10QSB 1 q601.txt FORM 10QSB FOR PERIOD ENDING JUNE 30, 2001 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-QSB QUARTERLY REPORT UNDER SECTION 13 or 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2001 Commission File Number: 0-20307 AVALON CORRECTIONAL SERVICES, INC. (Exact name of small business issuer as specified in its charter) Nevada 13-3592263 (State of Incorporation) (I.R.S. Employer I.D. Number) 13401 Railway Drive, Oklahoma City, Oklahoma 73114 (Address of principal executive offices) (405) 752-8802 (Issuer's telephone number) Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15 (d) of the Exchange Act during the past 12 months (or such shorter period as the registrant was required to file such reports), and (2) been subject to such filing requirements for the past 90 days: Yes X No ___ As of July 27, 2001, 4,822,924 shares of the issuer's Class A common stock, par value $.001, were issued and outstanding. Transitional Small Business Disclosure Format: Yes ___; No X . PART I - FINANCIAL INFORMATION AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) June 30, December 31, 2001 2000 __________________________________ ASSETS Current assets: Cash and cash equivalents $ 1,426,000 $ 726,000 Related party receivables 328,000 317,000 Accounts receivable, net 2,277,000 3,719,000 Prepaid expenses and other 278,000 160,000 __________________________________ Total current assets 4,309,000 4,924,000 Property and equipment, net 29,307,000 29,673,000 Other assets 4,734,000 4,858,000 __________________________________ Total assets $ 38,350,000 $ 39,455,000 LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable, accrued liabilities 1,632,000 $ 1,477,000 and other Current maturities of long-term debt 1,872,000 2,992,000 _________________________________ Total current liabilities 3,504,000 4,469,000 Long-term debt, less current maturities 22,838,000 23,614,000 Convertible debentures 3,850,000 3,850,000 Redeemable Common Stock, $.001 par value 1,622,448 shares issued and outstanding 3,515,000 3,593,000 Stockholders' equity: Common stock: Par value $.001; 20,000,000 shares authorized; 4,822,924 and 4,765,630 shares issued and outstanding, less 1,622,448 shares subject to repurchase. 3,000 3,000 Preferred stock; par value $.001; 1,000,000 shares authorized; none issued ___ ___ Paid-In capital 7,450,000 7,285,000 Accumulated deficit (2,810,000) (3,359,000) __________________________________ Total liabilities and stockholders' equity 38,350,000 $ 39,455,000 __________________________________ The accompanying notes are an integral part of these consolidated financial statements. Page 1 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited) Three Months Ended Six Months Ended June 30, June 30, 2001 2000 2001 2000 ______________________________________________ Revenues $6,315,000 $5,417,000 $12,264,000 $10,665,000 ______________________________________________ Costs and expenses Direct operating $4,482,000 $3,511,000 $8,525,000 7,028,000 General and administrative 308,000 470,000 750,000 863,000 Depreciation and amortization 464,000 337,000 859,000 671,000 Interest expense 756,000 870,000 1,580,000 1,659,000 ______________________________________________ Income from continuing operations before income tax expense $306,000 $ 229,000 $550,000 $444,000 Income tax expense --- --- --- --- ______________________________________________ Net income $ 306,000 $ 229,000 $ 550,000 $ 444,000 ______________________________________________ Basic income per share: Net income per share, basic $ 0.06 $ 0.05 $ 0.11 $0.09 ______________________________________________ Weighted average number of common and common equivalent shares outstanding 4,779,260 4,743,652 4,772,483 4,729,641 ______________________________________________ Diluted income per share: Net income per share, diluted $ 0.06 $ 0.05 $ 0.11 $0.09 ______________________________________________ Weighted average number of common and common equivalent shares outstanding, diluted 5,097,166 4,821,962 4,920,664 4,799,038 ______________________________________________ The accompanying notes are an integral part of these consolidated financial statements. Page 2 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED STATEMENTS OF CASH FLOW (Unaudited) For the six months ended June 30, 2001 2000 ___________________________________ OPERATING ACTIVITIES: Net income $ 550,000 $ 444,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation expense 577,000 671,000 Change in Other assets 124,000 176,000 Changes in operating assets and liabilities: Decrease (increase) in - Accounts receivable 1,433,000 (61,000) Prepaid expenses and other (118,000) 277,000 Increase in accounts payable, accrued liabilities and other 155,000 183,000 ___________________________________ Net cash provided by operating activities $ 2,721,000 $ 1,690,000 ___________________________________ INVESTING ACTIVITIES: Capital expenditures $ (214,000) $ (1,172,000) Proceeds from payments on notes receivable ___ 28,000 ___________________________________ Net cash used in investing activities $ (214,000) $ (1,144,000) ___________________________________ FINANCING ACTIVITIES: Proceeds from borrowings 13,337,000 11,367,000 Repayment of borrowings (15,231,000) (11,928,000) Proceeds from warrant and option exercise 87,000 67,000 ___________________________________ Net cash used in financing activities $ (1,807,000) $ (494,000) ___________________________________ NET INCREASE IN CASH $ 700,000 $ 52,000 CASH, BEGINNING OF PERIOD 726,000 601,000 ___________________________________ CASH, END OF PERIOD $ 1,426,000 $ 653,000 ___________________________________ The accompanying notes are an integral part of these consolidated financial statements. Page 3 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES Nature of Business - Avalon Correctional Services, Inc. ("Avalon" or the "Company") (formerly Avalon Community Services, Inc.) is an owner and operator of private community correctional services. Avalon specializes in privatized community correctional facilities and intensive correctional programming. Avalon is currently operating in Oklahoma, Texas and Colorado with plans to significantly expand into additional states. Avalon's business strategy is designed to elevate the Company into a dominant provider of community correctional services by expanding its operations through new state and Federal contracts and selective acquisitions. Avalon owns a 248-bed minimum security facility in Oklahoma City, Oklahoma; a 266-bed minimum security facility in Tulsa, Oklahoma; a 168-bed adult minimum security facility in Tulsa, Oklahoma; a 150-bed medium security facility in El Paso, Texas; a 300-bed medium security facility in El Paso, Texas; a 160-bed medium security juvenile facility in Union City, Oklahoma; a 115-bed minimum security facility in Henderson, Colorado; and a 300-bed minimum security multi-use facility in Greeley, Colorado. Avalon also operates a 37-bed minimum security facility in Denver, Colorado, and a day reporting center in Northglen, Colorado. The Colorado community corrections programs also provide non-residential services to approximately 520 offenders in the State of Colorado. Principles of Consolidation - The consolidated financial statements include the accounts of the Company and its wholly-owned subsidiaries after elimination of all material intercompany balances and transactions. Use of Estimates - The preparation of the consolidated financial statements requires the use of management's estimates and assumptions in determining the carrying values of certain assets and liabilities and disclosures of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts for certain revenues and expenses during the reporting period. Actual results could differ from those estimated. Cash and Cash Equivalents - The Company considers all highly liquid investments with original maturities of three months or less when purchased and money market funds to be cash equivalents. Concentrations of Credit Risk - Financial instruments potentially subjecting the Company to concentrations of credit risk consist principally of temporary cash investments, accounts receivable and notes receivable. The Company places its temporary cash investments with high credit quality financial institutions and money market funds and limits the amount of credit exposure to any one institution or fund. Concentrations of credit risk with respect to accounts receivable are limited due to the fact that a significant portion of the Company's receivables are from state governments. The Company maintains an allowance for doubtful accounts for potential credit losses. Actual bad debt expenses have not been material. Page 4 Property and Equipment - Property and equipment are recorded at cost. Expenditures for major additions and improvements are capitalized, while minor replacements, maintenance and repairs are charged to expense as incurred. When property and equipment are retired or otherwise disposed of, the cost and related accumulated depreciation are removed from the accounts and any resulting gain or loss is reflected in current operations. Depreciation is provided using the straight-line method over the following estimated useful lives: Buildings and Improvements 40 Years Furniture and Equipment 5 to 7 Years Transportation Equipment 3 to 15 Years Impairment losses are recorded on long-lived assets when indicators of impairment are present and the undiscounted cash flows estimated to be generated by those assets are less than the assets' carrying amounts. Impairment losses are recognized based upon the estimated fair value of the asset when required. Income Taxes - Deferred income taxes are recognized for the tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end based on enacted tax laws and statutory tax rates applicable to the period in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Income tax expense is the tax payable for the period and the change during the period in deferred tax assets and liabilities. Revenue Recognition - The Company recognizes revenues as services are provided. Revenues are earned based upon the number of inmates