CORNELL COMPANIES INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

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

For the Quarterly Period Ended June 30, 2003

OR

o	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
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)

1700 West Loop South, Suite 1500, Houston, Texas		77027
(Address of Principal Executive Offices)		(Zip Code)

Registrant’s telephone number, including area code:		(713) 623-0790

Indicate by a check mark whether Registrant (1) has filed all reports required to be filed by Sections 13 or 15(d) of 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 ý No o

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

Yes ý No o

At July 31, 2003 Registrant had outstanding 13,325,432 shares of its Common Stock.

PART I FINANCIAL INFORMATION

ITEM 1. Financial Statements

CORNELL COMPANIES, INC.

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share data)

	June 30, 2003			December 31, 2002
ASSETS
CURRENT ASSETS:
Cash and cash equivalents	$	51,541		$	52,610
Accounts receivable, net	56,487			60,035
Deferred tax asset	3,300			3,300
Prepaids and other	6,249			5,528
Other restricted assets	20,271			14,767
Total current assets	137,848			136,240
PROPERTY AND EQUIPMENT, net	257,120			255,450
OTHER ASSETS:
Debt service reserve fund	24,163			24,157
Intangible assets, net	12,683			13,062
Deferred costs and other	12,174			12,382
Total assets	$	443,988		$	441,291

LIABILITIES AND STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable and accrued liabilities	$	29,160		$	32,622
Current portion of long-term debt	7,623			7,630
Total current liabilities	36,783			40,252
LONG-TERM DEBT, net of current portion	232,894			232,258
DEFERRED TAX LIABILITIES	5,824			4,954
OTHER LONG-TERM LIABILITIES	1,241			3,875

Total liabilities	276,742			281,339

COMMITMENTS AND CONTINGENCIES

STOCKHOLDERS’ EQUITY:
Preferred stock, $.001 par value, 10,000,000 shares authorized, none outstanding	—			—
Common stock, $.001 par value, 30,000,000 shares authorized, 14,514,522 and 14,201,038 shares issued and outstanding, respectively	14			14
Additional paid-in capital	142,746			140,085
Notes from shareholders	(432		)	(442		)
Retained earnings	34,383			30,248
Treasury stock (1,490,938 and 1,429,586 shares of common stock, respectively, at cost)	(11,776		)	(11,038		)
Deferred compensation	(1,015		)	(811		)
Other comprehensive income	3,326			1,896
Total stockholders’ equity	167,246			159,952
Total liabilities and stockholders’ equity	$	443,988		$	441,291

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

CORNELL COMPANIES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME

(Unaudited)

(in thousands, except per share data)

	Three Months Ended June 30,						Six Months Ended June 30,
	2003			2002			2003			2002

REVENUES	$	67,586		$	69,077		$	133,612		$	137,552
OPERATING EXPENSES	51,758			53,511			103,452			107,317
PRE-OPENING AND START-UP EXPENSES	306			—			393			—
DEPRECIATION AND AMORTIZATION	2,604			2,374			5,173			4,580
GENERAL AND ADMINISTRATIVE EXPENSES	4,722			5,304			8,620			11,391

INCOME FROM OPERATIONS	8,196			7,888			15,974			14,264
INTEREST EXPENSE	4,946			5,000			9,793			10,795
INTEREST INCOME	(440		)	(387		)	(825		)	(915		)
MINORITY INTEREST IN LOSSES OF CONSOLIDATED SPECIAL PURPOSE ENTITIES	—			—			—			(40		)

INCOME BEFORE PROVISION FOR INCOME TAXES AND CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE	3,690			3,275			7,006			4,424
PROVISION FOR INCOME TAXES	1,513			1,301			2,873			1,813

INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE	2,177			1,974			4,133			2,611

CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING PRINCIPLE, NET OF RELATED INCOME TAX BENEFIT OF $671 IN 2002	—			—			—			(965		)

NET INCOME	$	2,177		$	1,974		$	4,133		$	1,646

EARNINGS PER SHARE:
BASIC
Income before cumulative effect of change in accounting principle	$	.17		$	.15		$	.32		$	.20
Cumulative effect of change in accounting principle	—			—			—			(.07		)
Net income	$	.17		$	.15		$	.32		$	.13

DILUTED
Income before cumulative effect of change in accounting principle	$	.17		$	.15		$	.32		$	.19
Cumulative effect of change in accounting principle	—			—			—			(.07		)
Net income	$	.17		$	.15		$	.32		$	.12

NUMBER OF SHARES USED IN PER SHARE COMPUTATION:
BASIC	12,854			13,004			12,817			12,978
DILUTED	13,173			13,307			13,055			13,406

Comprehensive income:
Net income	$	2,177		$	1,974		$	4,133		$	1,646
Unrealized gain on derivative instruments	981			200			1,430			200
Comprehensive income	$	3,158		$	2,174		$	5,563		$	1,846

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

CORNELL COMPANIES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

	Six Months Ended June 30,
	2003			2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income	$	4,133		$	1,646
Adjustments to reconcile net income to net cash provided by operating activities –
Cumulative effect of change in accounting principle	—			965
Minority interest in losses of consolidated special purpose entities	—			(40		)
Depreciation	4,734			4,141
Amortization of intangibles and other assets	439			439
Amortization of deferred compensation	290			40
Amortization of deferred financing costs	578			529
Provision for bad debts	1,224			322
Loss on sale of property and equipment	46			—
Deferred income taxes	870			(672		)
Change in assets and liabilities:
Accounts receivable	2,324			1,630
Restricted assets	47			(236		)
Other assets	(1,140		)	(161		)
Accounts payable and accrued liabilities	(3,462		)	(5,622		)
Deferred revenues and other liabilities	(1,238		)	(804		)
Net cash provided by operating activities	8,845			2,177

CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures	(6,447		)	(5,018		)
Escrow deposit on non-compete agreement	(1,000		)	—
Return of restricted assets from deferred bonus plan	—			1,000
Payments to restricted debt payment account, net	(4,557		)	(5,087		)
Purchases of marketable securities, net	—			(98		)
Net cash used in investing activities	(12,004		)	(9,203		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt	641			542
Payments of capital lease obligations	(14		)	(72		)
Proceeds from exercise of stock options and warrants	2,054			466
Purchases of treasury stock	(591		)	(443		)
Net cash provided by financing activities	2,090			493

NET DECREASE IN CASH AND CASH EQUIVALENTS	(1,069		)	(6,533		)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD	52,610			53,244
CASH AND CASH EQUIVALENTS AT END OF PERIOD	$	51,541		$	46,711

OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:
Purchases of treasury stock by deferred bonus plan	146			249
Other comprehensive income	1,430			200
Borrowings under capital leases	3			—

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

CORNELL COMPANIES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

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 in the United States (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, 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 2002 Annual Report on Form 10-K/A as filed with the Securities and Exchange Commission.

