**This Form 10-Q consists of 21 sequentiallynumbered pages.**

 

**FORM 10-Q**

 

**SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON, D.C. 20549**

 

**QUARTERLYREPORT UNDER SECTION 13 OR 15 (d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended March 31,2004**

 

**Commission file number 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES, INC.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                                                                 |   | **02-0426634**                        |
|------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization.)             |   | (I.R.S. Employer  Identification No.) |
|                                                                         |   |                                  |
| **6 Executive Circle, Suite 250**                                            |   |                                  |
| **Irvine, California**                                                       |   | **92614**                             |
| (Address of principal executive offices)                                     |   | (Zip Code)                            |
|                                                                         |   |                                  |
| Registrant’s telephone number, including  area code: **(949) 250-7700** |

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15 (d) of the Securities ExchangeAct of 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days:

 

Yes   ý              No o

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act).

 

Yes   ý              No o

 

The number of shares of Common Stock outstanding at April 30, 2004was 10,075,212.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED MARCH 31, 2004

 

INDEX

 

 
| Part I -  | Financial Information:                     |                                                                                                 |
|----------------|--------------------------------------------|------------------------------------------------------------------------------------------------------|
|           |                                       |                                                                                                 |   |
|           | Item 1 -                                   | Consolidated Financial Statements                                                                    |   |
|           |                                       |                                                                                                 |   |
|           |                                       | Consolidated Balance Sheets -  March 31, 2004 and December 31, 2003 (unaudited)            |   |
|           |                                       |                                                                                                 |   |
|           |                                       | Consolidated Statements of Operations -  Three Months Ended March 31, 2004 and 2003 (unaudited) |   |
|           |                                       |                                                                                                 |   |
|           |                                       | Consolidated Statements of Cash Flows -  Three Months Ended March 31, 2004 and 2003 (unaudited) |   |
|           |                                       |                                                                                                 |   |
|           |                                       | Notes to Consolidated Financial Statements                                                           |   |
|           |                                       |                                                                                                 |   |
|           | Item 2 -                                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations          |   |
|           |                                       |                                                                                                 |   |
|           | Item 3  -                                  | Quantitative  and Qualitative Disclosures About Market Risk                                          |   |
|           |                                       |                                                                                                 |   |
|           | Item 4  -                                  | Evaluation  of Disclosure Controls and Procedures                                                    |   |
|           |                                       |                                                                                                 |   |
| Part II - | Other Information:                         |                                                                                                 |
|           |                                       |                                                                                                 |
|           | Item 1 -Legal  Proceedings                 |                                                                                                 |
|           |                                       |                                                                                                 |   |
|           | Item 6  -Exhibits  and Reports on Form 8-K |                                                                                                 |
|           |                                       |                                                                                                 |   |
| SIGNATURE      |                                       |

 

2

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PART I.  FINANCIAL INFORMATION

 

ITEM 1 –FINANCIAL STATEMENTS

 

 CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED BALANCE SHEETS

 

(unaudited)

 

(in millions)

 
|                                                                                                      |   | **March 31,   2004** |   | **December 31,  2003** |   |
|-----------------------------------------------------------------------------------------------------------|--------|--------------------------------|--------|-----------------------------|--------|
|                                                                                                      |   |                           |   |                        |   |
| ASSETS                                                                                                    |   |                           |   |                        |   |
|                                                                                                      |   |                           |   |                        |   |
| Cash and cash equivalents                                                                                 |   | $                              | 10.2   |                        | $      | 14.7 |   |
| Real estate held for current development or  sale                                                         |   | 31.0                           |   | 27.5                        |   |
| Land held for future development                                                                          |   | 154.2                          |   | 153.6                       |   |
| Other assets                                                                                              |   | 2.3                            |   | 2.3                         |   |
|                                                                                                      |   |                           |   |                        |   |
|                                                                                                      |   | $                              | 197.7  |                        | $      | 198.1 |   |
|                                                                                                      |   |                           |   |                        |   |
| LIABILITIES AND STOCKHOLDERS’ EQUITY                                                                 |   |                           |   |                        |   |
|                                                                                                      |   |                           |   |                        |   |
| Liabilities:                                                                                              |   |                           |   |                        |   |
| Accounts payable and accrued liabilities                                                                  |   | $                              | 4.0    |                        | $      | 6.3 |   |
| Project debt                                                                                              |   | 12.6                           |   | 10.4                        |   |
| Other liabilities                                                                                         |   | 12.2                           |   | 12.9                        |   |
|                                                                                                      |   |                           |   |                        |   |
| Total liabilities                                                                                         |   | 28.8                           |   | 29.6                        |   |
|                                                                                                      |   |                           |   |                        |   |
| Minority interest                                                                                         |   | 3.9                            |   | 3.9                         |   |
|                                                                                                      |   |                           |   |                        |   |
| Commitments and contingencies                                                                             |   |                           |   |                        |   |
|                                                                                                      |   |                           |   |                        |   |
| Stockholders’ equity:                                                                                |   |                           |   |                        |   |
| Common Stock—$.05 par value; 11,000,000  shares authorized; 10,075,212 shares issued and outstanding |   | .5                             |   | .5                          |   |
| Excess Stock—$.05 par value; 11,000,000  shares authorized; no shares outstanding                    |   | —                         |   | —                      |   |
| Capital in excess of par value                                                                            |   | 143.2                          |   | 143.1                       |   |
| Retained earnings                                                                                         |   | 23.7                           |   | 23.4                        |   |
| Accumulated other comprehensive loss                                                                      |   | (2.4                           | )      | (2.4                        | )      |
| Total stockholders’ equity                                                                           |   | 165.0                          |   | 164.6                       |   |
|                                                                                                      |   |                           |   |                        |   |
|                                                                                                      |   | $                              | 197.7  |                        | $      | 198.1 |   |

 

