserve fund                                                                                                                                      |       | 23,800              |       | 23,801                 |       |
| Goodwill, net                                                                                                                                                  |       | 7,721               |       | 7,721                  |       |
| Intangible assets, net                                                                                                                                         |       | 6,629               |       | 7,026                  |       |
| Deferred costs and other                                                                                                                                       |       | 19,231              |       | 22,989                 |       |
| Total assets                                                                                                                                                   |       | $                   | 501,026    |                   | $          | 507,631 |   |
|                                                                                                                                                           |       |                |       |                   |       |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                                                                     |       |                |       |                   |       |
|                                                                                                                                                           |       |                |       |                   |       |
| CURRENT LIABILITIES:                                                                                                                                           |       |                |       |                   |       |
| Accounts payable and accrued liabilities                                                                                                                       |       | $                   | 46,538     |                   | $          | 47,237 |   |
| Current portion of long-term debt                                                                                                                              |       | 9,001               |       | 9,005                  |       |
| Total current liabilities                                                                                                                                      |       | 55,539              |       | 56,242                 |       |
| LONG-TERM DEBT, net of current portion                                                                                                                         |       | 276,893             |       | 279,528                |       |
| DEFERRED TAX LIABILITIES                                                                                                                                       |       | 6,658               |       | 8,088                  |       |
| OTHER LONG-TERM LIABILITIES                                                                                                                                    |       | 2,848               |       | 2,461                  |       |
| Total liabilities                                                                                                                                              |       | 341,938             |       | 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, 14,976,925 and 14,845,107 shares issued and 13,429,342 and  13,297,524 outstanding, respectively |       | 15                  |       | 15                     |       |
| Additional paid-in capital                                                                                                                                     |       | 147,433             |       | 145,825                |       |
| Retained earnings                                                                                                                                              |       | 24,514              |       | 26,785                 |       |
| Treasury stock (1,547,583 shares of common  stock, at cost)                                                                                                    |       | (12,573             | )          | (12,573                | )          |
| Deferred compensation                                                                                                                                          |       | (1,112              | )          | (432                   | )          |
| Accumulated other comprehensive income                                                                                                                         |       | 811                 |       | 1,692                  |       |
| Total stockholders’ equity                                                                                                                                |       | 159,088             |       | 161,312                |       |
| Total liabilities and stockholders’ equity                                                                                                                |       | $                   | 501,026    |                   | $          | 507,631 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVEINCOME (LOSS)**

**(Unaudited)**

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

 
| ** **                                                                                                         | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                         | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                                                               |       |                              |       |   |   |
| REVENUES                                                                                                           |       | $                                 | 74,693     |   | $ | 66,386 |   |
| OPERATING EXPENSES                                                                                                 |       | 56,443                            |       | 51,801 |   |
| PRE-OPENING AND START-UP EXPENSES                                                                                  |       | 4,694                             |       | 1,646 |   |
| DEPRECIATION AND AMORTIZATION                                                                                      |       | 3,793                             |       | 3,135 |   |
| GENERAL AND ADMINISTRATIVE EXPENSES                                                                                |       | 6,338                             |       | 4,160 |   |
| GAIN ON SALE OF FIXED ASSETS                                                                                       |       | (10                               | )          | (11 | ) |
|                                                                                                               |       |                              |       |   |   |
| INCOME FROM OPERATIONS                                                                                             |       | 3,435                             |       | 5,655 |   |
| INTEREST EXPENSE                                                                                                   |       | 6,339                             |       | 5,019 |   |
| INTEREST INCOME                                                                                                    |       | (595                              | )          | (370 | ) |
|                                                                                                               |       |                              |       |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS BEFORE  PROVISION (BENEFIT) FOR INCOME TAXES                              |       | (2,309                            | )          | 1,006 |   |
| PROVISION (BENEFIT) FOR INCOME TAXES                                                                               |       | (878                              | )          | 413 |   |
|                                                                                                               |       |                              |       |   |   |
| INCOME (LOSS) FROM CONTINUING OPERATIONS                                                                           |       | (1,431                            | )          | 593 |   |
|                                                                                                               |       |                              |       |   |   |
| DISCONTINUED OPERATIONS, NET OF TAX  PROVISION (BENEFIT) OF ($454) AND $75, RESPECTIVELY                           |       | (840                              | )          | 113 |   |
|                                                                                                               |       |                              |       |   |   |
| NET INCOME (LOSS)                                                                                                  |       | $                                 | (2,271     | ) | $ | 706 |   |
|                                                                                                               |       |                              |       |   |   |
| EARNINGS (LOSS) PER SHARE:                                                                                         |       |                              |       |   |   |
| BASIC                                                                                                              |       |                              |       |   |   |
| Income (loss) from continuing operations                                                                           |       | $                                 | (.11       | ) | $ | .04 |   |
| Income (loss) on discontinued operations,  net of tax                                                              |       | (.06                              | )          | .01 |   |
| Net income (loss)                                                                                                  |       | $                                 | (.17       | ) | $ | .05 |   |
|                                                                                                               |       |                              |       |   |   |
| DILUTED                                                                                                            |       |                              |       |   |   |
| Income (loss) from continuing operations                                                                           |       | $                                 | (.11       | ) | $ | .04 |   |
| Income (loss) on discontinued operations,  net of tax                                                              |       | (.06                              | )          | .01 |   |
| Net income (loss)                                                                                                  |       | $                                 | (.17       | ) | $ | .05 |   |
|                                                                                                               |       |                              |       |   |   |
| NUMBER OF SHARES USED IN PER SHARE  COMPUTATION:                                                                   |       |                              |       |   |   |
| BASIC                                                                                                              |       | 13,428                            |       | 13,081 |   |
| DILUTED                                                                                                            |       | 13,428                            |       | 13,312 |   |
|                                                                                                               |       |                              |       |   |   |
| COMPREHENSIVE INCOME (LOSS):                                                                                       |       |                              |       |   |   |
| Net income (loss)                                                                                                  |       | $                                 | (2,271     | ) | $ | 706 |   |
| Unrealized gain (loss) on derivative  instruments, net of tax (benefit) provision of ($427) and $318, respectively |       | (881                              | )          | 458 |   |
| Comprehensive income (loss)                                                                                        |       | $                                 | (3,152     | ) | $ | 1,164 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

3

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**CORNELL COMPANIES, INC.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Unaudited)**

**(in thousands)**

 
| ** **                                                                                                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                      | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                                           |       |                              |       |   |   |
| Net income (loss)                                                                                               |       | $                                 | (2,271     | ) | $ | 706 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used) in operating activities –– |       |                              |       |   |   |
| Depreciation                                                                                                    |       | 3,385                             |       | 2,889 |   |
| Amortization of intangibles and other  assets                                                                   |       | 428                               |       | 270 |   |
| Amortization of deferred compensation                                                                           |       | (488                              | )          | (50 | ) |
| Amortization of deferred financing costs                                                                        |       | 487                               |       | 209 |   |
| Amortization of Senior Notes Discount                                                                           |       | 46                                |       | 3⁄4 |   |
| Provision for bad debts                                                                                         |       | 1,099                             |       | 170 |   |
| Gain on sale of property and equipment                                                                          |       | (10                               | )          | (11 | ) |
| Deferred income taxes                                                                                           |       | (3,446                            | )          | 295 |   |
| Change in assets and liabilities:                                                                               |       |                              |       |   |   |
| Accounts receivable                                                                                             |       | 7,047                             |       | (1,931 | ) |
| Restricted assets                                                                                               |       | 158                               |       | 158 |   |
| Other assets                                                                                                    |       | 336                               |       | (183 | ) |
| Accounts payable and accrued liabilities                                                                        |       | (564                              | )          | (8,250 | ) |
| Deferred revenues and other liabilities                                                                         |       | 119                               |       | (13 | ) |
| Net cash provided by (used in) operating  activities                                                            |       | 6,326                             |       | (5,741 | ) |
|                                                                                                            |       |                              |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                                           |       |                              |       |   |   |
| Capital expenditures                                                                                            |       | (5,383                            | )          | (8,192 | ) |
| Purchases of investment securities                                                                              |       | (335,495                          | )          | 3⁄4 |   |
| Sale of investment securities                                                                                   |       | 345,610                           |       | 3⁄4 |   |
| Deposits in (withdrawals from) restricted  debt payment account, net                                            |       | 823                               |       | 1,048 |   |
| Proceeds from sale of property and  equipment                                                                   |       | 3⁄4                            |       | 163 |   |
| Sale of restricted assets from deferred  bonus plan                                                             |       | 3⁄4                            |       | 86 |   |
| Net cash provided by (used in) investing  activities                                                            |       | 5,555                             |       | (6,895 | ) |
|                                                                                                            |       |                              |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                                           |       |                              |       |   |   |
| Proceeds from long-term debt and line of  credit                                                                |       | 3⁄4                            |       | 36,000 |   |
| Payments on line of credit                                                                                      |       | 3⁄4                            |       | (24,000 | ) |
| Payments on capital lease obligations                                                                           |       | (1                                | )          | (6 | ) |
| Payments of debt issuance and other  financing costs                                                            |       | 3⁄4                            |       | (100 | ) |
| Proceeds from exercise of stock options and  warrants                                                           |       | 1,358                             |       | 819 |   |
| Purchases of treasury stock                                                                                     |       | 3⁄4                            |       | (116 | ) |
| Net cash provided by financing activities                                                                       |       | 1,357                             |       | 12,597 |   |
|                                                                                                            |       |                              |       |   |   |
| NET INCREASE (DECREASE) IN CASH AND CASH  EQUIVALENTS                                                           |       | 13,238                            |       | (39 | ) |
| CASH AND CASH EQUIVALENTS AT BEGINNING OF  PERIOD                                                               |       | 9,895                             |       | 40,171 |   |
| CASH AND CASH EQUIVALENTS AT END OF PERIOD                                                                      |       | $                                 | 23,133     |   | $ | 40,132 |   |
|                                                                                                            |       |                              |       |   |   |
| OTHER NON-CASH INVESTING AND FINANCING  ACTIVITIES:                                                             |       |                              |       |   |   |
| Other comprehensive income (loss)                                                                               |       | $                                 | (881       | ) | $ | 458 |   |
| Common stock issued for board of directors  fees                                                                |       | 58                                |       | 3⁄4 |   |
| Decrease in fair value of interest rate  swap                                                                   |       | 2,681                             |       | 3⁄4 |   |

 

Theaccompanying notes are an integral part of these consolidated financialstatements.

 

4

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**CORNELL COMPANIES, INC.**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

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

 

The accompanying unauditedconsolidated financial statements have been prepared by Cornell Companies, Inc.(the “Company”) pursuant to the rules and regulations of the Securities andExchange Commission.  Certain informationand footnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles in the United States(GAAP) have been condensed or omitted pursuant to such rules andregulations.  In the opinion of management,adjustments and disclosures necessary for a fair presentation of thesefinancial statements have been included. Estimates were used in the preparation of these financialstatements.  Actual results could differfrom those estimates.  These financialstatements should be read in conjunction with the financial statements andnotes thereto included in the Company’s 2004 Annual Report on Form 10-K asfiled with the Securities and Exchange Commission.

 

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

 

See a description of ouraccounting policies in our 2004 Annual Report on Form 10-K.

 

### ***AccountingFor Stock Based Compensation***

### * *

Inaccordance with the provisions of Statement of Financial Accounting Standard(SFAS) No. 123, “Accounting for Stock-Based Compensation,” we have elected toaccount for our stock-based compensation plans under the intrinsic value methodestablished 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 fixed stockoptions granted to employees is not reflected in net income, as all optionsgranted under those plans had an exercise price equal to or in excess of themarket 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 on netincome (loss) and earnings (loss) per share as if we had applied the fair valuerecognition provisions of SFAS No. 123, “Accounting for Stock-BasedCompensation,” to stock-based employee compensation (in thousands, expect pershare amounts):

 
| ** **                                                                                                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                                                                                  | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                                                                                        |       |                              |       |   |   |
| Net income (loss), as reported                                                                                                              |       | $                                 | (2,271     | ) | $ | 706 |   |
| Add: total stock-based compensation recorded,  net of tax                                                                                   |       | 34                                |       | — |   |
| Less: total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | 357                               |       | (157 | ) |
| Pro forma net income (loss)                                                                                                                 |       | $                                 | (2,662     | ) | $ | 549 |   |
| Earnings (loss) per share:                                                                                                                  |       |                              |       |   |   |
| Basic, as reported                                                                                                                          |       | $                                 | (.17       | ) | $ | .05 |   |
| Basic, pro forma                                                                                                                            |       | (.20                              | )          | .04 |   |
| Diluted, as reported                                                                                                                        |       | (.17                              | )          | .05 |   |
| Diluted, pro forma                                                                                                                          |       | (.20                              | )          | .04 |   |

 

***New Accounting Pronouncements***

 

InDecember 2004, the Financial Accounting Standards Board (FASB) issued SFAS No.123R, “Share Based Payment,” that requires companies to expense the value ofemployee stock options and other types of equity-based compensation based onthe fair value of the options at the award’s grant date based on the estimatednumber of

 

5

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awards that are expected tovest.  Compensation cost for awards thatvest would not 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, 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 Commissionadopted a rule that amends the adoption date of SFAS No. 123R to January 1,2006.  We are currently evaluating thealternative transition methods permitted by SFAS No. 123R.

 

Under SFAS No.123R, compensatory employee stock purchase plans (ESPP) are required torecognize compensation cost over the requisite service period for grants madeunder the ESPP.  The criteria that anESPP must meet to be considered non-compensatory are more restrictive underSFAS No. 123R than they were under ABP No. 25. We are currently evaluating the impact on our ESPP by SFAS No. 123R.

