General

Cornell Companies, Inc. is a leading provider of correctional, detention, educational, rehabilitation and treatment services outsourced by federal, state, county and local government agencies. We provide a diversified portfolio of services for adults and juveniles through our three operating divisions:
(1) Adult Secure Services; (2) Abraxas Youth and Family Services and (3) Adult Community-Based Services. At September 30, 2009, we operated 68 facilities with a total service capacity of 20,597 and had one vacant facility with a service capacity of 70 beds. Our facilities are located in 15 states and the District of Columbia.

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

                                                         September 30,    September 30,
                                                             2009             2008
Residential
Service capacity (1)                                            18,334           17,788
Contracted beds in operation (end of period) (2)                17,480           17,017
Average contract occupancy based on contracted beds in
operation (3) (4)                                                 91.6 %           92.7 %
Non-Residential
Service capacity (5)                                             2,333            2,403

(2) At certain residential facilities, the contracted capacity is lower than the facility's service capacity. We could increase a facility's contracted capacity by obtaining additional contracts or by renegotiating existing contracts to increase the number of beds covered. However, we may not be able to obtain contracts that provide occupancy levels at a facility's service capacity or be able to maintain current contracted capacities in future periods.

(3) Occupancy percentages reflect less than normalized occupancy during the start-up phase of any applicable facility, resulting in a lower average occupancy in periods when we have substantial start-up activities.

(4) Average contract occupancy percentages are calculated based on actual occupancy for the period as a percentage of the contracted capacity for residential facilities in operation. These percentages do not reflect the operations of non-residential community-based programs. At certain residential facilities, our contracted capacity is lower than the facility's service capacity. Additionally, certain facilities have and are currently operating above the contracted capacity. As a result, average contract occupancy percentages can exceed 100% if the average actual occupancy exceeded contracted capacity.

(5) Service capacity for non-residential programs is based on either contractual terms or an estimate of the number of clients to be served. We update these estimates at least annually based on the program's budget and other factors.

Our operating results for the nine months ended September 30, 2009 were impacted by a few significant events. We completed the 700 bed expansion at D. Ray James Prison at the beginning of April 2009 and continued construction on a new 1,250 bed facility in Hudson, Colorado. Our 2008 results of operation were positively affected by a 300 bed expansion at the D. Ray James Prison which we activated in February 2008. In addition, in the nine months ended September 30, 2008, we recorded a contract-based revenue adjustment of approximately $1.5 million at the Regional Correctional Center ("RCC") for the contract year ended March 2008.

Although we believe we will continue to see steady demand across our various business segments and customer base (federal, state and local) in 2010, we are monitoring the declining economic trends (which began in 2008) and the related impact on government budget plans and the effect tightened spending plans could have on our business (with respect to possible areas including utilization, per diem rates, etc.) We expect one of the key areas of focus for our performance for the remainder of 2009 to be our ability to manage our facility construction currently in process in Hudson, Colorado and the related activation of this facility in the fourth quarter of 2009 (for our contract with the State of Alaska Department of Corrections ("Alaska DOC")). We also plan to remain focused on our operating margins, on increasing utilization (particularly in the Abraxas division) and improving customer mix as we believe those initiatives are key elements of our financial performance.

Management Overview

Demand. Our business is driven generally by demand for incarceration or treatment services, and specifically by demand for private incarceration or treatment services, within our three primary business segments: Adult Secure Services; Abraxas Youth and Family Services; and Adult Community-Based Services. The demand for adult and juvenile corrections and treatment services has

generally increased at a steady rate over the past ten years, largely as a result of increasing sentence terms and/or mandatory sentences for criminals and as well a greater range of criminal acts, increasing demand for incarceration of illegal aliens and a public recognition of the need to provide services to juveniles that will improve the possibility that they will lead productive lives. Moreover, demand for our services is also affected by the amount of available capacity in the government systems to enable governments to provide the services themselves, as well as desire and ability of these systems to add additional capacity. In addition, the balance between community-based corrections treatment of adults as an alternative to traditional incarceration continues to be analyzed by many political and societal parties. Among other things, we monitor federal, state and industry communications and statistics relative to trends in prison populations, juvenile justice statistics and initiatives, and developments in alternatives to traditional incarceration or detention of adults for opportunities to expand our scope or delivery of services.