See the accompanying notes to consolidatedfinancial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
|                                          |   | **Three  Months EndedMarch 31,** |   |
|-----------------------------------------------|--------|---------------------------------------|--------|
|                                          |   | **2004**                              |   | **2003** | ** ** |
|                                          |   |                                  |   |   |   |
| Revenues                                      |   | $                                     | 5.6    |   | $ | 3.9 |   |
|                                          |   |                                  |   |   |   |
| Costs of sales                                |   | 4.3                                   |   | 3.3 |   |
|                                          |   |                                  |   |   |   |
| Gross operating profit                        |   | 1.3                                   |   | .6 |   |
|                                          |   |                                  |   |   |   |
| Selling, general and administrative  expenses |   | .9                                    |   | .8 |   |
| Interest expense                              |   | .1                                    |   | .1 |   |
| Income from unconsolidated joint ventures     |   | (.1                                   | )      | (.1 | ) |
| Other expense, net                            |   | —                                |   | .1 |   |
|                                          |   |                                  |   |   |   |
| Income (loss) before income taxes             |   | .4                                    |   | (.3 | ) |
|                                          |   |                                  |   |   |   |
| Provision (benefit) for income taxes          |   | .1                                    |   | (.1 | ) |
|                                          |   |                                  |   |   |   |
| Net income (loss)                             |   | $                                     | .3     |   | $ | (.2 | ) |
|                                          |   |                                  |   |   |   |
| Earnings (loss) per common share - basic      |   | $                                     | .03    |   | $ | (.02 | ) |
|                                          |   |                                  |   |   |   |
| Earnings (loss) per common share - diluted    |   | $                                     | .03    |   | $ | (.02 | ) |

 

See the accompanyingnotes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

 

(unaudited)

 
|                                                                       |   | **Three  Months Ended  March 31,** |   |
|----------------------------------------------------------------------------|--------|-----------------------------------------|--------|
|                                                                       |   | **2004**                                |   | **2003** |   |
|                                                                       |   |                                    |   |   |   |
| Cash flows from operating activities:                                      |   |                                    |   |   |   |
| Net income (loss)                                                          |   | $                                       | .3     |   | $ | (.2 | ) |
| Adjustments to reconcile net income to cash  used in operating activities: |   |                                    |   |   |   |
| Non-cash interest expense                                                  |   | .1                                      |   | .1 |   |
| Gains on sales of real estate held for  current development or sale        |   | (1.3                                    | )      | (.6 | ) |
| Proceeds from asset sales, net                                             |   | 5.6                                     |   | 3.9 |   |
| Investments in real estate held for current  development or sale           |   | (7.8                                    | )      | (4.5 | ) |
| Investments in land held for future  development                           |   | (.6                                     | )      | (.5 | ) |
| Changes in assets and liabilities:                                         |   |                                    |   |   |   |
| Increase in other assets                                                   |   | —                                  |   | (.3 | ) |
| Decrease in accounts payable, accrued and  other liabilities, net          |   | (3.0                                    | )      | (2.4 | ) |
|                                                                       |   |                                    |   |   |   |
| Cash used in operating activities                                          |   | (6.7                                    | )      | (4.5 | ) |
|                                                                       |   |                                    |   |   |   |
| Cash flows from financing activities:                                      |   |                                    |   |   |   |
| Borrowings of project debt                                                 |   | 2.2                                     |   | 3.7 |   |
| Repayments of project debt                                                 |   | —                                  |   | (2.5 | ) |
|                                                                       |   |                                    |   |   |   |
| Cash provided by financing activities                                      |   | 2.2                                     |   | 1.2 |   |
|                                                                       |   |                                    |   |   |   |
| Net decrease in cash and cash equivalents                                  |   | (4.5                                    | )      | (3.3 | ) |
|                                                                       |   |                                    |   |   |   |
| Cash and cash equivalents - beginning of  period                           |   | 14.7                                    |   | 9.2 |   |
|                                                                       |   |                                    |   |   |   |
| Cash and cash equivalents - end of period                                  |   | $                                       | 10.2   |   | $ | 5.9 |   |
|                                                                       |   |                                    |   |   |   |
| Supplemental disclosures of cash flow  information:                        |   |                                    |   |   |   |
| Cash paid during the period for income  taxes                              |   | $                                       | (.4    | ) | $ | (.6 | ) |

 

See the accompanying notes to consolidatedfinancial statements.

 

5

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

(UNAUDITED)

 

**Note 1 - Basis ofPresentation**

 

The accompanying financial statements have beenprepared by California Coastal Communities, Inc. and its consolidated subsidiaries(the “Company”), without audit, pursuant to the rules and regulations of theSecurities and Exchange Commission. Certain information and footnotedisclosures normally included in financial statements prepared in accordancewith generally accepted accounting principles have been condensed or omittedpursuant to such rules and regulations. The Company believes that theseunaudited consolidated financial statements reflect all material adjustments(consisting only of normal recurring adjustments) and disclosures necessary forthe fair presentation of the results of operations and statements of financialposition when read in conjunction with the Financial Statements and Notesthereto included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003. The results for interim periods are not necessarilyindicative of the results to be expected for the full year. This reportcontains forward-looking statements. Readers are cautioned that any suchforward-looking statements are not guarantees of future performance and involverisks and uncertainties that actual events or results may differ materiallyfrom those described herein as a result of various factors, including withoutlimitation, the factors discussed generally in this report.

 

# **Note 2 – Significant Accounting Policies**

 

#### *Earnings PerCommon Share*

#### * *

For the three months ended March 31, 2004 and2003, the weighted-average common shares outstanding was 10.1 million. Earningsper share, assuming dilution, is computed using the weighted-average number ofcommon shares outstanding and the dilutive effect of potential common sharesoutstanding. For the three months ended March 31, 2004, the average marketprice of the Company’s common stock exceeded the exercise price of outstanding stockoptions. Therefore, the dilutive effect of the 754,996 common shares frompotential exercise of options is reflected in the 10.8 million weighted-averagecommon shares assuming dilution. For the three months ended March 31,2003, the average market price of the Company’s common stock exceeded theexercise price of outstanding stock options and did not exceed the exerciseprice of outstanding warrants. However, the outstanding options are notincluded in the loss per share calculation because the effect is anti-dilutive.

