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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 or 15 (D)OF
THE SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2004
Commission File Number: 0-20307
AVALON CORRECTIONAL SERVICES, INC.
(Exact name of registrant as specified in its charter)
Nevada 13-3592263
(State of Incorporation) (I.R.S. Employer I.D. Number)
13401 Railway Drive, Oklahoma City, Oklahoma 73114
(Address of principal executive offices)
(405) 752-8802
(Issuer's telephone number)
Indicate by check mark whether the registrant issuer (1) filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes X No ______
As of August 10, 2004, 4,929,789 shares of the issuer's Class A common
stock, par value $.001, were issued and outstanding.
PART I - FINANCIAL INFORMATION
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(Unaudited)
June 30, December 31,
2004 2003
------------- -----------
ASSETS
Current assets:
Cash and cash equivalents $ 956,000 $ 1,015,000
Certificates of deposit (pledged) 1,600,000 1,600,000
Accounts receivable, net 2,971,000 2,662,000
Prepaid expenses and other 453,000 426,000
--------- ----------
Total current assets $ 5,980,000 $ 5,703,000
Assets held for sale 5,900,000 -
Property and equipment, net 26,275,000 30,636,000
Intangible assets, net 2,285,000 2,395,000
Other assets 752,000 967,000
---------- ----------
Total assets 41,192,000 $ 39,701,000
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable, accrued liabilities and other $ 1,743,000 $ 1,990,000
Current maturities of long-term debt 12,492,000 2,030,000
----------- ---------
Total current liabilities $ 14,235,000 $ 4,020,000
Long-term debt, less current maturities 10,773,000 20,305,000
Convertible debentures 3,850,000 3,850,000
Deferred income taxes 182,000 175,000
Redeemable common stock, $.001 par value
1,622,448 shares issued and outstanding 3,829,000 2,628,000
Stockholders' equity:
Common stock: Par value $.001; 24,000,000 shares
authorized; 4,929,789 shares issued and
outstanding, less 1,622,448 shares subject
to repurchase 3,000 3,000
Preferred stock; par value $.001; 1,000,000
shares authorized; none is - -
Paid-in capital 7,310,000 8,459,000
Retained Earnings 1,010,000 261,000
--------- ----------
Total liabilities and stockholders' equity $ 41,192,000 $ 39,701,000
=========== ==========
The accompanying notes are an integral part of these consolidated financial
statements.
Page 1
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
2004 2003 2004 2003
----------------- --------------- ---------------- -----------------
Revenues $ 6,830,000 $ 6,112,000 $ 13,263,000 $ 12,282,000
----------------- --------------- ---------------- -----------------
Costs and expenses
Direct operating 4,419,000 4,327,000 8,872,000 8,602,000
General and administrative 578,000 472,000 975,000 830,000
Depreciation and amortization 517,000 343,000 915,000 756,000
Interest expense 648,000 515,000 1,217,000 1,183,000
----------------- --------------- ---------------- -----------------
Income from continuing
operations before income tax
expense $ 668,000 $ 455,000 $ 1,284,000 $ 911,000
Income tax expense 264,000 189,000 487,000 360,000
----------------- --------------- ---------------- -----------------
Income from continuing
operations $ 404,000 $ 266,000 $ 797,000 $ 551,000
Discontinued operations (17,000) (14,000) (48,000) (39,000)
----------------- --------------- ---------------- -----------------
Net income $ 387,000 $ 252,000 $ 749,000 $ 512,000
================= =============== ================ =================
Net income (loss) per share, basic
Continuing operations $ 0.08 $ 0.05 $ 0.16 $ 0.11
================= =============== ================ ================
Discontinued operations $ - $ - $ (0.01) $ (0.01)
================= =============== ================ ================
Total $ 0.08 $ 0.05 $ 0.15 $ 0.10
================= =============== ================ ================
Net income (loss) per share, diluted
Continuing operations $ 0.06 $ 0.05 $ 0.14 $ 0.11
================= =============== ================ ================
Discontinued operations $ - $ - $ (0.01) $ (0.01)
================= =============== ================ ================
Total $ 0.06 $ 0.05 $ 0.13 $ 0.10
================= =============== ================ ================
The accompanying notes are an integral part of these consolidated financial
statements.