on a per diem basis at the Company's correctional facilities. Correctional revenues are received monthly from various governmental agencies. Development Costs - The Company expenses development and new facility opening costs as incurred. Net Income Per Common Share - Basic net income per share has been computed on the basis of weighted average shares outstanding during each period. Diluted income per share has been computed based on the assumption that all dilutive options, warrants, and convertible instruments are exercised. Interim Financial Statements - The consolidated balance sheet as of June 30, 2001 and the statements of operations and cash flows for the three months and six months ended June 30, 2001 and 2000 are unaudited and, in the opinion of management, reflect all adjustments that are necessary for a fair presentation of the financial position as of such date and the results of operations and cash flows for the period then ended. All such adjustments are of a normal and recurring nature. The financial statements included herein have been prepared in conformity with generally accepted accounting principles and should be read in conjunction with the December 31, 2000 Form 10-KSB filing. Footnote disclosures which would substantially duplicate the disclosure contained in the most recent annual report on Form 10-KSB have been condensed or omitted. The results of operations for the three months and six months ended June 30, 2001, are not necessarily indicative of the results that may be expected for the entire year ended December 31, 2001. Page 5 NOTE 2. LONG-TERM DEBT Long-term debt consists of the following: June 30, December 31, 2001 2000 ___________________________ Revolving bank line of credit, collateralized by accouts receivable, with interest at 1% over $ 71,000 $ 1,070,000 prime (effective rate of 7.00% at June 30, 2001; due February 2003). Notes payable to banks, collateralized by transportation equipment, due in installments through March 2012 with interest ranging from 4.90% to 9.49%. 767,000 806,000 Notes payable to banks, collateralized by land, buildings, and improvements due in installments through June 2012 with interest ranging from 6.56% to 11.00%. 13,600,000 14,441,000 Note payable to an investment company, uncollateralized with interest at 12.5%, due in four installments beginning in 2005, including original issue premium 10,272,000 10,289,000 __________________________ $24,710,000 $26,606,000 Less - current maturities $ 1,872,000 $ 2,992,000 __________________________ $22,838,000 $23,614,000 __________________________ The Company completed a $15,000,000 private placement of debt and equity with an investment company on September 16, 1998. Pursuant to the terms of the agreement, the Company tendered an unsecured subordinated note with a face value of $10,000,000 bearing interest of 12.5% with interest payable in quarterly installments until December 31, 2005, when the first of four quarterly principal installments is due. The Company also tendered 1,622,448 shares of redeemable common stock to the investment company. These shares are subject to repurchase by the Company under certain circumstances, or beginning September 16, 2003 at the holders option, at the then current average traded price of the stock. The Company is accreting the difference between the carrying value and the estimated redemption price of the stock by periodic charges / credits to additional paid-in capital. The financial covenants require the Company, among other things, to maintain certain earnings and debt coverage ratios. The Company obtained an independent fair value appraisal of the debt and equity instruments reflecting a fair value allocation of the debt of $10,365,000 and the fair value allocation of the redeemable common stock of $4,635,000. The original issue premium of $365,000 is being accreted as a reduction of interest expense over the term of the debt instrument. Debt issue costs of $1,654,000 (including $266,000 representing the fair value of warrants issued to financial advisors) have been allocated to the debt and redeemable common stock based upon their fair values. Costs of $511,000 allocated to the redeemable common stock reduced its original book value to $4,124,000. Costs of $1,143,000 allocated to the debt instrument are included in other assets and are being amortized to interest expense over the life of the debt instrument using the effective interest method. Page 6 NOTE 3. CONVERTIBLE DEBENTURES The Company completed a private placement of $4,150,000 of convertible debentures on September 12, 1997. The convertible debentures bear interest at 7.5% and mature on September 12, 2007. The convertible debentures may be redeemed by the Company at any time after May, 2000 at 106.5% of principal, declining to 100% at maturity. The convertible debentures are convertible into common stock at $3.00 per share at any time until their maturity. The convertible debenture holders signed agreements to subordinate the debentures to the $10,000,000 face value note issued on September 16, 1998. The