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 March 31, 2005

 

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

 

Yes  ý No o

 

At April 30, 2005 Registrant had outstanding 13,430,394 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)

 

		March 31, 2005			December 31, 2004
ASSETS
CURRENT ASSETS:
Cash and cash equivalents		$	23,133		$	9,895
Investment securities available for sale		41,625			51,740
Accounts receivable – trade (net of allowance for doubtful accounts of $4,577 and $3,198, respectively)		52,554			60,174
Other receivables (net of allowance for doubtful accounts of $5,040 and $5,039, respectively)		4,566			4,691
Other restricted assets		18,733			19,713
Deferred tax assets		9,923			8,520
Prepaids and other		8,648			9,106
Total current assets		159,182			163,839
PROPERTY AND EQUIPMENT, net		284,463			282,255
OTHER ASSETS:
Debt service reserve fund		23,800			23,801
Goodwill, net		7,721			7,721
Intangible assets, net		6,629			7,026
Deferred costs and other		19,231			22,989
Total assets		$	501,026		$	507,631
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES:
Accounts payable and accrued liabilities		$	46,538		$	47,237
Current portion of long-term debt		9,001			9,005
Total current liabilities		55,539			56,242
LONG-TERM DEBT, net of current portion		276,893			279,528
DEFERRED TAX LIABILITIES		6,658			8,088
OTHER LONG-TERM LIABILITIES		2,848			2,461
Total liabilities		341,938			346,319
COMMITMENTS AND CONTINGENCIES
STOCKHOLDERS’ EQUITY:
Preferred stock, $.001 par value, 10,000,000 shares authorized, none issued		––			––
Common stock, $.001 par value, 30,000,000 shares authorized, 14,976,925 and 14,845,107 shares issued and 13,429,342 and 13,297,524 outstanding, respectively		15			15
Additional paid-in capital		147,433			145,825
Retained earnings		24,514			26,785
Treasury stock (1,547,583 shares of common stock, at cost)		(12,573		)	(12,573		)
Deferred compensation		(1,112		)	(432		)
Accumulated other comprehensive income		811			1,692
Total stockholders’ equity		159,088			161,312
Total liabilities and stockholders’ equity		$	501,026		$	507,631

 

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 (LOSS)

(Unaudited)

(in thousands, except per share data)

 

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

 

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)

 

		Three Months Ended March 31,
		2005			2004
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss)		$	(2,271	)	$	706
Adjustments to reconcile net income (loss) to net cash provided by (used) in operating activities ––
Depreciation		3,385			2,889
Amortization of intangibles and other assets		428			270
Amortization of deferred compensation		(488		)	(50		)
Amortization of deferred financing costs		487			209
Amortization of Senior Notes Discount		46			¾
Provision for bad debts		1,099			170
Gain on sale of property and equipment		(10		)	(11		)
Deferred income taxes		(3,446		)	295
Change in assets and liabilities:
Accounts receivable		7,047			(1,931		)
Restricted assets		158			158
Other assets		336			(183		)
Accounts payable and accrued liabilities		(564		)	(8,250		)
Deferred revenues and other liabilities		119			(13		)
Net cash provided by (used in) operating activities		6,326			(5,741		)
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures		(5,383		)	(8,192		)
Purchases of investment securities		(335,495		)	¾
Sale of investment securities		345,610			¾
Deposits in (withdrawals from) restricted debt payment account, net		823			1,048
Proceeds from sale of property and equipment		¾			163
Sale of restricted assets from deferred bonus plan		¾			86
Net cash provided by (used in) investing activities		5,555			(6,895		)
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from long-term debt and line of credit		¾			36,000
Payments on line of credit		¾			(24,000		)
Payments on capital lease obligations		(1		)	(6		)
Payments of debt issuance and other financing costs		¾			(100		)
Proceeds from exercise of stock options and warrants		1,358			819
Purchases of treasury stock		¾			(116		)
Net cash provided by financing activities		1,357			12,597
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		13,238			(39		)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD		9,895			40,171
CASH AND CASH EQUIVALENTS AT END OF PERIOD		$	23,133		$	40,132
OTHER NON-CASH INVESTING AND FINANCING ACTIVITIES:
Other comprehensive income (loss)		$	(881	)	$	458
Common stock issued for board of directors fees		58			¾
Decrease in fair value of interest rate swap		2,681			¾

 

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

 

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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 2004 Annual Report on Form 10-K as filed with the Securities and Exchange Commission.