Page 2
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOW
(Unaudited)
For the six months ended June 30,
2004 2003
------------ -----------
OPERATING ACTIVITIES:
Net income $ 749,000 $ 512,000
Adjustments to reconcile net income to
net cash provided by operating activities:
Depreciation and amortization 944,000 840,000
Amortization of debt issue costs 115,000 123,000
Loss (gain) on sale of property - 14,000
Changes in operating assets and liabilities:
Decrease (increase) in:
Accounts receivable (309,000) (344,000)
Prepaid expenses and other 48,00 (218,000)
Increase (decrease) in:
Accounts payable, accrued liabilities, and other (240,000) (198,000)
---------- -----------
Net cash provided by operating activities $ 1,307,000 729,000
--------- -----------
INVESTING ACTIVITIES:
Capital expenditures (765,000) (1,534,000)
Proceeds from the disposition of property 17,000 -
--------- -----------
Net cash used in investing activities $ (748,000) $ (1,534,000)
---------- ----------
FINANCING ACTIVITIES:
Proceeds from borrowings 14,196,000 15,258,000
Repayment of borrowings (14,866,000) (15,259,000)
Proceeds from warrant and option exercise 52,000 -
----------- -----------
Net cash used in financing activities $ (618,000) $ (1,000)
----------- -----------
NET DECREASE IN CASH AND CASH EQUIVALENTS (59,000) (806,000)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 1,015,000 1,250,000
----------- -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 956,000 $ 444,000
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
Page 3
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
NOTE 1. BASIS OF PRESENTATION
Interim Financial Statements -
The unaudited consolidated financial statements included herein have been
prepared pursuant to the rules and regulations of the Securities and Exchange
Commission. Accordingly, certain disclosures normally included in financial
statements prepared in conformity with accounting principles generally accepted
in the United States of America have been omitted. The accompanying unaudited
consolidated financial statements and notes should be read in conjunction with
the Company's audited financial statements for the year ended December 31, 2003
and the notes thereto contained in the Company's Form 10-K filing for the year
ended December 31, 2003. The results of operations for the three months and six
months ended June 30, 2004, are not necessarily indicative of the results that
may be expected for the entire year ended December 31, 2004.
The consolidated balance sheet as of June 30, 2004, the statements of
operations for the three and six months ended June 30, 2004 and 2003 and the
statements of cash flows for the six months ended June 30, 2004 and 2003 are
unaudited and, in the opinion of management, reflect all adjustments that are
necessary for a fair presentation of the financial position as of such date and
the results of operations and cash flows for the periods then ended. All such
adjustments are of a normal and recurring nature.
Stock-Based Compensation -
The Company has a stock-based compensation plan. The Company accounts for
this plan under the recognition and measurement principles of APB Opinion No.
25, Accounting for Stock Issued to Employees, and related Interpretations. No
stock-based employee compensation cost is reflected in net income, as all
options granted under this plan had an exercise price equal to the market value
of the underlying common stock on the date of grant. The following table
illustrates the effect on net income and earnings per share if the Company had
applied the fair value recognition provisions of FASB Statement No. 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation.
Three months ended June 30, Six months ended June 30,
------------------------------------- -------------------------------------
2004 2003 2004 2003
---------------- ----------------- ---------------- -----------------
Net income, as reported $ 387,000 $ 252,000 $ 749,000 $ 512,000
Deduct: Total stock-based employee
compensation expense determined
under fair value based method for all
awards, net of related tax effects 20,000 26,000 39,000 52,000
---------------- ----------------- ---------------- -----------------
Pro forma net income $ 367,000 $ 226,000 $ 710,000 $ 460,000
================ ================= ================ =================
Earnings per share:
Basic - as reported $ 0.08 $ 0.05 $ 0.15 $ 0.10
================ ================= ================ =================
Basic - pro forma $ 0.07 $ 0.05 $ 0.14 $ 0.09
================ ================= ================ =================
Diluted - as reported $ 0.06 $ 0.05 $ 0.13 $ 0.10
================ ================= ================ =================
Diluted - pro forma $ 0.06 $ 0.04 $ 0.11 $ 0.07
================ ================= ================ =================
Page 4
NOTE 2. LONG-TERM DEBT
Long-term debt consists of the following:
June 30, December 31,
2004 2003
---------------- ------------------
Senior credit facility:
revolving line of credit $ 208,000 $ 40,000
term loan 10,324,000 11,034,000
Notes payable to banks and finance companies, collateralized by
transportation equipment, due in installments through March 2012
with interest ranging from 2.9% to 11.0% 1,050,000 1,110,000
Notes secured by certificates of deposit 1,600,000 -
Notes payable to an investment company, uncollateralized;
interest at 14.5%, payable quarterly; principal due in four quarterly
installments beginning December 31, 2005; includes unaccreted
original issue premium 10,083,000 10,151,000
---------------- ------------------
$ 23,265,000 $ 22,335,000
Less - current maturities 12,492,000 2,030,000
---------------- ------------------
$ 10,773,000 $ 20,305,000
================ ==================
The Company has a senior credit facility collateralized by certain assets
of the Company with Fleet Capital consisting of a term loan and a revolving line
of credit equal to the lesser of $3,000,000 or 80% of eligible accounts
receivable. At June 30, 2004, the outstanding balances were $10,324,000 on the
term loan and $208,000 under the revolving line of credit. The term loan
requires principal payments in the amount of $355,000 plus interest on the first
day of each calendar quarter. The remaining principal outstanding, together with
any and all other amounts due, shall be due and payable on February 25, 2005.