2. Accounting Policies

See a description of the Company’s accounting policies in the Company’s 2002 Annual Report on Form 10-K/A.

The Company accounts for its stock-based compensation plans in accordance with Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”). In accordance with the provisions of APB No. 25, stock-based employee compensation cost is not reflected in net income, as all options granted under those plans had an exercise price equal to or in excess of the market value of the underlying common stock on the date of grant. The following table illustrates, in accordance with Statement of Financial Accounting Standard (“SFAS”) No. 148, the effect of net income and earnings per share as if the Company had applied the fair value recognition provisions of SFAS No. 123, “Accounting for Stock-Based Compensation,” to stock-based employee compensation (in thousands, expect per share amounts):

	Three Months Ended June 30,						Six Months Ended June 30,
	2003			2002			2003			2002

Net income, as reported	$	2,177		$	1,974		$	4,133		$	1,646
Add: stock based employee compensation expense, net of related tax effect	—			—			—			—
Less: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects	(345		)	(530		)	(880		)	(799		)
Pro forma net income	$	1,832		$	1,444		$	3,253		$	847
Earnings per share:
Basic, as reported	$	.17		$	.15		$	.32		$	.13
Basic, pro forma	.14			.11			.25			.07
Diluted, as reported	.17			.15			.32			.12
Diluted, pro forma	.14			.11			.25			.06

New Accounting Pronouncements

The Company implemented SFAS No. 143, SFAS No. 146 and SFAS No. 148 and FIN 45 in the six months ended June 30, 2003 with no impact on the Company’s reported financial position or results of operations.

In April 2002, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, 64, Amendment of FASB Statement No. 13, and Technical Corrections”, effective for fiscal years beginning after May 15, 2002. SFAS No. 145 rescinds FASB Statement No. 4, 44, 64 and amends SFAS No. 13, “Accounting for Leases,” to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Additionally, SFAS No. 145 requires that gains and losses on the extinguishment of debt be classified as income or loss from continuing operations rather than as extraordinary items as previously required under SFAS No. 4. The Company adopted SFAS No. 145 as required on January 1, 2003 and will affect the classification of the extraordinary losses previously reported in the third and fourth quarter of 2001.

In January 2003, the FASB issued Interpretation No. 46, “Consolidation of Variable Interest Entities” (“FIN 46”), which addresses the consolidation of variable interest entities as defined in the Interpretation. FIN 46 requires an assessment of equity investments to determine if they are variable interest entities. FIN 46 is effective immediately for all variable interest entities created after January 31, 2003. For variable interest entities created before February 1, 2003, the provisions of FIN 46 must be applied no later than the beginning of the first interim period or annual reporting period beginning after June 15, 2003. In addition, if it is reasonably possible that an enterprise will consolidate or disclose information about a variable interest entity, the enterprise must discuss the following information in all financial statements issued after January 31, 2003: (1) the nature, purpose, size or activities of the variable interest entity and (2) the enterprise’s maximum exposure to loss as a result of its involvement with the variable interest entity. The Company’s adoption of FIN 46 does not change the Company’s accounting for the 2000 synthetic lease transaction and the 2001 Sale and Leaseback Transaction, which are consolidated for reporting purposes. The Company may enter into future arrangements for the development of new facilities or to operate facilities which may become subject to the provisions of FIN 46 and, in some cases, may be required to consolidate the related activities, facilities and financings.

In April 2003 the FASB issued SFAS No. 149, “Amendment of SFAS No. 133 on Derivative Instruments and Hedging Activities” (SFAS No. 149). SFAS No. 149 amends and clarifies the accounting for derivative instruments, including certain derivative instruments embedded in other contracts, and for hedging activities under SFAS No. 133. SFAS No. 149 is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003, and should be applied prospectively. The provisions of SFAS No. 149 that relate to SFAS No. 133 implementation issues that have been effective for fiscal quarters that began prior to June 15, 2003 should continue to be applied in accordance with their respective effective dates. The Company does not expect the adoption of SFAS No. 149 to have a material effect on the Company’s financial position or results of operations.

In May 2003 the FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.” SFAS No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity in its statements of financial position. SFAS No. 150 is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 and must be applied prospectively by reporting the cumulative effect of a change in an accounting principle for financial instruments created before the issuance date of the statement and still existing at the beginning of the interim period of adoption. The Company does not expect SFAS No. 150 to have a material effect on its results of operations or financial position.

after the beginning of the first interim period beginning after May 28, 2003. The Company adopted the provisions of EITF 01-8 as of July 1, 2003 and is currently determining the impact of EITF 01-8 on the Company’s consolidated financial statements.

3. Change in Accounting Principle

In June 2001, the FASB issued 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 under these statements require that the purchase method of accounting be used for all business combinations initiated after June 30, 2001 and 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 annually. Other intangible assets that meet the new criteria under the new rules will continue to be amortized over their remaining useful lives. The Company adopted SFAS No. 141 and SFAS No. 142 as of January 1, 2002 and recorded a cumulative effect of change in accounting principle charge of $965,000, net of tax, related to the impairment of goodwill for an acquisition made in November 1999.

4. Other Intangible Assets

Other intangible assets at June 30, 2003 and December 31, 2002 consisted of the following (in thousands):

	June 30, 2003			December 31, 2002

Non-compete agreements	$	8,360		$	8,300
Accumulated amortization	(3,398		)	(2,959		)
Other intangibles, net	$	4,962		$	5,341

Amortization expense for non-compete agreements was approximately $220,000 and $440,000 for the three and six months ended June 30, 2003 and 2002. Amortization expense for non-compete agreements is expected to be approximately $878,000 for each of the fiscal years ended December 31 for the next five years.