 

*Real Estate*

 

Real estate held for current development or sale iscarried at the lower of cost, or fair value, less costs to sell. Land held forfuture development is carried at cost, with write-downs to fair value only inthe event that costs cannot be recovered from estimated undiscounted futurecash flows, as described under “Impairment of Long-Lived Assets.” Theestimation process involved in the determination of fair value is inherentlyuncertain since it requires estimates as to future events and marketconditions. Such estimation process assumes the Company’s ability to completedevelopment and dispose of its real estate properties in the ordinary course ofbusiness based on management’s present plans and intentions. Economic, market,environmental and political conditions may affect management’s development andmarketing plans. In addition, the implementation of such development andmarketing plans could be affected by the availability of future financing fordevelopment and construction activities. Accordingly, the ultimate values ofthe Company’s real estate properties are dependent upon future economic andmarket conditions, the availability of financing, and the resolution ofpolitical, environmental and other related issues.

 

The cost of sales of multi-unit projects is generally computed usingthe relative sales value method. Interest cost is capitalized to real estateprojects during their development and construction period.

 

*Impairmentof Long-Lived Assets*

 

The Company assesses the impairment of land held for future developmentand other long-lived assets in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets”, which requires an impaired asset, for whichcosts cannot be recovered from estimated undiscounted future cash flows, bewritten down to fair value. Long-lived assets are reviewed for impairmentwhenever events or changes in circumstances indicate that the carrying amountof an asset may not be recoverable. As provided by SFAS No. 144, impairment isevaluated by comparing an asset’s carrying value to the undiscounted estimatedcash flows

 

6

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expected from the asset’s operations and eventual disposition. If thesum of the undiscounted estimated future cash flows is less than the carryingvalue of the asset, an impairment loss is recognized based on the fair value ofthe asset. If an impairment occurs, the fair value of an asset for purposes ofSFAS No. 144 is deemed to be the amount a willing buyer would pay awilling seller for such asset in a current transaction.

 

In accordance with SFAS No. 144, in developing estimated future cashflows for impairment testing, the Company has incorporated its own assumptionsregarding the entitlement prospects of land held for future development and itsown market assumptions including those regarding home prices, infrastructureand home-building costs for both land held for future development and realestate held for current development or sale. Additionally, as appropriate, the Company identifies alternative coursesof action to recover the carrying value of its long-lived assets and evaluatesall likely alternatives under a probability-weighted approach as indicated inSFAS No. 144.

 

### *Recent Accounting Pronouncements*

### * *

In January 2003, theFASB issued FIN No. 46, “Consolidation of Variable Interest Entities” and inDecember 2003, issued Interpretation No. 46 (revised December 2003)“Consolidation of Variable Interest Entities – An Interpretation of APB No.51.” In general, a variable interest entity is a corporation, partnership,trust, or any other legal structure used for business purposes that either (a)does not have equity investors with voting rights or (b) has equity investorsthat do not provide sufficient financial resources for the entity to supportits activities. FIN No. 46 requires certain variable interest entities to beconsolidated by the primary beneficiary of the entity if the investors in the entitydo not have the characteristics of a controlling financial interest or do nothave sufficient equity at risk for the entity to finance its activities withoutadditional subordinated financial support from other parties. FIN No. 46 (R)clarifies the application of Accounting Research Bulletin (“APB”) No. 51,“Consolidated Financial Statements, “ to certain entities in which equityinvestors do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without subordinated financial support from other parties. TheCompany adopted all requirements of FIN No. 46 effective January 1, 2003,including those which apply immediately to variable interest entities createdafter January 31, 2003, and certain of the disclosure requirementsapplicable in all financial statements issued after January 31, 2003,regardless of when the variable interest entity was established and theconsolidation requirements applicable to older entities in the first fiscalyear or interim period ending after December 15, 2003. FIN No. 46 (R)applies immediately to variable interest entities created afterDecember 31, 2003, and to variable interest entities in which anenterprise obtains an interest after that date. It applies no later than thefirst reporting period ending after December 15, 2004, to variableinterest entities in which an enterprise holds a variable interest (other thanspecial purpose) that it acquired before January 1, 2004.  FIN No. 46 (R) applies to public enterprisesas of the beginning of the applicable interim or annual period. The Companybelieves that the adoption of FIN No. 46 and FIN No. 46 (R) will not have amaterial impact on its financial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accounting for CertainInstruments with Characteristics of Both Liabilities and Equity” (“SFAS 150”),which establishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. SFAS150 requires that an issuer classify a financial instrument that is within itsscope, which may have previously been reported as equity, as a liability (or anasset in some circumstances). This statement is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning afterJune 15, 2003 for public companies. In October 2003, the FASBdeferred implementation of paragraphs 9 and 10 of SFAS 150 regarding parentcompany treatment of minority interest for certain limited life entities. Thisdeferral is for an indefinite period. As of March 31, 2004, the Companyconsolidated one joint venture which is affected by this deferral (see Note 7).The adoption of other provisions of SFAS 150 did not have a material effect onthe Company’s financial statements.

 

**Note 3 - Land Heldfor Future Development**

 

The Company owns approximately 350 acres located in Orange County, Californiaoverlooking the Pacific Ocean and the Bolsa Chica wetlands (which were sold bythe Company to the State of California in 1997), surrounded by the City ofHuntington Beach and approximately 35 miles south of downtown Los Angeles. TheCompany’s holdings include 208 acres on a mesa north of the Bolsa Chicawetlands (“Bolsa Chica Mesa”), approximately 100 acres on, or adjacent to, theHuntington Mesa and 42 acres of lowlands which were acquired by the Company inSeptember 1997.