The interest rate on the senior credit facility is comprised of a base rate
margin and LIBOR margin, which varies in relation to the senior debt to EBITDA
ratio. At June 30, 2004, the rate was approximately 4.75% on the senior credit
facility. At June 30, 2004, the outstanding debt under the senior credit
facility was classified as current. The Company and the senior debt holder are
negotiating a restructure of the senior credit facility. The senior credit
facility contains certain covenant requirements that the Company must maintain.
The covenants are based on a trailing twelve month period and are comprised of a
required fixed coverage ratio; a liabilities to tangible net worth ratio; a
maximum ratio of indebtedness to EBITDA; a required minimum EBITDA and a limit
on certain capital expenditures. The Company was in compliance with all debt
covenants at June 30, 2004.
The Company completed a $15,000,000 private placement of debt and equity
with an investment company on September 16, 1998. Pursuant to the terms of the
agreement, the Company tendered an unsecured subordinated note with a face value
of $10,000,000 bearing interest of 14.5%.
Page 5
The Company also tendered 1,622,448 shares of redeemable common stock to
the investment company. These shares are subject to repurchase by the Company
under certain circumstances, or beginning September 16, 2003 at the holders
option, at the then current average traded price of the stock. The Company is
accreting the difference between the carrying value and the estimated redemption
price of the stock by periodic charges / credits to additional paid-in capital.
The Company obtained an independent fair value appraisal of the equity
instrument reflecting a fair value allocation of the redeemable common stock of
$4,635,000. Issue costs of $511,000 allocated to the redeemable common stock
reduced its original book value to $4,124,000.
Certain notes payable to finance and investment companies contain covenants
that require the Company, among other things, to maintain certain earnings and
debt coverage ratios and receive approval for certain capital expenditures as
defined in the agreements. The Company was in compliance with all debt covenants
at June 30, 2004.
On July 15, 2004, Adams County, Colorado issued $19,900,000 of bonds ("the
Bonds") and loaned the proceeds to a subsidiary of the Company. The Bonds were
issued at par, bear interest at rates ranging from 8.375% to 10.25% and maturing
on various dates between August 1, 2011 and August 1, 2024. The proceeds from
the Bonds were utilized to retire debt with an investment company bearing
interest at 14.5%, reduce the existing senior credit facility with Fleet
Capital, fund a debt service reserve fund, and pay fees associated with the
issuance of the bonds.
NOTE 3. STOCK OPTION PLAN
The Company adopted a stock option plan (the "Plan") providing for the
issuance of 250,000 shares of Class A common stock pursuant to both incentive
stock options, intended to qualify under Section 422 of the Internal Revenue
Code, and options that do not qualify as incentive stock options
("non-statutory"). The Option Plan was registered with the Securities and
Exchange Commission in November 1995. The purpose of the Plan is to provide
continuing incentives to the Company's officers, key employees, and members of
the Board of Directors.
The options generally vest within five years and have a ten-year expiration
period. The Company amended its Plan on December 1, 1996, increasing the number
of shares available under the Plan to 600,000, and further amended its plan on
May 21, 2003, increasing the number of shares available to 700,000.
Non-statutory options have been granted providing for the issuance of 651,725
shares of Class A common stock at exercise prices ranging from $1.32 to $4.25
per share. Options providing for the issuance of 580,456 shares were exercisable
at June 30, 2004.
NOTE 4. LITIGATION AND CONTINGENCIES
The Company is a party to litigation arising in the normal course of
business. Management believes that the ultimate outcome of these matters will
not have a material effect on the Company's financial condition or results of
operations.
NOTE 5. EARNINGS PER SHARE
The following table sets forth the computation of earnings per share and
earnings per share assuming dilution.