 

2.              Accounting Policies

 

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

 

Accounting For Stock Based Compensation

 

In accordance with the provisions of Statement of Financial Accounting Standard (SFAS) No. 123, “Accounting for Stock-Based Compensation,” we have elected to account for our stock-based compensation plans under the intrinsic value method established by Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees.”  In accordance with the provisions of APB No. 25, the fair value of fixed stock options granted to employees 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 SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure, an Amendment of SFAS No. 123,” the effect on net income (loss) and earnings (loss) per share as if we 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 March 31,
		2005			2004
Net income (loss), as reported		$	(2,271	)	$	706
Add: total stock-based compensation recorded, net of tax		34			—
Less: total stock-based employee compensation expense determined under fair value based method for all awards, net of related tax effects		357			(157		)
Pro forma net income (loss)		$	(2,662	)	$	549
Earnings (loss) per share:
Basic, as reported		$	(.17	)	$	.05
Basic, pro forma		(.20		)	.04
Diluted, as reported		(.17		)	.05
Diluted, pro forma		(.20		)	.04

 

New Accounting Pronouncements

 

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

 

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awards that are expected to vest.  Compensation cost for awards that vest would not be reversed if the awards expired without being exercised.  When measuring fair value, companies can choose an option-pricing model (e.g., Black-Sholes or binominal models) that approximately reflects their specific circumstances and the economics of their transactions.  Companies will recognize compensation cost for share-based payment awards as they vest, including the related tax effects.  The effective date of SFAS No. 123R, applies to annual periods beginning after June 15, 2005, and applies to all outstanding and unvested share based payment awards at the company’s adoption date. In April 2005, the Securities and Exchange Commission adopted a rule that amends the adoption date of SFAS No. 123R to January 1, 2006.  We are currently evaluating the alternative transition methods permitted by SFAS No. 123R.

 

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

 

We do not have an equity interest in the variable interest entity that was formed in connection with the 2001 Sale and Leaseback Transaction.  The variable interest entity was formed for the purpose of owning and leasing certain facilities to us.  Reference is made to the “Non-Guarantor Subsidiary” information included in Note 12 for a summary of the financial information related to the variable interest entity.  The debtholders of the variable interest entity have no recourse to our general credit.

 

Reclassifications

 

Certain reclassifications have been made to the prior year financial statements contained herein to conform to current year presentation.

 

3.              Discontinued Operations and Management Restructuring

 

We classify as discontinued operations those components of our business that we hold for sale or disposition that have operations and cash flows that are clearly distinguishable operationally and for financial reporting purposes from the rest of the Company. For those components, we have no significant continuing involvement after disposal and their operations are eliminated from our ongoing operations.  During the quarter ended March 31, 2005, we classified certain components as discontinued operations. This was the result of a management decision to initiate the shut down of operations at certain facilities.  These facilities/programs include Residential School, Maple Creek Home and the mental health wrap programs in Pennsylvania.  Notifications have been made to the required contracting entities regarding the terminations of the related programs. The related facility assets will be disposed of or transferred to other existing operations.  At March 31, 2005 we have net property and equipment of $0.6 million pertaining to these operations.   The discontinued operations generated revenues of approximately $0.9 million and $2.9 million for the three months ended March 31, 2005 and 2004, respectively.