 

We do not have an equityinterest in the variable interest entity that was formed in connection with the2001 Sale and Leaseback Transaction.  Thevariable interest entity was formed for the purpose of owning and leasingcertain facilities to us.  Reference ismade to the “Non-Guarantor Subsidiary” information included in Note 12 for asummary of the financial information related to the variable interestentity.  The debtholders of the variableinterest entity have no recourse to our general credit.

 

***Reclassifications***

 

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

 

**3.****             ****Discontinued Operations and ManagementRestructuring**

 

We classify as discontinued operations those components of our businessthat we hold for sale or disposition that have operations and cash flows thatare clearly distinguishable operationally and for financial reporting purposesfrom the rest of the Company. For those components, we have no significantcontinuing involvement after disposal and their operations are eliminated fromour ongoing operations.  During thequarter ended March 31, 2005, we classified certain components as discontinuedoperations. This was the result of a management decision to initiate the shutdown of operations at certain facilities. These facilities/programs include Residential School, Maple Creek Homeand the mental health wrap programs in Pennsylvania.  Notifications have been made to the requiredcontracting entities regarding the terminations of the related programs. Therelated facility assets will be disposed of or transferred to other existingoperations.  At March 31, 2005 we havenet property and equipment of $0.6 million pertaining to these operations.   The discontinued operations generatedrevenues of approximately $0.9 million and $2.9 million for the three monthsended March 31, 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 this, acharge was recorded of approximately $2.1 million in the quarter ended March31, 2005.  The charge was recorded in operatingexpenses (approximately $1.0 million) and general and administrative expenses(approximately $1.1 million).  Theaccrued liability pertaining to this charge at March 31, 2005 was approximately$2.0 million.  There are no costsexpected to be incurred in conjunction with this activity in subsequentperiods.

 

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

 

Intangible assets at March31, 2005 and December 31, 2004 consisted of the following (in thousands):

 

6

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| ** **               | ** ** | **March 31,****2005** | ** ** | **December 31,****2004** | ** ** |
|--------------------------|------------|-----------------------|------------|--------------------------|------------|
|                     |       |                  |       |                     |       |
| Non-compete agreements   |       | $                     | 9,870      |                     | $          | 9,840 |   |
| Acquired contract value  |       | 2,405                 |       | 2,405                    |       |
| Accumulated amortization |       | (5,646                | )          | (5,219                   | )          |
| Intangible assets, net   |       | 6,629                 |       | 7,026                    |       |
| Goodwill, net            |       | 7,721                 |       | 7,721                    |       |
|                     |       | $                     | 14.350     |                     | $          | 14,747 |   |

 

Amortization expense for our non-compete agreements was approximately$0.3 million for the three months ended March 31, 2005 and 2004.  Amortization expense for our non-competeagreements is expected to be approximately $1.1 million for each of the nextfour years ended December 31 and approximately $0.7 million for the fifth year.

 

Amortization expense for our acquired contract value was approximately$0.1 million for the three months ended March 31, 2005.  Amortization expense for our acquiredcontract value is expected to be approximately $0.5 million for each of thenext four years of the contract term.

 

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

 

Our long-term debt consisted of the following (in thousands):

 
| ** **                                                                                                                                                     | ** ** | **March 31,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------|------------|------------------------|------------|
|                                                                                                                                                           |       |                |       |                   |       |
| **Debt of Cornell Companies, Inc.:**                                                                                                                           |       |                |       |                   |       |
| Senior Notes, unsecured, due July 2012 with  an interest rate of 10.75%, net of discount                                                                       |       | $                   | 110,665    |                   | $          | 110,619 |   |
| Fair-value adjustment of Senior Notes as a result  of interest rate swap                                                                                       |       | 527                 |       | 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                                                                                                                                      |       | 2                   |       | 6                      |       |
| Subtotal                                                                                                                                                       |       | 111,194             |       | 113,833                |       |
|                                                                                                                                                           |       |                |       |                   |       |
| **Debt of Special Purpose Entity:**                                                                                                                            |       |                |       |                   |       |
| 8.47% Bonds due 2016                                                                                                                                           |       | 174,700             |       | 174,700                |       |
|                                                                                                                                                           |       |                |       |                   |       |
| Total consolidated debt                                                                                                                                        |       | 285,894             |       | 288,533                |       |
|                                                                                                                                                           |       |                |       |                   |       |
| Less: current maturities                                                                                                                                       |       | (9,001              | )          | (9,005                 | )          |
|                                                                                                                                                           |       |                |       |                   |       |
| Consolidated long-term debt                                                                                                                                    |       | $                   | 276,893    |                   | $          | 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 March 31, 2005.  We had no outstanding borrowings on the 2004Credit Facility at March 31, 2005, but we had outstanding letters of credit ofapproximately $8.6 million.  Subject tocertain requirements, we have the right to increase the aggregate commitmentsunder 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 

 

7

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bysubstantially all of our assets, including the assets and stock of all of oursubsidiaries.  The 2004 Credit Facilityis not secured by the assets of MCF.  The2004 Credit Facility contains standard covenants including compliance withlaws, 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 ata rate of 8.47% per annum and are payable in semi-annual installments ofinterest and annual installments of principal. All unpaid principal and accrued interest on the bonds is due on theearlier of August 1, 2016 (maturity) or as noted under the bond documents.  The bonds are limited, nonrecourseobligations of MCF and secured by the property and equipment, bond reserves,assignment of subleases and substantially all assets related to the facilitiesincluded in the 2001 Sale and Leaseback Transaction.  The bonds are not guaranteed by us.

 

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

 

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

 

Any time prior to July 1, 2007, we may redeemup to 35% of the original aggregate principal amount of the Senior Notes at aredemption price of 110.75% of the principal amount thereof with the net cashof public offerings of equity, provided that at least 65% of the originalaggregate principal amount of the Notes remains outstanding after theredemption and other conditions are met. Upon the occurrence of specified change of control events, unless wehave exercised our option to redeem all the Senior Notes as described above,each holder will have the right to require us to repurchase all or a portion ofsuch holder’s Senior Notes at a purchase price in cash equal to 101% of the aggregateprincipal amount of the notes repurchased plus accrued and unpaid interest, ifany, on the Senior Notes repurchased, to the applicable date of purchase.  The Senior Notes were issued under anindenture (the “Indenture”) that limits our ability and the ability of ourGuarantors to, among other things, incur additional indebtedness, pay dividendsor make other distributions, make other restricted payments and investments,create liens, incur restrictions on the ability of the Guarantors to pay dividendsor other payments to us, enter into transactions with affiliates, and engage inmergers, consolidations and certain sales of assets.

 

In conjunction with the issuance of theSenior Notes, we entered into an interest rate swap transaction with afinancial institution to hedge our exposure to changes in the fair value on$84.0 million of our Senior Notes.  Thepurpose of this transaction was to convert future interest due on $84.0 millionof the Senior Notes to a variable rate. The terms of the interest rate swap contract and the underlying debtinstrument are identical.  We havedesignated the swap agreement as a fair value hedge.  The swap has a notional amount of $84.0million and matures in July 2012 to mirror the maturity of the SeniorNotes.  Under the agreement, we pay on asemi-annual basis (each January 1 and July 1) a floating rate based on asix-month U.S. dollar LIBOR rate, plus a spread, and receive a fixed-rateinterest of 10.75%.  For the three monthsended March 31, 2005, we recorded interest savings related to this interestrate swap of approximately $0.5 million, 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 March 31, 2005 and December 31, 

 

8

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2004 the fair value of this derivative instrument was approximately$0.5 million and $3.2 million, respectively, and is included in otherassets.  The carrying value of the SeniorNotes as of these dates was increased by the same amount. Because the swapagreement is an effective fair-value hedge, there is no effect on our resultsof operations from the mark-to-market adjustment as long as the swap is ineffect.

 

9

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

 

***Moshannon Valley Correctional Center***

 

InMarch 2003, we reached an agreement with the Commonwealth of Pennsylvania thatresolved all outstanding administrative issues relative to the contract awardedby the BOP to operate the Moshannon Valley Correctional Center.  In October 2004, we received the signedFinding of No Significant Impact for the facility.  Construction of the facility, which willhouse 1,300 male federal inmates, began immediately.  We have a three-year contract with the BOP tooperate the facility and the BOP has the option to grant seven one-yearextensions.  The facility is scheduled tobegin operations in early 2006.

 

InSeptember 2004, we resolved our claim with the BOP for the reimbursement of aportion 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.  The excessreimbursement of approximately $5.6 million over the $1.4 million in accountsreceivable was credited against the carrying cost of the facility.

 

As of March 31, 2005, we had incurred (net of the BOP reimbursement)approximately $22.7 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***

*** ***

We closed 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 March 31, 2005, we are focusing our efforts on both the potential insertionof a program as well as the possible sale or lease of the facility to certaingovernmental agencies in Pennsylvania, as well as private enterprises. We aremaintaining a small staff to secure and maintain the facility. We haverecognized pre-tax costs of $0.9 million and $0.8 million in our ConsolidatedStatements of Operations and Comprehensive Income (Loss) for the three monthsended March 31, 2005 and 2004, respectively, for related holding costs(depreciation, interest, property, taxes and other maintenance costs).

 

The developing inabilityduring late 2004 of various governmental agencies with whom we had been innegotiations to obtain the level of funding to contract with us for the use ofthe New Morgan Academy indicated an expectation of continuing losses associatedwith this facility.  As a result, werecorded an impairment charge of $9.3 million, pursuant to the requirements ofSFAS No. 144, at December 31, 2004.  Asof March 31, 2005, we believe that, pursuant to the provisions of SFAS No. 144,no additional impairment charge is necessary. The carrying value of theproperty and equipment for the New Morgan Academy, after the impairment charge,was approximately $20.2 million and $20.4 million at March 31, 2005 andDecember 31, 2004, respectively.

 

***Central California Treatment Center***

*** ***

***In January 2004, we purchased a buildingin Los Angeles, California for approximately $2.5 million.  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, it hasbeen submitted for consideration in several recent proposals.  We***

 

10

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***believe that due to the growth ofthe inmate population, severe budget crisis and recent legal settlementsrequiring additional community services, this facility will fill a small partof the overall demand in California.  Thepotential uses for the facility range from a “halfway back” program to acomprehensive drug and alcohol treatment program.***

*** ***

**7.****             ****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 March 31, 2005 and2004, there were 291,071 shares ($14.51 average price) and 195,503 shares ($14.72average price), respectively, of stock options that were not included in thecomputation of diluted EPS because to do so would have been anti-dilutive.

 

Thefollowing table summarizes the calculation of net earnings and weighted averagecommon shares and common equivalent shares outstanding for purposes of thecomputation of earnings per share (in thousands, except per share data):

 
| ** **                                                               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                               | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                     |       |                              |       |   |   |
| Net earnings (loss)                                                      |       | $                                 | (2,271     | ) | $ | 706 |   |
|                                                                     |       |                              |       |   |   |
| Weighted average common  share outstanding                               |       | 13,428                            |       | 13,081 |   |
| Weighted average common  share equivalents outstanding                   |       | 3⁄4                            |       | 231 |   |
| Weighted average common  shares and common share equivalents outstanding |       | 13,428                            |       | 13,312 |   |
|                                                                     |       |                              |       |   |   |
| Basic earnings (loss)  per share                                         |       | $                                 | (.17       | ) | $ | 0.05 |   |
| Diluted earnings (loss)  per common share                                |       | $                                 | (.17       | ) | $ | 0.05 |   |

 

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

 

***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 the Superior Court of Fulton County,Georgia under theories of fraud, conversion, breach of contract and othertheories to determine the location of and to recover funds previously depositedby us into what we believed to be an escrow account in connection with thedevelopment and construction of the Southern Peaks Regional Treatment Center. Ofthe funds previously deposited, approximately $5.3 million remains to berecovered at March 31, 2005. In December 2004, the case was tried before a juryand the jury verdict awarded approximately $6.5 million in compensatory damagesand approximately $1.4 million in punitive damages, plus attorneys’ fees. Weexpect that the actual damages awarded under the verdict will be adjusteddownward to the $5.4 million actually lost by us and that the punitive damagesaward may be adjusted downward because of a Georgia statute regarding caps onpunitive damages awards.  No judgment hasyet been entered on this verdict.  Theaward for compensatory damages accrues pre-judgment interest at a rate of 7percent from the date of loss through the date of judgment. Following the juryverdicts, we collected approximately $0.4 million in January 2005 in fundswhich had been previously frozen under a temporary restraining order issued atthe time that we commenced this litigation. Currently, certain of thedefendants have filed motions for a new trial. No judgment will be entered onthe verdict until after these motions for a new trial have been heard and ruledon by the court. Due to the continued uncertainty surrounding the ultimaterecovery of the funds previously deposited, we will continue to maintain ourexisting reserve of approximately $5.0 million in an allowance for doubtfulaccounts.

