10-Q 1 q604.txt FORM 10-Q FOR PERIOD ENDING JUNE 30, 2004 UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q QUARTERLY REPORT PURSUANT TO SECTION 13 or 15 (D)OF THE SECURITIES EXCHANGE ACT OF 1934 For the Quarterly Period Ended June 30, 2004 Commission File Number: 0-20307 AVALON CORRECTIONAL SERVICES, INC. (Exact name of registrant 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) Indicate by check mark whether the registrant issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ______ As of August 10, 2004, 4,929,789 shares of the issuer's Class A common stock, par value $.001, were issued and outstanding. PART I - FINANCIAL INFORMATION AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES CONSOLIDATED BALANCE SHEETS (Unaudited) June 30, December 31, 2004 2003 ------------- ----------- ASSETS Current assets: Cash and cash equivalents $ 956,000 $ 1,015,000 Certificates of deposit (pledged) 1,600,000 1,600,000 Accounts receivable, net 2,971,000 2,662,000 Prepaid expenses and other 453,000 426,000 --------- ---------- Total current assets $ 5,980,000 $ 5,703,000 Assets held for sale 5,900,000 - Property and equipment, net 26,275,000 30,636,000 Intangible assets, net 2,285,000 2,395,000 Other assets 752,000 967,000 ---------- ---------- Total assets 41,192,000 $ 39,701,000 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable, accrued liabilities and other $ 1,743,000 $ 1,990,000 Current maturities of long-term debt 12,492,000 2,030,000 ----------- --------- Total current liabilities $ 14,235,000 $ 4,020,000 Long-term debt, less current maturities 10,773,000 20,305,000 Convertible debentures 3,850,000 3,850,000 Deferred income taxes 182,000 175,000 Redeemable common stock, $.001 par value 1,622,448 shares issued and outstanding 3,829,000 2,628,000 Stockholders' equity: Common stock: Par value $.001; 24,000,000 shares authorized; 4,929,789 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 is - - Paid-in capital 7,310,000 8,459,000 Retained Earnings 1,010,000 261,000 --------- ---------- Total liabilities and stockholders' equity $ 41,192,000 $ 39,701,000 =========== ========== 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)

~~For~~Three ~~the~~Months ~~nine~~Ended ~~months~~Six ~~ended~~Months ~~September~~Ended June 30, June 30, 2004 2003 ~~2002~~2004 2003 ----------------- --------------- ---------------- ~~OPERATING~~----------------- ~~ACTIVITIES:~~Revenues ~~Net~~$ ~~income~~6,830,000 $ ~~929~~6,112,000 $ ~~886~~13,263,000 ~~Adjustments~~$ to12,282,000 ~~reconcile~~----------------- ~~net~~--------------- ~~income~~---------------- to----------------- ~~net~~Costs ~~cash~~and ~~provided~~expenses byDirect operating ~~activities: Depreciation and amortization 1~~4,~~130~~419,000 14,~~499~~327,000 ~~Amortization of debt issue costs 200~~8,~~000 247~~872,000 ~~Loss on sale of property 14~~8,602,000 ~~---~~General ~~Changes in operating assets~~ and ~~liabilities:~~administrative ~~Increase in: Accounts receivable (603~~578,000) ~~(251~~472,000) ~~Prepaid expenses and other (148~~975,000) ~~(480~~830,000) ~~Increase~~Depreciation ~~(decrease) in: Accounts payable, accrued liabilities,~~ and ~~other~~amortization ~~415~~517,000 ~~(491~~343,000) ~~Accrued payroll (281~~915,000) ~~(202~~756,000) ~~Accrued~~Interest ~~income~~expense ~~tax~~648,000 ~~(48~~515,000) 751,217,000 ~~Deferred income taxes 84~~1,183,000 --- --------------~~---~~ ---------------~~---~~ ~~Net cash provided by operations $ 1,692,000 $ 1,283,000~~ ----------------- ------------------ ~~INVESTING~~Income ~~ACTIVITIES:~~from ~~Capital~~continuing ~~expenditures~~operations before income tax expense $ (2668,~~017,~~000) $ ~~(653~~455,000) ~~Proceeds~~$ ~~from~~1,284,000 ~~disposition~~$ ~~of property 67~~911,000 ~~---~~Income ~~Purchases~~tax ofexpense ~~certificates~~264,000 of189,000 ~~deposit~~487,000 ~~--- (1~~360,~~500,~~000) ----------------- ---------------~~---~~ ~~Net cash used in investing activities $ (1,950,000) $ (2,153,000)~~ ----------------- ------------------ ~~FINANCING~~Income ~~ACTIVITIES:~~from ~~Proceeds~~continuing ~~from~~operations ~~borrowing~~$ 404,000 $ 21266,~~758,~~000 $ 21797,~~303,~~000 ~~Repayment~~$ of551,000 ~~borrowing~~Discontinued operations (2117,~~893,~~000) (2114,~~879,~~000) ~~Proceeds from warrant and option exercise 4~~(48,000) 79(39,000) ----------------- ---------------~~---~~ ~~Net cash used in financing activities $ (131,000) $ (497,000)~~ ----------------- ------------------ ~~NET~~Net ~~DECREASE~~income IN$ ~~CASH~~387,000 ~~AND~~$ ~~CASH~~252,000 ~~EQUIVALENTS~~$ 749,000 $ ~~(389~~512,000 ================= =============== ================ ================= Net income (loss) per share, basic Continuing operations $ 0.08 $ 0.05 $ 0.16 $ 0.11 ================= =============== ================ ================ Discontinued operations $ - $ - $ (~~1,367,000~~0.01) ~~CASH~~$ ~~AND~~(0.01) ~~CASH~~================= ~~EQUIVALENTS,~~=============== ~~BEGINNING~~================ OF================ ~~PERIOD~~Total ~~1,250,000~~$ 20.08 $ 0.05 $ 0.15 $ 0.10 ================= =============== ================ ================ Net income (loss) per share,~~389,000~~ diluted Continuing operations $ 0.06 $ 0.05 $ 0.14 $ 0.11 ================= =============== ================ ================ Discontinued operations $ -~~----------------~~ $ -~~-----------------~~ ~~CASH~~$ ~~AND~~(0.01) ~~CASH~~$ ~~EQUIVALENTS,~~(0.01) ~~END~~================= OF=============== ~~PERIOD~~================ ================ Total $ ~~861,000~~0.06 $ ~~1,022,000~~0.05 $ 0.13 $ 0.10 ================= =============== ================ ================

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)

~~Three~~For ~~months~~the ~~ended~~six ~~September 30, Nine~~ months ended ~~September~~June 30, 2004 2003 ------------ ----------- OPERATING ACTIVITIES: Net income $ 749,000 $ 512,000 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 944,000 840,000 Amortization of debt issue costs 115,000 123,000 Loss (gain) on sale of property - 14,000 Changes in operating assets and liabilities: Decrease (increase) in: Accounts receivable (309,000) (344,000) Prepaid expenses and other 48,00 (218,000) Increase (decrease) in: Accounts payable, accrued liabilities, and other (240,000) (198,000) ----------~~---~~ ----------- Net cash provided by operating activities $ 1,307,000 729,000 --------- ------------- ~~2003~~INVESTING ~~2002~~ACTIVITIES: ~~2003~~Capital ~~2002~~expenditures (765,000) (1,534,000) Proceeds from the disposition of property 17,000 - ---------~~----~~ ------------- Net cash used in investing activities $ (748,000) $ (1,534,000) ------------ ---------- ~~Net~~FINANCING ~~income,~~ACTIVITIES: asProceeds ~~reported~~from $borrowings ~~346~~14,196,000 ~~$ 220~~15,258,000 $Repayment ~~929~~of borrowings (14,866,000) ~~$ 886~~(15,259,000) ~~Deduct:~~Proceeds ~~Total~~from ~~stock-based~~warrant ~~employee~~and ~~compensation~~option ~~expense~~exercise ~~determined~~52,000 ~~under~~- ~~fair~~----------- ~~value~~----------- ~~based~~Net ~~method~~cash ~~for~~used ~~all~~in ~~awards,~~financing ~~net~~activities of$ ~~related tax effects 22~~(618,000) ~~43,000~~$ 66(1,000) ~~130,000~~ ------------- ----------- NET DECREASE IN CASH AND CASH EQUIVALENTS (59,000) (806,000) CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 1,015,000 1,250,000 ------------ ------------- ~~Pro~~CASH ~~forma~~AND ~~net~~CASH ~~income $ 324~~EQUIVALENTS,~~000~~ $END ~~177,000~~OF PERIOD $ ~~863~~956,000 $ ~~756~~444,000 ============= ============= ============= ============= Earnings per share: Basic - as reported $0.07 $0.04 $0.19 $0.18 Basic - pro forma 0.07 0.04 0.18 0.16 Diluted - as reported 0.06 0.04 0.17 0.16 Diluted - pro forma 0.06 0.03 0.16 0.14

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. BASIS OF PRESENTATION Interim Financial Statements - The unaudited consolidated financial statements included herein have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Accordingly, certain disclosures normally included in financial statements prepared in conformity with accounting principles generally accepted in the United States of America have been omitted. The accompanying unaudited consolidated financial statements and notes should be read in conjunction with the Company's audited financial statements for the year ended December 31, 2003 and the notes thereto contained in the Company's Form 10-K filing for the year ended December 31, 2003. The results of operations for the three months and six months ended June 30, 2004, are not necessarily indicative of the results that may be expected for the entire year ended December 31, 2004. The consolidated balance sheet as of June 30, 2004, the statements of operations for the three and six months ended June 30, 2004 and 2003 and the statements of cash flows for the six months ended June 30, 2004 and 2003 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 periods then ended. All such adjustments are of a normal and recurring nature. Stock-Based Compensation - The Company has a stock-based compensation plan. The Company accounts for this plan under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under this plan had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.

Page 4 NOTE 2. LONG-TERM DEBT Long-term debt consists of the following:

The Company has a senior credit facility collateralized by certain assets of the Company with Fleet Capital consisting of a term loan and a revolving line of credit equal to the lesser of $3,000,000 or 80% of eligible accounts receivable. At June 30, 2004, the outstanding balances were $10,324,000 on the term loan and $208,000 under the revolving line of credit. The term loan requires principal payments in the amount of $355,000 plus interest on the first day of each calendar quarter. The remaining principal outstanding, together with any and all other amounts due, shall be due and payable on February 25, 2005. The interest rate on the senior credit facility is comprised of a base rate margin and LIBOR margin, which varies in relation to the senior debt to EBITDA ratio. At June 30, 2004, the rate was approximately 4.75% on the senior credit facility. At June 30, 2004, the outstanding debt under the senior credit facility was classified as current. The Company and the senior debt holder are negotiating a restructure of the senior credit facility. The senior credit facility contains certain covenant requirements that the Company must maintain. The covenants are based on a trailing twelve month period and are comprised of a required fixed coverage ratio; a liabilities to tangible net worth ratio; a maximum ratio of indebtedness to EBITDA; a required minimum EBITDA and a limit on certain capital expenditures. The Company was in compliance with all debt covenants at June 30, 2004. 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 14.5%. Page 5 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 equity instrument reflecting a fair value allocation of the redeemable common stock of $4,635,000. Issue costs of $511,000 allocated to the redeemable common stock reduced its original book value to $4,124,000. 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. The Company was in compliance with all debt covenants at June 30, 2004. On July 15, 2004, Adams County, Colorado issued $19,900,000 of bonds ("the Bonds") and loaned the proceeds to a subsidiary of the Company. The Bonds were issued at par, bear interest at rates ranging from 8.375% to 10.25% and maturing on various dates between August 1, 2011 and August 1, 2024. The proceeds from the Bonds were utilized to retire debt with an investment company bearing interest at 14.5%, reduce the existing senior credit facility with Fleet Capital, fund a debt service reserve fund, and pay fees associated with the issuance of the bonds. NOTE 3. 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, and further amended its plan on May 21, 2003, increasing the number of shares available to 700,000. Non-statutory options have been granted providing for the issuance of 651,725 shares of Class A common stock at exercise prices ranging from $1.32 to $4.25 per share. Options providing for the issuance of 580,456 shares were exercisable at June 30, 2004. NOTE 4. LITIGATION AND CONTINGENCIES 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. NOTE 5. EARNINGS PER SHARE The following table sets forth the computation of earnings per share and earnings per share assuming dilution. Page 6

NOTE 6. RECENTLY ADOPTED ACCOUNTING STANDARDS In January 2003, the Financial Accounting Standards Board (FASB) issued Interpretation No. 46 ("FIN 46"), "Consolidation of Variable Interest Entities" (VIEs), which is an interpretation of Accounting Research Bulletin (ARB) No. 51, "Consolidated Financial Statements." FIN 46, as revised by FIN 46(R), addresses the application of ARB No. 51 to VIEs, and generally would require that assets, liabilities and results of the activity of a VIE be consolidated into the financial statements of the enterprise that is considered the primary beneficiary. This interpretation applies immediately to VIEs created after January 31, 2003, and to VIEs in which a company obtains an interest after that date. The Company had not created or obtained an interest in any VIEs in 2003. In addition, the interpretation becomes applicable on December 31, 2003 for special purpose entities (SPEs) created prior to February 1, 2003. As of December 31, 2003, the Company had no SPEs for which it was considered the primary beneficiary. For non-SPEs in which a company holds a variable interest that it acquired before February 1, 2003, the FASB postponed the date on which the interpretation become applicable to March 31, 2004. The Company has identified one non-consolidated entity as a VIE where the Company is considered the primary beneficiary (see Note 8). In accordance with the provisions of FIN 46, as revised, the Company has consolidated this VIE as of January 1, 2004. Consolidation of this VIE did not have a material effect on the consolidated results of operations or financial position. In December 2003, the Staff of the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin (SAB) No. 104, "Revenue Recognition," which supersedes SAB No. 101. The primary purpose of SAB No. 104 is to rescind accounting guidance contained in SAB No. 101 and the SEC's "Revenue Recognition in Financial Statements Frequently Asked Questions