Page 6
Three months ended Six months ended
June 30, June 30,
2004 2003 2004 2003
------------ ------------ ------------- ------------
Numerator:
Net income - basic $ 387,000 $ 252,000 $ 749,000 $ 512,000
Effect of dilutive securities:
- interest reduction on assumed debenture
conversions, net of income tax 43,000 43,000 87,000 87,000
------------ ------------ ------------- ------------
Numerator for earnings per share, diluted $ 430,000 $ 295,000 $ 836,000 $ 599,000
============ ============ ============= ============
Denominator for earnings per share:
Weighted average shares outstanding - basic 4,908,994 4,895,002 4,902,974 4,895,002
Effect of dilutive securities:
- debenture conversions 1,283,333 1,283,333 1,283,333 1,283,333
- stock options 185,359 5,186 157,902 299
- stock warrants 275,316 - 243,243 -
------------ ------------ ------------- ------------
Denominator for earnings per share, diluted 6,653,002 6,183,521 6,587,452 6,178,634
============ ============ ============= ============
Earnings per share, basic $ 0.08 $ 0.05 $ 0.15 $ 0.10
============ ============ ============= ============
Earnings per share, diluted $ 0.06 $ 0.05 $ 0.13 $ 0.10
============ ============ ============= ============
Number of outstanding warrants and options
excluded from the above calculations as they
would be anti-dilutive 103,000 1,300,432 154,000 1,413,632
NOTE 6. RECENTLY ADOPTED ACCOUNTING STANDARDS
In January 2003, the Financial Accounting Standards Board (FASB) issued
Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities"
(VIEs), which is an interpretation of Accounting Research Bulletin (ARB) No. 51,
"Consolidated Financial Statements." FIN 46, as revised by FIN 46(R), addresses
the application of ARB No. 51 to VIEs, and generally would require that assets,
liabilities and results of the activity of a VIE be consolidated into the
financial statements of the enterprise that is considered the primary
beneficiary. This interpretation applies immediately to VIEs created after
January 31, 2003, and to VIEs in which a company obtains an interest after that
date. The Company had not created or obtained an interest in any VIEs in 2003.
In addition, the interpretation becomes applicable on December 31, 2003 for
special purpose entities (SPEs) created prior to February 1, 2003. As of
December 31, 2003, the Company had no SPEs for which it was considered the
primary beneficiary. For non-SPEs in which a company holds a variable interest
that it acquired before February 1, 2003, the FASB postponed the date on which
the interpretation become applicable to March 31, 2004.
The Company has identified one non-consolidated entity as a VIE where the
Company is considered the primary beneficiary (see Note 8). In accordance with
the provisions of FIN 46, as revised, the Company has consolidated this VIE as
of January 1, 2004. Consolidation of this VIE did not have a material effect on
the consolidated results of operations or financial position.
In December 2003, the Staff of the Securities and Exchange Commission (SEC)
issued Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition," which
supersedes SAB No. 101. The primary purpose of SAB No. 104 is to rescind
accounting guidance contained in SAB No. 101 and the SEC's "Revenue Recognition
in Financial Statements Frequently Asked Questions and Answers" (the FAQ)
related to multiple element revenue arrangements. The issuance of SAB No. 104
did not significantly impact the Company's current revenue recognition policies.
NOTE 7. CHANGE IN ACCOUNTING ESTIMATE
The Company is required to make certain estimates, including those related
to useful lives of depreciable assets, uncollectible accounts receivable, and a
valuation allowance for deferred tax assets in preparing its financial
statements. The Company periodically reviews its estimates to ensure that the
estimates appropriately reflect changes in its business or as new information
becomes available.
Page 7
The Company's estimate of the useful life of certain depreciable vehicles
has historically been three years. The Company re-evaluated the estimated useful
life of certain vehicles and determined a depreciable life of eighteen months
was more representative of the vehicles' actual useful life. As a result of this
evaluation the depreciable life of certain vehicles was changed from three years
to eighteen months in the second quarter of 2004 and the Company increased
depreciation expense by $127,000 during the period to catch-up the depreciation
expense for the applicable vehicles.
NOTE 8. ASSETS HELD FOR SALE AND DISPOSITION
Assets held for sale are valued on an asset-by-asset basis at the lower of
the carrying amount or fair value, less costs to sell, and consist of property
and equipment. In estimating fair value, management considered the pending
status of the Union City facility and the appraised value of the assisted living
center. The Company anticipates a sale of the Union City facility will result in
proceeds in excess of the carrying value of the Union City facility.