 

11

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**ShareholderLawsuits**

 

InMarch and April 2002, the company, Steven W. Logan (our former President andChief Executive Officer), and John L. Hendrix (our former Chief FinancialOfficer), were named as defendants in four federal putative class actionlawsuits styled as follows: (1) *Graydon Williams,On Behalf 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 ofTexas, Houston Division; (3) *Louis A. Daly,On Behalf of Himself and All Others Similarly Situated v. Cornell Companies,Inc., et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1567, in the United States District Court for the Southern District ofTexas, Houston Division.  Theaforementioned lawsuits were putative class action lawsuits brought on behalfof all purchasers of our common stock between March 6, 2001 and March 5, 2002and relate to our 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 Securities ExchangeAct of 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b) ofthe Exchange Act, Section 20(a) of the Exchange Act, Section 11 of theSecurities Act of 1933 (the “Securities Act”) and/or Section 15 of theSecurities Act.  The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees.  The Company filed amotion to dismiss the lawsuit.  In anorder entered April 1, 2005, the court granted the motion to dismiss withrespect to the plaintiffs' securities fraud claims pursuant to Sections 10(b)and 20(a) of the Exchange Act and Rule 10b-5. The court denied the motion to dismiss as to the remaining claimscovering the Company's secondary offering in 2001.  Subject to court approval and documentation,the parties have agreed to settle this matter. Under the proposed agreement, the Company has not admitted any wrongdoing.  Settlement in the amount of $7 million willbe funded through the Company's Directors' and Officers' liabilityinsurance.  The Company has not reachedsettlement in the pending derivative litigation discussed below.

 

InMarch 2002, the company, our directors, and our former independent auditorArthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of HarrisCounty, Texas.  The lawsuit related toour restatement in 2002 of certain financial statements.  The lawsuit alleged breaches of fiduciaryduty by all of the individual defendants and asserted breach of contract andprofessional negligence claims only against Arthur Andersen LLP.  This lawsuit has been dismissed without prejudiceby agreement.

 

OnJanuary 27, 2004, we received a letter from William Williams, the plaintiff inthe *William Williams* actiondiscussed above, demanding that we pursue breach of fiduciary duty claimsagainst various officers and directors based on the August 2001 saleleaseback transaction and the subsequent restatement.  We have issued a preliminary response to theletter indicating that the Board will consider the request and inform Mr.Williams of its decision.

 

InMay and September 2002, the company and our directors were sued in three otherderivative lawsuits styled as follows: (1) *JuanGuitierrez, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.,* No. H-02-1812, in the United Stated District Courtfor 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 theUnited 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 District Court of HarrisCounty, Texas.  These lawsuits relate toour restatement in 2002 of certain financial statements.  These lawsuits all allege breaches offiduciary 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 plaintiff’s claims asto Cornell are tolled until 30 days following the final resolution of the *Guitierrez* case, including any appeals.

 

12

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The plaintiffs in these cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty.  However, we believe we havegood defenses and intend to vigorously defend against the claims asserted inthese actions.  We have not recorded anyloss accruals related to these claims.

 

***Certaininsurance policies held by us to cover potential director and officer liabilitymay limit our cash outflows in the event of a decision adverse to us in thematters discussed above.  However, if anadverse decision in these matters exceeds the insurance coverage or if theinsurance coverage is deemed not to apply to these matters, an adverse decisionto us in these matters could have a material adverse effect on us, ourfinancial 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 2000 through May 2003, our generalliability and professional liability coverage was provided by Specialty SurplusInsurance Company, 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 charge of $0.6 million, and have 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.

 

As of March 31, 2005, Kemper has continued to implement its run-offplan.  We believe that the uncertaintysurrounding Kemper remains, and while no additional allowance is considerednecessary at March 31, 2005, the existing reserve of $0.6 million will bemaintained.  We continue to believe ourestimated range of exposure to be approximately $0.5 million for thoseoutstanding claims which would become our obligation to resolve if not settledthrough Kemper.

 

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

 

13

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***9.***              Derivative Financial 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 March 31, 2005, was established to make payments on MCF’soutstanding bonds in the event we (as lessee) should fail to make the scheduledrental payments to MCF and (2) MCF’s Debt Service Fund, aggregating $16.3million and $17.1 million at March 31, 2005 and December 31, 2004, respectively,used to accumulate the monthly lease payments that MCF receives from us untilsuch funds are used to pay MCF’s semi-annual bond interest and annual bondprincipal payments.  Both reserve fundaccounts are subject to the agreements with the MCF Equity Investors wherebyguaranteed rates of return of 3.0% and 5.08%, respectively, are provided for inthe balance of the Debt Service Reserve Fund and the Debt Service Fund.  The guaranteed rates of return are characterizedas cash flow hedge derivative instruments. At inception, the derivatives had an aggregate fair value of $4.0million, which has been recorded as a decrease to the equity investment in MCFmade by the MCF Equity Investors (MCF minority interest) and as a deferredliability in our Consolidated Balance Sheets. Changes in the fair value of thederivative instruments are recorded as an adjustment to other long-termliabilities and reported as other comprehensive income (loss) in ourConsolidated Statements of Operations and Comprehensive Income (Loss).  At March 31, 2005 and December 31, 2004, thefair value of these derivative instruments was approximately $2.6 million and$2.2 million, respectively.  As a result,our Consolidated Statements of Operations and Comprehensive Income (Loss) includeother comprehensive income (loss) of approximately ($0.9) million and $0.5million for the three months ended March 31, 2005 and 2004, respectively.  The $0.9 million net unrealized loss reportedin comprehensive income (loss) for the three months ended March 31, 2005includes an adjustment of $0.6 million for the cumulative tax effect of changesin fair value during the years ended December 31, 2002 and 2003. Thisadjustment decreased accumulated other comprehensive income and increaseddeferred tax liabilities in our Consolidated Balance Sheet as of March 31,2005.

 

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.

 

**10.****      ****Correctional Systems, Inc.Acquisition**

 

In January 2005, we signed a definitiveagreement to acquire Correctional Systems, Inc. (CSI), a San Diego basedprovider of privatized jail, community corrections and alternative sentencingservices.  The purchase price wasapproximately $10.0 million in total consideration to common and preferredshareholders, less certain adjustments as described in the mergeragreement.  The transaction was completedApril 1, 2005.

 

The acquisition includes the operations ofeight jails, six community correction facilities and five alternativesentencing programs located in California, New Mexico, Texas and Kansas.  The transaction added 986 corrections beds,as well as alternatives to incarceration services.

 

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

 

Our three operating divisionsare our reportable segments.  The adultsecure institutional services segment consists of the operations of secureadult incarceration facilities.  Thejuvenile segment consists of providing residential treatment and educationalprograms and non-residential community-based programs to juveniles between theages of ten and 17 who have either been adjudicated or suffer from behavioralproblems.  The adult community-basedcorrections and treatment services segment consists of providing pre-releaseand halfway house programs for 

 

14

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adult offenders who are either on probationor serving the last three to six-months of their sentences on parole andpreparing for re-entry into society at large as well as community-basedtreatment and education programs as an alternative to incarceration.  All of our customers and long-lived assetsare located in the United States of America. The accounting policies of our reportable segments are the same as thosedescribed in the summary of significant accounting policies in our 2004 Form10-K.  Intangible assets are not includedin each segment’s reportable assets, and the amortization of intangible assetsis not included in the determination of a segment’s operating income.  We evaluate performance based on income orloss from operations before general and administrative expenses, incentivebonuses, amortization of intangibles, impairment charges on long-lived assets,interest and income taxes.  Corporate andother assets are comprised primarily of cash, accounts receivable, deposits,property and equipment, deferred taxes, deferred costs and other assets.  Corporate and other income from operationsprimarily consists of depreciation and amortization on the Corporate officefacilities and equipment, and is presented separately as such charges cannot bereadily identified for allocation to a particular segment.

 

15

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The only significant noncash items reported in the respective segments’income from operations is depreciation and amortization (excluding intangibles)(in thousands). The following table excludes the results of discontinuedoperations for the categories including revenues, pre-opening and start-upexpenses and income from operations for both periods presented.

 
| ** **                                                  | ** ** | **(in thousands)**                | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                  | ** ** | **Three Months Ended  March 31,** | ** ** |
| ** **                                                  | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                        |       |                              |       |   |   |
| Revenues                                                    |       |                              |       |   |   |
| Adult secure institutiona1                                  |       | $                                 | 30,857     |   | $ | 25,784 |   |
| Juvenile                                                    |       | 30,969                            |       | 28,200 |   |
| Adult community-based                                       |       | 12,867                            |       | 12,402 |   |
| Total revenues                                              |       | $                                 | 74,693     |   | $ | 66,386 |   |
|                                                        |       |                              |       |   |   |
| Pre-opening and start-up expenses                           |       |                              |       |   |   |
| Adult secure institutional                                  |       | $                                 | 2,890      |   | $ | 156 |   |
| Juvenile                                                    |       | 1,804                             |       | 1,490 |   |
| Adult community-based                                       |       | —                            |       | — |   |
| Total pre-opening and start-up expenses                     |       | $                                 | 4,694      |   | $ | 1,646 |   |
|                                                        |       |                              |       |   |   |
| Income from operations                                      |       |                              |       |   |   |
| Adult secure institutional                                  |       | $                                 | 6,073      |   | $ | 5,860 |   |
| Juvenile                                                    |       | 2,248                             |       | 2,556 |   |
| Adult community-based                                       |       | 2,278                             |       | 2,142 |   |
| Sub-total                                                   |       | 10,599                            |       | 10,558 |   |
| General and administrative expenses                         |       | (6,338                            | )          | (4,160 | ) |
| Gain on sale of fixed assets                                |       | 10                                |       | 11 |   |
| Amortization of intangibles                                 |       | (428                              | )          | (270 | ) |
| Corporate and other                                         |       | (408                              | )          | (484 | ) |
| Total income from operations                                |       | $                                 | 3,435      |   | $ | 5,655 |   |
|                                                        |       |                              |       |   |   |
| Income (loss) on discontinued operations,  net of tax       |       |                              |       |   |   |
| Adult secure institutional                                  |       | $                                 | —     |   | $ | — |   |
| Juvenile                                                    |       | (840                              | )          | 113 |   |
| Adult community-based                                       |       | —                            |       | — |   |
| Total income (loss) on discontinued  operations, net of tax |       | $                                 | (840       | ) | $ | 113 |   |

 
| ** **                 | ** ** | **March 31,   2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------|------------|----------------------|------------|------------------------|------------|
| Assets                     |       |                 |       |                   |       |
| Adult secure institutional |       | $                    | 170,270    |                   | $          | 172,793 |   |
| Juvenile                   |       | 113,695              |       | 123,890                |       |
| Adult community-based      |       | 61,139               |       | 62,984                 |       |
| Intangible assets, net     |       | 14,350               |       | 14,747                 |       |
| Corporate and other        |       | 141,572              |       | 133,217                |       |
| Total assets               |       | $                    | 501,026    |                   | $          | 507,631 |   |

 

16

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**12.          GuarantorDisclosures**

 

We completed an offering of $112.0million of Senior Notes in June 2004. The Senior Notes are guaranteed by each of our subsidiaries (GuarantorSubsidiaries).  These guarantees arejoint and several obligations of the Guarantor Subsidiaries.  MCF does not guarantee the Senior Notes(Non-Guarantor Subsidiary).  Thefollowing condensed consolidating financial information presents the financialcondition, results of operations and cash flows of us, the GuarantorSubsidiaries and the Non-Guarantor Subsidiary, together with the consolidatingadjustments necessary to present our results on a consolidated basis.

 

# **Condensed Consolidating Balance Sheet as of March 31, 2005 (inthousands) (unaudited)**

# ** **

| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor****Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-------------------------------|------------|---------------------------------|------------|-----------------|------------|------------------|------------|
|                                             |       |       |       |                          |       |                            |       |            |       |             |       |
| **Assets**                                       |       |       |       |                          |       |                            |       |            |       |             |       |
| Current assets:                                  |       |       |       |                          |       |                            |       |            |       |             |       |
| Cash and cash equivalents                        |       | $          | 22,735     |                          | $          | 342                             |       | $               | 56         |             | $          | — |   | $ | 23,133 |   |
| Investment securities                            |       | 41,625     |       | 3⁄4                        |       | 3⁄4                          |       | 3⁄4          |       | 41,625           |       |
| Accounts receivable                              |       | 2,922      |       | 54,004                        |       | 194                             |       | 3⁄4          |       | 57,120           |       |
| Other restricted assets                          |       | 3⁄4     |       | 2,415                         |       | 16,318                          |       | 3⁄4          |       | 18,733           |       |
| Prepaids and other                               |       | 17,463     |       | 1,108                         |       | 3⁄4                          |       | 3⁄4          |       | 18,571           |       |
| Total current assets                             |       | 84,745     |       | 57,869                        |       | 16,568                          |       | 3⁄4          |       | 159,182          |       |
| Property and equipment, net                      |       | 523        |       | 132,281                       |       | 157,808                         |       | (6,149          | )          | 284,463          |       |
| Other assets                                     |       |       |       |                          |       |                            |       |            |       |             |       |
| Debt service reserve fund                        |       | 3⁄4     |       | 3⁄4                        |       | 23,800                          |       | 3⁄4          |       | 23,800           |       |
| Deferred costs and other                         |       | 38,069     |       | 18,138                        |       | 9,214                           |       | (31,840         | )          | 33,581           |       |
| Investment in subsidiaries                       |       | 58,264     |       | 1,856                         |       | 3⁄4                          |       | (60,120         | )          | 3⁄4           |       |
| Total assets                                     |       | $          | 181,601    |                          | $          | 210,144                         |       | $               | 207,390    |             | $          | (98,109 | ) | $ | 501,026 |   |
|                                             |       |       |       |                          |       |                            |       |            |       |             |       |
| **Liabilities and Stockholders’ Equity**    |       |       |       |                          |       |                            |       |            |       |             |       |
|                                             |       |       |       |                          |       |                            |       |            |       |             |       |
| Current liabilities:                             |       |       |       |                          |       |                            |       |            |       |             |       |
| Accounts payable and accrued  liabilities        |       | $          | 39,965     |                          | $          | 6,606                           |       | $               | 2,537      |             | $          | (2,570 | ) | $ | 46,538 |   |
| Current portion of long-term  debt               |       | 3⁄4     |       | 1                             |       | 9,000                           |       | 3⁄4          |       | 9,001            |       |
| Total current liabilities                        |       | 39,965     |       | 6,607                         |       | 11,537                          |       | (2,570          | )          | 55,539           |       |
| Long-term debt, net of current  portion          |       | 111,192    |       | 1                             |       | 165,700                         |       | 3⁄4          |       | 276,893          |       |
| Deferred tax liabilities                         |       | 7,965      |       | (1,857                        | )          | 3⁄4                          |       | 550             |       | 6,658            |       |
| Other long-term liabilities                      |       | 5,609      |       | 165                           |       | 30,134                          |       | (33,060         | )          | 2,848            |       |
| Intercompany                                     |       | (142,218   | )          | 177,403                       |       | 3⁄4                          |       | (35,185         | )          | 3⁄4           |       |
| Total liabilities                                |       | 22,513     |       | 182,319                       |       | 207,371                         |       | (70,265         | )          | 341,938          |       |
| Stockholders’ equity                        |       | 159,088    |       | 27,825                        |       | 19                              |       | (27,844         | )          | 159,088          |       |
| Total liabilities and  stockholders’ equity |       | $          | 181,601    |                          | $          | 210,144                         |       | $               | 207,390    |             | $          | (98,109 | ) | $ | 501,026 |   |

