-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, T8wI4A2Yl3TAhrIGa2/KxSCl1sqvhZuOa2E3Yf/7xyo5Zp4kCT00nUJH8ArJ4rTR YLj0XHjTP8qOFsNP6TjOag== 0000872202-02-000020.txt : 20021104 0000872202-02-000020.hdr.sgml : 20021104 20021104152328 ACCESSION NUMBER: 0000872202-02-000020 CONFORMED SUBMISSION TYPE: 10QSB PUBLIC DOCUMENT COUNT: 1 CONFORMED PERIOD OF REPORT: 20020930 FILED AS OF DATE: 20021104 FILER: COMPANY DATA: COMPANY CONFORMED NAME: AVALON CORRECTIONAL SERVICES INC CENTRAL INDEX KEY: 0000872202 STANDARD INDUSTRIAL CLASSIFICATION: SERVICES-FACILITIES SUPPORT MANAGEMENT SERVICES [8744] IRS NUMBER: 133592263 STATE OF INCORPORATION: NV FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10QSB SEC ACT: 1934 Act SEC FILE NUMBER: 000-20307 FILM NUMBER: 02808276 BUSINESS ADDRESS: STREET 1: 13401 RAILWAY DR STREET 2: 13401 RAILWAY DRIVE CITY: OKLAHOMA CITY STATE: OK ZIP: 73114 BUSINESS PHONE: 4057528802 MAIL ADDRESS: STREET 1: 13401 RAILWAY DRIVE CITY: OKLAHOMA CITY STATE: OK ZIP: 73114 FORMER COMPANY: FORMER CONFORMED NAME: AVALON ENTERPRISES INC DATE OF NAME CHANGE: 19600201 FORMER COMPANY: FORMER CONFORMED NAME: AVALON COMMUNITY SERVICES INC DATE OF NAME CHANGE: 19930328 10QSB 1 q902.txt FORM 10-QSB FOR PERIOD ENDING SEPTEMBER 30, 2002 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 September 30, 2002 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 October 31, 2002, 4,895,002 shares of the issuer's Class A common stock, par value $.001, were ssued and outstanding. Transitional Small Business Disclosure Format: Yes ___; No X . PART I - FINANCIAL INFORMATION AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) September 30, December 31, 2002 2001 --------------- --- ------------- ASSETS Current assets: Cash and cash equivalents $ 1,022,000 $ 2,389,000 Certificates of deposit 1,500,000 --- Related party receivables 16,000 161,000 Accounts receivable, net 3,007,000 2,611,000 Prepaid expenses and other 426,000 239,000 --------------- --- --------------- Total current assets $ 5,971,000 $ 5,400,000 Property and equipment, net 29,946,000 30,414,000 Other assets 3,940,000 4,273,000 --------------- --- --------------- Total assets $ 39,857,000 $ 40,087,000 =============== === =============== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable, accrued liabilities and other Current maturities of $ 1,552,000 $ 2,170,000 long-term debt 3,387,000 2,545,000 -------------- --- --------------- Total current liabilities $ 4,939,000 $ 4,715,000 Long-term debt, less current maturities 21,128,000 22,547,000 Convertible debentures 3,850,000 3,850,000 Redeemable common stock, $.001 par value 1,622,448 shares issued and outstanding 3,461,000 3,470,000 Stockholders' equity: Common stock: Par value $.001; 24,000,000 authorized; 4,895,002 and 4,847,624 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 7,624,000 7,536,000 Accumulated deficit (1,148,000) (2,034,000) -------------- --- --------------- Total liabilities and stockholders' equity $ 39,857,000 $ 40,087,000 =============== === =============== 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 Nine Months Ended September 30, September 30, 2002 2001 2002 2001 ---------------- ---------------- --------------- --------------- Revenues $ 6,878,000 $ 6,359,000 $ 20,247,000 $ 18,623,000 ---------------- ---------------- --------------- --------------- Costs and expenses Direct operating $ 4,891,000 $ 4,211,000 $ 14,008,000 $ 12,736,000 General and administrative 470,000 527,000 1,547,000 1,277,000 Depreciation and amortization 510,000 508,000 1,499,000 1,367,000 Interest expense 644,000 718,000 1,939,000 2,298,000 ---------------- ---------------- --------------- --------------- Net income from operations before income tax expense $ 363,000 $ 395,000 $ 1,254,000 $ 945,000 Income tax expense 143,000 --- 368,000 --- ---------------- ---------------- --------------- --------------- Net income $ 220,000 $ 395,000 $ 886,000 $ 945,000 ================ ================ =============== =============== Basic income per share: Net income per share, basic $ 0.04 $ 0.08 $ 0.18 $ 0.20 ================ ================ =============== ============= Weighted average number of common and common equivalent shares outstanding, basic 4,894,628 4,838,520 4,876,664 4,794,737 ================ ================ =============== ============= Diluted income per share: Net income per share, diluted $ 0.04 $ 0.07 $ 0.16 $ 0.19 ================ ================ =============== ============= Weighted average number of common and common equivalent shares outstanding, diluted 6,416,256 6,445,786 6,489,795 6,277,861 ================ ================ =============== =============