5. Credit Facilities

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

	June 30, 2003			December 31, 2002

Debt of Cornell Companies, Inc.:
Capital lease obligations	$	25		$	37
Subtotal	25			37

Debt of Consolidated Special Purpose Entities:
Synthetic Lease Investor Note A due July 2005 with an interest rate of LIBOR plus 3.25%	41,662			41,117
Synthetic Lease Investor Note B due July 2005 with an interest rate of LIBOR plus 3.50%	8,230			8,134
MCF 8.47% Bonds due 2016	190,600			190,600
Subtotal	240,492			239,851

Consolidated total debt	$	240,517		$	239,888

Less: current maturities	(7,623		)	(7,630		)

Consolidated long-term debt	$	232,894		$	232,258

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 and by outstanding letters of credit. The Company had outstanding letters of credit of approximately $5.1 million at June 30, 2003. Accordingly, as of June 30, 2003, the Company had $33.5 million of available commitment under its revolving line of credit. 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. Additionally, the Company is limited to $2.5 million annually for the repurchase of its common stock with an aggregate limit of $7.5 million. 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. Additionally, the Company has 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 (see Note 6). This waiver is effective through October 31, 2004. Included in the Company’s cash and cash equivalents at June 30, 2003 is approximately $39.6 million that is invested in a separate account that is available to the Company for investment purposes or working capital with the approval of the lenders under the amended 2000 Credit Facility. The lenders could limit the Company’s ability to use such funds. 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

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 $51.7 million had been utilized as of June 30, 2003. The Company expects to utilize the remaining capacity under this synthetic lease financing arrangement for 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 the provisions of FIN 46, utilization of this synthetic lease financing arrangement to complete the construction of the Moshannon Valley Correctional Center will result in the continued consolidation of the facility and the related financing in the Company’s financial statements.

6. New Facilities and Projects Under Development

The Company closed the New Morgan Academy in the fourth quarter of 2002 and is currently considering several options ranging from the sale or lease of the facility to utilization of the facility for another type of program. The Company is using a small staff to maintain the facility while the Company considers its options for the use or sale or lease of the facility.

The carrying value of the property and equipment at the New Morgan Academy was approximately $30.9 million at June 30, 2003. Currently, management of the Company believes that its long-lived assets at the New Morgan Academy are recoverable either from the cash flows of an alternative program operating at the facility or upon the sale or lease of the facility to a third party, and accordingly, pursuant to the provisions of SFAS No. 144, an impairment provision is not deemed necessary as of June 30, 2003. However, management estimates that, were the Company to sell the facility, it is reasonably possible that the Company may not be able to fully recover the carrying value of its long-lived assets for this facility.

In January 2003, the Company executed a lease for the Bernalillo County Jail in Albuquerque, New Mexico. The facility, which has been vacated by the County in favor of a new jail, is expected to be remodeled by the Company and used to provide adult secure confinement for a wide array of government agencies that have demonstrated a need for additional bed space. The facility added approximately 1,000 beds to the Company’s current service capacity. The lease must be approved by the State Attorney General and requires monthly rental payments of approximately $80,000 to $100,000 over the five year lease term.

In May 2003, the Company acquired a building in San Antonio, Texas for approximately $2.1 million in cash. The Company is currently renovating this 121 bed residential juvenile facility called the Texas Adolescent Center and expects it to become operational in the fourth quarter of 2003.

In June 2003, the Company entered into an agreement with a developer to purchase a 160 bed residential treatment center for juveniles upon completion of construction of the facility by the developer. This facility is named the Southern Peaks Regional Treatment Center and is located near Canon City, Colorado. Under the development agreement, the Company is obligated to fund into an escrow account the purchase price of the real property of approximately $13.0 million by August 15, 2003.

In March 2003, the Company reached an agreement with the Commonwealth of Pennsylvania that resolved all outstanding administrative issues relative to the contract awarded to the Company by the Federal Bureau of Prisons (“BOP”) to operate the Moshannon Valley Correctional Center. If the Company is able to negotiate an amendment to the contract with the BOP, this agreement will allow the Company to move forward with the construction and operation of the facility, subject to re-approval of the project by the lenders under the Company’s amended 2000 Credit Facility, and agreement by such lenders to amend certain financial covenants and provisions of the 2000 Credit Facility.

As of June 30, 2003, the Company had incurred approximately $16.8 million for construction and land development costs and capitalized interest related to the Moshannon Valley Correctional Center. According to the BOP contract, as amended, the Company is required to complete the construction of the project by October 15, 2003. The Company does not anticipate completing construction by that date and anticipates obtaining another long-term contract amendment from the BOP extending the construction deadline. In the event the Company is not able to negotiate a contract amendment with the BOP, then the BOP may have the right to assert that the Company has not completed construction of the facility within the time frame provided in the BOP contract, as amended. 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 BOP decides not to continue with the construction of the Moshannon Valley Correctional Center and terminates the contract, management believes that the Company has the right to and will recover its invested costs. In the event any portion of these costs are determined not to be recoverable upon contract termination by the BOP, such costs would be expensed. Management currently believes that the invested costs would be fully recoverable in the event of this contract being terminated.

At June 30, 2003, accounts receivable include costs totaling approximately $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 by the BOP. Although no formal written agreement exists, management believes that these costs will be reimbursed by the BOP in the near term. In the event any portion of these costs are determined not to be reimbursable, such costs will be expensed in the period such determination is made.

7. 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 three months ended June 30, 2003 and 2002, there were 360,489 shares ($14.16 average price) and 279,880 shares ($15.23 average price), respectively, of stock options that were not included in the computation of diluted EPS because to do so would have been anti-dilutive. For the six months ended June 30, 2003 and 2002 there were 633,946 shares ($12.38 average price) and 533,663 shares ($10.36 average price), respectively, of stock options that were not included in the computation of diluted EPS because to do so would have been anti-dilutive.

8. Commitments and Contingencies

Litigation

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. Flyline Partners, LP has been appointed as the lead plaintiff and has filed a consolidated complaint. The consolidated complaint alleges 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, Section 20(a) of the Exchange Act and Section 11 of the Securities Act of 1933. The consolidated complaint seeks, among other things, restitution damages, compensatory damages, rescission or a rescissory measure of damages, costs, expenses, attorneys’ fees and expert fees. A motion to dismiss is currently pending. The Company believes that it has good defenses to each of the plaintiffs’ claims and intends to vigorously defend against each of these 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 127^th 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 these 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 164^th 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 was filed. The court dismissed the Pagano action as duplicative of the Guitierrez action. The motion to dismiss the Guitierrez action is still pending. A motion to dismiss the Menning action is also 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, 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.