 

During the first quarter of 2005, a review was performed of our management structure and as a result, approximately 14 positions were eliminated.  In conjunction with this, a charge was recorded of approximately $2.1 million in the quarter ended March 31, 2005.  The charge was recorded in operating expenses (approximately $1.0 million) and general and administrative expenses (approximately $1.1 million).  The accrued liability pertaining to this charge at March 31, 2005 was approximately $2.0 million.  There are no costs expected to be incurred in conjunction with this activity in subsequent periods.

 

4.              Intangible Assets

 

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

 

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

 

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

 

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

 

5.               Credit Facilities

 

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

 

		March 31, 2005			December 31, 2004
Debt of Cornell Companies, Inc.:
Senior Notes, unsecured, due July 2012 with an interest rate of 10.75%, net of discount		$	110,665		$	110,619
Fair-value adjustment of Senior Notes as a result of interest rate swap		527			3,208
Revolving Line of Credit due June 2008 with an interest rate of LIBOR plus 2.25% to 3.5% or prime plus 0.75% to 2.00% (the "2004 Credit Facility")		¾			—
Capital lease obligations		2			6
Subtotal		111,194			113,833
Debt of Special Purpose Entity:
8.47% Bonds due 2016		174,700			174,700
Total consolidated debt		285,894			288,533
Less: current maturities		(9,001		)	(9,005		)
Consolidated long-term debt		$	276,893		$	279,528

 

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

 

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by substantially all of our assets, including the assets and stock of all of our subsidiaries.  The 2004 Credit Facility is not secured by the assets of MCF.  The 2004 Credit Facility contains standard covenants including compliance with laws, limitations on capital expenditures, restrictions on dividend payments, limitations on mergers and compliance with financial covenants.

 

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

 

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

 

 

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

 

In conjunction with the issuance of the Senior Notes, we entered into an interest rate swap transaction with a financial institution to hedge our exposure to changes in the fair value on $84.0 million of our Senior Notes.  The purpose of this transaction was to convert future interest due on $84.0 million of the Senior Notes to a variable rate.  The terms of the interest rate swap contract and the underlying debt instrument are identical.  We have designated the swap agreement as a fair value hedge.  The swap has a notional amount of $84.0 million and matures in July 2012 to mirror the maturity of the Senior Notes.  Under the agreement, we pay on a semi-annual basis (each January 1 and July 1) a floating rate based on a six-month U.S. dollar LIBOR rate, plus a spread, and receive a fixed-rate interest of 10.75%.  For the three months ended March 31, 2005, we recorded interest savings related to this interest rate swap of approximately $0.5 million, which is reflected as a reduction to interest expense in the accompanying financial statements.  The swap agreements are marked to market each quarter with a corresponding mark-to-market adjustment reflected as either a discount or premium on the Senior Notes.  At March 31, 2005 and December 31,

 

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

 

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6.              Projects Under Development, Construction or Renovation

 

Moshannon Valley Correctional Center

 

In March 2003, we reached an agreement with the Commonwealth of Pennsylvania that resolved all outstanding administrative issues relative to the contract awarded by the BOP to operate the Moshannon Valley Correctional Center.  In October 2004, we received the signed Finding of No Significant Impact for the facility.  Construction of the facility, which will house 1,300 male federal inmates, began immediately.  We have a three-year contract with the BOP to operate the facility and the BOP has the option to grant seven one-year extensions.  The facility is scheduled to begin operations in early 2006.

 

In September 2004, we resolved our claim with the BOP for the reimbursement of a portion of the expenses we incurred in connection with the issuance of the Stop-Work Order and the delay of the project (included among these expenses was approximately $1.4 million in accounts receivable for expenses incurred by us after the September 1999 issuance of the Stop–Work Order).  We settled the claim, as well as the claim for the reimbursement of costs related to the original construction efforts incurred beginning in 1999, with the BOP and were reimbursed approximately $7.0 million in September 2004.  The excess reimbursement of approximately $5.6 million over the $1.4 million in accounts receivable was credited against the carrying cost of the facility.

 

As of March 31, 2005, we had incurred (net of the BOP reimbursement) approximately $22.7 million for the design, construction and development costs and capitalized interest related to the Moshannon Valley Correctional Center facility.  We believe that our existing cash and credit facilities will provide adequate funding to complete the construction of the facility.

