CORNELL COMPANIES INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549

FORM 10-Q

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

FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2002

OR

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

FOR THE TRANSITION PERIOD __________ TO ______________

COMMISSION FILE NUMBER 1-14472

CORNELL COMPANIES, INC.
-------------------------------------------
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

DELAWARE 76-0433642
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(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NO.)

1700 WEST LOOP SOUTH, SUITE 1500, HOUSTON, TEXAS 77027
- ------------------------------------------------ ----------------------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)

REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (713) 623-0790

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

Yes X No
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At July 31, 2002 Registrant had outstanding 13,043,341 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)

The accompanying notes are an integral part of these consolidated financial
statements.

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CORNELL COMPANIES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(UNAUDITED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)

The accompanying notes are an integral part of these consolidated financial
statements.

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CORNELL COMPANIES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
(IN THOUSANDS)

The accompanying notes are an integral part of these consolidated financial
statements.

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CORNELL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1. BASIS OF PRESENTATION

The accompanying unaudited consolidated financial statements have been
prepared by Cornell Companies, Inc. (the "Company") pursuant to the rules and
regulations of the Securities and Exchange Commission. Certain information
and footnote disclosures normally included in financial statements prepared
in accordance with generally accepted accounting principles have been
condensed or omitted pursuant to such rules and regulations. In the opinion
of management, all normal and recurring adjustments and disclosures necessary
for a fair presentation of these financial statements have been included.
Estimates were used in the preparation of these financial statements. Actual
results could differ from those estimates. These financial statements should
be read in conjunction with the financial statements and notes thereto
included in the Company's 2001 Annual Report on Form 10-K, as amended, as
filed with the Securities and Exchange Commission.

2. RESTATEMENT

The Company's lease financing arrangement under its 2000 Credit Facility
is a "synthetic lease". A synthetic lease is a form of lease financing that
qualifies for operating lease accounting treatment and, when all criteria
pursuant to generally accepted accounting principles (GAAP) are met, is
accounted for "off- balance sheet". Under such a structure, the owner/lessor
of the properties ("Synthetic Lease Investor") may be considered a virtual
special purpose entity when it obtains debt and equity capital to finance the
acquisition or construction of project(s) and leases the project(s) to a
company. This financial structure was used by the Company to finance the
construction of the New Morgan Academy completed in the first quarter of
2001, the acquisition of the Taylor Street Center building in early 1999, and
the construction-to-date costs of the Moshannon Valley Correctional Center.
The synthetic lease used to finance the above projects was executed in
December 1998 and was amended in July 2000 whereby the available financing
was increased from $40 million to $100 million and the lease term extended to
July 2005.

Under current accounting rules, a Synthetic Lease Investor in a synthetic
lease treated as a virtual special purpose entity, as described above, must
maintain at least a 3% equity ownership interest in the property throughout the
life of the lease. The Company's synthetic lease documents, as amended in July
2000, provide for the equity investor to fund 3.5% of project costs. There are
provisions in the lease and related credit documents for the lenders and
Synthetic Lease Investor to fund and be paid interest, yield and fees. Under
current GAAP rules, the payment of any yield and fees to the investors is
required to be treated as a return of capital rather than a return on capital.

The Synthetic Lease Investor for the above mentioned projects received
payments to assist as co-arranger in the structure of the initial $40 million
synthetic lease facility in 1998 and in July 2000 when the synthetic lease
facility was increased to $100 million. Although the Company does not believe
the lessor is a special purpose entity, the lessor is considered as a virtual
special purpose entity under certain accounting interpretations. Therefore,
these payments could be interpreted to reduce the Synthetic Lease Investor's
equity ownership in the leased projects below the required 3% level as of the
second quarter of 2000. Pursuant to this interpretation, the Company's synthetic
leases no longer qualified for off-balance sheet treatment as of the beginning
of the second quarter of 2000. Accordingly, the assets and liabilities and the
results of operations of the synthetic lease owned by the Synthetic Lease
Investor have been consolidated in the Company's financial statements since that
time.

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As a result of consolidating the synthetic lease assets and liabilities,
the Company's accompanying consolidated financial statements reflect, among
other things, the depreciation expense for the associated properties and
interest expense related to the Synthetic Lease Investor's debt, instead of rent
expense.

On August 14, 2001, the Company completed an arms' length sale and
leaseback transaction involving 11 of its real estate facilities (the "2001
Sale and Leaseback Transaction"). The Company sold the facilities to an
unaffiliated company, Municipal Corrections Finance, L.P. ("MCF"), and is
leasing them back for an initial period of 20 years, with approximately 25
years of additional renewal period options. The Company received $173.0
million of proceeds from the sale of the facilities. The proceeds were used
to repay $120.0 million of the Company's long-term debt and the remainder was
invested in short-term securities, with $43.1 million of these securities
being invested in a separate account to be held as collateral for the
Company's Credit Facility (See Notes).

MCF is an unaffiliated special purpose entity ("SPE"). Under current
accounting rules, a SPE must maintain at least a 3% equity ownership interest
throughout the life of the lease. In September 2001, the Company entered into
a separate retainer agreement with affiliates of the equity investor in MCF
("MCF Equity Investor"), and in November 2001, paid the related retainer fee
of $3.65 million for financial advisory services related to specific separate
potential future financing projects and the strategic development of the
Company's business. The retainer will be applied on a mutually agreed upon
basis toward future contingent fees associated with investment banking
services that are expected to be provided to the Company. Under certain
accounting interpretations, this retainer has been deemed to reduce the
equity investment in MCF to below the required 3% level. As a result, the
Company has consolidated the assets, liabilities, and results of operations
of MCF in the Company's accompanying consolidated financial statements
beginning August 14, 2001. As a result of consolidating the assets and
liabilities of MCF, the Company's consolidated financial statements reflect,
among other things, the depreciation expense on the associated properties and
interest expense on the bond debt of MCF used to finance MCF's acquisition of
the 11 facilities in the 2001 Sale and Leaseback Transaction. For income tax
purposes, the Company recognizes rent expense pursuant to the terms of its
lease with MCF and does not consolidate the assets, liabilities or results of
operations of MCF.

All applicable amounts relating to the aforementioned restatements have
been reflected in the consolidated financial statements and notes thereto.

3. NEW ACCOUNTING PRONOUNCEMENTS

In August 2001, the Financial Accounting Standards Board issued SFAS No
144, "Accounting for Impairment or Disposal of Long-Lived Assets (SFAS 144),
which addresses financial accounting and reporting for the impairment of
long-lived assets to be held and used and for long-lived assets to be
disposed of by sale. Under SFAS 144, the presentation of discontinued
operations is broadened to include a component of an entity rather than being
limited to a segment of a business. Additionally, accrual of future operating
losses of discontinued businesses is no longer permitted. The Company adopted
SFAS 144 during the first quarter of 2002 with no impact on the current
results of operations, financial condition or cash flows.

In June 2001, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standard (SFAS) No. 143, "Accounting for Asset Retirement
Obligations" (SFAS 143) which requires entities to recognize the fair value of a
liability for legal obligations associated with the retirement of tangible
long-lived assets in the period incurred, if a reasonable estimate of the fair
value can be made.

In April 2002, the Financial Accounting Standards Board issued SFAS 145,
"Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections," which is effective for transactions
occurring after May 15, 2002. SFAS 145 rescinds SFAS 4 and SFAS 64, which
addressed the accounting for gains and losses from extinguishment of debt. SFAS
44 set forth industry- specific transitional guidance that did not apply to the
Company. SFAS 145 amends SFAS 13 to require that

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certain lease modifications that have economic effects similar to
sale-leaseback transactions be accounted for in the same manner as
sale-leaseback transactions. SFAS 145 also makes technical corrections to
certain existing pronouncements that are not substantive in nature.

In July 2002, the Financial Accounting Standards Board issued SFAS No.
146. "Accounting for Costs Associated with Exit or Disposal Activities (SFAS
146), which addresses financial accounting and reporting associated with exit
or disposal activities. Under SFAS 146, costs associated with an exit or
disposal activity will be recognized and measured at fair value in the period
in which the liability is incurred rather than at the date of a commitment to
an exit or disposal plan.

The Company is required to adopt SFAS 143 and SFAS 145 at the beginning of
fiscal year 2003 and SFAS 146 for all exit and disposal activities initiated
after December 31, 2002. Management believes there will be no material effect on
the Company's financial position, results of operations or stockholders' equity
as result of the adoption of the new pronouncements discussed above.