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 nine months ended September 30, 2002 2001 --------------------------------------- OPERATING ACTIVITIES: Net income $ 886,000 $ 945,000 Adjustments to reconcile net income to net cash provided by operating activities Depreciation and amortization 1,499,000 815,000 Amortization of debt issue costs 247,000 422,000 Changes in operating assets and liabilities Decrease (increase) in - Accounts receivable (251,000) 1,166,000 Prepaid expenses and other (480,000) (65,000) Increase (decrease) in accounts payable, accrued liabilities and other (618,000) 27,000 ------------------------- Net cash provided by operating activities $ 1,283,000 $ 3,310,000 ------------------------- INVESTING ACTIVITIES: Capital expenditures $ (653,000) $(1,002,000) Purchase of certificates of deposit $ (1,500,000) --- ---------------------------- Net cash used in investing activities $ (2,153,000) $(1,002,000) ---------------------------- FINANCING ACTIVITIES: Proceeds from borrowings $ 21,303,000 $ 19,933,000 Repayment of borrowings (21,879,000) (21,941,000) Proceeds from warrant and option exercise 79,000 127,000 ---------------------------- Net cash used in financing activities (497,000) $ (1,881,000) ---------------------------- NET INCREASE (DECREASE) IN CASH $ (1,367,000) $ 427,000 CASH, BEGINNING OF PERIOD 2,389,000 726,000 ---------------------------- CASH, END OF PERIOD $ 1,022,000 $ 1,153,000 ============================ 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") is an owner and operator of private community correctional facilities. Avalon specializes in privatized community correctional facilities and 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 300-bed community corrections facility in Oklahoma City, Oklahoma; a 320-bed community corrections facility in Tulsa, Oklahoma; a 150-bed community corrections 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 180-bed community corrections facility on leased land in Del Valle, Texas; a 160-bed medium security juvenile facility in Union City, Oklahoma; a 139-bed community corrections facility in Henderson, Colorado; and a 307-bed multi-use community corrections facility in Greeley, Colorado. Avalon also operates four programs in leased facilities: a 352-bed intermediate sanction unit in Tulsa, Oklahoma; a 35-bed community corrections facility in Denver, Colorado; a 48 bed juvenile substance abuse treatment facility in San Angelo, Texas; and a day reporting center in Northglen, Colorado. The Colorado community corrections programs also provide non-residential services to approximately 175 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 estimates. 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 is from government agencies. The Company maintains an allowance for doubtful accounts for potential credit losses. The allowance for doubtful accounts at September 30, 2002 and December 31, 2001 was $21,000 and $27,000, respectively. 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: Page 4 Buildings and improvements 10 to 40 Years Furniture and equipment 5 to 10 Years Transportation equipment 2 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 related 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 period 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 by management 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. The Company's effective rate differs from the statutory rate of thirty-four percent due to the utilization of net operating loss carryforwards and state income tax effects. Revenue Recognition - The Company recognizes revenues as services are provided. Revenues are generally earned based upon the number of offenders 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 and warrants are exercised using the treasury stock method. The dilutive effect of convertible obligations is determined using the if-converted method. Interim Financial Statements - The consolidated balance sheet as of September 30, 2002, the statements of operations for the three months and nine months ended September 30, 2002 and 2001, and the statements of cash flows for the nine months ended September 30, 2002 and 2001 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 accounting principles generally accepted in the United States and should be read in conjunction with the December 31, 2001 Form 10-KSB filing. The results of operations for the three months and nine months ended September 30, 2002, are not necessarily indicative of the results that may be expected for the entire year ended December 31, 2002. Subsequent Event - On October 10, 2002, the board of directors of the Oklahoma Office of Juvenile Affairs (OJA) voted to not renew their contract with Avalon for 80 beds at the Company's Union City facility. The vote was a cost-cutting move as a part of the board's state mandate to reduce expenditures from its budget in the current fiscal year. The contract is scheduled to cease on December 2, 2002. The OJA contract contributed approximately $3,800,000 to the Company's annual revenues for the year ended December 31, 2001. The OJA contract was the primary source of revenue for the Union City facility. The Company is currently evaluating other sources of offenders for the facility. Page 5 NOTE 2. LONG-TERM DEBT Long-term debt consists of the following:
September 30, December 31, 2002 2001 ---------------- --------------- Revolving line of credit with finance company, collateralized by accounts receivable, with interest at 0.75% over prime (effective rate of 5.5% at September 30, 2002); due Feb 2005. $ 1,358,000 $ 495,000 Notes payable to banks, collateralized by transportation equipment, due in installments through March 2012 with interest ranging from 0.00% to 10.85%. 680,000 699,000 Notes payable to banks and finance companies, collateralized by land, buildings, and improvements due in installments through February 2005 with interest ranging from 4.31% to 11.00%. 12,261,000 13,644,000 Note payable to an investment company, uncollateralized with interest at 12.5%, due in four installments beginning in 2005, including original issue premium 10,216,000 10,254,000 ---------------- --------------- $ 24,515,000 $ 25,092,000 Less - current maturities $ (3,387,000) $ (2,545,000) ---------------- --------------- $ 21,128,000 $ 22,547,000 ================ ===============
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 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. Certain notes payable to finance and investment companies contain covenants that require the Company, among other things, to maintain certain earnings and debt coverage ratios and receive approval for certain capital expenditures as defined in the agreements. 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 Company may redeem the convertible debentures 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. NOTE 4. STOCKHOLDERS' EQUITY 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 was classified in other assets on the balance sheet. The debenture issue cost was amortized to expense over the term of the convertible debentures. The Class E stock purchase warrants provided for the purchase of the Company's common stock at a price of $3.00 per share until they expired on September 12, 2002. 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 provided for the purchase of the Company's common stock at any time until their expiration on September 16, 2002. The exercise price of the warrants was $3.75 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, respectively. 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 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 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 508,032 shares of Class A common stock at exercise prices ranging from $1.50 to $4.25 per share. Options providing for the issuance of 442,558 shares were exercisable at September 30, 2002. 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 Nine months ended September 30, September 30, 2002 2001 2002 2001 ------------ ------------ ------------ ------------ Numerator: Net income - basic $ 220,000 $ 395,000 $ 886,000 $ 945,000 Effect of dilutive securities: - interest reduction on assumed debenture conversions, less 40% effective tax rate 43,000 72,000 130,000 217,000 ------------ ------------ ------------ ------------ Numerator for earnings per share, diluted $ 263,000 $ 467,000 $ 1,016,000 $ 1,162,000 ============ ============ ============ ============ Denominator for earnings per share: Weighted average shares outstanding - basic 4,894,628 4,838,520 4,876,664 4,794,737 Effect of dilutive securities: - debenture conversions 1,283,333 1,283,333 1,283,333 1,283,333 - stock options 56,477 97,189 91,162 46,228 - stock warrants 181,818 226,744 238,636 153,563 ------------ ------------ ------------ ------------ Denominator for earnings per share, diluted 6,416,256 6,445,786 6,489,795 6,277,861 ============ ============ ============ ============ Income per share, basic $ 0.04 $ 0.08 $ 0.18 $ 0.20 ============ ============ ============ ============ Income per share, diluted $ 0.04 $ 0.07 $ 0.16 $ 0.19 ============ ============ ============ ============
Outstanding options and warrants of 104,700 for the three months and nine months ended September 30, 2002, respectively, and 282,539 for the three months and nine months ended September 30, 2001, respectively, have been excluded from the above calculations as they would be anti-dilutive. Page 8 8. INTANGIBLE ASSETS - ADOPTION OF STATEMENT 142 The following table presents the effects of Statement of Financial Accounting Standards (SFAS) Number 142, Goodwill and Intangible Assets, as if the statement had been adopted for all prior periods presented. The amortization expense and net income of the Company for the presented periods follow:
Three months ended Nine months ended September 30, September 30, 2002 2001 2002 2001 ----------- ---------- ---------- ----------- Reported net income $ 305,000 $ 395,000 $ 666,000 $ 945,000 Add back: Intangible assets amortization --- 56,000 --- 169,000 ----------- ---------- ---------- ----------- Adjusted net income $ 305,000 $ 451,000 $ 666,000 $ 1,114,000 =========== ========== ========== =========== Basic earnings per share: Reported net income $ .04 $ .08 $ .18 $ .20 Intangible assets amortization --- .01 --- .04 ----------- ---------- ---------- ----------- Adjusted net income $ .04 $ .09 $ .18 $ .24 =========== ========== ========== =========== Diluted earnings per share: Reported net income $ .04 $ .07 $ .16 $ .19 Intangible assets amortization --- .01 --- .03 ----------- ---------- ---------- ----------- Adjusted net income $ .04 $ .08 $ .16 $ .22 =========== ========== ========== ===========