 

A Local Coastal Program (“LCP”) for development of upto 2,500 homes on the Bolsa Chica Mesa was approved by the Orange County Boardof Supervisors in December 1994 and by the Coastal Commission inJanuary 1996. In October 1997, in response to a trial court decisionin a  lawsuit that challenged the 1996approvals of the Coastal Commission (the “Coastal Act Lawsuit”), the CoastalCommission approved modifications to the LCP which eliminated the filling ofWarner Pond and thereby reduced the maximum number of homes to be built from2,500 to no more than

 

7

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1,235 homes on the Bolsa Chica Mesa. The Orange County Board ofSupervisors subsequently accepted the Coastal Commission’s suggestedmodifications; however, this approval was challenged in trial court and then inthe Court of Appeals.

 

In November 2000, in response to theApril 1999 Court of Appeal’s decision in the Coastal Act Lawsuit, theCoastal Commission held another public hearing on the LCP and approvedsuggested modifications that would limit development to only the approximately105-acre upper bench of the Bolsa Chica Mesa (“Upper Mesa”). The CoastalCommission’s suggested modifications to the LCP would prohibit the Company fromdeveloping the approximately 103-acre lower bench of the Bolsa Chica Mesa (the“Lower Mesa”). In May 2001, the County of Orange declined to consider theCoastal Commission’s November 2000 suggested modifications. In theirresponse to the Coastal Commission, the County stated that the Commission’s suggestedmodifications were infeasible and unacceptable. In particular, the County notedthat the Commission’s suggested modifications would remove 140 acres of viableresidentially-zoned land from the County’s plan.

 

In January 2001, the Company challenged theCoastal Commission’s suggested modifications to the LCP. The Company’s petitionalleged that the Coastal Commission arbitrarily abandoned decades of priorapprovals that would have permitted development on the entire Bolsa Chica Mesa.The petition challenged the Commission’s decision as to how to protect certainraptor habitat on the Bolsa Chica Mesa, including the Commission’srecommendation that the Lower Mesa not be developed. In February 2003, thecourt issued a ruling which denied the Company’s petition on the grounds thatthe Coastal Commission’s November 2000 decision had expired by operationof law when the County rejected the Coastal Commission’s suggestedmodifications. As a result, the Coastal Commission’s decision to prohibitdevelopment on the Lower Mesa is no longer of any force or effect. In addition,the court’s opinion recommended that the Company put a new, legally reviewableplan before the Coastal Commission and, accordingly, the Company is continuingits pursuit of reasonable development on the Bolsa Chica Mesa as discussedbelow.

 

The Company is currently seeking approval of permitsfor development of the Upper Mesa. During 2002, the County of Orange approvedthe Company’s site plan and tentative tract map for development of 379 single-familyhomes on the Upper Mesa. This development plan now requires approval by theCoastal Commission. The planned community on the Upper Mesa, known as“Brightwater”, is currently expected to offer a broad mix of home choices,averaging 2,900 square feet and ranging in size from 1,560 square feet to 4,450square feet. Brightwater would also include 28 acres of parks, public trailsand open space on the 105-acre Upper Mesa. With only 379 homes on approximately77 acres of the Upper Mesa, the resulting low-density plan would equate toapproximately five homes per acre, which would be consistent and compatiblewith the neighboring Huntington Beach communities. In addition, the Companywould offer to dedicate 51 acres of land on the Huntington Mesa to the Countyof Orange in order to complete the Harriett M. Wieder Linear Park, a 105-acreplanned regional park. The 1,200-acre Bolsa Chica Wetlands are fully preservedand protected in accordance with previous agreements with the State ofCalifornia and are not included in the Brightwater plan.

 

The Company submitted a Coastal Development Permit(“CDP”) application for Brightwater to the Coastal Commission inNovember 2002, which was deemed complete in September 2003. TheCompany currently expects that the Coastal Commission will hold a publichearing on the Company’s CDP application during the second half of 2004;however, there can be no assurance that further delays will not be encountered.The Company does not believe that the Coastal Commission process will permanentlyprevent it from developing a planned community at Bolsa Chica; however, therecan be no assurance in that regard, or as to (i) when development couldcommence, (ii) the number of acres or homes the Company will be permitted todevelop, or  (iii) the absence offurther litigation or administrative delay.

 

On September 2, 1997, the Company completed arecapitalization pursuant to court confirmation of a Prepackaged Plan ofReorganization (the “Recapitalization”), and the Company applied the principlesrequired by the American Institute of Certified Public Accountant’s Statementof Position (“SOP”) 90-7, “Financial Reporting by Entities in ReorganizationUnder the Bankruptcy Code” (“Fresh-Start Reporting”), and the carrying value ofland held for development (Bolsa Chica) was adjusted to fair value afterconsideration of the October 1997 Coastal Commission action discussedabove. The fair value was determined in 1997 using discounted estimated cashflows expected from the asset’s operations and eventual disposition. Followingthe Coastal Commission’s November 2000 approval of suggested modificationsto the Bolsa Chica Local Coastal Program, which would limit development to onlythe Upper Mesa, an assessment of impairment was conducted by the Company forthe year ended December 31, 2000. The Company has updated its analysis ateach year-end since 2000, and has noted no indicators of impairment since thatdate. Future costs incurred for capitalizable development activities for theBolsa Chica project will increase the basis of the land. An estimate for thesecosts has been included in the Company’s estimated undiscounted cash flowforecast used in its impairment analyses. In accordance with the Company’spolicy described in Note 2 – Impairment of Long-Lived Assets, since theestimated undiscounted future

 

8

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cash flows from the Upper Mesa and the Company’s additional 194 acresat Bolsa Chica exceed its March 31, 2004 carrying value, the Companybelieves there has been no impairment.

 

The estimation process involved in the determinationof value is inherently uncertain because it requires estimates as to futureevents and market conditions. Such estimation process assumes the Company’sability to complete the development and disposition of its real estateproperties in the ordinary course of business based on management’s presentplans and intentions. Economic, market, environmental and political conditionsmay affect management’s development and marketing plans. In addition, theimplementation of such development and marketing plans could be affected by theavailability of future financing for development and construction activities.The development of the Company’s Bolsa Chica Mesa project is dependent upon variousgovernmental approvals and economic factors. Accordingly, the amount ultimatelyrealized from such project may differ materially from current estimates and theproject’s carrying value.