4. CHANGES IN ACCOUNTING PRINCIPLES

CHANGE EFFECTIVE JANUARY 1, 2002

In June 2001, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 141, "Business
Combinations" and SFAS No. 142, "Goodwill and Other Intangible Assets",
effective for fiscal years beginning after December 15, 2001. The new rules
require that the purchase method of accounting be used for all business
combinations initiated after June 30, 2001 and also specifies the criteria
for the recognition of intangible assets separately from goodwill. Under the
new rules, goodwill is no longer amortized but is subject to an impairment
test at least annually. For the six months ended June 30, 2001, goodwill
amortization was $323,000. Other intangible assets that meet the new criteria
will continue to be amortized over their useful lives.

The Company adopted SFAS No. 141 and 142 and recorded a cumulative effect
of change in accounting principle charge of $965,000, net of tax, on January 1,
2002 related to an acquisition made in November 1999.

The following table reflects, on a pro-forma basis, the results of
operations as though goodwill was no longer amortized as of January 1, 2001 (in
thousands):

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The changes in the carrying amounts of goodwill for the six months ended
June 30, 2002 are as follows (in thousands):

Other intangible assets at June 30, 2002 and December 31, 2001 consisted of
the following (in thousands):

Amortization expense for non-compete agreements was $219,000 and
$439,000 for the three and six months ended June 30, 2002, respectively.
Amortization expense will be approximately $878,000 for each of the fiscal
years ended December 31 for the next five years.

CHANGE EFFECTIVE JANUARY 1, 2001

On January 1, 2001, management changed its method of accounting for
supplies whereby the Company capitalizes durable operating supply purchases
such as uniforms, linens and books and amortizes these costs to operating
expense over the estimated period of benefit of 18 months. Effective January
1, 2001, the Company capitalized a portion of previously expensed operating
supplies and recognized a benefit in the consolidated statements of
operations of $770,000 (net of income taxes of $535,000) which has been
reflected as a cumulative effect of a change in accounting principle in the
accompanying consolidated statements of operations.

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5. CREDIT FACILITIES

The Company's long-term debt consisted of the following (in thousands):

The Company's 2000 Credit Facility, as amended, provides for borrowings
of up to $45.0 million under a revolving line of credit. The commitment
amount is reduced by $1.6 million quarterly beginning in July 2002. The
amended 2000 Credit Facility matures in July 2005 and bears interest, at the
election of the Company, at either the prime rate plus a margin of 2.0%, or a
rate which is 3.0% above the applicable LIBOR rate. The amended 2000 Credit
Facility is collateralized by substantially all of the Company's assets,
including the stock of all of the Company's subsidiaries; does not permit the
payment of cash dividends; and requires the Company to comply with certain
leverage, net worth and debt service coverage covenants. Due to the
consolidation for financial reporting purposes of MCF as of August 14, 2001,
the Company was not in compliance with certain leverage ratio covenants. On
April 5, 2002, the 2000 Credit Facility was amended to waive such
non-compliance and to revise the covenants to levels that accommodate the
Company's consolidation of special purpose entities in its consolidated
balance sheets, statements of operations and cash flows. As a result of this
waiver and amendment, the Company recognized a pre-tax charge to interest
expense of approximately $825,000 during the first quarter of 2002 for lender
and other professional fees. On April 11, 2002, the Company obtained a waiver
from the lenders under the amended 2000 Credit Facility regarding the pending
contractual default for the Moshannon Valley Correctional Center's
construction delay. The waiver is effective through September 2002. Included
in the Company's cash and cash equivalents at June 30, 2002 is approximately
$43.1 million that is invested in a separate account. Approximately $39.1
million of the funds in this separate account are available to the Company
for investment purposes or working capital with the approval of the lenders
under the amended 2000 Credit Facility. The remaining funds of approximately
$4.0 million are available to the Company without lender approval. This
separate account is maintained, in part, to assure future credit availability.

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Additionally, the amended 2000 Credit Facility provides the Company with
the ability to enter into synthetic lease agreements for the acquisition or
development of operating facilities. This synthetic lease financing arrangement
provides for funding to the lessor under the operating leases of up to $100.0
million, of which approximately $50.5 million had been utilized as of June 30,
2002. The Company expects to utilize the remaining capacity under this synthetic
lease financing arrangement to complete construction of the Moshannon Valley
Correctional Center. The Synthetic Lease Investor's Note A and Note B have total
credit commitments of $81.4 million and $15.1 million, respectively. The Company
pays commitment fees at a rate of 0.5% annually for the unused portion of the
synthetic lease financing capacity. The Synthetic Lease Investor's Notes A and B
are cross collateralized with the Company's revolving line of credit and contain
cross default provisions. Under current accounting rules, utilization of the
synthetic lease financing arrangement to complete the Moshannon Valley
Correctional Center would likely result in the consolidation of the facility and
the related financing in the Company's financial statements.

On August 14, 2001, MCF issued $197.4 million of 8.47% taxable revenue
bonds due August 1, 2016. Interest on the bonds is payable by MCF semiannually
on February 1 and August 1, commencing February 1, 2002, and principal is
payable by MCF in escalating annual installments commencing August 1, 2002.

On August 14, 2001, the Company repaid the $50.0 million of outstanding
7.74% Senior Secured Notes with a portion of the proceeds from the 2001 Sale and
Leaseback Transaction.

On November 30, 2001 the Company completed an offering of its common stock.
Net proceeds to the Company from the sale of 3,450,000 newly issued shares was
approximately $43.8 million. The Company used a portion of the proceeds to repay
outstanding borrowings of $39.4 million and retired the notes under the
Company's Note and Equity Purchase Agreements (the "Subordinated Notes") entered
into in July 2000.

As a result of the early retirement of the Subordinated Notes during the
fourth quarter of 2001, the Company recognized extraordinary charges of $2.9
million, net of income tax of $2.0 million due to the write-off of related
unamortized deferred debt issuance costs and debt discount and assessed
contractual prepayment fees.

6. DERIVATIVE FINANCIAL INSTRUMENT AND GUARANTEE

In August 2001, MCF completed a bond offering to finance the 2001 Sale
and Leaseback Transaction. In connection with the bond offering, two reserve
fund accounts were established by MCF pursuant to the terms of the indenture.
MCF's Debt Service Reserve Fund, aggregating $23.8 million, was established
to make payments on MCF's outstanding bonds in the event the Company (as
lessee) should fail to make scheduled rental payments to MCF. MCF's Debt
Service Fund, which aggregated $15.3 million at June 30, 2002, is used to
accumulate the monthly lease payments that MCF receives from the Company
until such funds are used to pay MCF's semi-annual bond payments. Both
reserve fund accounts are subject to agreements with the MCF Equity Investor
whereby guaranteed rates of return of 3% and 5.08%, respectively, are
provided for the balance in the Debt Service Reserve Fund and the Debt
Service Fund. The guaranteed rates of return are characterized as cash flow
hedge derivative instruments. At inception, the derivatives had an aggregate
fair value of $4.0 million, which has been recorded as a decrease to the
equity investment in MCF made by the MCF Equity Investor (MCF Minority
Interest) and as deferred income (a liability account) in the accompanying
consolidated balance sheets. Changes in the fair value of derivative
instruments are recorded as an adjustment to deferred income and reported as
a component of other comprehensive income.

In connection with MCF's bond offering, the MCF Equity Investor provided
a guarantee of the Debt Service Reserve Fund if a bankruptcy of the Company
were to occur and a trustee for the estate of the Company were to include the
Debt Service Reserve Fund as an asset in the Company's estate. This

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guarantee is characterized as an insurance contract. The insurance contract has
an estimated fair value of $2.5 million, which has been recorded as an increase
to the MCF minority interest and as a deferred asset. The recorded cost of this
insurance contract is being amortized over the 15 year life of MCF's outstanding
bonds and the Debt Service Reserve Fund.

7. NEW FACILITIES AND PROJECT UNDER DEVELOPMENT

The New Morgan Academy was completed and became operational in two
phases during the fourth quarter of 2000 and the first quarter of 2001. In
the current year, the New Morgan Academy has experienced a reduction in
occupancy as a result of budget appropriation reductions of a significant
customer. The Company is currently seeking to obtain referrals from other
governmental agencies and management believes that occupancy will be restored
to normal operating levels by mid year 2003. A continued occupancy level
below contract capacity could have an adverse effect on the Company's
operating results.

In April 1999, the Company was awarded a contract to design, build and
operate a 1,095 bed prison for the FBOP in Moshannon Valley, Pennsylvania (the
"Moshannon Valley Correctional Center"). Construction and activation activities
commenced immediately. In June 1999, the FBOP issued a Stop-Work Order pending a
re-evaluation of its environmental documentation supporting the decision to
award the contract. The environmental study was completed with a finding of no
significant impact and the Stop-Work Order was lifted by the FBOP on August 9,
2001.