Additionally, 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. The outcome of such matters cannot be predicated with certainty, based on the information known to date, 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.

9. Segment Disclosure

The Company’s three operating divisions are its reportable segments. The adult secure institutional segment consists of the operation of secure adult incarceration facilities. The juvenile segment consists of providing residential treatment and educational programs and non-residential community-based programs to juveniles between the ages of ten and 17 who have either been adjudicated or suffer from behavioral problems. The pre-release segment consists of providing pre-release and halfway house programs for adult offenders who are either on probation or serving the last three to six months of their sentences on parole and

preparing for re-entry into society at large as well as community-based treatment and education programs as an alternative to incarceration. All of the Company’s customers and long-lived assets are located in the United States of America. 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. 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, certain accounts receivable, deposits, property and equipment, deferred taxes, deferred costs and other assets.

The only significant non-cash item reported in the respective segment’s income or loss from operations is depreciation and amortization.

	Three Months Ended June 30,						Six Months Ended June 30,
	2003			2002			2003			2002

Revenues
Adult secure institutional	$	25,593		$	24,937		$	50,656		$	48,945
Juvenile	29,463			31,786			58,029			63,596
Pre-release	12,530			12,354			24,927			25,011
Total revenues	$	67,586		$	69,077		$	133,612		$	137,552

Pre-opening and start-up expenses
Adult secure institutional	$	62		$	—		$	149		$	—
Juvenile	244			—			244			—
Pre-release	—			—			—			—
	$	306		$	—		$	393		$	—
Income from operations
Adult secure institutional	$	6,600		$	6,422		$	13,276		$	12,412
Juvenile	3,917			4,873			7,001			8,824
Pre-release	2,599			2,610			5,060			5,739
General and administrative expense	(4,722		)	(5,304		)	(8,620		)	(11,391		)
Incentive bonuses	—			—			—			(197		)
Amortization of intangibles	(220		)	(218		)	(439		)	(439		)
Corporate and other	22			(495		)	(304		)	(684		)
Total income from operations	$	8,196		$	7,888		$	15,974		$	14,264

	June 30, 2003		December 31, 2002
Assets
Adult secure institutional	$	154,208	$	156,315
Juvenile	97,296		96,239
Pre-release	56,616		58,071
Intangible assets, net	12,683		13,062
Corporate and other	123,185		117,604
Total assets	$	443,988	$	441,291

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, 2003, the Company was developing or had contracts to operate 70 facilities with a total service capacity of 16,514. The Company’s facilities are located in 14 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.

	June 30, 2003		June 30, 2002

Total service capacity (1):
Residential	12,378		11,267
Non-residential community-based	4,136		4,177
Total	16,514		15,444
Service capacity in operation (end of period)	13,971		14,349
Contracted beds in operation (end of period)	9,492		9,503
Average occupancy based on contracted beds in operation (2) (3)	99.9	%	98.7	%
Average occupancy excluding start-up operations (2)	100.0	%	98.7	%

(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. Revenues may fluctuate from year to year due to changes in government funding policies, the number of people referred to the Company’s facilities by governmental agencies or the opening of additional facilities.

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 historically 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 a 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 a facility’s contract revenue. A decline in occupancy of certain juvenile division facilities may have a more significant impact on operating results than the adult secure division due to higher per diem revenues of certain juvenile facilities. The Company has experienced and expects to experience interim period operating margin fluctuations 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 is generally responsible for all facility operating costs, except for certain debt service and lease payments with respect to facilities for which the Company has only a management contract (10 facilities in operation at June 30, 2003 and 11 facilities in operation at June 30, 2002).

A majority of the Company’s facility operating costs consists 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 costs increase. The amount of the Company’s variable operating costs, including food, medical services, supplies and clothing, depend on occupancy levels at the facilities operated by the Company. The Company’s largest single operating cost, facility payroll expense and related employment taxes and costs, has both a fixed and a variable component. The Company can adjust a facility’s staffing levels and the related payroll expense to a certain extent based on occupancy at a facility, however a minimum fixed number of employees is required to operate and maintain any facility regardless of occupancy levels. Personnel costs are subject to increases 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 operated under any future contracts with the BOP because these contracts are currently and expected to continue to be take-or-pay contracts, meaning that the BOP will pay the Company at least 95.0% 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 collected.

For the three and six months ended June 30, 2003, the Company incurred pre-opening and start-up costs of $306,000 and $393,000, respectively, related to the combined pre-opening and start-up operations of the Bernalillo County Jail, the Jos-Arz Residential Treatment Center and the Texas Adolescent Center. Revenues attributable to start-up operations were $54,000 for the three and six months ended June 30, 2003 and were attributable to the Jos-Arz Residential Treatment Center.

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, business development and related costs of business development and outside professional fees.

New Accounting Pronouncements

The Company implemented Statement of Financial Accounting Standard (“SFAS”) No. 143, SFAS No. 146 and SFAS No. 148 and FIN 45 in the six months ended June 30, 2003 with no impact on the Company’s reported financial position or results of operations.

In April 2002, the FASB issued SFAS No. 145, “Rescission of FASB Statements No. 4, 44, 64, Amendment of FASB Statement No. 13, and Technical Corrections” (“SFAS No. 145”), effective for fiscal years beginning after May 15, 2002. SFAS No. 145 rescinds FASB Statement No. 4, 44, 64 and amends SFAS No. 13, “Accounting for Leases,” to eliminate an inconsistency between the required accounting for sale-leaseback transactions and the required accounting for certain lease modifications that have economic effects that are similar to sale-leaseback transactions. Additionally, SFAS No. 145 requires that gains and losses on the extinguishment of debt to be classified as income or loss from continuing operations rather than as extraordinary items as previously required under SFAS No. 4. The Company adopted SFAS No. 145 as required on January 1, 2003 and will affect the classification of the extraordinary losses previously reported in the third and fourth quarter of 2001.

In May 2003, the Emerging Issues Task Force (“EITF”) reached a consensus on EITF 01-8 “Determining Whether an Arrangement Contains a Lease.” EITF 01-8 provides guidance for determining whether an arrangement contains a lease that is within the scope of SFAS No. 13 and is effective for arrangements initiated after the beginning of the first interim period beginning after May 28, 2003. The Company adopted the provisions of EITF 01-8 as of July 1, 2003 and is currently determining the impact of EITF 01-8 on the Company’s consolidated financial statements.