 

New Morgan Academy

 

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

 

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

 

Central California Treatment Center

 

In January 2004, we purchased a building in Los Angeles, California for approximately $2.5 million.  This new facility could provide service to 220 inmates in a work-furlough type program.  Although we do not currently have a contract for this facility, it has been submitted for consideration in several recent proposals.  We

 

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believe that due to the growth of the inmate population, severe budget crisis and recent legal settlements requiring additional community services, this facility will fill a small part of the overall demand in California.  The potential uses for the facility range from a “halfway back” program to a comprehensive drug and alcohol treatment program.

 

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 March 31, 2005 and 2004, there were 291,071 shares ($14.51 average price) and 195,503 shares ($14.72 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.

 

The following table summarizes the calculation of net earnings and weighted average common shares and common equivalent shares outstanding for purposes of the computation of earnings per share (in thousands, except per share data):

 

		Three Months Ended March 31,
		2005			2004
Net earnings (loss)		$	(2,271	)	$	706
Weighted average common share outstanding		13,428			13,081
Weighted average common share equivalents outstanding		¾			231
Weighted average common shares and common share equivalents outstanding		13,428			13,312
Basic earnings (loss) per share		$	(.17	)	$	0.05
Diluted earnings (loss) per common share		$	(.17	)	$	0.05

 

8.              Commitments and Contingencies

 

Legal Proceedings

 

Southern Peaks Regional Treatment Center

 

On January 5, 2004, we initiated legal proceedings in the lawsuit styled Cornell Corrections of California, Inc. v. Longboat Global Advisors, LLC, et al., No.2004 CV79761 in the Superior Court of Fulton County, Georgia under theories of fraud, conversion, breach of contract and other theories to determine the location of and to recover funds previously deposited by us into what we believed to be an escrow account in connection with the development and construction of the Southern Peaks Regional Treatment Center. Of the funds previously deposited, approximately $5.3 million remains to be recovered at March 31, 2005. In December 2004, the case was tried before a jury and the jury verdict awarded approximately $6.5 million in compensatory damages and approximately $1.4 million in punitive damages, plus attorneys’ fees. We expect that the actual damages awarded under the verdict will be adjusted downward to the $5.4 million actually lost by us and that the punitive damages award may be adjusted downward because of a Georgia statute regarding caps on punitive damages awards.  No judgment has yet been entered on this verdict.  The award for compensatory damages accrues pre-judgment interest at a rate of 7 percent from the date of loss through the date of judgment. Following the jury verdicts, we collected approximately $0.4 million in January 2005 in funds which had been previously frozen under a temporary restraining order issued at the time that we commenced this litigation. Currently, certain of the defendants have filed motions for a new trial. No judgment will be entered on the verdict until after these motions for a new trial have been heard and ruled on by the court. Due to the continued uncertainty surrounding the ultimate recovery of the funds previously deposited, we will continue to maintain our existing reserve of approximately $5.0 million in an allowance for doubtful accounts.

 

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Shareholder Lawsuits

 