The federal government contracts with private providers for the incarceration of adults, whether they are serving prison sentences, detained as illegal aliens, detained in anticipation of pending judicial administration or transitioning from prison to society. Chief among the federal agencies which use private providers are the Federal Bureau of Prisons ("BOP"), U.S. Immigration and Customs Enforcement ("ICE") and United States Marshalls Service ("USMS"). We provide adult secure and adult community-based services to the federal government. Most of the federal involvement in juvenile administration in the federal system is handled via Medicare and Medicaid assistance to state governments. Although there are circumstances in which we may contract with a federal agency on a sole source basis, the primary means by which we secure a contract with a federal agency is via the RFP bidding process. From time to time, we contract to provide management services to a local governmental unit who then bids on a federal contract.

States and smaller governmental units remain divided on the issue of private prisons and private provision of juvenile and community-based programs, although a majority of states permit private provision for our services. We anticipate that increasing budget pressure on states and smaller governmental units may cause more states and smaller governmental units to consider utilizing private providers such as us to provide these services on a more economical basis. We believe capital budget constraints among prison agencies may encourage them to continue to explore outsourcing to private operators as an alternative to deploying their own capital for prison construction or major refurbishment. Although it varies from governmental unit to governmental unit, the primary political forces who typically oppose privatization of prisons are organized labor and religious groups.

Private juvenile and community-based programs are utilized by states and local governmental units and are organized on a profit and not-for-profit basis. We monitor opportunities in these segments via our corporate and business division development officers. Many opportunities are typically not published in any formal manner and, accordingly, we believe that taking the initiative at the state and local levels is key in developing sole source opportunities.

Performance. We track a number of factors as we monitor financial performance. Chief among them are:

† capacity (the number of beds within each business segment's facilities),

† occupancy (utilization),

† per diem reimbursement rates,

† revenues,

† operating margins, and

† operating expenses.

Capacity. Capacity, commonly expressed in terms of number of beds, is primarily impacted by the number and size of the facilities we own or lease and the facilities we operate on behalf of a third party owner or lessee. We view capacity as one of the measures of our development efforts, through which we may increase capacity by adding new projects or by expanding existing projects (as we have done in 2007 through 2009 at several of our facilities including Great Plains Correctional Facility and D. Ray James Prison). As part of the evaluation of our development efforts, we will assess (a) whether a given development project was brought into service in accordance with our expectation as to time and expense; and (b) the number of projects in development or under consideration at the relevant point in time. In addition to the focus on new projects, capacity will reflect our success in renewing and maintaining existing contracts and facilities. It will also reflect any closure of programs or facilities due to underutilization or failure to earn an adequate risk-adjusted rate of return. We must also be cognizant of the possibility that state or local budgetary limitations may cause the contractual commitment to a given facility to be reduced or even eliminated, which would require us to either secure an alternate customer or close the operation.

Occupancy. Occupancy is typically expressed in terms of percentage of contract capacity utilized. We look at occupancy to assess the efficacy of both our efforts to market our facilities and our efforts to retain existing customers or contracts. Because revenue varies directly with occupancy, occupancy is a principal driver of our revenues. Our industry experiences significant economies of scale, whereby as occupancy rises, operating costs per resident decline. Some of our contracts are "take-or-pay," meaning that the agency making use of the facility is obligated to pay for beds even though they are not used. Historically, occupancy percentages in many of our facilities have been high and we are mindful of the need to maintain such occupancy levels. As new