 

17

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# **Condensed Consolidating Balance Sheet as of December 31, 2004 (inthousands) (unaudited)**

 
| ** **                                       | ** ** | **Parent** | ** ** | **Guarantor****Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Elimination** | ** ** | **Consolidated** | ** ** |
|--------------------------------------------------|------------|------------|------------|-------------------------------|------------|---------------------------------|------------|-----------------|------------|------------------|------------|
|                                             |       |       |       |                          |       |                            |       |            |       |             |       |
| **Assets**                                       |       |       |       |                          |       |                            |       |            |       |             |       |
| Current assets:                                  |       |       |       |                          |       |                            |       |            |       |             |       |
| Cash and cash equivalents                        |       | $          | 9,559      |                          | $          | 296                             |       | $               | 40         |             | $          | — |   | $ | 9,895 |   |
| Investment securities                            |       | 51,740     |       | 3⁄4                        |       | 3⁄4                          |       | 3⁄4          |       | 51,740           |       |
| Accounts receivable                              |       | 3,298      |       | 61,189                        |       | 378                             |       | 3⁄4          |       | 64,865           |       |
| Other restricted assets                          |       | 121        |       | 2,451                         |       | 17,141                          |       | 3⁄4          |       | 19,713           |       |
| Prepaids and other                               |       | 15,664     |       | 1,962                         |       | 3⁄4                          |       | 3⁄4          |       | 17,626           |       |
| Total current assets                             |       | 80,382     |       | 65,898                        |       | 17,559                          |       | 3⁄4          |       | 163,839          |       |
| Property and equipment, net                      |       | 672        |       | 128,965                       |       | 158,863                         |       | (6,245          | )          | 282,255          |       |
| Other assets                                     |       |       |       |                          |       |                            |       |            |       |             |       |
| Debt service reserve fund                        |       | 3⁄4     |       | 3⁄4                        |       | 23,801                          |       | 3⁄4          |       | 23,801           |       |
| Deferred costs and other                         |       | 39,392     |       | 19,225                        |       | 9,362                           |       | (30,243         | )          | 37,736           |       |
| Investment in subsidiaries                       |       | 20,613     |       | 1,856                         |       | 3⁄4                          |       | (22,469         | )          | 3⁄4           |       |
| 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               |       | 3⁄4     |       | 5                             |       | 9,000                           |       | 3⁄4          |       | 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                         |       | 3⁄4          |       | 279,528          |       |
| Deferred tax liabilities                         |       | 7,966      |       | 3⁄4                        |       | 3⁄4                          |       | 122             |       | 8,088            |       |
| Other long-term liabilities                      |       | 5,846      |       | 80                            |       | 28,546                          |       | (32,011         | )          | 2,461            |       |
| Intercompany                                     |       | (184,083   | )          | 184,083                       |       | 3⁄4                          |       | 3⁄4          |       | 3⁄4           |       |
| 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 |   |

 

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# **Condensed Consolidating Statement of Operations for the three monthsended March 31, 2005**(in thousands) (unaudited)

 
| ** **                                                                             | ** ** | **Parent** | ** ** | **Guarantor****Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                   |       |       |       |                          |       |                            |       |             |       |             |       |
| Revenues                                                                               |       | $          | 4,527      |                          | $          | 84,510                          |       | $                | 4,502      |             | $          | (18,846 | ) | $ | 74,693 |   |
| Operating expenses                                                                     |       | 4,265      |       | 70,681                        |       | 10                              |       | (18,513          | )          | 56,443           |       |
| Pre-opening and start-up  expenses                                                     |       | 3⁄4     |       | 4,694                         |       | 3⁄4                          |       | 3⁄4           |       | 4,694            |       |
| Depreciation and amortization                                                          |       | 21         |       | 2,813                         |       | 1,056                           |       | (97              | )          | 3,793            |       |
| Gain on sale of fixed assets                                                           |       | 3⁄4     |       | (10                           | )          | 3⁄4                          |       | 3⁄4           |       | (10              | )          |
| General and administrative  expenses                                                   |       | 6,319      |       | 3⁄4                        |       | 19                              |       | 3⁄4           |       | 6,338            |       |
| Income (loss) from operations                                                          |       | (6,078     | )          | 6,332                         |       | 3,417                           |       | (236             | )          | 3,435            |       |
| Overhead allocations                                                                   |       | (8,925     | )          | 8,925                         |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                                          |       | 921        |       | 1,273                         |       | 3,540                           |       | 10               |       | 5,744            |       |
| Equity (loss) in subsidiaries                                                          |       | (5,026     | )          | 3⁄4                        |       | 3⁄4                          |       | 5,026            |       | 3⁄4           |       |
| Income (loss) before provision  (benefit) for income taxes and discontinued operations |       | (3,100     | )          | (3,866                        | )          | (123                            | )          | 4,780            |       | (2,309           | )          |
| Provision (benefit) for income  taxes                                                  |       | (829       | )          | 3⁄4                        |       | 3⁄4                          |       | (49              | )          | (878             | )          |
| Income (loss) before  discontinued operations                                          |       | (2,271     | )          | (3,866                        | )          | (123                            | )          | 4,829            |       | (1,431           | )          |
| Discontinued  operations, net of income tax benefit of $454                            |       | 3⁄4     |       | (840                          | )          | 3⁄4                          |       | 3⁄4           |       | (840             | )          |
| Net income (loss)                                                                      |       | $          | (2,271     | )                             | $          | (4,706                          | )          | $                | (123       | )                | $          | 4,829 |   | $ | (2,271 | ) |

 

19

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**CondensedConsolidating Statement of Operations for the three months ended March 31, 2004(in thousands) (unaudited)**

 
| ** **                                                                             | ** ** | **Parent** | ** ** | **Guarantor****Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Eliminations** | ** ** | **Consolidated** | ** ** |
|----------------------------------------------------------------------------------------|------------|------------|------------|-------------------------------|------------|---------------------------------|------------|------------------|------------|------------------|------------|
|                                                                                   |       |       |       |                          |       |                            |       |             |       |             |       |
| Revenues                                                                               |       | $          | 4,557      |                          | $          | 75,136                          |       | $                | 4,502      |             | $          | (17,809 | ) | $ | 66,386 |   |
| Pre-opening and start-up  expenses                                                     |       | 3⁄4     |       | 1,646                         |       | 3⁄4                          |       | 3⁄4           |       | 1,646            |       |
| Operating expenses                                                                     |       | 5,823      |       | 63,728                        |       | 3⁄4                          |       | (17,750          | )          | 51,801           |       |
| Depreciation and amortization                                                          |       | 20         |       | 2,130                         |       | 1,056                           |       | (71              | )          | 3,135            |       |
| Gain on sale of fixed assets                                                           |       | 3⁄4     |       | (11                           | )          | 3⁄4                          |       | 3⁄4           |       | (11              | )          |
| General and administrative  expenses                                                   |       | 4,141      |       | 3⁄4                        |       | 19                              |       | 3⁄4           |       | 4,160            |       |
| Income (loss) from operations                                                          |       | (5,427     | )          | 7,643                         |       | 3,427                           |       | 12               |       | 5,655            |       |
| Overhead allocations                                                                   |       | (7,230     | )          | 7,230                         |       | 3⁄4                          |       | 3⁄4           |       | 3⁄4           |       |
| Interest, net                                                                          |       | (853       | )          | 1,739                         |       | 3,753                           |       | 10               |       | 4,649            |       |
| Equity (loss) in subsidiaries                                                          |       | (1,231     | )          | 3⁄4                        |       | 3⁄4                          |       | 1,231            |       | 3⁄4           |       |
| Income (loss) before provision  (benefit) for income taxes and discontinued operations |       | 1,425      |       | (1,326                        | )          | (326                            | )          | 1,233            |       | 1,006            |       |
| Provision (benefit) for income  taxes                                                  |       | 719        |       | (160                          | )          | 3⁄4                          |       | (146             | )          | 413              |       |
| Income (loss) before  discontinued operations                                          |       | 706        |       | (1,166                        | )          | (326                            | )          | 1,379            |       | 593              |       |
| Discontinued  operations, net of income tax provision of $75                           |       | 3⁄4     |       | 113                           |       | 3⁄4                          |       | 3⁄4           |       | 113              |       |
| Net income (loss)                                                                      |       | $          | 706        |                          | $          | (1,053                          | )          | $                | (326       | )                | $          | 1,379 |   | $ | 706 |   |

 

20

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**CondensedConsolidating Statement of Cash Flows for the three months ended March 31, 2005(in thousands) (unaudited)**

 
| ** **                                           | ** ** | **Parent** | ** ** | **Guarantor****Subsidiaries** | ** ** | **Non-Guarantor****Subsidiary** | ** ** | **Consolidated** | ** ** |
|------------------------------------------------------|------------|------------|------------|-------------------------------|------------|---------------------------------|------------|------------------|------------|
| **Cash flows from  operating activities:**           | ** ** | ** ** | ** ** | ** **                    | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Net cash provided by (used in)  operating activities |       | $          | 1,703      |                          | $          | 5,430                           |       | $                | (807       | ) | $ | 6,326 |   |
| **Cash flows from  investing activities:**           | ** ** | ** ** | ** ** | ** **                    | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Capital expenditures                                 |       | 3⁄4     |       | (5,383                        | )          | 3⁄4                          |       | (5,383           | )          |
| Purchase of investment  securities                   |       | (335,495   | )          | 3⁄4                        |       | 3⁄4                          |       | (335,495         | )          |
| Sales of investment securities                       |       | 345,610    |       | 3⁄4                        |       | 3⁄4                          |       | 345,610          |       |
| Payments to  restricted debt payment account, net    |       | 3⁄4     |       | 3⁄4                        |       | 823                             |       | 823              |       |
| Proceeds from sale of fixed  assets                  |       | 3⁄4     |       | 3⁄4                        |       | 3⁄4                          |       | 3⁄4           |       |
| Net cash provided by (used in)  investing activities |       | 10,115     |       | (5,383                        | )          | 823                             |       | 5,555            |       |
|                                                 |       |       |       |                          |       |                            |       |             |       |
| **Cash flows from  financing activities:**           | ** ** | ** ** | ** ** | ** **                    | ** ** | ** **                      | ** ** | ** **       | ** ** |
| Payments on capital lease  obligations               |       | 3⁄4     |       | (1                            | )          | 3⁄4                          |       | (1               | )          |
| Proceeds from exercise of stock  options             |       | 1,358      |       | 3⁄4                        |       | 3⁄4                          |       | 1,358            |       |
| Net cash provided by (used in)  financing activities |       | 1,358      |       | (1                            | )          | 3⁄4                          |       | 1,357            |       |
|                                                 |       |       |       |                          |       |                            |       |             |       |
| Net increase in cash and cash equivalents            |       | 13,176     |       | 46                            |       | 16                              |       | 13,238           |       |
| Cash and cash equivalents at beginning of  period    |       | 9,559      |       | 296                           |       | 40                              |       | 9,895            |       |
| Cash and cash equivalents at end of period           |       | 22,735     |       | 342                           |       | 56                              |       | 23,133           |       |
|                                                      |            |            |            |                               |            |                                 |            |                  |            |  |  |  |  |

 