 

**Note 4 - Project Debt**

 

In conjunction with the acquisition of single-familyresidential lots, the Company’s homebuilding subsidiary, Hearthside Homes, Inc.and its subsidiaries, enter into construction loan agreements with a commercialbank. These loan facilities finance a portion of the land acquisition and themajority of the construction of infrastructure and homes. The loans are securedby deeds of trust on individual projects and require principal repayments uponthe delivery of homes. The loans bear an interest rate of prime plusthree-fourths percent (4.75% at March 31, 2004).  The following amounts were available and outstanding under theseloan facilities as of March 31, 2004 and December 31, 2003 ($ inmillions):

 
|   |   |             |   |        |   |         |    | **Outstanding  at** |   |
|--------|--------|------------------|--------|-------------|--------|--------------|---------|---------------------|--------|
|   |   | **Amount**       |   | **Number**  |   | **Maturity** |    | **March 31,**  |   | **December 31,** |   |
|   |   | **of  Facility** |   | **of Lots** |   | **Date**     |    | **2004**            |   | **2003** |   |
|   |   |             |   |        |   |         |    |                |   |   |   |
| Chino  |   | $                | 15.4   |        | 77     |         | 5/30/04 |                | $      | 12.6 |   | $ | 10.4 |   |
|        |        |                  |        |             |        |              |         |                     |        |  |  |  |  |  |

 

For the three months ended March 31, 2004 and2003, approximately $100,000 of construction period interest was capitalized toprojects in the construction stage for each period.

 

**Note 5 – OtherLiabilities**

 

Other liabilities were comprised of the following (in millions):

 
|                                                |   | **March 31,  2004** |   | **December 31,  2003** |   |
|-----------------------------------------------------|--------|--------------------------|--------|-----------------------------|--------|
| Net deferred taxes and other tax  liabilities       |   | $                        | 3.6    |                        | $      | 3.6 |   |
| Accrued pensions and benefits                       |   | 4.6                      |   | 4.9                         |   |
| Home warranty reserves                              |   | 1.2                      |   | 1.2                         |   |
| Contingent indemnity and environmental  obligations |   | 3.6                      |   | 4.1                         |   |
| Unamortized discount                                |   | (.8                      | )      | (.9                         | )      |
|                                                |   | $                        | 12.2   |                        | $      | 12.9 |   |

 

Contingent indemnity and environmental obligations primarily reflect(i) reserves before related discount (recorded pursuant to Fresh-StartReporting) for contingent indemnity obligations for businesses disposed of byformer affiliates and unrelated to the Company’s current operations, and (ii)the prospective liability of a subsidiary of the Company for PCB contaminationon its 42-acre Bolsa Chica lowlands property as further described below.

 

*Dresser Litigation*

 

In May 2002, Dresser Industries, Inc. (“Dresser”) filed litigation,captioned Dresser Industries, Inc. vs. California Coastal Communities, Inc. andRESCO Holdings, Inc. (“RESCO”, a former affiliate), in the 58thJudicial District Court of Jefferson County, Texas. Dresser seeks a declaratoryjudgment regarding the rights and obligations of the parties under aJanuary 1988 purchase agreement. Under the agreement, Dresser acquired anengineering and construction business from M.W. Kellogg Company (“Kellogg”), a corporation formerly affiliated withthe Company. Kellogg and its parent company, Wheelabrator Technologies, Inc.(“Wheelabrator”, a former affiliate), agreed to indemnify Dresser againstcertain pre-closing claims. In a subsequent transaction, Wheelabrator assignedcertain assets and liabilities relating to the January 1988 purchaseagreement to the Company. Dresser also seeks unspecified damages for breach ofthe 1988 purchase agreement,

 

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along with attorney’s fees and costs. Dresser’s indemnity claims relateto several hundred lawsuits encompassing approximately 5,800 contested asbestosclaims made by third parties in connection with work in facilities in which theDresser-acquired engineering and construction business was allegedly connected.

 

The Company denies Dresser’s allegations and is vigorously defendingitself in this case and related matters. The Company was not formed untilSeptember 1988 and, when it was spun-off from Wheelabrator inDecember 1988, the Company agreed to indemnify Wheelabrator for itspotential liabilities under the January 1988 purchase agreement withDresser, to the extent that any such liabilities are not covered by insurance.However, the Company and RESCO contend that under the terms of theJanuary 1988 purchase agreement, any contractual duty to indemnify Dresserfor any third-party asbestos claims expired in March 1991. The Companyalso believes that it has a number of other meritorious defenses to thislitigation.

 

Currently, this litigation is in the discovery process. The Company hasparticipated in initial settlement discussions in connection with a mediationwhich was ordered by the Texas court in advance of the trial. The trial hasbeen postponed to August 2004 in order to allow time for Dresser to emergefrom its Chapter 11 bankruptcy proceedings and to allow the mediation processto continue. However, there can be no assurance that a settlement can bereached before trial. Given the preliminary nature of these proceedings, theCompany is not able to assess its potential exposure with any degree ofaccuracy. The Company’s litigation accrual reflects its estimate for theminimum costs which are probable and estimable at this time.  However, defense costs and damage awards inasbestos cases can involve amounts that would have a material adverse effect onthe Company’s business, operations and financial condition, in the event thatthe Company was required to provide indemnification to Dresser.