development projects are brought into service, occupancy percentages may decline until the projects reach full utilization (as, for example, with the activation of the 1,100 bed expansion at Great Plains Correctional Facility during the fourth quarter of 2008 and the 700 bed expansion at D. Ray James Prison during the second quarter of 2009). Where we have commitments for utilization before the commencement of operations, occupancy percentages reflect the speed at which a facility achieves full service/implementation. However, we may decide to undertake development projects without written commitments to make full use of a facility. In these instances, we have performed our own assessment of the existing or anticipated demand, based on discussions with local government or other potential customer representatives and our analysis of other factors, of the demand for services at the facility. There is no assurance that we would recover our initial investment in these projects. We will monitor occupancy as a measure of the accuracy of our estimation of the demand for the services of a development facility and will incorporate this information in future assessments of potential projects. In addition, the ramp phase for our youth facilities is typically longer than that experienced in our adult facilities, which will impact our occupancy in the Abraxas Youth and Family Services division in a given period.

Per Diem Reimbursement Rates. Per diem reimbursement rates are another key element of our gross revenue and operating margin since per diem contracts represent a majority of our revenues (approximately 61.0% and 61.2% for the three and nine months ended September 30, 2009, respectively). Per diem rates are a function of negotiation between management and a governmental unit at the inception of a contract or through the bidding process. Actual per diem rates vary dramatically across our business segments, as well as within each business segment, depending upon the particular service or program provided. The initial per diem rates often change during the term of a contract in accordance with a schedule. The amount of the change can be a fixed amount set forth within the contract, an amount determined by formulas set forth within the contract or an amount determined by negotiations between management and the governmental unit (often these negotiations are along the same lines as the original per diem negotiation - a review of expenses and approval of an amount to recompense for expenses and assure the potential of an operating profit). In recent years, as budgetary pressures on governmental units have increased, some of our customers have negotiated relief from formulaic increase provisions within their agreements or have declined to include in their appropriation legislation amounts that would increase the per diem rates payable under the contract. Based on the economic turmoil which began in the second half of 2008, we are expecting such pressures to continue through the remainder of 2009 and likely into 2010 for many of our customers. In similar prior situations we have attempted to mitigate the impact of these developments by negotiating services provided, obtaining commitments for increased volume and other measures. We may also choose to consider terminating an existing relationship at a given facility and replacing it with a new customer (as was done with our Great Plains Correctional Facility in 2007).

Revenues. We derive substantially all of our revenues from providing adult corrections and treatment and juvenile justice, educational and treatment services outsourced by federal, state and local government agencies in the United States. Revenues for our 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. For the three months ended September 30, 2009, our revenue base consisted of 61.0% for services provided under per diem contracts, 34.0% for services provided under take-or-pay and management contracts, 2.9% for services provided under cost-plus reimbursement contracts, 1.9% for services provided under fee-for-service contracts and 0.2% from other miscellaneous sources. For the three months ended September 30, 2008, our revenue base consisted of 54.3% for services provided under per diem contracts, 40.2% for services provided under take-or-pay and management contracts, 3.4% for services provided under cost-plus reimbursement contracts, 1.9% for services provided under fee-for-service contracts and 0.2% from other miscellaneous sources. For the nine months ended September 30, 2009 our revenue base consisted of 61.2% for services provided under per diem contracts, 33.5% for services provided under take-or-pay and management contracts, 3.3% for services provided under cost-plus reimbursement contracts, 1.8% for services provided under fee-for-service contracts and 0.2% from other miscellaneous sources. For the nine months ended September 30, 2008 our revenue base consisted of 52.4% for services provided under per diem contracts, 41.6% for services provided under take-or-pay and management contracts, 3.8% for services provided under cost-plus reimbursement contracts, 2.0% for services provided under fee-for-service contracts and 0.2% from other miscellaneous sources. The increase in revenues in the respective 2009 periods provided under per diem contracts (and the corresponding decrease in revenues provided under take-or-pay and management contracts) primarily reflects the transition of our contract with the Arizona Department of Corrections from a take-or-pay contract to a per diem contract upon the activation (and subsequent ramp in the fourth quarter of 2008) of its 1,100 bed expansion. In addition, we also terminated several management contracts in 2008 (including Salt Lake Valley Detention Center and Lincoln County Detention Center in September 2008 and February 2008, respectively).