The Company holds a 15% equity interest in an assisted living center and
has guaranteed debt related to the building of the investee and has pledged
$1,600,000 in certificates of deposit for the guarantee. The Company has
recognized losses of the investee and has reduced its carrying value in the
investment to zero. The outstanding debt balances were approximately $1,600,000
and $1,900,000 at June 30, 2004 and 2003, respectively. On July 17, 2004, the
Company repaid $700,000 of the outstanding debt, which released the pledged
certificate of deposit. The Company would have the right to sell the assisted
living center as a going concern and use any proceeds, after payment of debts,
to recover amounts owed to it by the assisted living center in the event of
default of the debt payments. The appraised value of the assisted living center
exceeds the carrying value and the existing debt. The Company has consolidated
this entity under FIN 46, as revised by FIN 46 (R) as of January 1, 2004 (see
Note 6) and if the Company would sell the asset for less than the carrying
value, the Company could be required at that time to recognize a loss on the
disposition of the asset. Total assets of the assisted living center totaled
approximately $1,608,000 as of June 30, 2004. Losses for the six months ended
June 30, 2004 equaled $4,000, and gains for the three months ended June 30, 2004
equaled $6,000. The assisted living center is for sale and the Company has
classified the asset as held for sale and has recorded its operations as
discontinued operations.
The Company owns a facility in Union City, Oklahoma utilized until December
2, 1999 for a contract with the Oklahoma Office of Juvenile Affairs. The
facility is currently utilized as an overflow center for weekend clients
assigned to the Carver Center. The Company has classified the facility as held
for sale and has recorded the operations of the facility as discontinued
operations. The Company is in discussions with several parties expressing an
interest in a transaction for a purchase or lease of the facility. In the event
these potential transactions are not successful, an impairment of the carrying
value may be required at a future date. The Company has reviewed the carrying
value of the facility and determined an impairment of the carrying value is not
warranted at this time.
Page 8
Following is the revenue and net income (loss) of the Union City facility
and the assisted living center:
Three months ended June 30,
2004 2003 2004 2003
----------------- ---------------- --------------- --------------
Assisted Living Center Union City Facility
Revenue $ 181,000 - - -
Net income (loss) 6,000 - (23,000) (14,000)
Six months ended June 30,
2004 2003 2004 2003
----------------- ---------------- ----------------- --------------
Assisted Living Center Union City Facility
Revenue $ 360,000 - - -
Net income (loss) (4,000) - (44,000) (39,000)
Certain reclassifications of prior periods' amounts have been made to
interest, income tax expense, and discontinued operations to conform with the
current period presentation.
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations
This document contains statements that are not historical but are
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These
include statements regarding the expectations, beliefs, intentions or strategies
for the future. The Company intends that all forward-looking statements be
subject to the safe-harbor provisions of the Private Securities Litigation
Reform Act of 1995. These forward-looking statements reflect the Company's views
as of the date they are made with respect to future events and financial
performance, but are subject to many uncertainties and risks which could cause
the actual results of the Company to differ materially from any future results
expressed or implied by such forward-looking statements. Examples of such
uncertainties and risks include, but are not limited to: fluctuations in
occupancy levels and labor costs; the ability to secure both new contracts and
the renewal of existing contracts; the availability and cost of financing to
redeem common shares and to expand the Company's business; public resistance to
privatization and the sale of the Union City facility and the assisted living
center for an amount in excess of the carrying value of the assets. Additional
risk factors include those discussed in periodic reports filed by the Company
from time to time. The Company does not undertake any obligation to update any
forward-looking statements.
Overview
Avalon Correctional Services, Inc. is an owner and operator of private
community correctional facilities containing approximately 2,600 beds. Avalon
Correctional Services, Inc. and its wholly owned subsidiaries specialize in
operating private community correctional facilities and providing alternative
correctional programming. Avalon currently operates facilities and manages
programs in Oklahoma, Texas, and Colorado, with plans to significantly expand
into additional states. Avalon's business strategy is designed to elevate the
Company into a dominant role as a provider of community correctional services.
Avalon's development plan is to expand operations through new state and federal
contracts and selective acquisitions. Avalon has been providing private
community correctional services since 1985. Avalon contracts with various
governmental agencies to provide community corrections operations and services.
Page 9
The management and rehabilitation of inmate populations are of utmost concern to
cities, counties, states and a variety of federal agencies throughout the
country. Increasingly, government is partnering with private companies to assist
them with their correctional needs. Management of the Company closely monitors
the operations and assesses the residential and nonresidential census data. For
further information, see Results of Operations.
Results of Operations -
Three Months Ended June 30, 2004 Compared to the Three Months Ended June 30,
2003.