9. COMMITMENTS AND CONTINGENCIES The Board of Director's voted to terminate the Company's deferred compensation plan on August 29, 2002. The plan was fully accrued and the termination will have no effect on income. 10. RECENTLY ADOPTED ACCOUNTING STANDARDS In July 2002, the FASB issued SFAS No. 146 "Accounting for Costs Associated with Exit or Disposal Activities", (SFAS 146). SFAS 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructing)". SFAS 146 requires that a liability for a cost associated with an exit or disposal activity be recognized when the liability is incurred, rather than at the date of the entity's commitment to an exit plan. This statement is effective for exit and disposal activities that are initiated after December 31, 2002. Since adoption of this SFAS is prospective, the Company does not believe that the implementation of this SFAS will have a material impact on its financial statements. Page 9 AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations This document contains statements that are not historical but are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These include statements regarding the expectations, beliefs, intentions, or strategies for the future. The Company intends that all forward-looking statements be subject to the safe-harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements reflect the Company's views as of the date they are made with respect to future events and financial performance, but are subject to many uncertainties and risks which could cause the actual results of the Company to differ materially from any future results expressed or implied by such forward-looking statements. Examples of such uncertainties and risks include, but are not limited to: fluctuations in occupancy levels and labor costs; the ability to secure both new contracts and the renewal of existing contracts; the availability and cost of financing to redeem common shares and to expand the Company's business; and public resistance to privatization. Additional risk factors include those discussed in reports filed by the Company from time to time on Forms 10-KSB, 10-QSB, and 8-K. The Company does not undertake any obligation to update any forward-looking statements. 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 $38 million of new capital and credit facilities since September 1997. The Company had approximately $3.5 million of cash, short-term investments, and revolving credit available for new projects at September 30, 2002. 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. The Company obtained an $18 million senior credit facility with Fleet Capital Corporation in February 1999. The credit facility with Fleet Capital Corporation was amended in December 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 for working capital. While this amount is adequate for the foreseeable future, additional Company growth or a slowdown in revenue collections may require additional working capital. The Fleet loan facility contains financial covenants that require the Company to maintain certain earnings levels, limit capital expenditures, and maintain ratios relating to fixed charges, liabilities to tangible net worth, and total indebtedness. The total amount due to Fleet at the end of the quarter was $12,732,000. The credit facility matures in February 2005. On October 10, 2002, the board of director's of the Oklahoma Office of Juvenile Affairs (OJA) voted to not renew their contract with Avalon for 80 beds at the Company's Union City facility. The vote was a cost-cutting move as a part of the board's state mandate to reduce expenditures from its budget in the current fiscal year. The contract is now scheduled to cease on December 2, 2002. The OJA contract contributed approximately $3,800,000 to the Company's annual revenues for the year ended December 31, 2001. The OJA contract was the primary source of revenue for the Union City facility. The Company is currently evaluating other sources of offenders for the facility. Results of Operations - Three Months Ended September 30, 2002 Compared to the Three Months Ended September 30, 2001. The Company's revenues increased by 8% to $6,878,000 million for the three months ended September 30, 2002 from $6,359,000 for the three months ended September 30, 2001. The increased revenues were a result of increased offender census, the acquisition of the Austin Treatment Center in December 2001, and the expansion of the Phoenix Center in Colorado in February 2002. Earnings before interest, taxes, depreciation, and amortization for the three months ended September 30, 2002 were $1,517,000 compared to $1,621,000 for the three months ended September 30, 2001. The new Riverside Intermediate Sanction Unit, which is