Revenues can fluctuate from year to year due to changes in government funding policies, changes in the number or types of clients referred to our facilities by governmental agencies, changes in the types of services delivered to our customers, the opening of new facilities or the expansion of existing facilities and the termination of contracts for a facility or the closure of a facility.

Factors considered in determining billing rates 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 could reasonably be expected to be maintained and the duration of time required to reach such occupancy levels.

Revenues-Adult Secure Services. Revenues for our Adult Secure Services division are primarily generated from per diem, take-or-pay and management contracts. For the three months ended September 30, 2009 and 2008, we realized average per diem rates on our adult secure facilities of approximately $53.72 and $53.12, respectively. For the nine months ended September 30, 2009 and 2008, we realized average per diem rates of approximately $54.25 and $54.00, respectively. The average per diem rate for the nine months ended September 30, 2008 benefited from a contract-based revenue adjustment for the contract year ended March 2008 in the amount of approximately $1.5 million at the RCC. We periodically have experienced pressure from contracting governmental agencies to limit or even reduce per diem rates. Many of these governmental entities are under severe budget pressures and we anticipate that these agencies may periodically approach us in the remainder of 2009 and likely in 2010 about per diem rate concessions (or decline to provide funding for contractual rate increases). Decreases in, or the lack of anticipated increases in, per diem rates could adversely impact our operating margin.

Revenues-Abraxas Youth and Family Services. Revenues for our Abraxas Youth and Family Services division are primarily generated from per diem, fee-for-service and cost-plus reimbursement contracts. For the three months ended September 30, 2009 and 2008, we realized average per diem rates on our residential youth and family services facilities of approximately $195.74 and $193.89, respectively. For the nine months ended September 30, 2009 and 2008, we realized average per diem rates of approximately $195.88 and $191.03, respectively. The increase in the average per diem rate for 2009 reflects the continued ramp-up of the Abraxas Academy (reactivated in the fourth quarter of 2006), the reactivation of the Hector Garza Residential Treatment Center in August 2007 as well as changes in the mix of services provided and customers served at our other facilities. For the three months ended September 30, 2009 and 2008, we realized average fee-for-service rates for our non-residential community-based Abraxas Youth and Family Services facilities and programs, including rates that are limited by Medicaid and other private insurance providers, of approximately $45.91 and $45.32, respectively. For the nine months ended September 30, 2009 and 2008, we realized average fee for service rates of approximately $45.36 and $47.85, respectively. The fluctuation in the average fee-for-service rates for 2009 and 2008 is due to changes in the mix of services provided at our non-residential facilities. The majority of our Abraxas Youth and Family Services contracts renew annually.

Revenues-Adult Community-Based Services. Revenues for our Adult Community-Based Services division are primarily generated from per diem and fee-for-service contracts. For the three months ended September 30, 2009 and 2008, we realized average per diem rates on our residential adult community-based facilities of approximately $66.47 and $68.46, respectively. For the nine months ended September 30, 2009 and 2008, we realized average per diem rates on our residential Adult Community-Based Services facilities of approximately $66.97 and $66.44, respectively. For the three months ended September 30, 2009 and 2008, we realized average fee-for-service rates on our non-residential Adult Community-Based Services facilities and programs of approximately $12.22 and $11.90, respectively. For the nine months ended September 30, 2009 and 2008, we realized average fee-for-service rates on our non-residential Adult Community-Based Services facilities and programs of approximately $9.93 and $13.71, respectively. Our average fee-for-service rates fluctuate from year to year principally due to changes in the mix of services provided by our various Adult Community-Based Services programs and facilities.