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,				Six Months Ended June 30,
	2003		2002		2003		2002

Revenues	100.0	%	100.0	%	100.0	%	100.0	%
Operating expenses	76.6		77.5		77.4		78.0
Pre-opening and start-up expenses	0.5		0.0		0.3		0.0
Depreciation and amortization	3.8		3.4		3.9		3.3
General and administrative expenses	7.0		7.7		6.5		8.3
Income from operations	12.1		11.4		11.9		10.4
Interest expense, net	6.7		6.7		6.7		7.2
Minority interest in losses of consolidated special purpose entities	0.0		0.0		0.0		0.0
Income before provision for income taxes and cumulative effect of changes in accounting principle	5.4		4.7		5.2		3.2
Provision for income taxes	2.2		1.9		2.2		1.3
Income before cumulative effect of changes in accounting principle	3.2	%	2.8	%	3.0	%	1.9	%

Three Months Ended June 30, 2003 Compared to Three Months Ended June 30, 2002

Revenues. Revenues decreased 2.2% to $67.6 million for the three months ended June 30, 2003 from $69.1 million for the three months ended June 30, 2002.

Adult secure institutional division revenues increased 2.6% to $25.6 million for the three months ended June 30, 2003 from $24.9 million for the three months ended June 30, 2002 due primarily to increased occupancy at the Big Spring Complex, the Baker Community Correctional Facility and the Leo Chesney Community Correctional Facility. In the three months ended June 30, 2002, the Baker and Leo Chesney facilities had a reduction in occupancy as these facilities were preparing for potential closure in June 2002. The contracts were subsequently renewed and, as a result, occupancy was at contract levels during the three months ended June 30, 2003. Average occupancy was 100.3% for the three months ended June 30, 2003 compared to 98.9% for the three months ended June 30, 2002. There were no revenues attributable to start-up operations for the three months ended June 30, 2003 and 2002.

Juvenile division revenues decreased 7.3% to $29.5 million for the three months ended June 30, 2003 from $31.8 million for the three months ended June 30, 2002 due primarily to the closure of the New Morgan Academy in the fourth quarter of 2002, offset in part, by an increase in revenue due to increased occupancy and service hours at various juvenile facilities and programs. The closure of the New Morgan Academy decreased revenues by approximately $4.6 million in the second quarter of 2003 as compared to the same quarter of 2002. This decrease was offset by a net increase in revenue of approximately $2.2 million as a result of increased occupancy at various facilities and programs including the Alexander Youth Center, Dauphin Mental Health, the Leadership Development Program (“LDP”) and Cornell Abraxas I (“A-1”). Revenues attributable to start-up operations were approximately $54,000 for the three months ended June 30, 2003 and were attributable to the Jos-Arz Residential Treatment Center. Excluding the occupancy and contract capacity for the New Morgan Academy and the start-up activities of the Jos-Arz Residential Treatment Center in 2003, average occupancy for the three months ended June 30, 2003 was 92.2% compared

to 94.2% for the three months ended June 30, 2002.

Pre-release division revenues increased 1.4% to $12.5 million for the three months ended June 30, 2003 from $12.4 million for the three months ended June 30, 2002 due to overall increased occupancy throughout the division. Average occupancy was 109.7% for the three months ended June 30, 2003 compared to 109.5% for the three months ended June 30, 2002.

Operating Expenses. Operating expenses decreased 3.3% to $51.8 million for the three months ended June 30, 2003 from $53.5 million for the three months ended June 30, 2002.

Adult secure institutional division operating expenses increased 2.1% to $18.0 million for the three months ended June 30, 2003 from $17.6 million for the three months ended June 30, 2002 due primarily to increased staffing and other services due to the higher occupancy levels at the Big Spring Complex, the Baker Community Correctional Facility and the Leo Chesney Community Correctional Facility in the three months ended June 30, 2003 as compared to the same period of the prior year. As a percentage of segment revenues, adult secure institutional division operating expenses were 70.3% for the three months ended June 30, 2003 compared to 70.4% for the three months ended June 30, 2002.

Juvenile division operating expenses decreased 6.6% to $24.6 million for the three months ended June 30, 2003 from $26.3 million for the three months ended June 30, 2002 due to primarily to the closure of the New Morgan Academy in the fourth quarter of 2002. Operating expenses for the New Morgan Academy were approximately $0.4 million for the three months ended June 30, 2003 compared to $3.7 million for the three months ended June 30, 2002. Excluding the New Morgan Academy’s operating expenses in both periods, juvenile division operating expenses increased 6.9%, or $1.6 million, due to increased staffing and other services due to the increased occupancy at various facilities and programs including the Alexander Youth Center, Dauphin Mental Health, LDP and A-1. As a percentage of segment revenues, operating expenses were 83.5% for the three months ended June 30, 2003 compared to 82.7% for three months ended June 30, 2002. Excluding start-up operations in 2003 and the operations of the New Morgan Academy in both periods, juvenile division operating expenses, as a percentage of segment revenue, were 82.3% and 83.2% respectively. The 2003 operating margin was favorably impacted by the revenue increases at the facilities discussed above.

Pre-release division operating expenses increased 0.6% to $9.5 million for the three months ended June 30, 2003 from $9.4 million for the three months ended June 30, 2002. As a percentage of revenues, operating expenses were 75.6% for the three months ended June 30, 2003 compared to 76.2% for the three months ended June 30, 2002.

Pre-Opening and Start-up Expenses. Pre-opening and start-up expenses for the three months ended June 30, 2003 were approximately $0.3 million and related to the pre-opening and start-up operations of the Bernalillo County Jail, the Texas Adolescent Center and the Jos-Arz Residential Treatment Center.

Depreciation and Amortization. Depreciation and amortization was $2.6 million for the three months ended June 30, 2003 compared to $2.4 million for the three months ended June 30, 2002. The increase in depreciation and amortization expense was primarily due to current year property and equipment purchases. Amortization of intangibles was approximately $220,000 for the three months ended June 30, 2003 and 2002.