In September 1999, the Company received correspondence from the Office
of the Attorney General of the Commonwealth of Pennsylvania indicating its
belief that the operation of a private prison in Pennsylvania is unlawful.
The Company and the FBOP have had, and continue to have, discussions with the
Attorney General's staff regarding these and related issues. Management
anticipates that these discussions will be resolved in the near-term. As a
result of these issues, the Company has not recommenced construction efforts.
As of June 30, 2002, the Company had incurred approximately $15.4 million for
construction and land development costs and capitalized interest for the
Moshannon Valley Correctional Center. According to the FBOP contract, as
amended, the Company must have completed the construction of the project by
August 15, 2002. The Company will not have completed construction within that
time frame. The Company anticipates obtaining another contract amendment from
the FBOP extending the construction deadline. If the Company is not able to
negotiate a contract amendment with the FBOP, then the FBOP may have the
right to assert that the Company has not completed construction of the
project within the time frames provided in the FBOP contract, as amended. In
the event that the FBOP desires to continue with the Moshannon Valley
Correctional Center, management expects that the contract will be amended to
address cost and construction timing matters resulting from the extended
delay. In the event that the FBOP decides not to continue with the Moshannon
project and terminates the contract, management believes that the Company has
the right to recover its invested costs. In the event any portion of these
costs are determined not to be reimbursed upon contract termination, such
costs would be expensed.

At June 30, 2002, accounts receivable include costs totaling $1.4 million
for direct costs incurred by the Company since the issuance of the Stop-Work
Order in June 1999 for payroll and other operating costs related to the
Moshannon Valley Correctional Center. These costs were incurred with the
understanding that such costs would be reimbursed. Although no formal written
agreement exists, management believes that these costs will be reimbursed by the
FBOP in the near term. In the event any portion of these costs is determined not
to be reimbursable, such costs will be expensed.

8. RECLASSIFICATIONS

Current reclassifications have been made to the prior period financial
statements contained herein to conform to current period presentation.

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9. EARNINGS PER SHARE

Basic earnings per share ("EPS") is computed by dividing net income by
the weighted average number of shares of common stock outstanding during the
period. Diluted EPS reflects the potential dilution from common stock
equivalents such as stock options and warrants. For the six months ended June
30, 2002 and 2001, there were 256,741 and 88,302, respectively, of stock
options that were not included in the computation of diluted EPS because to
do so would have been anti-dilutive.

10. DEFERRED BONUS PLAN

At June 30, 2002, restricted assets and other current assets included
approximately $2.2 million and $99,000, respectively, representing amounts
deposited on behalf of individual participants into a rabbi trust account
under the Company's deferred bonus plan. At December 31, 2001, restricted
assets included approximately $3.6 million of such deposits. The investments
of the rabbi trust represent assets of the Company and are included in the
accompanying balance sheets based on the nature of the assets held. Assets
placed into the rabbi trust are irrevocable; therefore they are restricted as
to the Company's use under the terms of the trust and the deferred bonus plan.

11. LITIGATION

The Company and certain officers and directors have been named as
defendants in four lawsuits and four derivative actions during 2002. The
plaintiffs in these cases have not quantified their claim of damages and the
outcome of the matters discussed above cannot be predicted with certainty.
However, based on the Company's assessment of information known to date and
review of applicable insurance coverage, management believes that the
ultimate resolution of these matters will not have a material adverse effect
on the Company's financial position, operating results or cash flows. The
Company has recorded a receivable from its insurance carrier of approximately
$300,000 as of June 30, 2002 related to the expected reimbursement for legal
costs incurred to date to defend the Company in the above matters.

12. RELATED PARTY TRANSACTION

One of the Directors of the Company is a partner in a law firm that
provides legal services to the Company. The Company pays customary legal fees
for such services.

On July 8, 1996, the current President and the Company founder,
currently a Director of the Company, exercised options to purchase an
aggregate 137,100 and 82,750 shares of Class A Common Stock and Class B
Common Stock at an aggregate price of $274,220 and $180,638, respectively. In
connection with the exercise, each officer entered into a promissory note
with the Company and the respective aggregate exercise amounts. The
promissory notes, as amended in July 2000, bear interest at an annual rate of
6.63%, mature in June 2004, are full recourse and are collateralized by
shares of the Company's common stock.

Effective September 1, 1999, the Company entered into a consulting
agreement with the Company founder, currently a Director. As compensation for
services, the Company agreed to an annual salary of at least $255,000 for
each of the first four years of the seven-year initial term of the consulting
agreement with an annual salary of at least $180,000 for each of the last
three years of the seven-year initial term. The Company has an option to
renew the consulting agreement for an additional three-year renewal term at
an annual salary of at least $300,000 for each of the three years of the
renewal term. As additional compensation, the Company agreed to an annual
bonus, subject to certain limitations, equal to $75,000 during the first four
years of the initial term and an annual bonus of $60,000 during the last
three years of the initial term and during any renewal term. The Company also
agreed to grant options to purchase an aggregate of 120,000 shares of the
Company's common stock in four equal annual installments beginning on

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September 1, 2000. The options have an exercise price equal to the fair market
value of the Common Stock on the date of grant and vest at the time such options
are granted, subject to certain limitations on exercise.

As part of the consulting agreement discussed above, the Company entered
into a non-compete agreement with this Director. The non-compete agreement
has a term of 10 years and the Company agreed to a $10,000 monthly fee for
the seven-year initial term of the related consulting agreement.

Additionally, the Company maintains a key-man life insurance policy for
this Director.

13. SEGMENT DISCLOSURE

The Company's three operating divisions are its reportable segments. The
accounting policies of the segments are the same as those described in the
summary of significant accounting policies in the Notes to Consolidated
Financial Statements included in the Company's 2001 Annual Report on Form 10-K,
as amended. Intangible assets are not included in each segment's reportable
assets, and the amortization of intangible assets is not included in the
determination of a segment's operating income or loss. The Company evaluates
performance based on income or loss from operations before general and
administrative expenses, incentive bonuses, amortization of intangibles,
interest and income taxes. Corporate and other assets are comprised primarily of
cash, investments, accounts receivable, deposits, deferred costs, property and
equipment and deferred taxes.

The only significant non-cash item reported in the respective segments'
income or loss from operations is depreciation and amortization (excluding
intangibles) (in thousands):

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS

GENERAL

The Company is a leading provider of privatized correctional, treatment and
educational services outsourced by federal, state and local government agencies.
The Company provides a diversified portfolio of services for adults and
juveniles through its three operating divisions: (1) adult secure institutional
services, (2) juvenile treatment, educational and detention services and (3)
pre-release correctional and treatment services. As of June 30, 2002, the
Company had contracts to operate 69 facilities with a total service capacity of
15,444. The Company's facilities are located in 13 states and the District of
Columbia.

The following table sets forth for the periods indicated total service
capacity, the service capacity and contracted beds in operation at the end of
the periods shown and the average occupancy percentages.

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(1) The Company's service capacity is comprised of the number of beds available
for service upon completion of construction of residential facilities and
the average program capacity of non-residential community-based programs.
(2) Occupancy percentages are based on contracted service capacity of
residential facilities in operation. Since certain facilities have service
capacities that exceed contracted capacities, occupancy percentages can
exceed 100% of contracted capacity.
(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 the Company has substantial start-up activities.

The Company derives substantially all its revenues from providing
corrections, treatment and educational services outsourced by federal, state and
local government agencies in the United States. Revenues for the Company's
services are generally recognized on a per diem rate based upon the number of
occupant days or hours served for the period, on a guaranteed take-or-pay basis
or on a cost-plus reimbursement basis.

Factors that the Company considers in determining the per diem rate to
charge include (1) the programs specified by the contract and the related
staffing levels, (2) wage levels customary in the respective geographic areas,
(3) whether the proposed facility is to be leased or purchased and (4) the
anticipated average occupancy levels that the Company believes could reasonably
be maintained.

The Company has experienced higher operating margins in its adult secure
institutional and pre-release divisions as compared to the juvenile division.
Additionally, the Company's operating margins within a division can vary from
facility to facility based on whether the facility is owned or leased, the level
of competition for the contract award, the proposed length of the contract, the
occupancy levels for a facility, the level of capital commitment required with
respect to a facility, the anticipated changes in operating costs over the term
of the contract, and the Company's ability to increase contract revenues. A
decline in occupancy of certain juvenile division facilities may have a more
significant impact on operating results than

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the adult divisions due to the higher per diem revenues of certain juvenile
facilities. The Company has and expects to experience interim period
operating margin differences due to the number of calendar days in the
period, higher payroll taxes in the first half of the year, and salary and
wage increases that are incurred prior to certain contract revenue increases.
The Company has experienced higher employee insurance costs in the six months
ended June 30, 2002 as compared with the same period of prior year due to
rising health care costs.