21

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# **Condensed Consolidating Statement of Cash Flows for the three monthsended March 31, 2004 (in thousands) (unaudited)**

 
| ** **                                            | ** ** | **Parent** | ** ** | **Guarantor  Subsidiaries** | ** ** | **Non-Guarantor  Subsidiary** | ** ** | **Consolidated** | ** ** |
|-------------------------------------------------------|------------|------------|------------|-----------------------------|------------|-------------------------------|------------|------------------|------------|
|                                                  |       |       |       |                        |       |                          |       |             |       |
| **Cash  flows from operating activities:**            |       |       |       |                        |       |                          |       |             |       |
| Net cash provided by  (used in) operating activities  |       | $          | (12,537    | )                           | $          | 7,866                         |       | $                | (1,070     | ) | $ | (5,741 | ) |
| **Cash  flows from investing activities:**            |       |       |       |                        |       |                          |       |             |       |
| Capital expenditures                                  |       | 3⁄4     |       | (8,192                      | )          | 3⁄4                        |       | (8,192           | )          |
| Deposits in restricted  debt payment account, net     |       | 3⁄4     |       | 3⁄4                      |       | 1,048                         |       | 1,048            |       |
| Proceeds from sale of  property and equipment         |       | 3⁄4     |       | 163                         |       | 3⁄4                        |       | 163              |       |
| Sale of restricted  assets from deferred bonus plan   |       | 86         |       | 3⁄4                      |       | 3⁄4                        |       | 86               |       |
| Net cash provided by  (used in) investing activities  |       | 86         |       | (8,029                      | )          | 1,048                         |       | (6,895           | )          |
|                                                  |       |       |       |                        |       |                          |       |             |       |
| **Cash  flows from financing activities:**            |       |       |       |                        |       |                          |       |             |       |
| Proceeds from long-term  debt and line of credit      |       | 36,000     |       | 3⁄4                      |       | 3⁄4                        |       | 36,000           |       |
| Payments on line of  credit                           |       | (24,000    | )          | 3⁄4                      |       | 3⁄4                        |       | (24,000          | )          |
| Payments on capital  lease obligations                |       | (6         | )          | 3⁄4                      |       | 3⁄4                        |       | (6               | )          |
| Payment for debt  issuance and other financing costs  |       | (100       | )          | 3⁄4                      |       | 3⁄4                        |       | (100             | )          |
| Proceeds from exercise  of stock options and warrants |       | 819        |       | 3⁄4                      |       | 3⁄4                        |       | 819              |       |
| Purchases of treasury  stock                          |       | (116       | )          | 3⁄4                      |       | 3⁄4                        |       | (116             | )          |
| Net cash provided by  financing activities            |       | 12,597     |       | 3⁄4                      |       | 3⁄4                        |       | 12,597           |       |
|                                                  |       |       |       |                        |       |                          |       |             |       |
| Net increase (decrease) in cash and cash equivalents  |       | 146        |       | (163                        | )          | (22                           | )          | (39              | )          |
| Cash and cash equivalents at beginning of period      |       | 39,827     |       | 289                         |       | 55                            |       | 40,171           |       |
| Cash and cash equivalents at end of period            |       | 39,973     |       | 126                         |       | 33                            |       | 40,132           |       |
|                                                       |            |            |            |                             |            |                               |            |                  |            |  |  |  |  |

 

22

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**ITEM 2.  Management’s Discussion and Analysis ofFinancial Condition and Results 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)juvenile justice, educational and treatment services and (3) adultcommunity-based corrections and treatment services.

 

We classify asdiscontinued operations those components of our business that we hold for saleor disposition that have operation and cash flows that are clearlydistinguishable operationally and for financial reporting purposes from therest of the Company.  For the threemonths ended March 31, 2005, we have classified certain facilities/programs asdiscontinued operations.  This was theresult of a management decision to initiate the shut down of operations atcertain facilities.  Thesefacilities/programs include Residential School, Maple Creek Home and the mentalhealth wrap programs in Pennsylvania. Notifications have been made to the required contracting entitiesregarding the terminations of the related programs. The related facility assetswill be disposed of or transferred to other existing operations.  Accordingly, these facilities have beenexcluded from such statistics and information as the number of facilities inoperation, service capacity, contracted beds in operation and average contractoccupancy percentages, as well as management’s discussions regarding revenueand expenses.  Discontinued operationshave been presented separately in our Consolidated Statements of Operations forthe three months ended March 31, 2005 and 2004.

 

At March 31,2005, we operated 62 facilities with a total service capacity of 15,996 and had2 facilities under development or construction with an aggregate servicecapacity of 1,514 upon completion. Our facilities are located in 16 states andthe District of Columbia.

 

The following table sets forth for the periods indicated totalresidential service capacity and contracted beds in operation at the end of theperiods shown, average occupancy percentages and total non-residential servicecapacity, excluding in both periods those facilities which have been classifiedas discontinued operations.

 
| ** **                                                                | ** **   | **March 31,  2005** | ** **   | **March 31,  2004** | ** **   |
|---------------------------------------------------------------------------|--------------|---------------------|--------------|---------------------|--------------|
|                                                                      |         |                |         |                |         |
| **Residential**                                                           | *** *** | *** ***        | *** *** | *** ***        | *** *** |
| Service capacity (1)                                                      |         | 13,392              |         | 12,516              |         |
| Contracted beds in  operation (end of period) (2)                         |         | 11,409              |         | 9,356               |         |
| Average contract  occupancy based on contracted beds in operation (3) (4) |         | 93.6                | %            | 100.8               | %            |
| Average contract  occupancy excluding start-up operations (3) (4)         |         | 100.7               | %            | 101.4               | %            |
| **Non-Residential**                                                       | *** *** | *** ***        | *** *** | *** ***        | *** *** |
| Service capacity (5)                                                      |         | 4,118               |         | 3,774               |         |

 

----

| (1) |   | Residential service  capacity is comprised of the number of beds currently available for service  or available upon the completion of construction or renovation of residential  facilities.                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|-----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) |   | At certain residential facilities, the contracted capacity is lower  than the facility’s service capacity. We could increase a facility’s  contracted capacity by obtaining additional contracts or by renegotiating  existing contracts to increase the number of beds covered. However, there is  no guarantee that we will be able to obtain contracts that provide occupancy  levels at a facility’s service capacity or that current contracted capacities  can be maintained in future periods.                                                                                                                      |
| (3) |   | Occupancy percentages reflect less than normalized occupancy during  the start-up phase of any applicable facility, resulting in a lower average  occupancy in periods when we have substantial start-up activities.                                                                                                                                                                                                                                                                                                                                                                                                                      |
| (4) |   | Average contract occupancy percentages are calculated based on actual  occupancy for the period as a percentage of the contracted capacity for  residential facilities in operation. These percentages do not reflect the  operations of non-residential community-based programs. At certain  residential facilities, our contracted capacity is lower than the facility’s  service capacity. Additionally, certain facilities have and are currently  operating above the contracted capacity. As a result, average contract  occupancy percentages can exceed 100% if the average actual occupancy  exceeded contracted capacity. |
| (5) |   | Service capacity for non-residential programs is based on either  contractual terms or an estimate of the number of clients to be served. We  update these estimates at least annually based on the program’s budget and  other factors.                                                                                                                                                                                                                                                                                                                                                                                             |

 

 

23

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We derive substantially all of our revenues from providing adultcorrections and treatment and juvenile justice, educational and treatmentservices outsourced by federal, state and local government agencies in theUnited States. Revenues for our services are generally recognized on a per diemrate based upon the number of occupant days or hours served for the period, ona guaranteed take-or-pay basis or on a cost-plus reimbursement basis. For thethree months ended March 31, 2005, our revenue base consisted of 76.6% forservices provided under per diem contracts, 10.5% for services provided undertake-or-pay and management contracts, 9.3% for services provided undercost-plus reimbursement contracts, 4.1% for services provided underfee-for-service contracts and 1.5% from other miscellaneous sources. Thesepercentages are generally consistent with comparable statistics for the threemonths ended March 31, 2004. Revenues can fluctuate from period to period dueto 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.

 

Revenues for our adult secure institutional services division areprimarily generated from per diem, take-or-pay and management contracts.  For the three months ended March 31, 2005 and2004, we realized average per diem rates on our adult secure institutionalfacilities of approximately $48.47 and $48.02, respectively. The increase inthe per diem rate for 2005 as compared to 2004 is due primarily to the openingof the two-unit Regional Correctional Center in July and December 2004 and theacquisition of the Walnut Grove Youth Correctional Facility management contractin June 2004. Additionally, we received rate increases at our Big SpringCorrectional Center in March 2004. Decreases in, or the lack of anticipatedincreases in, per diem rates could adversely impact our operating margin.

 

Revenues forour juvenile justice, educational and treatment services division are primarilygenerated from per diem, fee-for-service and cost-plus reimbursementcontracts.  For the three months ended March31, 2005 and 2004, we realized average per diem rates on our residentialjuvenile justice, educational and treatment facilities of approximately $171.82and $160.27, respectively.  The increasein the per diem rate for 2005 as compared to 2004 is due to the opening of theSouthern Peaks Regional Treatment Center in August 2004 and rate increases forour Pennsylvania programs and facilities in July 2004.  For the three months ended March 31, 2005 and2004, we realized average fee-for-service rates for our non-residentialcommunity-based juvenile facilities and programs, including rates that arelimited by Medicaid and other private insurance providers, of approximately$29.65 and $25.57, respectively. The increase in the average fee-for-servicerate for 2005 as compared to 2004 is due to changes in the mix of the servicesprovided by our various juvenile justice, educational and treatment programsand facilities. The majority of our juvenile services contracts renew annually.

 

Revenues forour adult community-based corrections and treatment services division areprimarily generated from per diem contracts and fee-for-service contracts.  For the three months ended March 31, 2005 and2004, we realized average per diem rates on our residential adult correctionsand treatment facilities of approximately $62.39 and $61.27, respectively.  The increase in the per diem rate for 2005 ascompared to 2004 is due to the opening of the Las Vegas Center in December 2004as well as certain rate increases as a result of contract renewals and othercontractual rate increases.   For thethree months ended March 31, 2005 and 2004, we realized average fee-for-servicerates on our non-residential adult community-based corrections and treatmentfacilities and programs of approximately $8.79 and $8.29, respectively.

 

Factors considered indetermining 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 be leasedor purchased and (4) the anticipated average occupancy levels that couldreasonably be maintained.

 

We have historicallyexperienced higher operating margins in our adult secure institutional servicesand adult community-based corrections and treatment services as compared to thejuvenile justice, educational and treatment services division.  Additionally, our operating margins within adivision can vary from facility to facility based on whether a facility isowned or leased, the level of competition for the contract award, the proposedlength of the contract, the occupancy levels for a facility, the level ofcapital commitment required with respect to a facility, the

 

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

 

We are responsible for allfacility operating costs, except for certain debt service and interest or leasepayments for facilities where we have a management contract only. At thesefacilities, the facility owner is responsible for all debt service and interestor lease payments related to the facility. We are responsible for all otheroperating expenses at these facilities. We operated 11 facilities undermanagement contracts at March 31, 2005 and nine facilities at March 31, 2004.

 

A majority of our facilityoperating costs consists of fixed costs. These fixed costs include lease and rental expense, insurance, utilitiesand depreciation.  As a result, when wecommence operation of new or expanded facilities, fixed operating costsincrease.  The amount of our variableoperating 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 afacility’s staffing levels and the related payroll expense to a certain extentbased on occupancy at a facility, however a minimum fixed number of employeesis required to operate and maintain any facility regardless of occupancylevels.  Personnel costs are subject toincreases in tightening labor markets based on local economic and other conditions.

 

We incur pre-opening and start-up expenses including payroll, benefits,training and other operating costs prior to opening a new or expanded facilityand during the period of operation while occupancy is ramping up. These costsvary by contract.  Since pre-opening andstart-up costs are generally factored into the revenue per diem rate that ischarged to the contracting agency, we typically expect to recover these upfrontcosts over the life of the contract.  Becauseoccupancy rates during a facility’s start-up phase typically result in capacityunder-utilization for at least 90 to 180 days, we may incur additionalpost-opening start-up costs.  We do notanticipate post-opening start-up costs at any adult secure facilities operatedunder any future contracts with the BOP because these contracts are currentlyexpected to continue to be take-or-pay contracts, meaning that the BOP will payat least 80.0% of the contractual monthly revenue once 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. Offendersor clients are typically assigned to a newly opened facility on a phased-inbasis 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 fornew adult operations is nine months from the date we begin recognizing revenueunless break-even occupancy levels are achieved before then. Although wetypically recover these upfront costs over the life of the contract, quarterlyresults can be substantially affected by the timing of the commencement ofoperations as well as the development and construction of new facilities.

 

Working capital requirements generally increase immediately prior tocommencing management of a new or expanded facility as we incur start-up costsand purchase necessary equipment and supplies before facility managementrevenue is realized.

 

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

 

#### **RecentDevelopments**

#### ** **

***Correctional SystemsInc, Acquisition***

 

In January 2005, we signed a definitiveagreement to acquire Correctional Systems, Inc. (CSI), a San Diego basedprovider of privatized jail, community corrections and alternative sentencingservices.  The purchase price wasapproximately $10.0 million in total consideration to common and preferredshareholders, less certain adjustments as described in the mergeragreement.  The transaction is expectedto generate annualized revenue of approximately $16.0 million.  The transaction was completed April 1, 2005.

 

Theacquisition includes the operations of eight jails, six community correctionfacilities and five alternative sentencing programs located in California, NewMexico, Texas and Kansas.  Thetransaction will add 986 corrections beds, as well as alternatives to incarcerationservices.

 

### ***FacilityClosures***

### * *

Duringthe three months ended March 31, 2005, based on internal analysis of factorsincluding risk adjusted return on capital employed, cash flow, operationalintensity and personnel requirements, we elected to close certain facilitiesand programs.  These included ResidentialSchool and Maple Creek Home facilities, as well as certain mental health WRAPprograms in Pennsylvania.  For the threemonths ended March 31, 2005, these discontinued operations generated a net lossof $0.8 million compared to net income of $0.1 million for the same quarter of2004.  The discontinued operationsgenerated revenues of approximately $0.9 million and $2.9 million for the threemonths ended March 31, 2005 and 2004, respectively.

 

**NewAccounting Pronouncements**

 

In December 2004, the FASBissued SFAS No. 123R, “Share Based Payment,” that requires companies to expensethe 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) thatapproximately reflects their specific circumstances and the economics of theirtransactions. Companies will

 

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recognize compensation cost pershare based payment awards as they vest, including the related taxeffects.  The effective date of SFAS No.123R, as amended, applies to annual periods beginning after June 15, 2005, andapplies to all outstanding and unvested share based payment awards at the company’sadoption date.  In April 2005, theSecurities and Exchange Commission adopted a rule that amends the adoption dateof SFAS No. 123R to January 1, 2006.  Weare currently evaluating the alternative transition methods permitted by SFASNo. 123R.