General and Administrative Expenses. General and administrative expenses decreased 11.0% to $4.7 million for the three months ended June 30, 2003 from $5.3 million for the three months ended June 30, 2002. Included in general and administrative expenses for the three months ended June 30, 2003 were costs of approximately $580,000 for site acquisition costs and legal expenses primarily associated with the Company’s increased development activity and a charge related to the deferred compensation plan. 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 Bureau of Prisons (“BOP”) 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. Excluding the above charges from the applicable 2003 and 2002 periods, general and administrative expenses increased 0.9% from the same period of the prior year.

Interest. Interest expense, net of interest income, decreased to $4.5 million for the three months ended June 30, 2003 from $4.6 million for the three months ended June 30, 2002. Capitalized interest for the three months ended June 30, 2003 and 2002 was approximately $200,000 and related to the Moshannon Valley Correctional Center.

Income Taxes. For the three months ended June 30, 2003 and 2002, the Company recognized a provision for income taxes at an estimated effective rate of 41.0% and 40.0%, respectively. The increase in the effective rate was due to increased taxable income in certain states having higher rates.

Six Months Ended June 30, 2003 Compared to Six Months Ended June 30, 2002

Revenues. Revenues decreased 2.9% to $133.6 million for the six months ended June 30, 2003 from $137.6 million for the six months ended June 30, 2002.

Adult secure institutional division revenues increased 3.4% to $50.7 million for the six months ended June 30, 2003 from $48.9 million for the six months ended June 30, 2002 due primarily to increased occupancy at the Big Spring Complex, the Baker Community Correctional Facility and the Leo Chesney Community Correctional Facility. In the six months ended June 30, 2002, the Baker and Leo Chesney facilities had a reduction in occupancy as these facilities were preparing for potential closure in June 2002. These contracts were subsequently renewed and as a result occupancy was at contract levels during the six months ended June 30, 2003. There were no revenues attributable to start-up operations for the six months ended June 30, 2003 and 2002. Average occupancy was 99.0% for the six months ended June 30, 2003 compared to 97.7% for the six months ended June 30, 2002.

Juvenile division revenues decreased 8.8% to $58.0 million for the six months ended June 30, 2003 from $63.6 million for the six months ended June 30, 2002 due primarily to the closure of the New Morgan Academy in the fourth quarter of 2002, offset in part, by an increase in revenue due to increased occupancy and service hours at various juvenile facilities and programs. Revenues attributable to the New Morgan Academy were $26,000 in the six months ended June 30, 2003 as compared to $9.4 million in the six months ended June 30, 2002. This decrease was offset by a net increase in revenue of approximately $3.7 million as a result of improved occupancy and service hours at various facilities including the Alexander Youth Center, A-1, the Cornell Abraxas Center for Adolescent Females (“ACAF”), Dauphin Mental Health and the Griffin Juvenile Facility. Revenues attributable to start-up operations were approximately $54,000 for the six months ended June 30, 2003 and were attributable to the start-up operations of the Jos-Arz Residential Treatment Center. Excluding the occupancy and contract capacity for the New Morgan Academy and the start-up activities of the Jos-Arz Residential Treatment Center in 2003, average occupancy for the six months ended June 30, 2003 was 92.3% compared to 92.9% for the six months ended June 30, 2002.

Pre-release division revenues decreased 0.3% to $24.9 million for the six months ended June 30, 2003 from $25.0 million for the six months ended June 30, 2002 due primarily to the termination of the Santa Barbara Center contract in March 2003, offset in part, by overall improved occupancy throughout the division. There were no revenues attributable to start-up operations for the six months ended June 30, 2003

and 2002. Average occupancy was 109.7% for the six months ended June 30, 2003 compared to 107.7% for the six months ended June 30, 2002.

Operating Expenses. Operating expenses decreased 3.6% to $103.5 million for the six months ended June 30, 2003 from $107.3 million for the six months ended June 30, 2002.

Adult secure institutional division operating expenses increased 1.5% to $35.3 million for the six months ended June 30, 2003 from $34.8 million for the six months ended June 30, 2002 due primarily to increased staffing and other services due to increased occupancy at the Big Spring Complex, the Baker Community Correctional Facility and the Leo Chesney Community Correctional Facility. As a percentage of segment revenues, adult secure institutional division operating expenses were 69.8% for the six months ended June 30, 2003 compared to 71.1% for the six months ended June 30, 2002. The 2003 operating margin was impacted favorably as a result of lower inmate medical costs at certain facilities in the six months ended June 30, 2003 as compared to the same period of 2002.

Juvenile division operating expenses decreased 7.7% to $49.5 million for the six months ended June 30, 2003 from $53.7 million for the six months ended June 30, 2002 due primarily to the closure of the New Morgan Academy in the fourth quarter of 2002 offset, in part, by increased occupancy and service hours at various juvenile facilities. Operating expenses for the New Morgan Academy were approximately $0.8 million in the six months ended June 30, 2003 compared to $7.8 million in the six months ended June 30, 2002. Excluding the New Morgan Academy’s operating expenses in both periods, juvenile division operating expenses increased 6.4%, or $2.9 million, due to increased staffing and other services due to increased occupancy and service hours at various facilities and programs including the Alexander Youth Center, Dauphin Mental Health, LDP and A-1. As a percentage of segment revenues, operating expenses were 85.4% for the six months ended June 30, 2003 compared to 84.4% for six months ended June 30, 2002. Excluding start-up operations in 2003 and the operations of the New Morgan Academy in the six months ended June 30, 2003 and 2002, juvenile division operating expenses, as a percentage of segment revenue, were 84.0% and 84.4% respectively.

Pre-release division operating expenses increased 2.6% to $19.2 million for the six months ended June 30, 2003 from $18.7 million for the six months ended June 30, 2002 due primarily to a charge to bad debt expense of approximately $0.6 million in the six months ended June 30, 2003 to provide an allowance for certain insurance and medicaid receivable accounts. Excluding this 2003 charge, operating expenses decreased 0.6%, or $106,000. As a percentage of segment revenues, excluding the 2003 charge, operating expenses were 74.4% for the six months ended June 30, compared to 74.6% for the six months ended June 30, 2002.

Pre-Opening and Start-up Expenses. Pre-opening and start-up expenses for the six months ended June 30, 2003 were approximately $393,000 and were attributable to the pre-opening and start-up operations of the Bernalillo County Jail, the Texas Adolescent Center and the Jos-Arz Residential Treatment Center. There were no pre-opening and start-up expenses for the six months ended June 30, 2002.