In March and April 2002, the company, Steven W. Logan (our former President and Chief Executive Officer), and John L. Hendrix (our former Chief Financial Officer), 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 were putative class action lawsuits brought on behalf of all purchasers of our common stock between March 6, 2001 and March 5, 2002 and relate to our restatement in 2002 of certain financial statements.  The lawsuits involved disclosures made concerning two prior transactions executed by us: the August 2001 sale leaseback transaction and the 2000 synthetic lease transaction.  These four lawsuits were consolidated into the Graydon Williams action and Flyline Partners, LP was appointed lead plaintiff.  As a result, a consolidated complaint was filed by Flyline Partners, LP.  Richard Picard and Anthony Scolaro were also named as plaintiffs.  Since then, the court allowed plaintiffs to file an amended consolidated complaint. The amended 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, Section 11 of the Securities Act of 1933 (the “Securities Act”) and/or Section 15 of the Securities Act.  The amended consolidated complaint seeks, among other things, restitution damages, compensatory damages, rescission or a rescissory measure of damages, costs, expenses, attorneys’ fees and expert fees.  The Company filed a motion to dismiss the lawsuit.  In an order entered April 1, 2005, the court granted the motion to dismiss with respect to the plaintiffs' securities fraud claims pursuant to Sections 10(b) and 20(a) of the Exchange Act and Rule 10b-5.  The court denied the motion to dismiss as to the remaining claims covering the Company's secondary offering in 2001.  Subject to court approval and documentation, the parties have agreed to settle this matter.  Under the proposed agreement, the Company has not admitted any wrongdoing.  Settlement in the amount of $7 million will be funded through the Company's Directors' and Officers' liability insurance.  The Company has not reached settlement in the pending derivative litigation discussed below.

 

In March 2002, the company, our directors, and our 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 related to our restatement in 2002 of certain financial statements.  The lawsuit alleged breaches of fiduciary duty by all of the individual defendants and asserted breach of contract and professional negligence claims only against Arthur Andersen LLP.  This lawsuit has been dismissed without prejudice by agreement.

 

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

 

In May and September 2002, the company and our 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 relate to our restatement in 2002 of certain financial statements.  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.  The Menning action has been dismissed, but with an agreement that the plaintiff’s claims as to Cornell are tolled until 30 days following the final resolution of the Guitierrez case, including any appeals.

 

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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, we believe we have good defenses and intend to vigorously defend against the claims asserted in these actions.  We have not recorded any loss accruals related to these claims.

 

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

 

Other

 

Additionally, we currently and from time to time are 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. If an adverse decision in these matters exceeds our insurance coverage, or if our coverage is deemed not to apply to these matters, or if the underlying insurance carrier were unable to fulfill their obligation under the insurance coverage provided, it could have a material adverse effect on our financial position, results of operations or cash flows.

 

During the period of August 2000 through May 2003, our general liability and professional liability coverage was provided by Specialty Surplus Insurance Company, a Kemper Insurance Company (“Kemper”) group member.  In June 2004, the Illinois Department of Insurance gave Kemper permission to proceed with a run-off plan it had previously submitted.  The three-year plan is designed to help Kemper meet its goal of resolving, to the maximum extent possible, all valid policyholder claims.

 

In view of the risks and uncertainties involved in implementing the plan, including the need to achieve significant policy buybacks, commutation of reinsurance agreements, and further agreements with regulators, no assurance can be given that the plan will be successfully implemented by Kemper.  In the year ended December 31, 2004, we recorded a charge of $0.6 million, and have estimated our range of additional exposure to be approximately $0.5 million with respect to outstanding claims incurred during this policy period with Kemper which would become our obligation to resolve if not settled through Kemper.

 

As of March 31, 2005, Kemper has continued to implement its run-off plan.  We believe that the uncertainty surrounding Kemper remains, and while no additional allowance is considered necessary at March 31, 2005, the existing reserve of $0.6 million will be maintained.  We continue to believe our estimated range of exposure to be approximately $0.5 million for those outstanding claims which would become our obligation to resolve if not settled through Kemper.

 

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

 

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9.              Derivative Financial Instruments and Guarantees

 

Debt Service Reserve Fund and Debt Service Fund

 