 

*Lowland  Remediation*

 

In September 1997, the Company acquired 42 acres in the BolsaChica lowlands with the intent of selling it to the State of California inconnection with their planned restoration of 1,000 acres of adjacent wetlands.While the State continues to express interest in acquiring this property, nosuch agreement has been reached to date and there can be no assurances that anyagreement will ever be reached. However, in anticipation of entering into apurchase agreement, the State performed limited soils sampling on this propertyand notified the Company in 1999 that it had discovered contamination from agroup of chemicals called PCBs. The source of the contamination is presentlyunknown; however, the Company has never conducted any development, business oroperations on this property. In January 2002, the State’s Department ofToxic Substances Control (“DTSC”) became the regulatory agency responsible foroverseeing the Company’s efforts to remediate the contamination on thisproperty. In July 2002, a subsidiary of the Company entered into a consentorder with DTSC regarding remediation. The Company’s subsidiary prepared aRemedial Investigation (“RI”) Workplan, which was approved by DTSC inAugust 2003. During September and December 2003, the subsidiaryperformed soil sampling at the site according to the RI Workplan to determinethe nature and extent of contamination, and submitted an RI Report to DTSC inFebruary 2004. As of March 31, 2004, the subsidiary has accruedapproximately $1.0 million for environmental testing and remediation of thisproperty. While the accrual reflects the estimate for the minimum costs whichare probable and estimable, such accrual may not be adequate to satisfy thefull amount of remediation that may be required by the DTSC. Until aremediation plan has been approved by DTSC, the Company cannot accuratelyestimate how much, if any, additional costs may ultimately be incurred; however,the Company has been advised that costs could range up to approximately $1.5million in excess of the current accrual. There is no maximum limitation to theobligation of the Company’s subsidiary to remediate under the DTSC consentorder. Other parties, who have yet to be identified, may be responsible for allor a portion of these remediation costs. If any such party is subsequentlyidentified, the Company’s subsidiary may be entitled to seek reimbursement forsome or all of its costs; however, there can be no assurance in that regard.

 

*Home WarrantyReserve*

 

The Company provides a home warranty reserve to reflect its contingentliability for product liability. The Company generally records a provision ashomes are delivered, based upon historical and industry experience, subject tocertain minimums. The home warranty reserve activity is presented below (inmillions):

 
|                           |   | **Three  Months Ended  March 31,** |   |
|--------------------------------|--------|-----------------------------------------|--------|
|                           |   | **2004**                                |   | **2003** |   |
| Balance at beginning of period |   | $                                       | 1.2    |   | $ | 1.2 |   |
| Provision                      |   | —                                  |   | — |   |
| Payments                       |   | —                                  |   | — |   |
| Balance at end of period       |   | $                                       | 1.2    |   | $ | 1.2 |   |

 

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**Note 6 –Income Taxes**

 

The following is a summary of the tax provision(benefit):

 
|                                    |   | **Three  Months Ended  March 31,** |   |
|-----------------------------------------|--------|-----------------------------------------|--------|
|                                    |   | **2004**                                |   | **2003** |   |
| Current taxes                           |   | $                                       | — |   | $ | — |   |
| Deferred taxes                          |   | .2                                      |   | (.1 | ) |
| Reduction in contingent tax liabilities |   | (.1                                     | )      | — |   |
| Provision (benefit) for income taxes    |   | $                                       | .1     |   | $ | (.1 | ) |

 

Deferred tax benefits resulting from reductions in thedeferred tax asset valuation allowance on NOLs are recorded when the Companyconcludes that it is more likely than not that it will utilize additional NOLsto offset taxable income. Increases in the deferred tax asset valuationallowance on NOLs are recorded when the Company determines that it cannotconclude that it is more likely than not that it will utilize additional NOLsto offset taxable income. Pursuant to Fresh Start Reporting, during the threemonths ended March 31, 2004, a reduction in valuation allowance on federalPre-reorganization NOLs of approximately $100,000 was reflected by increasingthe Company’s capital in excess of par value.

 

The Internal Revenue Code (the “Code”) generallylimits the availability of NOLs if an ownership change occurs within anythree-year period under Section 382. If the Company were to experience anownership change of more than 50%, the use of all remaining NOLs wouldgenerally be subject to an annual limitation equal to the value of theCompany’s equity before the ownership change, multiplied by the long-termtax-exempt rate. The federal NOLs available as of March 31, 2004 wereapproximately $176 million. The amount of federal NOLs which expire if notutilized is zero, $1 million, $20 million, $8 million, $19 million and $128million for 2004, 2005, 2006, 2007, 2008 and thereafter, respectively.

 

In October 1999, in response to an unsolicited written consentfrom a majority of its stockholders, the Company amended its certificate ofincorporation in order to protect the ability of the Company to utilize its taxloss carryforwards. Since the Company’s use of its NOLs would be severelyrestricted if it experiences an ownership change of 50% or more, the Company’smajority stockholders requested that the Board of Directors enact theamendments, which were determined to be in the best interest of the Company andits stockholders. The amendments prohibit future purchases of the Company’scommon stock by persons who would become new 5% holders, and also prohibitcurrent holders of over 5% from increasing their positions, except in certainpermissible circumstances which would not jeopardize the Company’s ability touse its NOLs. While these amendments reduced the Company’s risk of an ownershipchange occurring due to the acquisition of shares by 5% stockholders, the riskremains that an ownership change could result from the sale of shares byexisting 5% stockholders. The Company estimates that after giving effect tovarious transactions by stockholders who hold a 5% or greater interest in theCompany, it has experienced a three-year cumulative ownership shift ofapproximately 29% as of March 31, 2004.

 

**Note 7 – MinorityInterest**

 

In April 2003, the Company entered into a Limited LiabilityCompany (“Chino LLC”) joint venture agreement for the purpose of designing,constructing and selling 77 homes in Chino, California. The Chino LLC acquiredthe 77 lots in May 2003 and is currently constructing and selling homes.Hearthside Homes, Inc. (one of the Company’s principal subsidiaries) is themanaging member of the Chino LLC, manages its operations and contributedcapital of approximately $400,000 (approximately 10%) to the venture. Minorityinterest represents the non-managing member’s equity interest in the ventureincluding a capital contribution of approximately $4.0 million (approximately 90%),as adjusted for the member’s allocation of profits and losses. Profits andlosses are generally allocated 50% to each member, after a 10% preferred returnon invested capital. The losses of the non-managing member are limited to theamount of its capital contribution of approximately $4.0 million.

 

##### **Note8 – Commitments and Contingencies**

 

*CorporateIndemnification Matters*

 

The Company and its former affiliates have, through avariety of transactions effected since 1986, disposed of several assets and businesses,many of which are unrelated to the Company’s current operations. By operationof law or

 

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contractual indemnity provisions, the Company may have retainedliabilities relating to certain of these assets and businesses.  There is generally no maximum obligation oramount of indemnity provided for such liabilities. A portion of suchliabilities are supported by insurance or by indemnities from certain of the Company’spreviously affiliated companies. The Company believes its balance sheetreflects adequate reserves for these matters; however there can be no assurancein that regard.