The Company is responsible for all facility operating expenses, except for
certain debt service and lease payments with respect to the facilities for which
the Company has only a management contract (11 facilities in operation at June
30, 2002).

A majority of the Company's facility operating expenses consist of fixed
costs. These fixed costs include lease and rental expense, insurance, utilities
and depreciation. As a result, when the Company commences operation of new or
expanded facilities, fixed operating expenses increase. The amount of the
Company's variable operating expenses, including food, medical services,
supplies and clothing, depend on occupancy levels at the facilities operated by
the Company. The Company's largest single operating expense, facility payroll
expense and related employment taxes and costs, has both a fixed and a variable
component. The Company can adjust the staffing and payroll to a certain extent
based on occupancy at a facility, but a minimum fixed number of employees is
required to operate and maintain any facility regardless of occupancy levels.
Personnel costs are subject to increase in tightening labor markets based on
local economic and other conditions.

Following a contract award, the Company incurs pre-opening and start-up
expenses including payroll, benefits, training and other operating costs prior
to opening a new or expanded facility and during the period of operation while
occupancy is ramping up. These costs vary by contract. Since pre-opening and
start-up costs are factored into the revenue per diem rate that is charged to
the contracting agency, the Company typically expects to recover these upfront
costs over the life of the contract. Because occupancy rates during a facility's
start-up phase typically result in capacity under-utilization for at least 90 to
180 days, the Company may incur additional post-opening start-up costs. The
Company does not anticipate post-opening start-up costs at facilities operating
under any future contracts with the FBOP because these contracts are currently
take-or-pay, meaning that the FBOP will pay the Company at least 95% of the
contractual monthly revenue once the facility opens regardless of actual
occupancy.

Newly opened facilities are staffed according to contract requirements when
the Company begins receiving offenders or clients. Offenders or clients are
typically assigned to a newly opened facility on a phased-in basis over a one-
to six-month period, although certain programs require a longer time period to
reach break-even occupancy levels. The Company incurs start-up operating losses
at new facilities until break-even occupancy levels are reached. Although the
Company typically recovers these upfront costs over the life of the contract,
quarterly results can be substantially affected by the timing of the
commencement of operations as well as development and construction of new
facilities.

Working capital requirements generally increase immediately prior to the
Company's commencing management of a new or expanded facility as the Company
incurs start-up costs and purchases necessary equipment and supplies before
facility management revenue is realized.

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

-15-

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The discussion and analysis of financial condition and results of
operations are based upon consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States. The preparation of these financial statements require that
management make estimates and judgments that affect the reported amounts of
assets, liabilities, revenues and expenses, and related disclosures of
contingent assets and liabilities. The Company evaluates its estimates on an
on-going basis, based on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances.
Actual results may differ from these estimates under different assumptions or
conditions. The assets and liabilities and results of operations of the
synthetic lease owned by the Synthetic Lease Investor and of MCF have been
consolidated in the Company's consolidated financial statements.

The Company believes the following critical accounting policies affect its
more significant adjustments and estimates used in the preparation of its
consolidated financial statements.

The Company extends credit to the government agencies contracted with other
parties in the normal course of business. Further, the Company regularly reviews
outstanding receivables, and provides estimated losses through an allowance for
doubtful accounts. In evaluating the level of established reserves, the Company
makes judgments regarding its customers' ability to make required payments,
economic events and other factors. As the financial condition of these parties
change, circumstances develop or additional information becomes available,
adjustments to the allowance for doubtful accounts may be required.

Deferred tax assets and liabilities are recognized for the difference
between the book basis and tax basis of its net assets. In providing for
deferred taxes, the Company considers current tax regulations, estimates of
future taxable income and available tax planning strategies. If tax regulations,
operating results or the ability to implement tax planning strategies vary,
adjustments to the carrying value of deferred tax assets and liabilities may be
required.

The Company maintains insurance coverage for various aspects of its
business and operations. The Company retains a portion of losses that occur
through the use of deductibles and retention under self- insurance programs.
The Company regularly reviews the estimates of reported and unreported claims
and provides for losses through insurance reserves. As claims develop and
additional information becomes available, adjustments to loss reserves may be
required.

-16-

RESULTS OF OPERATIONS

The following table sets forth for the periods indicated the percentages of
revenue represented by certain items in the Company's historical consolidated
statements of operations:

THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001

REVENUES. Revenues increased 5.1% to $69.1 million for the three months
ended June 30, 2002 from $65.7 million for the three months ended June 30, 2001.

Adult secure institutional division revenues decreased 1.6% to $24.9
million for the three months ended June 30, 2002 from $25.3 million for the
three months ended June 30, 2001 due principally to the Company's termination
of the Santa Fe County Detention Center contract in September 2001. This
decrease was offset, in part, by an increase in revenue due to per diem rate
increases realized in 2001 and in March 2002. There were no revenues
attributable to start-up operations for the three months ended June 30, 2002
and 2001. Average occupancy was 98.9% for the three months ended June 30,
2002 compared to 97.7% for the three months ended June 30, 2001. The
Company's contracts with the California Department of Corrections, or CDC,
for the operation of the Baker Community Correctional Facility and the Leo
Chesney Community Correctional Facility were set to expire June 30, 2002, and
were not expected to be renewed by the CDC due to the lack of governmental
budget appropriations. Facility shut down procedures were implemented and
occupancy levels at both facilities significantly decreased in June 2002. At
the Baker Community Correctional Center, all clients had been removed as of
June 30, 2002. In late June 2002, the CDC informed the Company that a
contract renewal for both facilities would be granted pending final budget
appropriations and began returning previously removed state equipment to both
facilities. The CDC began referring clients to the Leo Chesney Community
Correctional Center and the Baker Community Correctional Center in July and
mid August 2002, respectively. As of August 14, 2002, the Company did not
have a signed contract with the CDC, but is operating both facilities and
expects to obtain a signed contract upon final approval of the state budget.
In accordance with the provisions of SAB 101, the Company will defer any
payments received related to the operation of these two facilities until
persuasive evidence of an arrangement exists. Revenue related to these two
facilities was $1.5 million for the three months ended June 30, 2002.

-17-

Juvenile division revenues increased 14.1% to $31.8 million for the
three months ended June 30, 2002 from $27.9 million for the three months
ended June 30, 2001 due principally to (1) the commencement of a management
contract at the Alexander Youth Center in the third quarter of 2001, (2) the
opening of the William Penn Harrisburg Alternative School in the third
quarter of 2001, (3) increased occupancy at the Cornell Abraxas Center for
Adolescent Females, or ACAF, due to a facility expansion completed early in
2001 and (4) increased occupancy at various facilities. There were no
revenues attributable to start-up operations for the three months ended June
30, 2002. Revenues attributable to start-up operations were $88,000 for the
three months ended June 30, 2001 and were related to the expansion of ACAF.
Average occupancy, excluding start-up operations in 2001, was 92.6% for the
three months ended June 30, 2002 compared to 93.5% for the three months ended
June 30, 2001. In the current year, the New Morgan Academy has experienced a
reduction in occupancy as a result of budget appropriation reductions of a
significant customer. The Company is currently seeking to obtain referrals
from other governmental agencies and management believes that occupancy will
be restored to normal operating levels by mid year 2003. A continued
occupancy level below contract capacity could have an adverse effect on the
Company's operating results.

Pre-release division revenues decreased 1.4% to $12.4 million for the three
months ended June 30, 2002 from $12.5 million for the three months ended June
30, 2001 due principally to the termination of the Durham Treatment Center
contract effective June 30, 2001. This decrease was offset, in part, by
increased average occupancy at various facilities. There were no revenues
attributable to start-up operations for the three months ended June 30, 2002 and
2001. Average occupancy was 109.5% for the three months ended June 30, 2002
compared to 99.5% for the three months ended June 30, 2001.

OPERATING EXPENSES. Operating expenses increased 4.2% to $53.5 million for
the three months ended June 30, 2002 from $51.4 million for the three months
ended June 30, 2001.

Adult secure institutional division operating expenses decreased 7.7% to
$17.6 million for the three months ended June 30, 2002 from $19.1 million for
the three months ended June 30, 2001 due principally to the Company's
termination of the Santa Fe County Detention Center contract in September
2001. This decrease was offset, in part, by an increase in operating expenses
at the Big Spring Complex due to a facility expansion completed in the first
quarter of 2001. As a percentage of revenues, adult secure institutional
division operating expenses were 70.4% for the three months ended June 30,
2002 compared to 75.4% for the three months ended June 30, 2001. The
comparable operating margin was impacted favorably due to the termination of
the lower margin Santa Fe County Detention Center contract, the expansion of
the Big Spring Complex and per diem increases.