Depreciation and Amortization. Depreciation and amortization was $5.2 million for the six months ended June 30, 2003 compared to $4.6 million for the six months ended June 30, 2002. The increase in depreciation and amortization expense was due to depreciation and amortization related to current year property and equipment purchases. Amortization of intangibles was approximately $439,000 for the six months ended June 30, 2003 and 2002.

General and Administrative Expenses. General and administrative expenses decreased 24.3% to $8.6 million for the six months ended June 30, 2003 from $11.2 million for the six months ended June 30, 2002. Included in the general and administrative expenses for the six months ended June 30, 2003 were costs of approximately $580,000 for site acquisition costs and legal expenses primarily associated with the

Company’s increased development activity and a charge related to the deferred compensation plan. 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 BOP Southeast Project. This contract was not awarded to the Company and all associated costs were charged to expense. Excluding the above charges from the applicable 2003 and 2002 periods, general and administrative expenses decreased 5.7% from the same period of the prior year due primarily to cost management strategies implemented by management in late 2002. The majority of these savings were realized from a reduction in personnel and related costs. Management expects general and administrative expenses to increase over the remaining quarters of 2003 as certain open positions are filled and professional and other costs are incurred related to compliance with the Sarbanes-Oxley Act of 2002.

Interest. Interest expense, net of interest income, decreased to $9.0 million for the six months ended June 30, 2003 from $9.9 million for the six months ended June 30, 2002. 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. Capitalized interest for the six months ended June 30, 2003 and 2002 was approximately $384,000 and $410,000, respectively, and related to the Moshannon Valley Correctional Center.

Minority Interest in Losses of Consolidated Special Purpose Entities. Minority interest in consolidated special purpose entities represents third party equity contributed to the special purpose entities consolidated by the Company for financial reporting purposes. Minority interest is adjusted for income and losses of the 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 is recorded as minority interest by the Company, the excess losses are being recorded in the Company’s Consolidated Statement of Operations.

Income Taxes. For the six months ended June 30, 2003 and 2002, the Company recognized a provision for income taxes at an estimated effective rate of 41.0%.

Cumulative Effect of Change in Accounting Principle. 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.

Liquidity and Capital Resources

General. The Company’s primary capital requirements have generally been and are expected to be 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. 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.

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.

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 2003 until 2075. As of June 30, 2003, the Company’s total commitment under these operating leases was approximately $33.9 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, 2003 (in thousands):

	Payments Due by Period
	Total		2003		2004 - 2005		2006 - 2007		Thereafter

Contractual Obligations:
Long-term debt
- Special Purpose Entities	$	240,492	$	7,600	$	17,941	$	69,451	$	145,500
Capital lease obligations
- Cornell Companies, Inc.	25		25		—		—		—

Operating leases	33,915		3,304		6,930		4,706		18,975
Consultative and non-competition agreements	1,330		410		720		200		—
Total contractual cash obligations	$	275,762	$	11,339	$	25,591	$	74,357	$	164,475

The Company enters into letters of credit in the ordinary course of its operating and financing activities. As of June 30, 2003, the Company had outstanding letters of credit of $5.1 million related to insurance and other operating activities. The following table details the Company’s letter of credit commitments as of June 30, 2003 (in thousands):

	Total Amounts Committed		Amount of Commitment Expiration Per Period
	Total Amounts Committed		Less than 1 Year		1-3 Years		4-5 Years		Over 5 Years

Commercial Commitments:
Standby letters of credit	$	5,108	$	5,108	$	—	$	—	$	—

Long-Term Credit Facilities. 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 and by outstanding letters of credit. The Company had outstanding letters of credit of approximately $5.1 million at June 30, 2003. Accordingly, as of June 30, 2003, the Company had $33.5 million of available commitment under its revolving line of credit. 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. Additionally, the Company is limited to $2.5 million annually for the repurchase of its common stock with an aggregate limit of $7.5 million. 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. Additionally, the Company has 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 (see Note 6). This waiver is effective through October 31, 2004. Included in the Company’s cash and cash equivalents at June 30, 2003 is approximately $39.6 million that is invested in a separate account that is available to the Company for investment purposes or working capital with the approval of the lenders under the amended 2000 Credit Facility. The lenders could limit the Company's ability to use such funds. 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 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 $51.7 million had been utilized as of June 30, 2003. The Company expects to utilize the remaining capacity under this synthetic lease financing arrangement for 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 the provisions of FIN 46, utilization of this synthetic lease financing arrangement to complete the construction of the Moshannon Valley Correctional Center will also result in the consolidation of the facility and the related financing in the Company’s financial statements.

Cash Flows From Operating Activities. Cash flows provided by operations were approximately $8.8 million for the six months ended June 30, 2003 compared to approximately $2.2 million for the six months ended June 30, 2002. The increase is primarily attributable to increased earnings and working capital changes.

Cash Flows From Investing Activities. Cash used in investing activities was approximately $12.0 million for the six months ended June 30, 2003 and included deposit payments to the restricted debt payment account, net of amounts withdrawn for debt service payments, and capital expenditures of approximately $6.4 million related to the purchase and renovation of the Texas Adolescent Center, various facility improvements and/or expansions, information technology and software development costs. Additionally, the Company made a deposit of $1.0 million into an escrow account for a non-compete agreement related to the Jos-Arz Residential Treatment Center management contract. Cash used in investing activities was approximately $9.2 million for the six months ended June 30, 2002 primarily due to capital expenditures

of approximately $5.0 million and deposit payments to the restricted debt payment account, net of amounts withdrawn for debt service payments.

Cash Flows From Financing Activities. Cash provided by financing activities was approximately $2.1 million for the six months ended June 30, 2003 due primarily to proceeds from stock option exercises of approximately $2.1 million and proceeds from borrowings on the Company’s Synthetic Lease Facility of approximately $0.6 million offset, in part, by purchases of approximately $0.6 million of treasury shares. Cash provided by the financing activities for the six months ended June 30, 2002 was approximately $0.5 million due primarily to proceeds from borrowings on the Company’s Synthetic Lease Facility of approximately $0.5 million and proceeds from stock option exercises of approximately $0.5 million offset by cash used for treasury stock purchases of $0.4 million. Annual MCF Bond principal payments due August 1 will be reflected as an outflow from financing activities when disbursed from the restricted debt payment account.