The Company's revenues increased by 12% to $6,830,000 for the three months
ended June 30, 2004 from $6,112,000 for the three months ended June 30, 2003.
The increase in net revenues was primarily a result of an increase in the
Company's offender census during the three months ended loss June 30, 2004. The
Company's income from continuing operations before taxes increased 47% to
$668,000 during the second quarter of 2004 compared to $455,000 during the
second quarter of 2003.
Operating income before interest, depreciation and amortization,
discontinued operations and income taxes increased 40% to $1,833,000 for the
second quarter of 2004 from $1,313,000 for the second quarter of 2003. The
average daily residential offender census increased by 11% to 1,972 for the
second quarter of 2004 from 1,769 for the second quarter of 2003. The average
daily non-residential offender census was 296 for the second quarter of 2004
compared to 289 for the second quarter of 2003. The data to reconcile the
Company's income from continuing operations before tax for the second quarter of
2004 of $668,000 to operating income of $1,833,000 is as follows. Add back to
income from continuing operations before tax the amounts of $648,000 for
interest expense and $517,000 for depreciation and amortization expense. The
information necessary to reconcile the Company's income from continuing
operations before tax for the second quarter of 2003 of $455,000 to operating
income of $1,313,000 is as follows. Add back to income from continuing
operations before tax the amounts of $515,000 for interest expense and $343,000
for depreciation and amortization expense.
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
Direct operating expenses remained fairly constant at $4,419,000 and
$4,327,000 respectively, for the second quarter of 2004 and 2003
General and administrative expenses increased by 22% during the second
quarter of 2004 compared to the first quarter of 2003. This resulted primarily
from increases in contract labor and professional fees. General and
administrative expenses equaled approximately 8% of revenues during the second
quarter of 2004 and 2003. Depreciation and amortization expense increased by 51%
to $517,000 for the second quarter 2004 from $343,000 for the second quarter
2003. The increase was a result of the Company's change in accounting estimate
(see Note 7) related to the useful live of certain depreciable vehicles. The
amortization of intangible contract costs was $59,000 for the second quarter of
2004 and $67,000 for the second quarter of 2003. Interest expense increased by
$133,000 for the second quarter of 2004, as compared to the second quarter of
2003 as a result of higher interest rates and additional indebtedness from
vehicles.
The Company's income tax expense was $264,000 for the second quarter of
2004, an increase of $75,000 over the income tax expense of $189,000 for the
second quarter of 2003. Income from continuing operations increased $138,000 or
52% to $404,000 compared to $266,000 for the second quarter of 2003. Net income
after discontinued operations increased $135,000 or 54% in the second quarter of
2004 to $387,000, as compared to $252,000 for the second quarter of 2003.
The assisted living center and the Union City facility are for sale and the
Company has classified the assets as held for sale and has recorded the related
operations as discontinued operations (see Note 8).
Six Months Ended June 30, 2004 Compared to the Six Months Ended June 30,
2003.
The Company's revenues increased $981,000 to $13,263,000 for the six months
ended June 30, 2004 compared to $12,282,000 for the six months ended June 30,
2003. The increased revenues were a result of an increase in the company's
offender census during the six months ended June 30, 2004.
Page 10
Operating income before interest, depreciation and amortization,
discontinued operations and income taxes was $3,416,000 for the six months ended
June 30, 2004 compared to $2,850,000 for the six months ended June 30, 2003. The
increase in earnings before interest, taxes, depreciation and amortization was a
result of the increase in average daily residential offender census of 8% to
1,924 for the six months ended June 30, 2004 from 1,777 for the six months ended
June 30, 2003 and an increase in the average daily non-residential offender
census of 12% to 313 for the six months ended June 30, 2004 from 279 for the six
months ended June 30, 2003. Operating income before interest, depreciation and
amortization, discontinued operations and income taxes can be reconciled to
income from continuing operations before taxes by adding interest and
depreciation and amortization expenses to income before taxes.
Income from continuing operations before taxes increased $373,000 to
$1,284,000 for the six months ended June 30, 2004 from $911,000 for the six
months ended June 30, 2003.
The Company recorded a tax provision of $487,000 for the six months ended
June 30, 2004, compared to a provision of $360,000 for the six months ended June
30, 2003. Net income after discontinued operations increased $237,000 or 46% in
the six months ended June 30, 2004 to $749,000, as compared to $512,000 for the
six months ended June 30, 2003.