Juvenile division operating expenses increased 14.6% to $26.3 million for
the three months ended June 30, 2002 from $23.0 million for the three months
ended June 30, 2001 due to (1) the commencement of a management contract at the
Alexander Youth Center in the third quarter of 2001, (2) the opening of the
William Penn Harrisburg Alternative School in the third quarter of 2001, (3) the
expansion of ACAF completed in early 2001 and (4) increased average occupancy at
various facilities. As a percentage of revenues, excluding start-up operations
in 2001, juvenile division operating expenses were 82.7% for the three months
ended June 30, 2002 and 2001.

Pre-release division operating expenses increased 2.3% to $9.4 million
for the three months ended June 30, 2002 from $9.2 million for the three
months ended June 30, 2001 due to increased average occupancy at various
facilities. This increase was offset, in part, by the termination of the
Durham Treatment Center contract effective June 30, 2001. As a percentage of
revenues, operating expenses were 76.2% for the three months ended June 30,
2002 compared to 73.4% for the three months ended June 30, 2001. The
operating margin was impacted unfavorably primarily due to increased employee
insurance costs in the three months ended June 30, 2002 as compared to the
same period of the prior year.

-18-

PRE-OPENING AND START-UP EXPENSES. There were no pre-opening and start-up
expenses for the three months ended June 30, 2002. Pre-opening and start-up
expenses were $280,000 for the three months ended June 30, 2001 and were
attributable to the expansion of ACAF.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization was $2.4
million for the three months ended June 30, 2002 and June 30, 2001.
Amortization decreased $162,000 for the three months ended June 30, 2002 from
the same period of the prior year due to the Company's adoption of FASB 142,
"Goodwill and Other Intangible Assets," which eliminated the amortization of
goodwill effective January 1, 2002. Depreciation increased $164,000 for the
three months ended June 30, 2002 from the same period of the prior year due
to quarterly equipment and furniture purchases.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased 47.4% to $5.3 million for the three months ended June 30, 2002 from
$3.6 million for the three months ended June 30, 2001. Included in general and
administrative expenses for the three months ended June 30, 2002 was a charge of
approximately $1.0 million related to the write-off of deferred project
financing costs associated with the FBOP Southeast Project. This contract was
not awarded to the Company and all associated costs were charged to expense.
Also included in general and administrative expenses for the three months ended
June 30, 2002 is approximately $200,000 of legal and professional fees related
to the special committee review and defense of our shareholder litigation.
Excluding these charges, general and administrative expenses increased 14.0%
from the same period of the prior year due principally to increased compensation
costs, business development costs and certain public affairs costs.

INTEREST. Interest expense, net of interest income, decreased to $4.6
million for the three months ended June 30, 2002 from $4.7 million for the three
months ended June 30, 2001 due principally to increased interest income
resulting from higher cash balances held by the Company in 2002. There was no
capitalized interest for the three months ended June 30, 2002. Capitalized
interest for the three months ended June 30, 2001 was approximately $25,000 and
related to facility expansions.

MINORITY INTEREST IN LOSSES OF CONSOLIDATED SPECIAL PURPOSE ENTITIES.
The cumulative losses of MCF exceeded the recorded minority interest of MCF
during the first quarter of 2002. The cumulative losses of the Synthetic
Lease Investor exceeded the recorded minority interest of the Synthetic Lease
Investor during the third quarter of 2001. Since the cumulative losses of MCF
and the Synthetic Lease Investor exceed the equity which was recorded as
minority interest by the Company, the excess losses can no longer be
allocated to minority interest in 2002 in the Company's Consolidated
Statement of Operations in 2002. As a result, all future excess losses will
be reflected in the Company's Consolidated Statements of Operations.

INCOME TAXES. For the three months ended June 30, 2002 and 2001, the
Company recognized a provision for income taxes at an estimated effective rate
of 41.0%.

SIX MONTHS ENDED JUNE 30, 2002 COMPARED TO SIX MONTHS ENDED JUNE 30, 2001

REVENUES. Revenues increased 8.8% to $137.6 million for the six months
ended June 30, 2002 from $126.4 million for the six months ended June 30, 2001.

Adult secure institutional division revenues decreased 0.4% to $48.9
million for the six months ended June 30, 2002 from $49.2 million for the six
months ended June 30, 2001 due principally to the Company's termination of
the Santa Fe County Detention Center contract in September 2001. This decrease
was offset, in part, by per diem rate increases realized in June 2001 and
March 2002. There were no revenues attributable to start-up operations for
the six months ended June 30, 2002 and 2001. Average occupancy was 97.7% for
the six months ended June 30, 2002 compared to 97.2% for the six months ended
June 30, 2001. The Company's

-19-

contracts with the CDC for the operation of the Baker Community Correctional
Facility and the Leo Chesney Community Correctional Facility were set to
expire June 30, 2002, and were not expected to be renewed by the CDC due to
the lack of governmental budget appropriations. Facility shut down procedures
were implemented and occupancy levels at both facilities significantly
decreased in June 2002. At the Baker Community Correctional Center, all
clients had been removed as of June 30, 2002. In late June 2002, the CDC
informed the Company that a contract renewal for both facilities would be
granted pending final budget appropriations and began returning state
equipment previously removed to both facilities. The CDC began referring
clients to the Leo Chesney Community Correctional Center and the Baker
Community Correctional Center in July and mid August 2002, respectively. As
of August 14, 2002, the Company did not have a signed contract with the CDC,
but is operating both facilities and expects to obtain a signed contract upon
final approval of the state budget. In accordance with the provisions of SAB
101, the Company will defer any payments received related to the operation of
these two facilities until persuasive evidence of an arrangement exists.
Revenue related to these two facilities was $3.0 million for the six months
ended June 30, 2002.

Juvenile division revenues increased 21.1% to $63.6 million for the six
months ended June 30, 2002 from $52.5 million for the six months ended June
30, 2001 due principally to (1) the commencement of a management contract at
the Alexander Youth Center in the third quarter of 2001, (2) the New Morgan
Academy which began operations late in the fourth quarter of 2000, (3) the
opening of the William Penn Harrisburg Alternative School in the third
quarter of 2001, (4) increased occupancy at ACAF due to a facility expansion
completed early in 2001 and (5) increased occupancy at various facilities.
There were no revenues attributable to start-up operations for the six months
ended June 30, 2002. Revenues attributable to start-up operations were $2.8
million for the six months ended June 30, 2001 and related to the operations
of the New Morgan Academy and the expansion of ACAF. Average occupancy,
excluding start-up operations in 2001, was 91.3% for the six months ended
June 30, 2002 compared to 92.0% for the six months ended June 30, 2001. In
the current year, the New Morgan Academy has experienced a reduction in
occupancy as a result budget appropriation reductions by a significant
customer. The Company is currently seeking to obtain referrals from other
governmental agencies and management believes that occupancy will be restored
to normal operating levels by mid year 2003. A continued occupancy level
below contract capacity could have an adverse effect on the Company's
operating results.

Pre-release division revenues increased 1.0% to $25.0 million for the six
months ended June 30, 2002 from $24.7 million for the six months ended June 30,
2001 due to increased average occupancy at various facilities offset by a
reduction in revenue as a result the Company's termination of the Durham
Treatment Center contract effective June 30, 2001. There were no revenues
attributable to start-up operations for the six months ended June 30, 2002 and
2001. Average occupancy was 107.7% for the six months ended June 30, 2002
compared to 97.1% for the six months ended June 30, 2001.

OPERATING EXPENSES. Operating expenses increased 9.3% to $107.3 million for
the six months ended June 30, 2002 from $98.2 million for the six months ended
June 30, 2001.

Adult secure institutional division operating expenses decreased 7.3% to
$34.8 million for the six months ended June 30, 2002 from $37.6 million for
the six months ended June 30, 2001 due principally to the Company's
termination of the Santa Fe County Detention Center contract effective
September 30, 2001 offset, in part, by an increase in operating expenses at
the Big Spring Complex due to a facility expansion completed in the first
quarter of 2001. As a percentage of revenues, adult secure institutional
division operating expenses were 71.1% for the six months ended June 30, 2002
compared to 76.4% for the six months ended June 30, 2001. The comparable
operating margin was impacted favorably due to the termination of the lower
margin Santa Fe County Detention Center contract, the expansion of the Big
Spring Complex, per diem increases and unusually high utilities as a result
of increased natural gas prices and inmate medical expenses at certain

-20-

facilities during the first quarter of 2001.