In August 2001, MCF completed a bond offering to finance the 2001 Sale and Leaseback Transaction.  In connection with this bond offering, two reserve fund accounts were established by MCF pursuant to the terms of the indenture: (1) MCF’s Debt Service Reserve Fund, aggregating $23.8 million at March 31, 2005, was established to make payments on MCF’s outstanding bonds in the event we (as lessee) should fail to make the scheduled rental payments to MCF and (2) MCF’s Debt Service Fund, aggregating $16.3 million and $17.1 million at March 31, 2005 and December 31, 2004, respectively, used to accumulate the monthly lease payments that MCF receives from us until such funds are used to pay MCF’s semi-annual bond interest and annual bond principal payments.  Both reserve fund accounts are subject to the agreements with the MCF Equity Investors whereby guaranteed rates of return of 3.0% and 5.08%, respectively, are provided for in the balance of 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 Investors (MCF minority interest) and as a deferred liability in our Consolidated Balance Sheets. Changes in the fair value of the derivative instruments are recorded as an adjustment to other long-term liabilities and reported as other comprehensive income (loss) in our Consolidated Statements of Operations and Comprehensive Income (Loss).  At March 31, 2005 and December 31, 2004, the fair value of these derivative instruments was approximately $2.6 million and $2.2 million, respectively.  As a result, our Consolidated Statements of Operations and Comprehensive Income (Loss) include other comprehensive income (loss) of approximately ($0.9) million and $0.5 million for the three months ended March 31, 2005 and 2004, respectively.  The $0.9 million net unrealized loss reported in comprehensive income (loss) for the three months ended March 31, 2005 includes an adjustment of $0.6 million for the cumulative tax effect of changes in fair value during the years ended December 31, 2002 and 2003. This adjustment decreased accumulated other comprehensive income and increased deferred tax liabilities in our Consolidated Balance Sheet as of March 31, 2005.

 

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 of the Company’s estate.  This guarantee is characterized as an insurance contract and is being amortized to expense over the life of the debt.

 

10.       Correctional Systems, Inc. Acquisition

 

In January 2005, we signed a definitive agreement to acquire Correctional Systems, Inc. (CSI), a San Diego based provider of privatized jail, community corrections and alternative sentencing services.  The purchase price was approximately $10.0 million in total consideration to common and preferred shareholders, less certain adjustments as described in the merger agreement.  The transaction was completed April 1, 2005.

 

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

 

11.       Segment Disclosure

 

Our three operating divisions are our reportable segments.  The adult secure institutional services segment consists of the operations 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 adult community-based corrections and treatment services segment consists of providing pre-release and halfway house programs for

 

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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 our customers and long-lived assets are located in the United States of America.  The accounting policies of our reportable segments are the same as those described in the summary of significant accounting policies in our 2004 Form 10-K.  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.  We evaluate performance based on income or loss from operations before general and administrative expenses, incentive bonuses, amortization of intangibles, impairment charges on long-lived assets, interest and income taxes.  Corporate and other assets are comprised primarily of cash, accounts receivable, deposits, property and equipment, deferred taxes, deferred costs and other assets.  Corporate and other income from operations primarily consists of depreciation and amortization on the Corporate office facilities and equipment, and is presented separately as such charges cannot be readily identified for allocation to a particular segment.

 

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

 

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

 

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

 

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12.          Guarantor Disclosures

 

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

 

Condensed Consolidating Balance Sheet as of March 31, 2005 (in thousands) (unaudited)

 

		Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiary			Elimination			Consolidated
Assets
Current assets:
Cash and cash equivalents		$	22,735		$	342		$	56		$	—		$	23,133
Investment securities		41,625			¾			¾			¾			41,625
Accounts receivable		2,922			54,004			194			¾			57,120
Other restricted assets		¾			2,415			16,318			¾			18,733
Prepaids and other		17,463			1,108			¾			¾			18,571
Total current assets		84,745			57,869			16,568			¾			159,182
Property and equipment, net		523			132,281			157,808			(6,149		)	284,463
Other assets
Debt service reserve fund		¾			¾			23,800			¾			23,800
Deferred costs and other		38,069			18,138			9,214			(31,840		)	33,581
Investment in subsidiaries		58,264			1,856			¾			(60,120		)	¾
Total assets		$	181,601		$	210,144		$	207,390		$	(98,109	)	$	501,026
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable and accrued liabilities		$	39,965		$	6,606		$	2,537		$	(2,570	)	$	46,538
Current portion of long-term debt		¾			1			9,000			¾			9,001
Total current liabilities		39,965			6,607			11,537			(2,570		)	55,539
Long-term debt, net of current portion		111,192			1			165,700			¾			276,893
Deferred tax liabilities		7,965			(1,857		)	¾			550			6,658
Other long-term liabilities		5,609			165			30,134			(33,060		)	2,848
Intercompany		(142,218		)	177,403			¾			(35,185		)	¾
Total liabilities		22,513			182,319			207,371			(70,265		)	341,938
Stockholders’ equity		159,088			27,825			19			(27,844		)	159,088
Total liabilities and stockholders’ equity		$	181,601		$	210,144		$	207,390		$	(98,109	)	$	501,026