 

*Legal Proceedings*

 

See Note 5 for a discussion of pending litigation filed against theCompany by Dresser.

 

There are various other lawsuits and claims pending against the Companyand certain subsidiaries. In the opinion of the Company’s management, ultimateliability, if any, will not have a material adverse effect on the Company’sfinancial condition or results of operations.

 

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ITEM2 -                                                 MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**General**

 

The Company is a residential land development andhomebuilding company with properties located primarily in southern California.The principal activities of the Company and its consolidated subsidiariesinclude: (i) obtaining zoning and other entitlements for land it owns orcontrols through purchase options and improving the land for residentialdevelopment; and (ii) designing, constructing and selling single-familyresidential homes in southern California. Once the residential land owned bythe Company is entitled, the Company may build homes, sell unimproved land toother developers or homebuilders, sell improved land to homebuilders, orparticipate in joint ventures with other developers, investors or homebuildersto finance and construct infrastructure and homes. During 2004, the Companywill focus its immediate efforts to (i) obtain approval from theCalifornia Coastal Commission (“Coastal Commission”) for  development permits to build 379 homes onthe upper bench of the Bolsa Chica Mesa (“Upper Mesa”), as further described inNote 3 to the Company’s Consolidated Financial Statements; and (ii) continue to expand its profitable homebuilding operations. However, the Companymay also consider other strategic and joint venture opportunities; and therecan be no assurance that the Company will accomplish, in whole or in part, allor any of these strategic goals.

 

Over the last four years (2000 – 2003), the Companyhas generated gross margins from homebuilding activities and cash flows onassets other than Bolsa Chica. The Company currently has on-going southernCalifornia projects in Riverside County near the cities of North Corona andRiverside, in San Bernardino County in the city of Chino, in Los Angeles Countyin the city of Lancaster, and in San Diego County in the area of Rancho SantaFe. These homebuilding projects are expected to generate cash flows and grossmargins through mid-2006. However, the Company’s inventory of entitled landavailable for homebuilding projects remains limited. Given this limitedinventory of buildable lots, the Company is continuing to pursue residentiallot acquisition opportunities. Due to delays in approvals for homebuilding atBolsa Chica, continuation of homebuilding operations beyond mid-2006 isdependent upon acquisition of suitable, entitled residential lots within thesouthern California area or Coastal Commission approval of the Company’sdevelopment plan for 379 homes on the Bolsa Chica Upper Mesa.

 

Bolsa Chica is the Company’s principal asset,representing 78% of total assets at March 31, 2004. It has required andcontinues to require significant investments for entitlement and landdevelopment activities. As discussed in Note 3 to the consolidated financialstatements, the Company has faced various delays in implementing its plans forresidential development on the Bolsa Chica Mesa.

 

The Company is currently pursuing approval ofdevelopment permits for the Upper Mesa. During 2002, the County of Orangeapproved the Company’s site plan and tentative tract map for development of 379single-family homes on the Upper Mesa. This development plan now requires approvalby the Coastal Commission. The planned community on the Upper Mesa, known as“Brightwater”, is currently expected to offer a broad mix of home choices,averaging 2,900 square feet and ranging in size from 1,560 square feet to 4,450square feet. Brightwater would also include 28 acres of parks, public trailsand open space on the 105-acre Upper Mesa. With only 379 homes on approximately77 acres of the Upper Mesa, the resulting low-density plan would equate toapproximately 5 homes per acre, which is consistent and compatible with theneighboring Huntington Beach communities. In addition, the Company would offerto dedicate 51 acres of land on the Huntington Mesa to the County of Orange inorder to complete the Harriett M. Wieder Linear Park, a 105-acre plannedregional park. The 1,200-acre Bolsa Chica Wetlands are fully preserved andprotected in accordance with previous agreements with the State of Californiaand are not included in the Brightwater plan.

 

The Company submitted a Coastal Development Permit(“CDP”) application for Brightwater to the Coastal Commission inNovember 2002, which was deemed complete in September 2003. TheCompany currently expects that the Coastal Commission will hold a publichearing on the Company’s CDP application during the second half of 2004;however, there can be no assurance that further delays will not be encountered.The Company does not believe that the Coastal Commission process willpermanently prevent it from developing a planned community at Bolsa Chica;however, there can be no assurance in that regard, or as to (i) whendevelopment could commence, (ii) the number of acres or homes the Company willbe permitted to develop, or  (iii) theabsence of further litigation or administrative delay.

 

In addition to theUpper Mesa land, the Company holds several other Bolsa Chica parcelsaggregating approximately 194 acres which may be developed as residential lotsor sold as park lands to various governmental agencies, subject to CoastalCommission approval or negotiations, if any, with potential purchasers of thevarious parcels. The Company believes that those additional parcels potentiallyrepresent substantial value if development permits can be obtained or sales tothird parties can be negotiated.

 

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The Bolsa ChicaLand Trust and other environmental groups have suggested that the Companyconsider selling the Bolsa Chica Mesa to a nonprofit corporation or the Stateof California. Historically, there has been no source of funding to financesuch a transaction. However, in November 2002, voters approved a $3.4billion bond measure on California’s ballot known as Proposition 50 andentitled the “Water Quality, Supply and Safe Drinking Water Projects. CoastalWetlands Purchase and Protection. Bonds.” The bond initiative includes anunquantified line item for the State of California to pursue the acquisition ofnot less than 100 acres of the Bolsa Chica Mesa. The State is conducting anappraisal of the Bolsa Chica Mesa; however, there can be no assurances that theCompany will ever (i) receive an offer from the State for all or any part ofthe Bolsa Chica Mesa, (ii) reach a mutually acceptable agreement on price andterms, or complete any sale transaction.