Juvenile division operating expenses increased 30.5% to $53.7 million for
the six months ended June 30, 2002 from $41.1 million for the six months ended
June 30, 2001 due principally to (1) the New Morgan Academy which began
operations late in the fourth quarter of 2000, (2) the commencement of a
management contract at the Alexander Youth Center in the third quarter of 2001,
(3) the opening of the William Penn Harrisburg Alternative School in the third
quarter of 2001, (4) increased occupancy at ACAF due to a facility expansion
completed early in 2001 and (5) increased average occupancy at various
facilities. As a percentage of revenues, excluding start-up operations in 2001,
juvenile division operating expenses were 84.4% for the six months ended June
30, 2002 compared to 82.7% for the six months ended June 30, 2001.

Pre-release division operating expenses decreased 3.9% to $18.7 million for
the six months ended June 30, 2002 from $19.4 million for the six months ended
June 30, 2001 due principally to the termination of the Durham Treatment Center
contract effective June 30, 2001. This increase was offset in part, by
fluctuations in average occupancy at various facilities. As a percentage of
revenue, pre-release division operating expenses were 74.6% for the six months
ended June 30, 2002 compared to 78.6% for the six months ended June 30, 2001.
The 2002 operating margin was impacted favorably due to the expiration of the
San Diego Center contract early in 2001 and the Durham Treatment Center contract
in June 2001. The 2002 operating margin was impacted unfavorably primarily due
to increased employee insurance costs in the six months ended June 30, 2002 as
compared to the same period of prior year.

PRE-OPENING AND START-UP EXPENSES. There were no pre-opening and start-up
expenses for the six months ended June 30, 2002. Start-up expenses were $3.9
million for the six months ended June 30, 2001 and were attributable to the
start-up activities of the New Morgan Academy and other facility expansions.

DEPRECIATION AND AMORTIZATION. Depreciation and amortization was $4.6
million for the six months ended June 30, 2002 compared to $4.5 million for the
six months ended June 30, 2001. Amortization decreased $323,000 for the six
months ended June 30, 2002 from the same period of prior year due to the
Company's adoption of FASB 142, "Goodwill and Other Intangible Assets," which
eliminated the amortization of goodwill effective January 1, 2002. Depreciation
increased $357,000 for the three months ended June 30, 2002 from the same period
of prior year due to furniture and equipment purchases in the six months
ended June 30, 2002.

GENERAL AND ADMINISTRATIVE EXPENSES. General and administrative expenses
increased 60.9% to $11.2 million for the six months ended June 30, 2002 from
$7.1 million for the six months ended June 30, 2001. General and
administrative expenses for the six months ended June 30, 2002 included
approximately $1.9 million of legal and professional fees related to the
special committee review and restatement of the Company's financial
statements and defense of our shareholder litigation. Also included in
general and administrative expenses for the six months ended June 30, 2002
was a charge of approximately $1.0 million related to the write-off of
deferred project financing costs associated with the FBOP Southeast Project.
This contract was not awarded to the Company and all associated costs were
charged to expense. Excluding these charges, general and administrative
expenses increased 19.9% from the same period of prior year due principally
to increased compensation costs, business development costs and certain
public affairs costs.

INTEREST. Interest expense, net of interest income, increased to $9.9
million for the six months ended June 30, 2002 from $9.4 million for the six
months ended June 30, 2001. For the six months ended June 30, 2002, interest
expense includes approximately $825,000 for lenders' fees and related
professional fees incurred to obtain certain waivers and amendments to the
Company's credit agreement obtained in conjunction with the restatement of the
Company's financial statements. This effect was partially offset by higher
interest income resulting from higher cash balances held by the Company in 2002.
There was no interest capitalized

-21-

for the six months ended June 30, 2002. For the six months ended June 30, 2001,
the Company capitalized interest of approximately $66,000 related to an
expansion at the Big Spring Complex.

MINORITY INTEREST IN LOSSES OF CONSOLIDATED SPECIAL PURPOSE ENTITIES. The
cumulative losses of MCF exceeded the recorded minority interest of MCF during
the first quarter of 2002. The cumulative losses of the Synthetic Lease Investor
exceeded the recorded minority interest of the Synthetic Lease Investor during
the third quarter of 2001. Since the cumulative losses of MCF and the Synthetic
Lease Investor exceed the equity which was recorded as minority interest by the
Company, the excess losses can no longer be allocated to the minority interest
in the Company's Consolidated Statement of Operations in 2002.

INCOME TAXES. For the six months ended June 30, 2002 and 2001, the
Company recognized a provision for income taxes at an estimated effective
rate of 41.0%.

CUMULATIVE EFFECT OF CHANGES IN ACCOUNTING PRINCIPLES. The Company recorded
a cumulative effect of a change in accounting principle charge of $965,000, net
of tax, in the six months ended June 30, 2002 related to the impairment of
certain goodwill that arose from an acquisition made in November 1999.

On January 1, 2001, the Company capitalized a portion of previously
expensed operating supplies and recognized a benefit of $770,000, net of
income taxes of $535,000, which has been recorded as a cumulative effect of a
change in accounting principle for the six months ended June 30, 2001.

LIQUIDITY AND CAPITAL RESOURCES

GENERAL. The Company's primary capital requirements are for (1)
construction of new facilities, (2) expansions of existing facilities, (3)
working capital, (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. The Company has also consumed working
capital in connection with the restatement of its financial statements and the
related litigation. Working capital requirements generally increase immediately
prior to the Company commencing management of a new facility as the Company
incurs start-up costs and purchases necessary equipment and supplies before
facility management revenue is realized.

2001 COMMON STOCK OFFERING. On November 30, 2001 the Company completed an
offering of its common stock. Net proceeds to the Company from the sale of the
3,450,000 newly issued shares were approximately $43.8 million. The Company used
a portion of the proceeds to repay outstanding borrowings of $39.4 million and
retired the notes under its Note and Equity Purchase Agreement (the
"Subordinated Notes") entered into in July 2000.

2001 SALE AND LEASEBACK TRANSACTION. On August 14, 2001, the Company
completed an arms' length sale and leaseback transaction involving 11 of its
real estate facilities (the "2001 Sale and Leaseback Transaction"). The Company
sold the facilities to an unaffiliated company, Municipal Corrections Finance
L.P. ("MCF"), and is leasing them back for an initial period of 20 years, with
approximately 25 years of additional renewal period options. The Company
received $173.0 million of proceeds from the sale of the facilities. The
proceeds were used to repay $120.0 million of the Company's long-term debt and
the remainder invested in short-term securities.

MCF is an unaffiliated special purpose entity ("SPE"). Under current
accounting rules, an SPE must maintain at least a 3% ownership interest
throughout the life of the lease. In September 2001, the Company entered into a
separate retainer agreement with affiliates of the equity investor in MCF ("MCF
Equity Investor"), and in November 2001, paid the related retainer fee of $3.65
million for financial advisory services related to specific separate potential
future financing projects and the strategic development of the

-22-

Company's business. The retainer will be applied on a mutually agreed upon
basis toward future contingent fees associated with investment banking
services that are expected to be provided to the Company. Under certain
accounting interpretations, this retainer has been deemed to reduce the
equity investment in MCF to below the required 3% level. As a result, the
Company has consolidated the assets, liabilities, and results of operations
of MCF in the Company's accompanying consolidated financial statements
beginning August 14, 2001. As a result of consolidating the assets and
liabilities of MCF, the Company's consolidated financial statements reflect,
among other things, the depreciation expense on the associated properties and
interest expense on the bond debt of MCF used to finance MCF's acquisition of
the 11 facilities in the 2001 Sale and Leaseback Transaction. For income tax
purposes, the Company recognizes rent expense pursuant to the terms of the
lease with MCF and does not consolidate the assets, liabilities or results of
operations of MCF.

MCF issued $197.4 million of 8.47% bonds due August 2016. The Company used
$120.0 million of the $173.0 million of proceeds received by the Company from
the sale of such facilities to repay the Company's long-term senior debt and
invested the remaining proceeds of approximately $53.0 million in short-term
securities.

The Company's consolidated financial statements include the financial
statements of MCF as of August 14, 2001 and thereafter.

On August 14, 2001, the Company repaid the $50.0 million of outstanding
7.74% Senior Secured Notes with a portion of the proceeds from the 2001 Sale and
Leaseback Transaction.