 

Under SFAS No.123R, compensatory employee stock purchase plans (ESPP) are required torecognize compensation cost over the requisite service period for grants madeunder the ESPP.  The criteria that anESPP must meet to be considered non-compensatory are more restrictive underSFAS No. 123R than they are under APB No. 25. We are currently evaluating the impact on our ESPP by SFAS No. 123R.

 

**Results ofOperations**

 

The following table sets forth for the periods indicated thepercentages of revenues represented by certain items in the Company’s historicalconsolidated statements of operations.

 
| ** **                                                                   | ** ** | **Three Months  Ended March 31,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                                                   | ** ** | **2005**                          | ** ** | **2004** | ** ** |
|                                                                         |       |                              |       |   |   |
| Total revenues                                                               |       | 100.0                             | %          | 100.0 | % |
| Operating expenses                                                           |       | 75.6                              |       | 78.0 |   |
| Pre-opening and start-up expenses                                            |       | 6.3                               |       | 2.5 |   |
| Depreciation and amortization                                                |       | 5.1                               |       | 4.7 |   |
| General and administrative expenses                                          |       | 8.5                               |       | 6.3 |   |
| Income from operations                                                       |       | 4.5                               |       | 8.5 |   |
| Interest expense, net                                                        |       | 7.7                               |       | 7.0 |   |
| Income (loss) before provision for income  taxes and Discontinued operations |       | (3.2                              | )          | 1.5 |   |
| Provision (benefit) for income taxes                                         |       | (1.2                              | )          | 0.6 |   |
| Income (loss) before discontinued  operations                                |       | (2.0                              | )          | 0.9 |   |
| Discontinued operations, net of taxes                                        |       | (1.1                              | )          | 0.2 |   |
| Net income (loss)                                                            |       | (3.1                              | )%         | 1.1 | % |

 

##### ***Three Months Ended March 31, 2005 Compared to Three Months Ended March31, 2004***

##### *** ***

Certain comparisons ofrevenue, expenses and average contract occupancy contained herein have beenmade excluding the effect of pre-opening and start-up expenses andrevenues.  Disclosures excluding theeffect of pre-opening and start-up expenses and revenues represent measurescalculated in a manner that is not consistent with U.S. generally acceptedaccounting principles (GAAP).  We believeexclusion of the non-recurring effect of pre-opening and start-up expenses andrevenues increases the reader’s understanding of our operating trends.

 

***Revenues***. Revenues increased approximately $8.3 million, or 12.5%, to $74.7million for the three months ended March 31, 2005 from approximately $66.4million for the three months ended March 31, 2004.

 

***Adult Secure***. Adult secure institutional servicesdivision revenues increased approximately $5.1 million, or 19.7%, to $30.9million for the three months ended March 31, 2005 from approximately $25.8million for the three months ended March 31, 2004 due to (1) per diem rateincreases and increased occupancy at the Big Spring Correctional Center which increasedrevenue approximately $1.4 million, (2) the opening of the two unit RegionalCorrectional Center in July and December 2004 which contributed revenue ofapproximately $1.5 million, (3) the

 

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acquisition of the Walnut GroveYouth Correctional Facility management contract in June 2004 which contributedrevenue of approximately $2.6 million and (4) a rate increase at the D. Ray JamesPrison which increased 2005 revenues by approximately $0.2 million.  The increase in revenue due to the above wasoffset, in part, by a decrease in revenue of approximately $0.8 million due tothe non-renewal of the Valencia County Detention Center contract as of December31, 2004.

 

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Our adultsecure institutional services division revenues are generated primarily fromcontracts with federal and state agencies. At March 31, 2005, we operated eight adult secureinstitutional facilities with an aggregate service capacity of 7,782.

 

Average contract occupancy was 92.6% for thethree months ended March 31, 2005 compared to 101.0% for the three months endedMarch 31, 2004.  The decline in theaverage contract occupancy percentage in 2005 is due to the two unit RegionalCorrectional Center, which opened in June and December 2004 and did not operateat full capacity during the three months ended March 31, 2005.  Excluding the actual occupancy and contractcapacity for the start-up activities of the Regional Correctional Center in2005, the average contract occupancy was 102.9% for the three months endedMarch 31, 2005.  The average per diemrate was approximately $48.47 and $48.02 for the three months ended March 31,2005 and 2004, respectively.  Revenuesattributable to start-up operations for the three months ended March 31, 2005were approximately $1.5 million and were attributable solely to the RegionalCorrectional Center.  There were norevenues attributable to start-up operations for the three months ended March31, 2004.

 

***Juvenile***. Juvenile justice, educational and treatmentservices division revenues increased approximately $2.8 million, or 9.9%, to$31.0 million for the three months ended March 31, 2005 from $28.2 million forthe three months ended March 31, 2004 due primarily to (1) the opening of theSouthern Peaks Regional Treatment Center in August 2004 which contributedrevenue of approximately $1.5 million, (2) the commencement of our managementcontract for the Lebanon Alternative Education Program in September 2004 whichcontributed revenue of approximately $0.4 million and (3) the commencement ofour management contract for the Philadelphia Alternative Education Program inAugust 2004 which contributed revenue of approximately $0.5 million.

 

***At March 31,2005, we operated 21 residential juvenile facilities and 12 non-residentialcommunity-based programs with an aggregate service capacity of 4,317.  Our contracts for these facilities andprograms are generally with state and local government agencies and generallyrenew annually.***

*** ***

***Averagecontract occupancy for the three months ended March 31, 2005 was 88.7% comparedto 92.2% for the three months ended March 31, 2004.  Excluding the actual occupancy and contractedcapacity for the start-up operations of the Southern Peaks Regional TreatmentCenter in 2005 and the actual occupancy and contracted capacity for the Jos-ArzResidential Treatment Center in 2004, average contract occupancy was 90.5% and95.3% for the three months ended March 31, 2005 and 2004, respectively.***

*** ***

***The average perdiem rate for our residential juvenile facilities was approximately $171.82 forthe three months ended March 31, 2005 compared to $160.27 for the three monthsended March 31, 2004. The increase in the average per diem rate is due to theopening of the Southern Peaks Regional Treatment Center in August 2004.  Our average fee-for-service rate for ournon-residential juvenile community-based facilities and programs was approximately$29.65 for the three months ended March 31, 2005 compared to approximately$25.57 for the three months ended March 31, 2004.  The increase in the average fee-for-servicerate in 2005 as compared to 2004 is due to changes in the mix of servicesprovided by our various non-residential community-based juvenile programs.***

*** ***

***Revenuesattributable to start-up operations for the three months ended March 31, 2005were approximately $1.5 million and were attributable to the start-upoperations of the Southern Peaks Regional Treatment Center.  Revenues attributable to start-up operationswere approximately $0.6 million for the three months ended March 31, 2004 andwere attributable solely to the operations of the Jos-Arz Residential TreatmentCenter.***

*** ***

***Adult Community-Based***. Adult community-based corrections andtreatment services division revenues increased approximately $0.5 million, or 4.0%,to $12.9 million for the three months ended March 31, 2005 from $12.4 millionfor the three months ended March 31, 2004 due primarily to the opening of theLas Vegas Center in December 2004.

 

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At March 31,2005, we operated 15 residential adult community-based facilities and sixnon-residential community-based programs with an aggregate service capacity of3,897.  Average contract occupancy for the threemonths ended March 31, 2005 was 99.5% compared to 108.2% for the three monthsended March 31, 2004. The average per diem rate for our residentialadult community-based facilities was $62.39 for the three months ended March31, 2005 compared to $61.27 for the three months ended March 31, 2004.  The average fee-for-service rate for ournon-residential adult community-based programs was $8.79 for the three monthsended March 31, 2005 compared to $8.29 for the three months ended March 31,2004.  There were no revenuesattributable to start-up operations for the three months ended March 31, 2005and 2004.

 

***Operating Expenses****.* Operating expenses increased approximately $4.6 million, or 8.9%, to$56.4 million for the three months ended March 31, 2005 from $51.8 million forthe three months ended March 31, 2004.

 

***Adult Secure***. Adult secure institutional servicesdivision operating expenses increased approximately $1.6 million, or 8.6%, to$20.3 million for the three months ended March 31, 2005 from $18.7 million forthe three months ended March 31, 2004.  Theincrease in operating expenses is primarily due to (1) an increase in operatingexpenses of approximately $1.2 million at the Big Spring Correctional Centerprincipally due to increased occupancy and (2) an increase in operatingexpenses of approximately $1.9 million due to acquisition of the Walnut GroveYouth Correctional Facility management contract in June 2004.  The increase in operating expenses due to theabove was offset, in part, by a decrease in operating expenses of $0.7 milliondue to the non-renewal of the Valencia County Detention Center contract as ofDecember 31, 2004.

 

As apercentage of segment revenues, adult secure institutional services divisionoperating expenses were 65.7% for the three months ended March 31, 2005compared to 72.5% for the three months ended March 31, 2004. Excluding $1.5million of revenue attributable to the start-up operations of the Regional CorrectionalCenter in 2005, adult secure institutional services division operating expenseswere 69.1%. The 2005 operating margin was favorably impacted by lower legalcosts in the three months ended March 31, 2005 offset, in part, by an increasein employee insurance costs.

 

***Juvenile***.****Juvenilejustice, educational and treatment services division operating expensesincreased approximately $2.8 million, or 12.0%, to $26.1 million for the threemonths ended March 31, 2005 from $23.3 million for the three months endedMarch 31, 2004 due to (1) an increase in operating expenses of $1.8million for the Jos-Arz Residential Treatment Center as such costs wereincluded in start-up expenses in the three months ended March 31, 2004, (2) anincrease of approximately $0.4 million due to the commencement of ourmanagement contract for the Philadelphia Alternative Education Program inAugust 2004, (3) an increase of approximately $0.3 million due to thecommencement of our management contract for the Lebanon Alternative EducationProgram in September 2004 and (4) a restructuring charge of approximately $1.0million in three months ended March 31, 2005 for personnel costs associatedwith management streamlining initiatives. The increase in operating expense due to the above, was offset, in part,by a decrease in operating expenses of $0.6 million due to the termination ofthe Santa Fe County Youth Development Program in January 2004.

 

As apercentage of segment revenues, juvenile services division operating expenseswere 84.2% for the three months ended March 31, 2005 compared to 82.8% for thethree months ended March 31, 2004. Excluding $1.5 million of revenueattributable to the start-up operations of the Southern Peaks RegionalTreatment Center in 2005 and $0.5 million of revenue attributable to thestart-up operations of the Jos-Arz Residential Treatment Center in 2004,juvenile services division operating expenses were 88.5% and 84.6% for thethree months ended March 31, 2005 and 2004, respectively.  The decline in the 2005 operating margin isdue to increased employee insurance costs and an increase in the provisions forbad debt in the three months ended March 31, 2005 as compared to the sameperiod of 2004, as well as the restructuring charge of $1.0 million in the threemonths ended March 31, 2005.

 

***Adult Community-Based***. Adult community-based corrections andtreatment services division operating expenses increased approximately $0.3million, or 3.1%, to $10.1 million for the three months ended March 31, 2005from

 

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$9.8 million for the three months ended March31, 2004 due primarily to the opening of the Las Vegas Center in December 2004.As a percentage of segment revenues, adult community-based corrections andtreatment services division operating expenses were 78.4% for the three monthsended March 31, 2005 compared to 78.6% for the three months ended March 31,2004.

 

***Pre-opening and start-up expenses.*******Pre-opening and start-up expenses for thethree months ended March 31, 2005 were approximately $4.7 million and wereprimarily attributable to the pre-opening and start-up operations of theRegional Correctional Center and the Southern Peaks Regional TreatmentCenter.  Pre-opening and start-upexpenses for the three months ended March 31, 2004 were approximately $1.6million and were attributable to the pre-opening and start-up activities of theJos-Arz Residential Treatment Center, the Southern Peaks Regional TreatmentCenter and the Regional Correctional Center. These expenses consisted primarily of personnel and related expenses,facility rent, professional and recruiting expenses.

 

***Depreciation and Amortization*****.** Depreciation and amortization was approximately $3.8 million for thethree months ended March 31, 2005 compared to approximately $3.1 million forthe three months ended March 31, 2004.  Depreciationand amortization of property and equipment increased approximately $0.5 milliondue primarily to the depreciation of the Southern Peaks Regional TreatmentCenter and the Regional Correctional Center buildings which were not inoperation in the three months ended March 31, 2004. Amortization of intangibles was approximately $0.4 million and $0.3million for the three months ended March 31, 2005 and 2004, respectively.  The increase in amortization ofintangibles for the three months ended March 31, 2005 is due primarily toamortization of the June 2004 purchased contract value for the Walnut GroveYouth Correctional Facility management contract.

 

***General and Administrative Expenses.*** General and administrative expenses increased approximately $2.1million, or 50.0%, to $6.3 million for the three months ended March 31, 2005from approximately $4.2 million for the three months ended March 31, 2004. Thiswas due primarily to a restructuring charge of approximately $1.1million for the three months ended March 31, 2005 for personnel costsassociated with management streamlining initiatives.  In addition, professional fees, principally associatedwith certain accounting services (including Sarbanes-Oxley compliance),executive recruitment services, and business development increased byapproximately $0.8 million.