and Answers" (the FAQ) related to multiple element revenue arrangements. The issuance of SAB No. 104 did not significantly impact the Company's current revenue recognition policies. NOTE 7. CHANGE IN ACCOUNTING ESTIMATE The Company is required to make certain estimates, including those related to useful lives of depreciable assets, uncollectible accounts receivable, and a valuation allowance for deferred tax assets in preparing its financial statements. The Company periodically reviews its estimates to ensure that the estimates appropriately reflect changes in its business or as new information becomes available. Page 7 The Company's estimate of the useful life of certain depreciable vehicles has historically been three years. The Company re-evaluated the estimated useful life of certain vehicles and determined a depreciable life of eighteen months was more representative of the vehicles' actual useful life. As a result of this evaluation the depreciable life of certain vehicles was changed from three years to eighteen months in the second quarter of 2004 and the Company increased depreciation expense by $127,000 during the period to catch-up the depreciation expense for the applicable vehicles. NOTE 8. ASSETS HELD FOR SALE AND DISPOSITION Assets held for sale are valued on an asset-by-asset basis at the lower of the carrying amount or fair value, less costs to sell, and consist of property and equipment. In estimating fair value, management considered the pending status of the Union City facility and the appraised value of the assisted living center. The Company anticipates a sale of the Union City facility will result in proceeds in excess of the carrying value of the Union City facility. The Company holds a 15% equity interest in an assisted living center and has guaranteed debt related to the building of the investee and has pledged $1,600,000 in certificates of deposit for the guarantee. The Company has recognized losses of the investee and has reduced its carrying value in the investment to zero. The outstanding debt balances were approximately $1,600,000 and $1,900,000 at June 30, 2004 and 2003, respectively. On July 17, 2004, the Company repaid $700,000 of the outstanding debt, which released the pledged certificate of deposit. The Company would have the right to sell the assisted living center as a going concern and use any proceeds, after payment of debts, to recover amounts owed to it by the assisted living center in the event of default of the debt payments. The appraised value of the assisted living center exceeds the carrying value and the existing debt. The Company has consolidated this entity under FIN 46, as revised by FIN 46 (R) as of January 1, 2004 (see Note 6) and if the Company would sell the asset for less than the carrying value, the Company could be required at that time to recognize a loss on the disposition of the asset. Total assets of the assisted living center totaled approximately $1,608,000 as of June 30, 2004. Losses for the six months ended June 30, 2004 equaled $4,000, and gains for the three months ended June 30, 2004 equaled $6,000. The assisted living center is for sale and the Company has classified the asset as held for sale and has recorded its operations as discontinued operations. The Company owns a facility in Union City, Oklahoma utilized until December 2, 1999 for a contract with the Oklahoma Office of Juvenile Affairs. The facility is currently utilized as an overflow center for weekend clients assigned to the Carver Center. The Company has classified the facility as held for sale and has recorded the operations of the facility as discontinued operations. The Company is in discussions with several parties expressing an interest in a transaction for a purchase or lease of the facility. In the event these potential transactions are not successful, an impairment of the carrying value may be required at a future date. The Company has reviewed the carrying value of the facility and determined an impairment of the carrying value is not warranted at this time. Page 8 Following is the revenue and net income (loss) of the Union City facility and the assisted living center:

Certain reclassifications of prior periods' amounts have been made to interest, income tax expense, and discontinued operations to conform with the current period presentation. 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; public resistance to privatization and the sale of the Union City facility and the assisted living center for an amount in excess of the carrying value of the assets. Additional risk factors include those discussed in periodic reports filed by the Company from time to time. The Company does not undertake any obligation to update any forward-looking statements. Overview Avalon Correctional Services, Inc. is an owner and operator of private community correctional facilities containing approximately 2,600 beds. Avalon Correctional Services, Inc. and its wholly owned subsidiaries specialize in operating private community correctional facilities and providing alternative correctional programming. Avalon currently operates facilities and manages programs 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 role as a provider of community correctional services. Avalon's development plan is to expand operations through new state and federal contracts and selective acquisitions. Avalon has been providing private community correctional services since 1985. Avalon contracts with various governmental agencies to provide community corrections operations and services. Page 9 The management and rehabilitation of inmate populations are of utmost concern to cities, counties, states and a variety of federal agencies throughout the country. Increasingly, government is partnering with private companies to assist them with their correctional needs. Management of the Company closely monitors the operations and assesses the residential and nonresidential census data. For further information, see Results of Operations. Results of Operations - Three Months Ended June 30, 2004 Compared to the Three Months Ended June 30, 2003. The Company's revenues increased by 12% to $6,830,000 for the three months ended June 30, 2004 from $6,112,000 for the three months ended June 30, 2003. The increase in net revenues was primarily a result of an increase in the Company's offender census during the three months ended loss June 30, 2004. The Company's income from continuing operations before taxes increased 47% to $668,000 during the second quarter of 2004 compared to $455,000 during the second quarter of 2003. Operating income before interest, depreciation and amortization, discontinued operations and income taxes increased 40% to $1,833,000 for the second quarter of 2004 from $1,313,000 for the second quarter of 2003. The average daily residential offender census increased by 11% to 1,972 for the second quarter of 2004 from 1,769 for the second quarter of 2003. The average daily non-residential offender census was 296 for the second quarter of 2004 compared to 289 for the second quarter of 2003. The data to reconcile the Company's income from continuing operations before tax for the second quarter of 2004 of $668,000 to operating income of $1,833,000 is as follows. Add back to income from continuing operations before tax the amounts of $648,000 for interest expense and $517,000 for depreciation and amortization expense. The information necessary to reconcile the Company's income from continuing operations before tax for the second quarter of 2003 of $455,000 to operating income of $1,313,000 is as follows. Add back to income from continuing operations before tax the amounts of $515,000 for interest expense and $343,000 for depreciation and amortization expense. AVALON CORRECTIONAL SERVICES, INC. AND SUBSIDIARIES Direct operating expenses remained fairly constant at $4,419,000 and $4,327,000 respectively, for the second quarter of 2004 and 2003 General and administrative expenses increased by 22% during the second quarter of 2004 compared to the first quarter of 2003. This resulted primarily from increases in contract labor and professional fees. General and administrative expenses equaled approximately 8% of revenues during the second quarter of 2004 and 2003. Depreciation and amortization expense increased by 51% to $517,000 for the second quarter 2004 from $343,000 for the second quarter 2003. The increase was a result of the Company's change in accounting estimate (see Note 7) related to the useful live of certain depreciable vehicles. The amortization of intangible contract costs was $59,000 for the second quarter of 2004 and $67,000 for the second quarter of 2003. Interest expense increased by $133,000 for the second quarter of 2004, as compared to the second quarter of 2003 as a result of higher interest rates and additional indebtedness from vehicles. The Company's income tax expense was $264,000 for the second quarter of 2004, an increase of $75,000 over the income tax expense of $189,000 for the second quarter of 2003. Income from continuing operations increased $138,000 or 52% to $404,000 compared to $266,000 for the second quarter of 2003. Net income after discontinued operations increased $135,000 or 54% in the second quarter of 2004 to $387,000, as compared to $252,000 for the second quarter of 2003. The assisted living center and the Union City facility are for sale and the Company has classified the assets as held for sale and has recorded the related operations as discontinued operations (see Note 8). Six Months Ended June 30, 2004 Compared to the Six Months Ended June 30, 