Operating Margins. We have historically experienced higher operating margins in our Adult Secure Services and Adult Community-Based Services divisions as compared to our Abraxas Youth and Family Services division. Our operating margin, in a given period, will be impacted by those facilities which may either be underutilized, dormant or have been reactivated during the period. As previously discussed, we have reactivated several facilities, including the Abraxas Academy and the Hector Garza Residential Treatment Center in 2006 and 2007, respectively. We have also expanded several of our Adult Secure facilities during 2008 and 2009 (D. Ray James Prison, Great Plains Correctional Facility and Walnut Grove Youth Correctional Facility, for example), which provides the opportunity to leverage existing infrastructure. Additionally, our 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 mix of services provided, 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 our ability to increase a facility's contract revenue. Under take-or-pay contracts, such as the contract at the Moshannon Valley Correctional Center, operating margins are typically higher during the early stages of the contract as the facility's population ramps up (as revenues are received at contract percentages regardless of actual occupancy). As the variable costs (primarily resident-related and certain facility costs) increase with the growth in population, operating margins will generally decline to a stabilized level. Following its activation in April 2006, we experienced such operating margin impact pertaining to the Moshannon Valley Correctional Center in the third and fourth quarters of 2006. A decline in occupancy at our Abraxas Youth and Family Services facilities can have a more significant negative impact on operating margins than a decline in occupancy in our Adult Secure Services division due to the longer periods typically required to ramp resident population at a youth facility (given the relative facility scale influences present in these divisions).

We have experienced and expect to continue to experience interim period operating margin fluctuations due to factors such as the number of calendar days in the period, higher payroll taxes (generally in the first half of the year) and salary and wage increases and insurance cost increases that are incurred prior to certain contract rate increases. Periodically, many of the governmental agencies with

whom we contract may experience budgetary pressures and may approach us to limit or reduce per diem rates (including contractual price increases as well). We have seen indications of such customer behavior in 2009 and believe it will continue into 2010. Decreases in, or the lack of anticipated increases in, per diem rates could adversely impact our operating margin. Additionally, a decrease in per diem rates without a corresponding decrease in operating expenses could also adversely impact our operating margin.

Operating Expenses. We track several different areas of our operating expenses. Foremost among these expenses are employee compensation and benefits and expenses, risk related areas such as general liability, medical and worker's compensation, client/inmate costs such as food, clothing, medical and programming costs, financing costs and administrative overhead expenses. Increases or decreases in one or more of these expenses, such as our experience with rising insurance costs, can have a material effect on our financial performance. Operating expenses are also impacted by decisions to close or terminate a particular program or facility. Such decisions are based on our assessments of operating results, operating efficiency and risk-adjusted returns and are an ongoing part of our portfolio management. In addition, decisions to restructure employee positions will typically increase period costs initially (at the time of such actions), but generally reduce post-restructuring expense levels.

We are responsible for all facility operating costs, except for certain debt service and interest or lease payments for facilities where we have a management contract only. At these facilities, the facility owner is responsible for all debt service and interest or lease payments related to the facility. We are responsible for all other operating expenses at these facilities. We operated 13 and 16 facilities under management contracts at September 30, 2009 and 2008, respectively. Included in the facilities under management contracts at September 30, 2009 were the Walnut Grove Youth Correctional Facility and the eight Los Angeles County Jails, which represented 1,714 beds of service capacity, or approximately 82.5%, of the residential service capacity represented by management contracts.

A majority of our facility operating costs consists of fixed costs. These fixed costs include lease and rental expense, insurance, utilities and depreciation. As a result, when we commence operation of new or expanded facilities, fixed operating costs may increase. The amount of our variable operating costs, including food, medical services, supplies and clothing, depend on occupancy levels at the facilities. Our largest single operating cost, facility payroll expense and related employment taxes and expenses, has both a fixed and a variable component. We 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 . . .