 

***Interest.*** Interest expense, net of interest income, increased to approximately$5.7 million for the three months ended March 31, 2005 from approximately $4.6million for the three months ended March 31, 2004.  Interest expense increasedapproximately $1.3 million due to interest on the Senior Notes of approximately$2.5 million (net of swap interest income of $0.5 million) offset by a decreasein expense of approximately $0.7 million due to the pay-off of the SyntheticLease Investor Notes A and B in June 2004. Capitalized interest for thethree months ended March 31, 2005 and 2004 was approximately $0.5 million and $0.2million, respectively, and is attributable to capitalized interest ondevelopment and construction costs of the Moshannon Valley CorrectionalCenter.  Additionally, interest incomeincreased approximately $0.2 million in the three months ended March 31, 2005as compared to the same period of 2004 due to higher fund balances and higherinterest rates in the 2005 period.

 

***Income Taxes.***  For the three monthsended March 31, 2005, we recognized an income tax benefit on our loss fromcontinuing operations at an estimated effective rate of 38.0%. Additionally, werecognized an income tax benefit on the loss from discontinued operations at anestimated effective rate of 35.1%.  Forthe three months ended March 31, 2004, we recognized a provision for income taxes41.0% on both income operations and income discontinued operations. The change in our estimated effective taxrate in 2005 is related to a reduction in operating income across certain ofour business segments and the impact of certain non-deductible expenses such aslobbying.

 

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## **Liquidity and Capital Resources**

## ** **

***General*****.**  Ourprimary capital requirements are for (1) purchases, construction or renovationof new facilities, (2) expansions of existing facilities, (3) workingcapital, (4) pre-opening and start-up costs related to new operating contracts,(5) acquisitions, (6) information systems hardware and software and(7) furniture, fixtures and equipment purchases.  Working capital requirements generally increaseimmediately prior to commencing management of a new facility as we incurstart-up costs and purchase necessary equipment and supplies before facilitymanagement revenue is realized.

 

***Cash Flows From Operating Activities.***  Cashflows provided by operations was approximately $6.3 million for the threemonths ended March 31, 2005 compared to cash used in operations ofapproximately $5.7 million for the three months ended March 31, 2004.  The increase was primarily due to adecrease in accounts receivable due to increased collections and a decrease inaccounts payable due to the timing of payments within the quarter ended March31, 2005.

 

***Cash Flows From Investing Activities*****.**  Cashflows provided by investing activities was approximately $5.6 million for thethree months ended March 31, 2005 due primarily to net sales of investmentsecurities of $10.1 million offset by capital expenditures of $5.4million.  Additionally, there werewithdrawals from the restricted debt payment account, net of deposits, of $0.8million.  Capital expenditures for thethree months ended March 31, 2005 were primarily attributable to constructionof the Moshannon Valley Correctional Center.** **Cash used in investing activities wasapproximately $6.9 million for the three months ended March 31, 2004 dueprimarily to capital expenditures of $8.2 million for the purchase of the LasVegas Center and Central California Treatment Center buildings, development andconstruction of the Southern Peaks Regional Treatment Center, renovation of theRegional Correctional Center in New Mexico and construction of the MoshannonValley Correctional Center and various other facility improvements and/orexpansions and information technology and software development costs.  This use of cash was offset, in part, bywithdrawals from the restricted debt payment account, net of deposits, ofapproximately $1.0 million.

 

***Cash Flows From Financing Activities*****.  **Cash provided by financingactivities was $1.4 million for the three months ended March 31, 2005 and isattributable primarily to proceeds from the exercise of stock options.  Cashprovided by financing activities was approximately $12.6 million for the threemonths ended March 31, 2004 due primarily to net borrowings under the Company’srevolving line of credit of $12.0 million and proceeds from the exercise ofstock options of $0.8 million.

 

***Treasury Stock/Repurchases.***  Wedid not purchase any of our common shares in the three months ended March 31,2005. We repurchased in the open market10,000 shares of our common stock for approximately $0.1 million in the threemonths ended March 31, 2004.

 

***Long-Term Credit Facilities.*** The 2004 Credit Facility provides forborrowings of up to $60.0 million under a revolving line of credit, and isreduced by outstanding letters of credit. The available commitment under the 2004 Credit Facility wasapproximately $51.4 million at March 31, 2005. We had no outstanding borrowings on the 2004 Credit Facility at March31, 2005, but we had outstanding letters of credit of approximately $8.6million.  Subject to certainrequirements, we have the right to increase the aggregate commitments under the2004 Credit Facility up to an aggregate amount of $100.0 million.  The 2004 Credit Facility matures in June 2008and bears interest, at our election, depending on our total leverage ratio, ateither the prime rate plus a margin ranging from 0.75% to 2.00%, or a ratewhich ranges from 2.25% to 3.50% above the applicable LIBOR rate. The 2004Credit Facility is collateralized by substantially all of our assets, includingthe 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.

 

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

 

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

 

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

 

Any time prior to July 1, 2007, we may redeemup to 35% of the original aggregate principal amount of the Senior Notes at aredemption price of 110.75% of the principal amount thereof with the net cashof public offerings of equity, provided that at least 65% of the originalaggregate principal amount of the Notes remains outstanding after theredemption and other conditions are met. Upon the occurrence of specified change of control events, unless wehave exercised our option to redeem all the Senior Notes as described above,each holder will have the right to require us to repurchase all or a portion ofsuch holder’s Senior Notes at a purchase price in cash equal to 101% of theaggregate principal amount of the notes repurchased plus accrued and unpaidinterest, if any, on the Senior Notes repurchased, to the applicable date ofpurchase.  The Senior Notes were issuedunder an indenture (the “Indenture”) which limits our ability and the abilityof our Guarantors to, among other things, incur additional indebtedness, paydividends or make other distributions, make other restricted payments andinvestments, create liens, incur restrictions on the ability of the Guarantorsto pay dividends or other payments to us, enter into transactions withaffiliates, and engage in mergers, consolidations and certain sales of assets.

 

In conjunction with the issuance of theSenior Notes, we entered into an interest rate swap transaction with afinancial institution to hedge our exposure to changes in the fair value on$84.0 million of our Senior Notes.  Thepurpose of this transaction was to convert future interest due on $84.0 millionof the Senior Notes to a variable rate. The terms of the interest rate swap contract and the underlying debtinstrument are identical.  We havedesignated the swap agreement as a fair value hedge.  The swap has a notional amount of $84.0million and matures in July 2012 to mirror the maturity of the SeniorNotes.  Under the agreement, we pay on asemi-annual basis (each January 1 and July 1) a floating rate based on asix-month U.S. dollar LIBOR rate, plus a spread, and receive a fixed-rateinterest of 10.75%.  For the three monthsended March 31, 2005, we recorded interest savings related to this interestrate swap of approximately $0.5 million, which is reflected as a reduction to interestexpense in the accompanying financial statements.  The swap agreements are marked to market eachquarter with a corresponding mark-to-market adjustment reflected as either adiscount or premium on the Senior Notes. At March 31, 2005 and December 31, 2004 the fair value of thisderivative instrument was approximately $0.5 million and $3.2 million,respectively, and is included in other assets. The carrying value of the Senior Notes as of these dates was increasedby the same amount.  Because the swapagreement is considered an effective fair-value hedge, there will be no effecton our results of operations from the mark-to-market adjustment as long as theswap is in effect.

 

33

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***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 March 31,2005, we had invested approximately $9.7 million on renovations and furnitureand equipment for both the Towers.  Forthe three months ended March 31, 2005, we incurred pre-opening and start-upexpenses of approximately $2.8 million and recognized revenue of approximately$1.5 million 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 of approximately$113,000 for the first two years and $130,000 for the last three years of thelease.

 

***New Morgan Academy. ***We closed theNew Morgan Academy in the fourth quarter of 2002 and are currently consideringseveral options ranging from the utilization of the facility for another typeof program or the sale or lease of the facility.  As of March 31, 2005, we are focusing ourefforts on both the potential insertion of a program as well as the possiblesale or lease of the facility to certain governmental agencies in Pennsylvania,as well as private enterprises.  We aremaintaining a small staff to secure and maintain the facility.  We have recognized pre-tax costs of $0.9million and $0.8 million in our Consolidated Statements of Operations andComprehensive Income (Loss) for the three months ended March 31, 2005 and 2004,respectively, for related holding costs (depreciation, interest, property,taxes and other maintenance costs).

 

The developing inability during late 2004 ofvarious governmental agencies with whom we had been in negotiations to obtainthe level of funding to contract with us for the use of the New Morgan Academyindicated an expectation of continuing losses associated with thisfacility.  As a result, we recorded animpairment charge of $9.3 million, pursuant to the requirements of Statement ofFinancial Accounting Standards (“SFAS”) No. 144, in the year ended December 31,2004.  As of March 31, 2005, we believethat, pursuant to the provisions of SFAS No. 144, no additional impairmentallowance is necessary.  The carryingvalue of the property and equipment for the New Morgan Academy, after theimpairment charge, was approximately $20.2 million and $20.4 million at March31, 2005 and December 31, 2004, respectively.

 

***Central California Treatment Center. ***In January2004, we purchased a building in Los Angeles, California for approximately $2.5million.  Upon the successful award of acontract to utilize this facility, we anticipate incurring renovation costs ofapproximately $2.0 million.  This newfacility could provide service to 220 inmates in a work-furlough typeprogram.  Although we do not currentlyhave a contract for this facility it has been submitted for consideration inseveral recent proposals.  We believedthat due to the growth of the inmate population, severe budget crisis andrecent legal settlements requiring additional community services, this facilitywill fill a small part of the overall demand in California.  The potential uses for the facility rangefrom a “halfway back” program to a comprehensive drug and alcohol treatmentprogram.

*** ***

***Future Liquidity*****.**  Webelieve that the existing cash and the cash flows generated from operations,together with the credit available under our 2004 Credit Facility, will providesufficient liquidity to meet our committed capital and working capitalrequirements for currently awarded and certain potential future developmentcontracts, including the construction of the Moshannon Valley CorrectionalCenter.  To the extent our cash andcurrent financing arrangements do not provide sufficient financing to fundconstruction costs related to future adult secure institutional contract awardsor significant facility expansions, we anticipate obtaining additional sourcesof financing to fund such activities. However, there can be no assurance that such financing will be availableor will be available on terms favorable to us.

 

34

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***Contractual Obligations and CommercialCommitments*****.**  We have assumed various financial obligationsand commitments in the ordinary course of conducting our business.  We have contractual obligations requiringfuture cash payments under our existing contractual arrangements, such asmanagement, consultative and non-competition agreements.

 

We maintain operating leasesin the ordinary course of our business activities.  These leases include those for operatingfacilities, office space and office and operating equipment, and the terms ofthe agreements vary from 2005 until 2075. As of March 31, 2005, the Company’s total commitment under theseoperating leases was approximately $29.6 million.

 

The following table details the Company’sknown future cash payments (on an undiscounted basis) related to variouscontractual obligations as of March 31, 2005 (in thousands):

 
| ** **                                   | ** ** | **Payments Due by Period** | ** ** |
|----------------------------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | **Total**                  | ** ** | **2005** | ** ** | **2006 -  2007** | ** ** | **2008 -  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.               |       | 77,307                     |       | 8,020 |   | 21,316 |   | 21,337 |   | 26,634 |   |
| - Special Purpose Entities              |       | 102,907                    |       | 7,399 |   | 27,248 |   | 23,682 |   | 44,578 |   |
| Construction commitments                     |       | 49,700                     |       | 47,000 |   | 2,700 |   | 3⁄4 |   | 3⁄4 |   |
| Capital lease obligations                    |       |                       |       |   |   |   |   |   |   |   |   |
| - Cornell Companies, Inc.               |       | 2                          |       | 1 |   | 1 |   | — |   | — |   |
| Operating  leases                            |       | 29,558                     |       | 5,602 |   | 8,760 |   | 3,328 |   | 11,868 |   |
| Consultative  and non-competition agreements |       | 944                        |       | 635 |   | 309 |   | — |   | — |   |
| Total contractual cash  obligations          |       | $                          | 547,118    |   | $ | 77,657 |   | $ | 80,534 |   | $ | 72,147 |   | $ | 316,780 |   |

 

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(1) We have an interest rate swap agreement under which we receive afixed interest rate and pay a floating interest rate.  The future cash payments on the CornellCompanies, Inc. long-term debt – interest assume an effective rate of 8.98% onthe related interest rate swap contract.

 

We enter into letters of credit in the ordinary course of operating andfinancing activities.  As of March 31,2005, 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 March 31, 2005 (in thousands):

 
| ** **                                         | ** ** | **Total**              | ** ** | **Amount of Commitment Expiration Per Period** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|------------------------------------------------|------------|
| ** **                                         | ** ** | **Amounts  Committed** | ** ** | **Less than  1 Year**                          | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **Over  5 Years** | ** ** |
| ** **                                         | ** ** | ** **             | ** ** | ** **                                     | ** ** | ** ** | ** ** | ** ** |   | ** ** |   |
| Commercial Commitments:  Standby letters of credit |       | $                      | 8,628      |                                           | $          | 8,628 |   | $ | — |   | $ | –– |   | $ | –– |   |
|                                                    |            |                        |            |                                                |            |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

In the normal course ofbusiness, we are exposed to market risk, primarily from changes in interestrates.  We continually monitor exposureto market risk and develop appropriate strategies to manage this risk.  We are not exposed to any other significantmarket risks, including commodity price risk, foreign currency exchange risk orinterest rate risks from the use of derivative financial instruments.  In connection with the issuance of the SeniorNotes, we entered into an interest rate swap of $84.0 million related to theinterest obligations under the Senior Notes in effect converting them to afloating rate based on six-month LIBOR.