2003. The Company's revenues increased $981,000 to $13,263,000 for the six months ended June 30, 2004 compared to $12,282,000 for the six months ended June 30, 2003. The increased revenues were a result of an increase in the company's offender census during the six months ended June 30, 2004. Page 10 Operating income before interest, depreciation and amortization, discontinued operations and income taxes was $3,416,000 for the six months ended June 30, 2004 compared to $2,850,000 for the six months ended June 30, 2003. The increase in earnings before interest, taxes, depreciation and amortization was a result of the increase in average daily residential offender census of 8% to 1,924 for the six months ended June 30, 2004 from 1,777 for the six months ended June 30, 2003 and an increase in the average daily non-residential offender census of 12% to 313 for the six months ended June 30, 2004 from 279 for the six months ended June 30, 2003. Operating income before interest, depreciation and amortization, discontinued operations and income taxes can be reconciled to income from continuing operations before taxes by adding interest and depreciation and amortization expenses to income before taxes. Income from continuing operations before taxes increased $373,000 to $1,284,000 for the six months ended June 30, 2004 from $911,000 for the six months ended June 30, 2003. The Company recorded a tax provision of $487,000 for the six months ended June 30, 2004, compared to a provision of $360,000 for the six months ended June 30, 2003. Net income after discontinued operations increased $237,000 or 46% in the six months ended June 30, 2004 to $749,000, as compared to $512,000 for the six months ended June 30, 2003. Liquidity and Capital Resources - The Company's business strategy is to focus on the private community corrections industry, expanding its operations in existing and additional states through new federal and state contracts and selective acquisitions. The successful implementation of the Company's growth plan will create the need for additional capital and financing. The Company's working capital deficit at June 30, 2004 was $8,256,000, compared to working capital of $1,651,00 and a current ratio of 1.39:1.00 at June 30, 2003. The working capital deficit at June 30, 2004 results from the Company's senior debt facility of $10,532,000, being classified as a current liability. The senior debt facility has a maturity date of February 25, 2005 and the Company and the senior debt holder are negotiating a restructure of the senior credit facility. The Company reduced the term loan balance on July 15, 2004 by $5,000,000 from proceeds from the issuance of the Bonds. Capital expenditures for the first half of 2004 were $508,000, compared to $1,534,000 for the first half of 2003. The first half 2004 capital expenditures include normal, operating purchases of vehicles and equipment. The Company also expanded Carver Center to 406 beds from 300. The first half 2003 capital expenditures included the expansion of the Phoenix Center to 207 beds, completed in the summer of 2003. The Company had approximately $5,348,000 (including $1,600,000 of pledged certificates of deposit) of cash, short-term investments, and revolving credit available for new projects at June 30, 2004. The Company believes it has adequate cash reserves and cash flow from operations to meet its current cash requirements (excluding payment of the senior credit facility due February 25, 2005). The Company expects current contracts to generate sufficient income to increase cash balances. On July 15, 2004, Adams County, Colorado issued $19,900,000 of bonds ("the Bonds") and loaned the proceeds to a subsidiary of the Company. The Bonds were issued at par, bear interest at rates ranging from 8.375% to 10.25% and maturing on various dates between August 1, 2011 and August 1, 2024. The proceeds from the Bonds were utilized to retire debt with an investment company bearing interest at 14.5%, reduce the existing senior credit facility with Fleet Capital, fund a debt service reserve fund, and pay fees associated with the issuance of the bonds. Page 11 Item 3. Quantitative and Qualitative Disclosures About Market Risk Market Risk Exposure The primary market risk exposures affecting the Company are changes in interest rates. The Company is exposed to market risk related to the senior bank credit facility. The interest on the senior credit facility is subject to fluctuations in interest rates. Assuming an immediate increase or decrease of 100 basis points in interest rates, the interest expense for the six months ended June 30, 2004 and 2003 would have been increased or decreased by approximately $52,000. The Company may from time to time, invest its cash in a variety of short-term financial instruments. These instruments generally consist of highly liquid investments. While these investments are subject to interest rate risk and could decline in value if market interest rates increase, a hypothetical 100 basis point increase or decrease in market interest rates would not materially affect the value of these instruments Item 4. 