Liquidity and Capital Resources -
The Company's business strategy is to focus on the private community
corrections industry, expanding its operations in existing and additional states
through new federal and state contracts and selective acquisitions. The
successful implementation of the Company's growth plan will create the need for
additional capital and financing. The Company's working capital deficit at June
30, 2004 was $8,256,000, compared to working capital of $1,651,00 and a current
ratio of 1.39:1.00 at June 30, 2003. The working capital deficit at June 30,
2004 results from the Company's senior debt facility of $10,532,000, being
classified as a current liability. The senior debt facility has a maturity date
of February 25, 2005 and the Company and the senior debt holder are negotiating
a restructure of the senior credit facility.
The Company reduced the term loan balance on July 15, 2004 by $5,000,000
from proceeds from the issuance of the Bonds. Capital expenditures for the first
half of 2004 were $508,000, compared to $1,534,000 for the first half of 2003.
The first half 2004 capital expenditures include normal, operating purchases of
vehicles and equipment. The Company also expanded Carver Center to 406 beds from
300. The first half 2003 capital expenditures included the expansion of the
Phoenix Center to 207 beds, completed in the summer of 2003.
The Company had approximately $5,348,000 (including $1,600,000 of pledged
certificates of deposit) of cash, short-term investments, and revolving credit
available for new projects at June 30, 2004. The Company believes it has
adequate cash reserves and cash flow from operations to meet its current cash
requirements (excluding payment of the senior credit facility due February 25,
2005). The Company expects current contracts to generate sufficient income to
increase cash balances.
On July 15, 2004, Adams County, Colorado issued $19,900,000 of bonds ("the
Bonds") and loaned the proceeds to a subsidiary of the Company. The Bonds were
issued at par, bear interest at rates ranging from 8.375% to 10.25% and maturing
on various dates between August 1, 2011 and August 1, 2024. The proceeds from
the Bonds were utilized to retire debt with an investment company bearing
interest at 14.5%, reduce the existing senior credit facility with Fleet
Capital, fund a debt service reserve fund, and pay fees associated with the
issuance of the bonds.
Page 11
Item 3. Quantitative and Qualitative Disclosures About Market Risk
Market Risk Exposure
The primary market risk exposures affecting the Company are changes in
interest rates. The Company is exposed to market risk related to the senior bank
credit facility. The interest on the senior credit facility is subject to
fluctuations in interest rates. Assuming an immediate increase or decrease of
100 basis points in interest rates, the interest expense for the six months
ended June 30, 2004 and 2003 would have been increased or decreased by
approximately $52,000.
The Company may from time to time, invest its cash in a variety of
short-term financial instruments. These instruments generally consist of highly
liquid investments. While these investments are subject to interest rate risk
and could decline in value if market interest rates increase, a hypothetical 100
basis point increase or decrease in market interest rates would not materially
affect the value of these instruments
Item 4. Controls and Procedures
The Company's Chief Executive Officer and its Vice President of Finance
have evaluated the effectiveness of the Company's disclosure controls and
procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)), as of the
end of the period covered by this report. Based upon that evaluation, the Chief
Executive Officer and Vice President of Finance concluded that the Company's
disclosure controls and procedures are effective in timely alerting them to
material information relating to the Company that is required to be included in
periodic SEC filings. There have not been any changes in the Company's internal
control over financial reporting (as defined in Exchange Act Rules 13a-15 (f)
and 15d-15(f)) during the fiscal quarter to which this report relates that have
materially affected, or are reasonably likely to materially affect, the
Company's internal control over financial reporting.
Page 12
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
PART II - OTHER INFORMATION
Item 1. Legal Proceedings - None.
Item 2. Changes in Securities - None.
Item 3. Defaults Upon Senior Securities - None.
Item 4. Submission of Matters to a Vote of Security Holders -
May 26, 2004 Annual Meeting
Directors Elected -
Robert O. McDonald - Votes for - 4,721,599
Votes withheld - 26,410
Charles W. Thomas - Votes for - 4,743,799
Votes withheld - 4,210
Directors Continued -
Mark S. Cooley
Donald E. Smith
James P. Wilson
Item 5. Other Information - None.
Item 6. Exhibits and reports on Form 8-K -
The Company filed a current report on Form 8-K, updated on Form 8-K/A, dated
June 21, 2004, reporting on "Item 4. Changes in Registrant's Certifying
Accountant" the change of the Company's independent public accountant to Cole &
Reed, P.C. for the fiscal year ending December 31, 2004 replacing Grant
Thornton, LLP.
The following exhibits are filed as a part of this Quarterly Report on Form
10-Q:
31.1 Certification of the Chief Executive Officer of Avalon
Correctional Services, Inc., pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of the Vice President of Finance of Avalon
Correctional Services, Inc., pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
32.1 Certification of the Chief Executive Officer of Avalon
Correctional Services, Inc., pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes Oxley Act of
2002.