still ramping up to operating capacity, recognized losses of approximately $116,000 during the three months ended September 30,2002. Page 10 The Company's net income was $220,000 for the three months ended September 30, 2002 and $395,000 for the three months ended September 30, 2001. The Company began recording a provision for income taxes in 2002 and recorded a provision of $143,000 for the three months ended September 30, 2002. A provision for income taxes was not recorded for the three months ended September 30, 2001, due to the utilization of tax loss carryforwards. Net income before income taxes was $363,000 for the three months ended September 30, 2002 and $395,000 for the three months ended September 30, 2001. The earnings per share were $.04 basic and $.04 diluted for the three months ended September 30, 2002 and were $.08 basic and $.07 diluted for the three months ended September 30, 2001. Corporate. General and administrative expenses decreased to $470,000 for the three months ended September 30, 2002, from $527,000 for the three months ended September 30, 2001. Interest expense decreased $74,000 for the three months ended September 30, 2002 over the third quarter of 2001as a result of lower interest rates and a reduction in long term debt. Depreciation and amortization expenses were virtually identical to the same quarter last year. Nine Months Ended September 30, 2002 Compared to the Nine Months Ended September 30, 2001. The Company's revenues increased $1,624,000 to $20,247,000 for the nine months ended September 30, 2002 compared to $18,623,000 for the nine months ended September 30, 2001. The increased revenues were a result of overall increased offender census, the acquisition of the Austin Transitional Center in December 2001, and the expansion of the Phoenix Center in Colorado in February 2002. Earnings before interest, taxes, depreciation, and amortization increased 2% for the nine months ended September 30, 2002 to $4,692,000 compared to $4,610,000 for the nine months ended September 30, 2001. The Company recognized losses of $305,000 on the new Riverside Intermediate Sanction Unit during the nine months ended September 30, 2002. The census at this facility increased substantially during September and Riverside is now expected to show a profit from this point forward. The Company began recording a provision for income taxes in 2002 with a provision of $368,000 for the nine months ended September 30, 2002. A provision for income taxes was not recorded for the nine months ended September 30, 2001, due to the utilization of tax loss carryforwards. Net income before income taxes was $1,254,000 for the nine months ended September 30, 2002 and $945,000 for the three months ended September 30, 2001. The Company's net income was $886,000 for the nine months ended September 30, 2002 compared to $945,000 for the nine months ended September 30, 2001. The Company's earnings per share were $.18 basic and $.16 diluted for the nine months ended September 30, 2002 compared to $.20 basic and $.19 diluted for the nine months ended September 30, 2001. Corporate. General and administrative expenses increased to $1,547,000 for the nine months ended September 30, 2002 compared to $1,277,000 for the nine months ended September 30, 2001. General and administrative expenses increased primarily due to increased legal, travel, and staffing costs for the Company's new operations and acquisitions. Interest expense decreased $359,000 for the nine months ended September 30, 2002 over the nine months ended September 30, 2001, as a result of lower interest rates and a reduction in long term debt. Depreciation and amortization have increased commensurate with the growth of the correctional operations. Critical Accounting Policies - Revenues. Many states and other governmental agencies are experiencing budgetary pressures that could affect future revenues of the Company as a result of the current economic downturn. Governmental agencies may look first at reducing payments to outside contracting companies to maintain the level of expenditures at the government agency, rather than looking for the most cost-effective services available. The Company has experienced reductions in revenues as a consequence of contracting agencies reducing the bed utilization in the Company's facilities. A reserve cannot be established to estimate future downturns. Intangible assets. Three of Avalon's facilities - the Avalon Correctional Center, The Villa at Greeley, and the Phoenix Center - have intangible assets on their books representing the value allocated to the operating contracts at the time of their acquisition. Through December 31, 2001, these intangible assets were being amortized over a twenty-year period. Financial Accounting Standards Board SFAS 142 requires that intangible assets, whose useful lives are estimated to be indefinite, can no longer be amortized. Avalon's intangible assets have indefinite lives inasmuch as they relate to contracts that are renewable at minimal costs, are routinely