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-15(e) and 15d-15(e)), as of the end of the period covered by this report. Based upon that evaluation, the Chief Executive Officer and Vice President of Finance concluded that the Company's disclosure controls and procedures are effective in timely alerting them to material information relating to the Company that is required to be included in periodic SEC filings. There have not been any changes in the Company's internal control over financial reporting (as defined in Exchange Act Rules 13a-15 (f) and 15d-15(f)) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting. 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 - May 26, 2004 Annual Meeting Directors Elected - Robert O. McDonald - Votes for - 4,721,599 Votes withheld - 26,410 Charles W. Thomas - Votes for - 4,743,799 Votes withheld - 4,210 Directors Continued - Mark S. Cooley Donald E. Smith James P. Wilson Item 5. Other Information - None. Item 6. Exhibits and reports on Form 8-K - The Company filed a current report on Form 8-K, updated on Form 8-K/A, dated June 21, 2004, reporting on "Item 4. Changes in Registrant's Certifying Accountant" the change of the Company's independent public accountant to Cole & Reed, P.C. for the fiscal year ending December 31, 2004 replacing Grant Thornton, LLP. The following exhibits are filed as a part of this Quarterly Report on Form 10-Q: 31.1 Certification of the Chief Executive Officer of Avalon Correctional Services, Inc., pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 31.2 Certification of the Vice President of Finance of Avalon Correctional Services, Inc., pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. 32.1 Certification of the Chief Executive Officer of Avalon Correctional Services, Inc., pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes Oxley Act of 2002. 32.2 Certification of the Vice President of Finance of Avalon Correctional Services, Inc., 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: August 10, 2004 AVALON CORRECTIONAL SERVICES, INC. By: s/ Donald E. Smith Donald E.Smith, Chief Executive Officer By: s/ Michael C.Bradley Michael C. Bradley, Vice President of Finance Page 14 Exhibit 31.1 CERTIFICATION I, Donald E. Smith, certify that: 1. I have reviewed this quarterly report on Form 10-Q 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-15 (e) and 15d-15 (e)) for the registrant and have: a) Designed such disclosure controls and procedures or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is make known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusion about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any changes in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant' board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weakness in the design or operation of internal controls over financial reporting, which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal over financial reporting. August 10, 2004 /s/ Donald E. Smith Donald E. Smith Chief Executive Officer Page 15 Exhibit 31.2 CERTIFICATION I, Michael C. Bradley, certify that: 1. I have reviewed this quarterly report on Form 10-Q 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-15 (e) and 15d-15 (e)) for the registrant and have: a) Designed such disclosure controls and procedures or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is make known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusion about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any changes in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant' board of directors (or persons performing the equivalent functions): a) all significant deficiencies and material weakness in the design or operation of internal controls over financial reporting, which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal over financial reporting. August 10, 2004 /s/ Michael C. Bradley Michael C. Bradley Vice President of Finance Page 16 Exhibit 31.1 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-Q for the period ended June 30, 2004 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 August 10, 2004 Page 17 Exhibit 31.2 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-Q for the period ended June 30, 2004, as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Michael C. Bradley, 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/ Michael C. Bradley Michael C. Bradley Vice President of Finance August 10, 2004 Page 18

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