 

**InterestRate Exposure**

 

Our exposure to changes ininterest rates primarily results from our long-term debt with both fixed andfloating interest rates.  The debt on ourconsolidated financial statements with fixed interest rates consists of the8.47% Bonds issued by MCF in August 2001 in connection with the 2001 Sale andLeaseback Transaction and approximately $28.0 million of the Senior Notes (nothedged by the interest rate swap).  AtMarch 31, 2005, approximately 29.4% ($84.0 million of debt outstanding on theSenior notes issued in June 2004) of our consolidated long-term debt wassubject to variable interest rates.  Thedetrimental effect of a hypothetical 100 basis point increase in interest rateswould be to reduce income before provision for income taxes by approximately$0.2 million for the three months ended March 31, 2005.  At March 31, 2005, the fair value of ourconsolidated fixed rate debt approximated carrying value based upon discounted futurecash flows using current market prices.

 

**ForwardLooking 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 of pendingputative class action shareholder and derivative lawsuits, and relatedinsurance coverage, (2) our ability to win new contracts and to execute ourgrowth strategy, (3) risks associated with acquisitions and the integrationthereof (including the ability to achieve administrative and operating costsavings and anticipated synergies), (4) the timing and costs of the opening ofnew programs and facilities or the expansions of existing facilities, (5) ourability to negotiate contracts at those facilities for which we currently donot have an operating contract, (6) significant charges to expense of deferredcosts associated with financing and other projects in development if wedetermine that one or more of such projects is unlikely to be successfullyconcluded, (7) results from alternative deployment or sale of facilities suchas the New Morgan Academy or the inability to do so, (8) our ability tocomplete the construction of the Moshannon Valley Correctional Center asanticipated, (9) changes in governmental policy and/or funding to discontinueor not renew existing arrangements, to eliminate or discourage theprivatization of correctional, detention and pre-release services in the UnitedStates, or to eliminate rate increase, (10) the availability of financing onterms that are favorable to us and (11) fluctuations in operating resultsbecause of occupancy levels and/or mix, competition (including competition fromtwo competitors that are substantially larger than us), increases in cost ofoperations, fluctuations in interest rates and risks of operations.

 

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**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 reported,within the time periods specified in the Securities and Exchange Commission’srules and forms. In addition, we designed these disclosure controls andprocedures to ensure that this information is accumulated and communicated tomanagement, including the chief executive officer (CEO) and chief financialofficer (CFO), to allow timely decisions regarding required disclosures. SECrules require that we disclose the conclusions of our CEO and CFO about theeffectiveness of our 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 the SecuritiesExchange Act of 1934, as amended (the Exchange Act) as of the end of the periodrequired by this report. Based on that evaluation, our principal executiveofficer and principal financial officer have concluded that these controls andprocedures are effective as of that date.

 

In connection with the evaluation describedabove, there have been no changes in our internal control over financialreporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) underExchange Act) during our fiscal quarter ended March 31, 2005 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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**PART II OTHER INFORMATION**

 

**ITEM 1.  Legal Proceedings**

 

**SouthernPeaks Regional Treatment Center**

 

On January 5, 2004, we initiated legalproceedings in the lawsuit styled *Cornell Corrections ofCalifornia, Inc. v. Longboat Global Advisors, LLC, et al*., No.2004CV79761 in the Superior Court of Fulton County, Georgia under theories offraud, conversion, breach of contract and other theories to determine thelocation of and to recover funds previously deposited by us into what webelieved to be an escrow account in connection with the development andconstruction of the Southern Peaks Regional Treatment Center. Of the fundspreviously deposited, approximately $5.3 million remains to be recovered atMarch 31, 2005. In December 2004, the case was tried before a jury and the juryverdict awarded approximately $6.5 million in compensatory damages andapproximately $1.4 million in punitive damages, plus attorneys' fees. We expectthat the actual damages awarded under the verdict will be adjusted downward tothe $5.4 million actually lost by us and that the punitive damages award may beadjusted downward because of a Georgia statute regarding caps on punitivedamages awards. No judgment has yet been entered on this verdict. The award forcompensatory damages accrues pre-judgment interest at a rate of 7 percent fromthe date of loss through the date of judgment. Following the jury verdicts, wecollected approximately $0.4 million in January 2005 in funds which had beenpreviously frozen under a temporary restraining order issued at the time thatwe commenced this litigation. Currently, certain of the defendants have filedmotions to move for a new trial. No judgment will be entered on the verdictuntil after these motions for a new trial have been heard and ruled on by thecourt. Due to the continued uncertainty surrounding the ultimate recovery ofthe funds previously deposited, we will continue to maintain our existingreserve of approximately $5.0 million in an allowance for doubtful accounts.

 

**ShareholderLawsuits**

 

InMarch and April 2002, the company, Steven W. Logan (our former President andChief Executive Officer), and John L. Hendrix (our former Chief FinancialOfficer), were named as defendants in four federal putative class actionlawsuits styled as follows: (1) *GraydonWilliams, On Behalf of Himself and All Others Similarly Situated v. CornellCompanies, Inc, et al.*, No. H-02-0866, in the United States DistrictCourt for the 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 ofTexas, Houston Division; (3) *Louis A. Daly,On Behalf of Himself and All Others Similarly Situated v. Cornell Companies,Inc., et al.,* No. H-02-1522, in the United States District Court forthe Southern District of Texas, Houston Division, and (4) *Anthony J. Scolaro, On Behalf of Himself and AllOthers Similarly Situated v. Cornell Companies, Inc., et al.,* No.H-02-1567, in the United States District Court for the Southern District ofTexas, Houston Division.  Theaforementioned lawsuits were putative class action lawsuits brought on behalfof all purchasers of our common stock between March 6, 2001 and March 5, 2002and relate to our 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 Securities ExchangeAct of 1934 (the “Exchange Act”), Rule 10b-5 promulgated under Section 10(b) ofthe Exchange Act, Section 20(a) of the Exchange Act, Section 11 of theSecurities Act of 1933 (the “Securities Act”) and/or Section 15 of theSecurities Act.  The amended consolidatedcomplaint seeks, among other things, restitution damages, compensatory damages,rescission or a rescissory measure of damages, costs, expenses, attorneys’ feesand expert fees.  The Company filed a motion to dismiss thelawsuit.  In an order entered April 1,2005, the court granted the motion to dismiss with respect to the plaintiffs'securities fraud claims pursuant to Sections 10(b) and 20(a) of the ExchangeAct and Rule 10b-5.  The court denied themotion to dismiss as to the remaining claims covering the Company's secondaryoffering in 2001.  Subject to courtapproval and documentation, the parties have agreed to settle this matter.  Under the proposed agreement, the Company hasnot admitted any wrongdoing.  Settlementin the amount of $7 million will be funded through the Company's Directors' andOfficers' liability insurance.  TheCompany has not reached settlement in the pending derivative litigationdiscussed below.

 

 

38

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InMarch 2002, the company, our directors, and our former independent auditorArthur Andersen LLP, were sued in a derivative action styled as *William Williams, Derivatively and on Behalf ofNominal Defendant Cornell Companies, Inc. v. Anthony R. Chase, et al.*,No. 2002-15614, in the 127th Judicial District Court of Harris County,Texas.  The lawsuit related to ourrestatement in 2002 of certain financial statements.  The lawsuit alleged breaches of fiduciaryduty by all of the individual defendants and asserted breach of contract andprofessional negligence claims only against Arthur Andersen LLP.  This lawsuit has been dismissed withoutprejudice by agreement.

 

OnJanuary 27, 2004, we received a letter from William Williams, the plaintiff inthe *William Williams* actiondiscussed above, demanding that we pursue breach of fiduciary duty claimsagainst various officers and directors based on the August 2001 saleleaseback transaction and the subsequent restatement.  We have issued a preliminary response to theletter indicating that the Board will consider the request and inform Mr.Williams of its decision.

 

InMay and September 2002, the company and our directors were sued in three otherderivative lawsuits styled as follows: (1) *JuanGuitierrez, Derivatively on Behalf of Cornell Companies, Inc. v. Steven W.Logan, et. al.,* No. H-02-1812, in the United Stated District Courtfor 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 theUnited 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 District Court of Harris County,Texas.  These lawsuits relate to ourrestatement in 2002 of certain financial statements.  These lawsuits all allege breaches offiduciary 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 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 cases have not quantified their claim ofdamages and the outcome of the matters discussed above cannot be predicted withcertainty.  However, we believe we havegood defenses and intend to vigorously defend against the claims asserted inthese actions.  We have not recorded anyloss accruals related to these claims.

 

***Certaininsurance policies held by us to cover potential director and officer liabilitymay limit our cash outflows in the event of a decision adverse to us in thematters discussed above.  However, if anadverse decision in these matters exceeds the insurance coverage or if theinsurance coverage is deemed not to apply to these matters, an adverse decisionto us in these matters could have a material adverse effect on us, ourfinancial condition, results of operations and future prospects.***

*** ***

***Other***

*** ***

Additionally,we currently and from time to time are subject to claims and suits arising in theordinary course of business, including claims for damages for personal injuriesor for wrongful restriction of or interference with offender privileges andemployment matters. If an adverse decision in these matters exceeds ourinsurance coverage, or if our coverage is deemed not to apply to these matters,or if the underlying insurance carrier were unable to fulfill their obligationunder the insurance coverage provided, it could have a material adverse effecton our financial position, results of operations or cash flows.

 

During the period of August 2000 through May2003, our general liability and professional liability coverage was provided bySpecialty Surplus Insurance Company, a Kemper Insurance Company (“Kemper”)group member.  In June 2004, the IllinoisDepartment of Insurance gave Kemper permission to proceed with a run-off planit had previously submitted.  Thethree-year plan is designed to help Kemper meet its goal of resolving, to themaximum extent possible, all valid policyholder claims.

 

39

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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 charge of $0.6 million, and have estimated our range of additionalexposure to $0.5 million with respect to outstanding claims incurred duringthis policy period with Kemper which would become our obligation to resolve ifnot settled through Kemper.

 

As of March 31, 2005, Kemper has continued to implement its run-offplan.  We believe that the uncertaintysurrounding Kemper remains, and while no additional allowance is considerednecessary at March 31, 2005, the existing reserve of $0.6 million will bemaintained.  We continue to believe ourestimated range of exposure to be approximately $0.5 million for those outstandingclaims which would 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.

 

40

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| **ITEM 2.** | ** ** | **Changes  in Securities, Use of Proceeds and Issuer Repurchases of Equity Securities** |
|-------------|------------|-----------------------------------------------------------------------------------------|
|        |       |                                                                                    |
|        |       | None                                                                                    |
|        |       |                                                                                    |
| **ITEM 3.** | ** ** | **Defaults  Upon Senior Securities**                                                    |
|        |       |                                                                                    |
|        |       | None                                                                                    |
|        |       |                                                                                    |
| **ITEM 4.** | ** ** | **Submission of Matters to a Vote of Security Holders**                                 |
|        |       |                                                                                    |
|        |       | None                                                                                    |
|        |       |                                                                                    |
| **ITEM 5.** | ** ** | **Other Information**                                                                   |
|        |       |                                                                                    |
|        |       | None                                                                                    |
|        |       |                                                                                    |
| **ITEM 6.** |       | **Exhibits**                                                                            |

 
|   | 2.1    |   | Amendment  to Agreement and Plan of Merger, dated March 16, 2005, among Cornell  Companies, Inc., Correctional Systems, Inc., Cornell Acquisition Corp. and  Infrastructure and Environmental Private Equity Fund III, L.P. (1) |
|--------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   | 10.1a  |   | Employment  Agreement, dated as of March 14, 2005, between Cornell Companies, Inc. and  James E. Hyman. (2)                                                                                                                     |
|   | 10.2a  |   | Restricted  Stock Agreement, dated as of March 14, 2005, between Cornell Companies, Inc.  and James E. Hyman. (2)                                                                                                               |
|   | 10.3a  |   | Employment/Separation  Agreement, dated as of March 15, 2005, between Cornell Companies, Inc. and  John R. Nieser. (2)                                                                                                          |
|   | 10.4a  |   | Summary  description of oral agreement, dated as of March 9, 2005, between Cornell  Companies, Inc. and Harry J. Phillips, Jr. (2)                                                                                              |
|   | 10.5a  |   | Release  of Claims, Covenant not to Sue, and Older Workers Act Waiver, dated as of  March 21, 2005, between Cornell Companies, Inc. and Thomas R. Jenkins. (3)                                                                  |
|   | 10.6a  |   | Release  of Claims, Covenant not to Sue, and Older Workers Act Waiver, dated as of  March 21, 2005, between Cornell Companies, Inc. and Paul B. Doucette. (3)                                                                   |
|   | 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 April 5, 2005.                                                                                                                                                                 |
|   | (2)    |   | Current  Report on Form 8-K of the Company filed March 15, 2005.                                                                                                                                                                |
|   | (3)    |   | Current  Report on Form 8-K of the Company filed March 24, 2005.                                                                                                                                                                |

 

41

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**SIGNATURES**

 

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

 
|                           |   | **CORNELL COMPANIES, INC.**            |
|--------------------------------|--------|----------------------------------------|
|                           |   |                                   |
|                           |   |                                   |
| Date:  May  10, 2004 | By:    | /s/  James E. Hyman                    |   |
|                           |   | JAMES  E. HYMAN                        |
|                           |   | Chief  Executive Officer and           |
|                           |   | Chairman  of the Board                 |
|                           |   | (Principal  Executive Officer)         |
|                           |   |                                   |
|                           |   |                                   |
| Date:  May  10, 2004 | By:    | /s/  John R. Nieser                    |   |
|                           |   | JOHN  R. NIESER                        |
|                           |   | Chief  Financial Officer and Treasurer |
|                           |   | (Principal  Financial Officer)         |

 

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