Treasury Stock/Repurchases. As of January 1, 2003, the Company could purchase approximately $2.1 million of its common stock as permitted under the terms of the amended 2000 Credit Facility. The Company purchased in the open market 57,500 shares of its common stock for approximately $0.6 million during the six months ended June 30, 2003. Accordingly, the Company can purchase approximately $1.5 million of shares during the remaining term of the 2000 Credit Facility.

New Facilities and Project Under Development. In January 2003, the Company executed a lease for the Bernalillo County Jail in Albuquerque, New Mexico. The facility, which has been vacated by the County in favor of a new jail, is expected to be remodeled by the Company and used to provide adult secure confinement for a wide array of government agencies that have demonstrated a need for additional bed space. The facility added approximately 1,000 beds to the Company’s current service capacity. The lease must be approved by the State Attorney General and requires monthly rental payments of approximately $80,000 to $100,000 over the five year lease term.

In March 2003, the Company reached an agreement with the Commonwealth of Pennsylvania that resolved all outstanding administrative issues relative to the contract awarded to the Company by the BOP to operate the Moshannon Valley Correctional Center. If the Company is able to negotiate an amendment to the contract with the BOP, this agreement will allow the Company to move forward with the construction and operation of the facility, subject to re-approval of the project by the lenders under the Company’s amended 2000 Credit Facility, and agreement by such lenders to amend certain financial covenants and provisions of the 2000 Credit Facility.

the construction deadline. In the event the Company is not able to negotiate a contract amendment with the BOP, then the BOP may have the right to assert that the Company has not completed construction of the facility within the time frame provided in the BOP contract, as amended. 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 BOP decides not to continue with the construction of the Moshannon Valley Correctional Center and terminates the contract, management believes that the Company has the right to and will recover its invested costs. In the event any portion of these costs are determined not to be recoverable upon contract termination by the BOP, such costs would be expensed. Management currently believes that the invested costs would be fully recoverable in the event of this contract being terminated.

At June 30, 2003, 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 BOP in the near term. In the event any portion of these costs are not reimbursed, such costs will be expensed if they are determined not to be reimbursable.

Future Liquidity. Management believes that the Company’s cash and the cash flows generated from operations, together with the credit available under the amended 2000 Credit Facility and the operating lease capacity thereunder, will provide sufficient liquidity to meet the Company’s committed capital and working capital requirements for currently awarded contracts. In order to finance the construction of the Moshannon Valley Correctional Center, the lenders under the 2000 Credit Facility must re-approve the project and agree to amend certain financial covenants and provisions of the 2000 Credit Facility. 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.

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. Management does not use derivative financial instruments 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, 2003, approximately 21% ($49.9 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 $125,000 and $250,000 for the three and six months ended June 30, 2003. At June 30, 2003, 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 related insurance coverage, (2) risks associated with acquisitions and the integration thereof (including the ability to achieve administrative and operating cost savings and anticipated synergies), (3) the timing and costs of the opening of new programs and facilities or the expansions of existing facilities, (4) changes in governmental policy and/or funding to discontinue or not renew existing arrangements or to eliminate or discourage the privatization of correctional, detention and pre-release services in the United States, (5) the availability of debt and equity financing on terms that are favorable to the Company, (6) 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, (7) 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, (8) results from alternative deployment or sale of facilities such as the New Morgan Academy and (9) the Company’s ability to negotiate a contract amendment with the BOP related to the Moshannon Valley Correctional Center.

ITEM 4. Controls and Procedures

Under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”) and as required by paragraph (b) of Rules 13a-15 and 15d-15(e) of the Exchange Act, as of the end of our second fiscal quarter of 2003. Based on that evaluation, our principal executive officer and principal financial officer have concluded that these controls and procedures are effective as of that date.

Disclosure controls and procedures are our controls and other procedures that are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified under the Exchange Act. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by us in the reports that we file under the Exchange Act is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure.

PART II OTHER INFORMATION

ITEM 1. Legal Proceedings

In March and April 2002, the Company, Steven W. Logan, and John L. Hendrix, were 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. Flyline Partners, LP has been appointed as the lead plaintiff and has filed a consolidated complaint. The consolidated complaint alleges 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, Section 20(a) of the Exchange Act and Section 11 of the Securities Act of 1933. The consolidated complaint seeks, among other things, restitution damages, compensatory damages, rescission or a rescissory measure of damages, costs, expenses, attorneys’ fees and expert fees. A motion to dismiss is currently pending. The Company believes that it has good defenses to each of the plaintiffs’ claims and intends to vigorously defend against each of these claims.

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. The outcome of such matters cannot be predicated with certainty, based on the information known to date, 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.

ITEM 4. Submission of Matters to a Vote of Security Holders

On June 12, 2003, the Company held its 2003 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 2004 Annual Meeting of Stockholders. Results by nominee were:

	Voted For	Authority Withheld

Anthony R. Chase	11,871,347	54,443
Arlene R. Lissner	11,730,759	195,031
Harry J. Phillips, Jr.	11,730,759	195,031
D. Stephen Slack	11,870,568	55,222
Tucker Taylor	11,731,217	194,573
Marcus A. Watts	10,878,393	1,047,397

Stockholders ratified the appointment of Pricewaterhouse Coopers LLP as the Company’s independent public accountants for the fiscal year ending December 31, 2003, with 11,825,988 shares voted for, 99,004 shares voted against and 798 abstained.

ITEM 6. Exhibits and Reports on Form 8-K

a.	Exhibits

	11.1	Computation of Per Share Earnings
	31.1	Section 302 Certification of Chief Executive Officer
	31.2	Section 302 Certification of Chief Financial Officer
	32.1	Section 906 Certification of Chief Executive Officer
	32.2	Section 906 Certification of Chief Financial Officer

b.	Reports on Form 8-K

	The Company filed a Current Report on Form 8-K dated May 7, 2003 reporting a press release announcing its financial results for the first quarter ended March 31, 2003.

	The Company filed a Current Report on From 8-K dated July 31, 2003 reporting a press release announcing its financial results for the second quarter ended June 30, 2003.

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, 2003	By:	/s/ Harry J. Phillips, Jr.
		HARRY J. PHILLIPS, JR.
		Executive Chairman, Chairman of the Board and Director (Principal Executive Officer)


Date: August 14, 2003	By:	/s/ John L. Hendrix
		JOHN L. HENDRIX
		Executive Vice President and Chief Financial Officer (Principal Financial Officer)