LONG-TERM CREDIT FACILITIES. The Company's amended 2000 Credit Facility
provides for borrowings of up to $45.0 million under a revolving line of
credit. The commitment amount is reduced by $1.6 million quarterly beginning
July 2002. The amended 2000 Credit Facility matures in July 2005 and bears
interest, at the election of the Company, at either the prime rate plus a
margin of 2.0%, or a rate which is 3.0% above the applicable LIBOR rate. The
amended 2000 Credit Facility is secured by substantially all of the Company's
assets, including the stock of all of the Company's subsidiaries; does not
permit the payment of cash dividends; and requires the Company to comply with
certain leverage, net worth and debt service coverage covenants. Due in part
to the consolidation of MCF as of August 14, 2001, the Company was not in
compliance with certain covenants required by the 2000 Credit Facility. On
April 5, 2002, the 2000 Credit Facility was amended to waive such
non-compliance and to revise the covenants to levels that accommodate the
Company's consolidation of special purpose entities in its Consolidated
Balance Sheets and Statements of Operations. As a result of this waiver and
amendment, the Company paid fees and recognized a pre-tax charge to interest
expense of approximately $825,000 in the first quarter of 2002. On April 11,
2002, the Company obtained a waiver from the lenders under the amended 2000
Credit Facility regarding the pending contractual default for the Moshannon
Valley Correctional Center's construction delay. The waiver is effective
through September 2002. Included in the Company's cash and cash equivalents
at June 30, 2002 is approximately $43.1 million that is invested in a
separate account. Approximately $39.1 million of the funds in this separate
account are available to the Company for investment purposes or working
capital with the approval of the lenders under the amended 2000 Credit
Facility. The remaining funds of approximately $4.0 million are available to
the Company without lender approval. This separate account is maintained, in
part, to assure future credit availability.

Additionally, the amended 2000 Credit Facility provides the Company with
the ability to enter into lease financing arrangements for the acquisition or
development of operating facilities. This lease financing arrangement provides
for funding to the lessor under the leases of up to $100.0 million, of which
approximately $50.0 million had been utilized as of June 30, 2002. The Company
expects to utilize the remaining capacity under this lease financing arrangement
to complete construction of the Moshannon Valley

-23-

Correctional Center. The Company pays commitment fees at a rate of 0.5% annually
for the unused portion of the lease financing capacity.

The Company's lease financing arrangement under its 2000 Credit Facility is
a "synthetic lease". A synthetic lease is a form of lease financing that
qualifies for operating lease accounting treatment and, when all criteria
pursuant to generally accepted accounting principles (GAAP) are met, is
accounted for "off- balance sheet". Under such a structure, the owner/lessor of
the properties ("Synthetic Lease Investor") may be considered a virtual SPE when
it obtains debt and equity capital to finance the project(s) and leases the
projects to a company. This financial structure was used to finance the
construction of the New Morgan Academy completed in the first quarter of 2001,
the acquisition of the Taylor Street Center building in early 1999, and the
construction-to-date of the incomplete Moshannon Valley Correctional Center
which is still in process. The synthetic lease used to finance the above
projects was originally entered into in December 1998 and was amended in July
2000 whereby the available financing was increased from $40 million to $100
million and the lease term extended to July 2005.

Under current accounting rules, the Synthetic Lease Investor in a virtual
SPE must maintain at least a 3% equity ownership interest in the property
throughout the life of the lease. The Company's synthetic lease documents, as
amended in July 2000, provide for the equity investor to fund 3.5% of project
costs. There are provisions in the lease and related credit documents for the
lenders and Synthetic Lease Investor to fund and be paid interest, yield and
fees. Under current GAAP rules, the payment of any yield and fees to the
investors is required to be treated as a return of capital rather than a return
on capital.

The Synthetic Lease Investor for the above projects received payments to
assist as co- arranger in the structure of the initial $40 million synthetic
lease facility in 1998 and in July 2000 when the synthetic lease facility was
increased to $100 million. Although the Company does not believe the lessor
is a special purpose entity, the lessor could be considered as a virtual
special purpose entity under certain accounting interpretations. Therefore,
these payments could be interpreted to reduce the Synthetic Lease Investor's
equity ownership in the leased projects below the required 3% level as of the
second quarter of 2000. Pursuant to this interpretation, these synthetic
leases would no longer qualify for off-balance sheet treatment beginning in
the second quarter of 2000. Accordingly, the assets and liabilities and
results of operations of the synthetic lease owned by the Synthetic Lease
Investor are consolidated in the Company's financial statements beginning in
the second quarter of 2000.

As a result of consolidating the synthetic lease assets and liabilities,
the Company's accompanying consolidated financial statements reflect the
depreciation expense on the associated properties and interest expense related
to the Synthetic Lease Investor's debt, instead of rent expense.

The Synthetic Lease Investor's Note A and Note B have total credit
commitments of $81.4 million and $15.1 million, respectively. The Synthetic
Lease Investor's Notes A and B are cross collateralized with the Company's
revolving line of credit and contain cross default provisions.

NEW FACILITIES AND PROJECT UNDER DEVELOPMENT. The New Morgan Academy was
completed and became operational in two phases during the fourth quarter of 2000
and the first quarter of 2001.

In April 1999, the Company was awarded a contract to design, build and
operate a 1,095 bed prison for the FBOP in Moshannon Valley, Pennsylvania (the
"Moshannon Valley Correctional Center"). Construction and activation activities
commenced immediately. In June 1999, the FBOP issued a Stop-Work Order pending a
re-evaluation of their environmental documentation supporting the decision to
award the contract. The environmental study was completed with a finding of no
significant impact and the Stop-Work Order was lifted by the FBOP on August 9,
2001.

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In September 1999, the Company received correspondence from the Office
of the Attorney General of the Commonwealth of Pennsylvania indicating its
belief that the operation of a private prison in Pennsylvania is unlawful.
The Company and the FBOP have had, and continue to have, discussions with the
Attorney General's staff regarding these and related issues. Management
anticipates that these discussions will be resolved in the near-term. As a
result of these issues, the Company has not recommenced construction efforts.
As of June 30, 2002, the Company had incurred approximately $15.4 million for
construction and land development costs and capitalized interest for the
Moshannon Valley Correctional Center. According to the FBOP contract, as
amended, the Company must have completed the construction of the project by
August 15, 2002. The Company will have not completed construction within that
time frame. The Company anticipates obtaining another contract amendment from
the FBOP extending the construction deadline. If the Company is not able to
negotiate a contract amendment with the FBOP, then the FBOP may have the
right to assert that the Company has not completed construction of the
project within the time frames provided in the FBOP contract, as amended. In
the event that the FBOP desires to continue with the Moshannon Valley
Correctional Center, management expects that the contract will be amended to
address cost and construction timing matters resulting from the extended
delay. In the event that the FBOP decides not to continue with the Moshannon
project and terminates the contract, management believes that the Company has
the right to recover its invested costs of approximately $15.4 million. In
the event any portion of these costs are determined not to be reimbursed upon
contract termination, such costs would be expensed, net of any amounts that
could be recovered from the litigation of the related assets.

At June 30, 2002, accounts receivable include costs totaling $1.4 million
for direct costs incurred by the Company since the issuance of the Stop-Work
Order in June 1999 for payroll and other operating costs related to the
Moshannon Valley Correctional Center. These costs were incurred with the
understanding that such costs would be reimbursed. Although no formal written
agreement exists, management believes that these costs will be reimbursed by the
FBOP in the near term. In the event any portion of these costs is determined not
to be reimbursable, such costs will be expensed.

Development and construction costs for the New Morgan Academy and the
Moshannon Valley Correctional Center have been financed with the Company's
synthetic lease financing arrangement discussed under "Long-Term Credit
Facilities".

CAPITAL EXPENDITURES. Capital expenditures for the three months ended June
30, 2002 were $5.0 million and related principally to various facility
improvements and/or expansions, information technology and software development.

TREASURY STOCK/REPURCHASES. The Company repurchased in the open market
44,500 shares of the Company's common stock for approximately $455,000 in the
six months ended June 30, 2002.

FUTURE LIQUIDITY. Management believes that the Company's existing cash and
cash equivalents and cash flows generated from operations, together with the
revolving credit available under the amended 2000 Credit Facility and the lease
financing capacity thereunder, will provide sufficient liquidity to meet the
Company's committed capital and working capital requirements for currently
awarded and certain potential future contracts. To the extent the Company's cash
and current financing arrangements do not provide sufficient financing to fund
construction costs related to future adult secure institutional contract awards
or significant facility expansions, the Company anticipates obtaining additional
sources of financing to fund such activities. However, there can be no assurance
that such financing will be available, or will be available on terms favorable
to the Company.

CONTRACTUAL OBLIGATIONS AND COMMERCIAL COMMITMENTS. The Company has assumed
various financial obligations and commitments in the ordinary course of
conducting its business. The Company has contractual obligations requiring
future cash payments under its existing contractual arrangements, such as
management, consultative and non-competition agreements.