renewed, and are expected to be renewed. If the intangible assets are shown to be impaired in some future period, they are required to be written down to their fair value in the period when the impairment Page 11 is ascertained. The Company's intangible assets with indefinite lives total $2,856,000 at September 30, 2002. Any impairments recorded would have an adverse effect on earnings, possibly materially, in the period the impairment is determined. During 2002, independent appraisals were obtained on the related properties. The value on each property was higher than the carrying value of the underlying intangible and tangible assets, so no impairment has been found to exist. Iintangible assets with indefinite lives will be tested for impairment annually. Equity valuation. 1,622,448 shares of the Company's stock (approximately one-third) have a put attached which can be exercised in 2003. This put is redeemable under certain circumstances at the holder's option and requires the Company to purchase the stock at the market value. The stock is recorded on the Company's books at an estimated redemption value and is updated quarterly. The stock was recorded at its estimated fair value and is being accreted to the estimated value at the redemption date. This accretion will become more volatile as the redemption date draws nearer, and will ultimately track the price of the stock. This change in stock value is offset by an equal change to Paid-in Capital. Item 3. Controls and Procedures The Company's chief executive officer and its vice president of finance have evaluated the effectiveness of the Company's disclosure controls and procedures (as defined in Exchange Act Rules 13a-14(c) and 15d-14(c) as of a date within 90 days of the filing date (the "Evaluation Date") of this quarterly report, and have concluded that as of the Evaluation Date, the Company's disclosure controls and procedures were adequate, effective, and ensure that material information relating to the Company and its consolidated subsidiaries would be made known to them timely by others within those entities. There were no significant changes in the Company's internal controls or in other factors that could significantly affect the Company's disclosure controls and procedures subsequent to the Evaluation Date, nor were there any significant deficiencies or material weaknesses in such disclosure controls and procedures requiring corrective actions. As a result, no corrective actions were taken. Page 12 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 - None. Item 5. Other Information - None. Item 6. Exhibits and reports on Form 8-K - None. The following exhibits are filed as a part of this Quarterly Report on Form 10-QSB: 99.1 Certification of Donald E. Smith, Chief Executive Officer, pursuant to 18.U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. 99.2 Certification of Lloyd Lovely, Vice President of Finance, pursuant to 18.U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. Page 13 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: November 1, 2002 AVALON CORRECTIONAL SERVICES, INC. By: s/ Donald E. Smith Donald E. Smith, Chief Executive Officer By: s/ Lloyd Lovely Lloyd Lovely, Vice President of Finance Page 14 CERTIFICATIONS I, Donald E. Smith, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Avalon Correctional Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in thiS quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. November 1, 2002 /s/ Donald E. Smith Donald E. Smith Chief Executive Officer I, Lloyd Lovely, certify that: 1. I have reviewed this quarterly report on Form 10-QSB of Avalon Correctional Services, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there ere significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. November 1, 2002 /s/ Lloyd Lovely Lloyd Lovely Vice President of Finance Exhibit 99.1 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Avalon Correctional Services, Inc. (the "Company") on Form 10-QSB for the period ended September 30, 2002 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Donald E. Smith, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Report fully complies with the requirements of section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Donald E. Smith Donald E. Smith Chief Executive Officer November 1, 2002 Exhibit 99.2 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 In connection with the Quarterly Report of Avalon Correctional Services, Inc. (the "Company") on Form 10-QSB for the period ended September 30, 2002, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Lloyd Lovely, Vice President of Finance of the Company, certify, pursuant to 18 U.S.C. section 1350, as adopted pursuant to section 906 of the Sarbanes-Oxley Act of 2002, that to the best of my knowledge: (1) The Report fully complies with the requirements of section 13 (a) or 15 (d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Lloyd Lovely Lloyd Lovely Vice President of Finance November 1, 2002 -----END PRIVACY-ENHANCED MESSAGE-----