32.2 Certification of the Vice President of Finance of Avalon
Correctional Services, Inc., pursuant to 18 U.S.C. Section 1350,
as adopted pursuant to Section 906 of the Sarbanes Oxley Act of
2002.
Page 13
AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES
SIGNATURES
In accordance with the requirement of the Exchange Act, the registrant has
caused this report to be signed on its behalf by the undersigned thereunto duly
authorized.
Date: August 10, 2004 AVALON CORRECTIONAL SERVICES, INC.
By: s/ Donald E. Smith
Donald E.Smith, Chief Executive Officer
By: s/ Michael C.Bradley
Michael C. Bradley, Vice President of Finance
Page 14
Exhibit 31.1
CERTIFICATION
I, Donald E. Smith, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Avalon
Correctional Services, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented
in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15 (e) and 15d-15 (e)) for the
registrant and have:
a) Designed such disclosure controls and procedures or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is make known
to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusion about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report based on such evaluation;
and
c) Disclosed in this report any changes in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
registrant' board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies and material weakness in the design or
operation of internal controls over financial reporting, which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal over financial reporting.
August 10, 2004
/s/ Donald E. Smith
Donald E. Smith
Chief Executive Officer
Page 15
Exhibit 31.2
CERTIFICATION
I, Michael C. Bradley, certify that:
1. I have reviewed this quarterly report on Form 10-Q of Avalon
Correctional Services, Inc.;
2. Based on my knowledge, this quarterly report does not contain any
untrue statement of a material fact or omit to state a material fact
necessary to make the statements made, in light of the circumstances
under which such statements were made, not misleading with respect
to the period covered by this quarterly report;
3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all
material respects the financial condition, results of operations and
cash flows of the registrant as of, and for, the periods presented
in this quarterly report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as
defined in Exchange Act Rules 13a-15 (e) and 15d-15 (e)) for the
registrant and have:
a) Designed such disclosure controls and procedures or caused such
disclosure controls and procedures to be designed under our
supervision, to ensure that material information relating to the
registrant, including its consolidated subsidiaries, is make known
to us by others within those entities, particularly during the
period in which this annual report is being prepared;
b) Evaluated the effectiveness of the registrant's disclosure controls
and procedures and presented in this report our conclusion about the
effectiveness of the disclosure controls and procedures, as of the
end of the period covered by this report based on such evaluation;
and
c) Disclosed in this report any changes in the registrant's internal
control over financial reporting that occurred during the
registrant's most recent fiscal quarter (the registrant's fourth
fiscal quarter in the case of an annual report) that has materially
affected, or is reasonably likely to materially affect, the
registrant's internal control over financial reporting; and
5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation of internal control over financial
reporting, to the registrant's auditors and the audit committee of
registrant' board of directors (or persons performing the equivalent
functions):
a) all significant deficiencies and material weakness in the design or
operation of internal controls over financial reporting, which are
reasonably likely to adversely affect the registrant's ability to
record, process, summarize and report financial information; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's
internal over financial reporting.
August 10, 2004
/s/ Michael C. Bradley
Michael C. Bradley
Vice President of Finance
Page 16
Exhibit 31.1
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Avalon Correctional Services, Inc.
(the "Company") on Form 10-Q for the period ended June 30, 2004 as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Donald E. Smith, Chief Executive Officer of the Company, certify, pursuant to 18
U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley
Act of 2002, that to the best of my knowledge:
(1) The Report fully complies with the requirements of section 13 (a)or 15(d)
of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and result of operations of
the Company.
/s/ Donald E. Smith
Donald E. Smith
Chief Executive Officer
August 10, 2004
Page 17
Exhibit 31.2
CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Quarterly Report of Avalon Correctional Services, Inc.
(the "Company") on Form 10-Q for the period ended June 30, 2004, as filed with
the Securities and Exchange Commission on the date hereof (the "Report"), I,
Michael C. Bradley, Vice President of Finance of the Company, certify, pursuant
to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the
Sarbanes-Oxley Act of 2002, that to the best of my knowledge:
(1) The Report fully complies with the requirements of section 13 (a) or 15
(d) of the Securities Exchange Act of 1934; and
(2) The information contained in the Report fairly presents, in all
material respects, the financial condition and result of operations of
the Company.
/s/ Michael C. Bradley
Michael C. Bradley
Vice President of Finance
August 10, 2004
Page 18