 

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

 

		Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiary			Elimination			Consolidated
Assets
Current assets:
Cash and cash equivalents		$	9,559		$	296		$	40		$	—		$	9,895
Investment securities		51,740			¾			¾			¾			51,740
Accounts receivable		3,298			61,189			378			¾			64,865
Other restricted assets		121			2,451			17,141			¾			19,713
Prepaids and other		15,664			1,962			¾			¾			17,626
Total current assets		80,382			65,898			17,559			¾			163,839
Property and equipment, net		672			128,965			158,863			(6,245		)	282,255
Other assets
Debt service reserve fund		¾			¾			23,801			¾			23,801
Deferred costs and other		39,392			19,225			9,362			(30,243		)	37,736
Investment in subsidiaries		20,613			1,856			¾			(22,469		)	¾
Total assets		$	141,059		$	215,944		$	209,585		$	(58,957	)	$	507,631
Liabilities and Stockholders’ Equity
Current liabilities:
Accounts payable and accrued liabilities		$	36,191		$	7,369		$	6,197		$	(2,520	)	$	47,237
Current portion of long-term debt		¾			5			9,000			¾			9,005
Total current liabilities		36,191			7,374			15,197			(2,520		)	56,242
Long-term debt, net of current portion		113,827			1			165,700			¾			279,528
Deferred tax liabilities		7,966			¾			¾			122			8,088
Other long-term liabilities		5,846			80			28,546			(32,011		)	2,461
Intercompany		(184,083		)	184,083			¾			¾			¾
Total liabilities		(20,253		)	191,538			209,443			(34,409		)	346,319
Stockholders’ equity		161,312			24,406			142			(24,548		)	161,312
Total liabilities and stockholders’ equity		$	141,059		$	215,944		$	209,585		$	(58,957	)	$	507,631

 

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Condensed Consolidating Statement of Operations for the three months ended March 31, 2005 (in thousands) (unaudited)

 

		Parent			Guarantor Subsidiaries			Non-Guarantor Subsidiary			Eliminations			Consolidated
Revenues		$	4,527		$	84,510		$	4,502		$	(18,846	)	$	74,693
Operating expenses		4,265			70,681			10			(18,513		)	56,443
Pre-opening and start-up expenses		¾			4,694			¾			¾			4,694
Depreciation and amortization		21			2,813			1,056			(97		)	3,793
Gain on sale of fixed assets		¾			(10		)	¾			¾			(10		)
General and administrative expenses		6,319			¾			19			¾			6,338
Income (loss) from operations		(6,078		)	6,332			3,417			(236		)	3,435
Overhead allocations		(8,925		)	8,925			¾			¾			¾
Interest, net		921			1,273			3,540			10			5,744
Equity (loss) in subsidiaries		(5,026		)	¾			¾			5,026			¾
Income (loss) before provision (benefit) for income taxes and discontinued operations		(3,100		)	(3,866		)	(123		)	4,780			(2,309		)
Provision (benefit) for income taxes		(829		)	¾			¾			(49		)	(878		)
Income (loss) before discontinued operations		(2,271		)	(3,866		)	(123		)	4,829			(1,431		)
Discontinued operations, net of income tax benefit of $454		¾			(840		)	¾			¾			(840		)
Net income (loss)		$	(2,271	)	$	(4,706	)	$	(123	)	$	4,829		$	(2,271	)

 

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