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The Company maintains operating leases in the ordinary course of its
business activities. These leases include those for operating facilities, office
space and office and operating equipment, and the terms of the agreements vary
from 2002 until 2075. As of June 30, 2002, the Company's total commitment under
operating leases were approximately $33.6 million.

The following table details the Company's known future cash payments (on an
undiscounted basis) related to various contractual obligations as of June 30,
2002 (in thousands):

The Company enters into letters of credit in the ordinary course of
operating and financing activities. As of June 30, 2002, the Company had
outstanding letters of credit of $1.2 million related to insurance and other
operating activities. The following table details the Company's letter of credit
commitments as of June 30, 2002 (in thousands):

INFLATION

Other than personnel and inmate medical costs at certain facilities during
2001, management believes that inflation has not had a material effect on the
Company's results of operations during the past three years. Most of the
Company's facility management contracts provide for payments to the Company of
either fixed per diem fees or per diem fees that increase by only small amounts
during the term of the contracts. Inflation could substantially increase the
Company's personnel costs (the largest component of operating expenses) or other
operating expenses at rates faster than any increases in contract revenues.

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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

In the normal course of business, the Company is exposed to market risk,
primarily from changes in interest rates. The Company continually monitors
exposure to market risk and develops appropriate strategies to manage this risk.
The Company is not exposed to any other significant market risks, including
commodity price risk, foreign currency exchange risk or interest rate risks from
the use of derivative financial instruments. The Company has entered into a cash
flow hedge derivative instrument as described in Note 6 to the Consolidated
Financial Statements. The Company has no cash flow or operating results exposure
due to the changes in the fair value of this derivative instrument. The Company
has no other derivative financial instruments it uses for trading or to
speculate on changes in interest rates or commodity prices.

INTEREST RATE EXPOSURE

The Company's exposure to changes in interest rates primarily results from
its long-term debt with both fixed and floating interest rates. The debt on the
Company's consolidated financial statements with fixed interest rates consists
of the 8.47% Bonds issued by MCF in August 2001 in connection with the 2001 Sale
and Leaseback Transaction. At June 30, 2002, approximately 19.8% ($48.7 million
of debt outstanding to the Synthetic Lease Investor) of the Company's
consolidated long-term debt was subject to variable interest rates. The
detrimental effect of a hypothetical 100 basis point increase in interest rates
would be to reduce income before provision for income taxes by approximately
$135,000 for the six months ended June 30, 2002. At June 30, 2002, the fair
value of the Company's consolidated fixed rate debt approximated carrying value
based upon discounted future cash flows using current market prices.

FORWARD LOOKING STATEMENT DISCLAIMER

This quarterly report on Form 10-Q contains forward-looking statements
within the meaning of the Private Securities Litigation Reform Act of 1995.
These statements are based on current plans and actual future activities and
results of operations may be materially different from those set forth in the
forward- looking statements. Important factors that could cause actual
results to differ include, among others, (1) the outcomes of pending putative
class action shareholder and derivative lawsuits and insurance recoveries for
related costs incurred, (2) changes in governmental policy or funding
decisions to eliminate or discourage the privatization or use of privatized
correctional, detention and pre-release services in the United States, (3)
the impact of the restatement of our financial statements on current,
anticipated or future Company awards, agreements, projects and financing
arrangements, (4) the timing and costs of expansions of existing facilities,
(5) fluctuations in operating results because of occupancy, competition
(including competition from two competitors that are substantially larger
than the Company), increases in cost of operations, fluctuations in interest
rates and risks of operations, (6) availability of debt and equity financing
on terms that are favorable to the Company, (7) risks associated with
acquisitions and the integration thereof (including the ability to achieve
administrative and operating cost savings and anticipated synergies), (8)
governmental approval of reimbursement to the Company for incurred costs on
the Moshannon Valley Correctional Center, the renewal of the Baker Community
Correctional Center and Leo Chesney Community Center contracts, as well as
other renewable contracts in the future and (9) significant charges to
expense of deferred costs associated with financing and other projects in
development if management determines that one or more of such projects is
unlikely to be successfully concluded.

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PART II OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

In March and April 2002, the Company, Steven W. Logan, and John L. Hendrix,
have been named as defendants in four Federal putative class action lawsuits
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 for the Southern District of Texas, Houston
Division; (2) RICHARD PICARD, ON BEHALF OF HIMSELF AND ALL OTHERS SIMILARLY
SITUATED V. CORNELL COMPANIES, INC., ET AL., No. H-02-1075, in the United States
District Court for the Southern District of Texas, 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 for
the Southern District of Texas, Houston Division, and (4) ANTHONY J. SCOLARO, ON
BEHALF OF HIMSELF AND ALL OTHERS SIMILARLY SITUATED V. CORNELL COMPANIES, INC.,
ET AL., No. H-02-1567, in the United States District Court for the Southern
District of Texas, Houston Division. The aforementioned lawsuits are putative
class action lawsuits brought on behalf of all purchasers of the Company's
common stock between March 6, 2001 and March 5, 2002. The lawsuits involve
disclosures made concerning two prior transactions executed by the Company: the
August 2001 sale leaseback transaction and the 2000 synthetic lease transaction.
These four lawsuits have all been consolidated into the GRAYDON WILLIAMS action
and a motion for the appointment of lead plaintiff is pending. The plaintiffs in
these actions allege that the defendants violated Section 10(b) of the
Securities Exchange Act of 1934 (the "Exchange Act"), Rule 10b-5 promulgated
under Section 10(b) of the Exchange Act, and/or Section 20(a) of the Exchange
Act. The Company believes that it has good defenses to each of the plaintiffs'
claims and intends to vigorously defend against each of the claims.

In March 2002, the Company, its directors, and its former independent
auditor Arthur Andersen LLP, were sued in a derivative action styled as WILLIAM
WILLIAMS, DERIVATIVELY AND ON BEHALF OF NOMINAL DEFENDANT CORNELL COMPANIES,
INC. V. ANTHONY R. CHASE, ET AL., No. 2002-15614, in the 127th Judicial District
Court of Harris County, Texas. The lawsuit alleges breaches of fiduciary duty by
all of the individual defendants and asserts breach of contract and professional
negligence claims only against Arthur Andersen LLP. The Company believes that it
has good defenses to each of the plaintiff's claims and intends to vigorously
defend against each of the claims.

In May and June 2002, the Company and its directors were sued in three
other derivative lawsuits styled as follows: (1) JUAN GUITIERREZ, DERIVATIVELY
ON BEHALF OF CORNELL COMPANIES, INC. V. STEVEN W. LOGAN, ET. AL., No. H-02-1812,
in the United Stated District Court for the Southern District of Texas, Houston
Division; (2) THOMAS PAGANO, DERIVATIVELY ON BEHALF OF CORNELL COMPANIES, INC.
V. STEVEN W. LOGAN, ET. AL., No. H-02- 1896, in the United Stated District Court
for the Southern District of Texas, Houston Division; 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 all allege breaches of fiduciary duty and waste of corporate
assets by all of the defendants. A motion to dismiss the GUITIERREZ and PAGANO
lawsuits has been filed and is currently pending. The Company believes that it
has good defenses to each of the plaintiffs' claims and intend to vigorously
defend against each of these claims.

While the plaintiffs in these cases have not quantified their claim of
damages and the outcome of the matters discussed above cannot be predicted with
certainty, based on information known to date and review of applicable
insurance coverage, management believes that the ultimate resolution of these
matters will not have a material adverse effect on the Company's financial
position, operating results or cash flow.

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The Company currently and from time to time is subject to claims and suits
arising in the ordinary course of business, including claims for damages for
personal injuries or for wrongful restriction of, or interference with, offender
privileges and employment matters.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On June 13, 2002, the Company held its 2002 Annual Meeting of Stockholders.
The matters voted on at the meeting and the results thereof are as follows:

Stockholders elected the persons listed below as directors whose terms
expire at the 2003 Annual Meeting of Stockholders. Results by nominee were:

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a. Exhibits

11.1 Computation of Per Share Earnings
99.1 Certification of Chief Executive Officer
99.2 Certification of Chief Financial Officer

b. Reports on Form 8-K

The Company filed a Current Report on Form 8-K dated May 30, 2002
reporting a change in the Company's independent auditors.

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SIGNATURES

Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the Registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.

CORNELL COMPANIES, INC.

Date: August 14, 2002 By: /s/ Harry J. Phillips, Jr.
-----------------------------------
HARRY J. PHILLIPS, JR.
Executive Chairman, Chairman of the
Board and Director
(Principal Executive Officer)

Date: August 14, 2002 By: /s/ John L. Hendrix
-----------------------------------
JOHN L. HENDRIX
Senior Vice President and
Chief Financial Officer
(Principal Financial Officer)

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