Company redeemed $300,000 of convertible debentures at face value in September 1998. NOTE 4. STOCKHOLDERS' EQUITY The Company issued 200,000 Class D stock purchase warrants in August 1996, in connection with the acquisition of the El Paso Intermediate Sanction Facility. The Class D stock purchase warrants provide for the purchase of the Company's common stock at any time until their expiration at August 2, 2001. The exercise price of the class D warrants is $4.20 per share as of the end of the quarter. The warrants may be redeemed by the Company upon certain events for $.01 per share. The Company issued Class E Warrants to purchase 79,000 shares of Common Stock in September 1997, in connection with the private placement of Convertible Debentures. The Company recognized $148,000 of cost based upon the difference in the exercise price of the Class E warrants and the current market price of the common stock on the date of issuance. This cost was recorded as debenture issue costs and is classified in other assets on the balance sheet. The debenture issue cost is amortized to expense over the term of the convertible debentures. The Class E stock purchase warrants provide for the purchase of the Company's common stock at a price of $3.00 per share at any time until their expiration at September 12, 2002. The warrants may be redeemed by the Company upon certain events for $.01 per share. The Company issued 200,539 stock purchase warrants to financial advisors in September 1998, in connection with the $15,000,000 private placement. The stock purchase warrants provide for the purchase of the Company's common stock at any time until their expiration at September 2002. The exercise price of the warrants is $3.75 per share as of the end of the quarter. The warrants may be redeemed by the Company upon certain events for $.01 per share. The fair value of the warrants was allocated between the proceeds the debt and equity issues as debt issue cost and a reduction in redeemable common stock. A 1994 agreement provided for the issuance of an option to issue 750,000 common stock purchase warrants to purchase common stock at $1.50 per share for each dollar of Company debt guaranteed by the Company's CEO. The warrants have a five year term from the date of issuance, March 9, 2001. NOTE 5. STOCK OPTION PLAN The Company adopted a stock option plan (the "Plan") providing for the issuance of 250,000 shares of Class A common stock pursuant to both incentive stock options, intended to qualify under Section 422 of the Internal Revenue Code, and options that do not qualify as incentive stock options ("non-statutory"). The Option Plan was registered with the Securities and Exchange Commission in November 1995. The purpose of the Plan is to provide continuing incentives to the Company's officers, key employees, and members of the Board of Directors. The options generally vest within five years and have a ten year expiration period. The Company amended its stock option plan on December 1, 1996, increasing the number of shares available under the Plan to 600,000. Non-statutory options have been granted providing for the issuance of 489,760 shares of Class A common stock at exercise prices ranging from $1.50 to $4.25 per share. Options providing for the issuance of 386,740 shares were exercisable at June 30, 2001. NOTE 6. LITIGATION The Company is a party to litigation arising in the normal course of business. Management believes that the ultimate outcome of these matters will not have a material effect on the Company's financial condition or results of operations. Page 7 NOTE 7. EARNINGS PER SHARE The following table sets forth the computation of income per share and income per share assuming dilution. Three months ended Six months ended June 30, June 30, 2001 2000 2001 2000 ___________________________________________ Numerator Net income $ 306,000 $ 229,000 $ 550,000 $ 444,000 ___________________________________________ Denominator for earnings per share Weighted average shares outstanding-basic 4,779,260 4,743,652 4,772,482 4,729,641 Effect of dilutive securities - stock options 317,906 78,310 148,182 78,310 _____________________________________________ Denominator for earnings per 5,097,166 4,821,962 4,920,664 4,799,038 share assuming dilution _____________________________________________ Income per share, basic $ 0.06 $ 0.05 $ 0.11 $ 0.09 _____________________________________________ Income per share assuming dilution $ 0.06 $ 0.05 $ 0.11 $ 0.09 _____________________________________________ Page 8 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations Liquidity and Capital Resources - The Company's business strategy is to focus on the private corrections industry, expanding its operations into additional states through new Federal and state contracts and selective acquisitions. The successful implementation of the Company's growth plan has created the need for additional capital and financing. The Company has been successful in securing $37 million of new capital and credit facilities since September 1997. The Company had approximately $2.6 million of cash and revolving credit available for new projects at June 30, 2001. The Company believes it has adequate cash reserves and cash flow from operations to meet its current cash requirements. The Company expects current contracts to generate sufficient income to increase cash reserves, while minimizing income taxes through the utilization of tax loss carryforwards. The Company secured an $18 million senior credit facility with Fleet Capital Corporation in February 1999. The credit facility with Fleet Capital Corporation was amended in December of 1999 to provide for a credit facility consisting of a $13.5 million term loan and a revolving line of credit equal to the lesser of $3 million or 80% of eligible accounts receivable. Cash flows for the first half of the year are significantly better than the first six months of the previous year primarily due to increased collections of accounts receivable. These collections had slowed at the end of the year 2000, thereby inflating the collections for the first two months of the current year, when receivables returned to normal levels. Results of Operations - Three Months Ended June 30, 2001 Compared to the Three Months Ended June 30, 2000. Total revenues increased by 17% to $6.32 million for the three months ended June 30, 2001 from $5.42 million for the three months ended June 30, 2000. The increase was a result of overall higher inmate populations. The Company had net income for the three months ended June 30, 2001 of $306,000 or $.06 basic and diluted income per share, as compared to net income for the three months ended June 30, 2000 of $229,000 or $.05 basic and diluted earnings per share. The Company's significant improvement was the result of overall higher inmate populations. Earnings before interest, taxes, depreciation, and amortization (EBITDA) increased 6% for the three months ended June 30, 2001 to $1,526,000 compared to $1,436,000 for the three months ended June 30, 2000. Corporate. General and administrative expenses were $308,000 for the three months ended June 30, 2001, compared to $470,000 for the three months ended June 30, 2000. These expenses are 4.9 % of revenues in the second quarter of 2001 and 8.7% of revenues for the second quarter of 2000. The decrease in interest expense of $114,000 for the three months ended June 30, 2001 over the second quarter of 2000 resulted from significantly lower interest rates and slightly less outstanding debt. Depreciation and amortization expense have increased commensurate with the growth of the correctional operations. Six Months Ended June 30, 2001 Compared to the Six Months Ended June 30, 2000. Revenues for the first two quarters of 2001 increased 15% to $12.3 million compared to $10.7 million for the same period in 2000. The Company had net income for the six months ended June 30, 2001 of $550,000 or $.11 basic and diluted income per share, as compared to net income for the six months ended June 30, 2000 of $444,000 or $.09 basic and diluted income per share. The Company's improvement was the result of the aforementioned higher inmate populations. Page 9 Earnings before interest, taxes, depreciation, and amortization (EBITDA) increased 8% for the six months ended June 30, 2001 to $2,989,000 compared to $2,774,000 for the six months ended June 30, 2000. Corporate. General and administrative expenses were $750,000 for the six months ended June 30, 2001 compared to $863,000 for the six months ended June 30, 2000. These expenses are 6.1% of revenues for the six months ended June 30, 2001 compared to 8.1% of revenues for the six months ended June 30, 2000. Depreciation and amortization have increased commensurate with the growth of the correctional operations. Interest expense declined significantly due to rate decreases from the primary lender. Page 10 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES PART II - OTHER INFORMATION Item 1. Legal Proceedings - None. Item 2. Changes in Securities - None. Item 3. Defaults Upon Senior Securities - None. Item 4. Submission of Matters to a Vote of Security Holders - May 23, 2001 Annual Meeting Directors Elected -- Robert O. McDonald and Charles W. Thomas Votes for -- 4,602,638 Votes against -- 8,530 Directors Continued Donald E. Smith Jim Wilson Mark S. Cooley Proposal: To ratify the selection of Grant Thornton, LLP as the Company's independent public countants and auditors for the fiscal year ending December 31, 2001 Votes for -- 4,362,926 Votes against -- 248,242 Item 5. Other Information - None. Item 6. Exhibits and reports on Form 8-K Page 11 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES SIGNATURES In accordance with the requirement of the Exchange Act, the registrant has caused this report to be signed on its behalf by the undersigned thereunto duly authorized. Date: July 27, 2001 AVALON CORRECTIONAL SERVICES, INC. s//Donald E. Smith By:________________________________________ Donald E. Smith, Chief Executive Officer s// Lloyd Lovely By:________________________________________ Lloyd Lovely, Vice President of Finance Page 12