 

Under the terms of Proposition 50, all propertyacquired must be from willing sellers, and not through a forced eminent domainprocess. Therefore, if the Company were to receive an offer from the State ofCalifornia to purchase all or a part of the Bolsa Chica Mesa, the Company wouldhave an opportunity to evaluate the value and terms of the offer beforedeciding whether to accept it, make a counter offer or reject it.  In reaching its decision, the Company wouldconsider how best to maximize stockholder value in light of the status andlikelihood of developing various portions of its Bolsa Chica property.  Given the facts and circumstances describedabove, the Company believes that the Upper Mesa can ultimately be developed,which would result in realization of an amount that is substantially in excessof the $154.2 million book value presently reflected in the Company’sconsolidated financial statements, although there can be no assurance in thatregard. Therefore, the Company has no present intention of selling the entireBolsa Chica Mesa to the State at any price that is not substantially in excessof the present carrying value.

 

The Company also believes that the public tradingprices of the Company’s common stock have not adequately reflected the BolsaChica Mesa’s true value. However, there can be no assurance that such publictrading price will ever reflect what the Company may believe to be the truevalue of the Bolsa Chica Mesa. From time to time, the Company has receivedoutside appraisals on an “as developed basis” which have supported theCompany’s beliefs.

 

Upon completion of the Recapitalization inSeptember 1997 as discussed in Note 3 to the Consolidated FinancialStatements included in this Quarterly Report, the Company applied theaccounting principles required by Fresh-Start Reporting and the carrying valueof land held for development (Bolsa Chica) was adjusted to fair value as ofSeptember 2, 1997, after consideration of the October 1997 CoastalCommission action discussed above. The fair value was determined in 1997 usingdiscounted estimated cash flows expected from the asset’s operations andeventual disposition. Following the November 2000 Coastal Commissionaction, an assessment of impairment was conducted by the Company for the yearended December 31, 2000. The Company updated its analysis at each year-endsince 2000, and has noted no indicators of impairment since that date. Futurecosts incurred for capitalizable development activities for the Bolsa Chicaproject will increase the basis of the land. An estimate for these costs hasbeen included in the Company’s estimated undiscounted cash flow forecast usedin its impairment analyses. In accordance with the Company’s policy describedin Note 2 to the Consolidated Financial Statements – Impairment of Long-LivedAssets, since the estimated undiscounted future cash flows from the Upper Mesaand the Company’s additional 194 acres at Bolsa Chica exceed its March 31,2004 carrying value, the Company believes there has been no impairment.

 

In evaluating the recoverability of the carrying value of Bolsa Chica,the Company considered the current status of development planning for the UpperMesa.  A tentative tract map and siteplan for the Upper Mesa have been approved by the County of Orange. The Companyalso evaluated the likelihood of obtaining Coastal Commission approval for itsCDP application for the Upper Mesa and several alternative outcomes for theLower Mesa in its probability-weighted approach to evaluating therecoverability of the carrying value of this asset under SFAS No. 144.

 

The Company’s application for a CDP from the Coastal Commission relatesonly to the Upper Mesa, where the Coastal Commission has previously approvedresidential development in four previous public hearings (1986, 1996, 1997 and2000). The Coastal Commission indicated in its 2000 public hearing on BolsaChica, that it would allow substantial development (up to 1,235 homes) on theUpper Mesa if the Company would grant a conservation easement over the LowerMesa.  Therefore, the Company believesthat it is likely that the Commission would allow reasonable development on theUpper Mesa in the future. Furthermore, the Company believes that it willeventually be permitted to reasonably develop the Upper Mesa, and that theCompany would recover substantially more from the Upper Mesa development thanthe $154.2 million carrying value for the entire Bolsa Chica Mesa as ofMarch 31, 2004.

 

Given that the Company has no debt which is secured by any of the BolsaChica property, and its current homebuilding operations are providing cashflow, the Company expects to be able to continue pursuing reasonabledevelopment as long as necessary until it succeeds in obtaining permits fordevelopment on the Upper Mesa.

 

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Alternatively, if the Company’s CDP is not approved, the Companyexpects to vigorously oppose any challenges to reasonable development of theUpper Mesa.  Furthermore, as discussedabove, any value recovered from the Lower Mesa and the Company’s other BolsaChica parcels would add to the ultimate proceeds from disposal of this class ofassets.

 

The following facts and assumptions were utilized by the Company inevaluating the potential value which could be derived from development of theBolsa Chica Upper Mesa:

 

•                  The Upper MesaCDP application encompasses 379 homes aggregating approximately 1.1 millionsquare feet.

•                  Followingreceipt of a CDP, the Upper Mesa development is projected to take approximatelysix months for infrastructure and two to three years for home construction.

•                  New home pricesapproximate $400 per square foot, before view and other premiums, in the localresidential market (coastal Huntington Beach).

•                  View, size andlocation premiums for the Upper Mesa could range from 5% to 25% of base homeprices.

•                  Finished lotvalues range from 40% to 60% of home prices, based on knowledge of the marketplace and discussions with advisors to the Company.

•                  Costs to improvethe lots from their raw condition to finished lots approximate $100,000 perlot.

•                  Home prices inthe coastal Huntington Beach area (as well as other Orange County coastalareas) appreciated approximately 20% during 2003 and demand continues to farexceed supply of housing, resulting in pressure for continued appreciation ofhome prices.

•                  Generally,homebuilders expect to earn a gross profit of 8% of the sales price of homes.

 

The estimation process involved in the determination of value isinherently uncertain because it requires estimates as to future events andmarket conditions. Such estimation process assumes the Company’s ability tocomplete development and dispose of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions.Economic, market, environmental and political conditions may affectmanagement’s development and marketing plans. In addition, the implementationof such development and marketing plans could be affected by the availabilityof future financing for development and construction activities. Thedevelopment of the Company’s Bolsa Chica Mesa project is dependent upon variousgovernmental approvals and economic factors. Accordingly, the amount ultimatelyrealized from such project may differ materially from current estimates and theproject’s carrying value.

 

**Impactof Inflation; Changing Prices and Economic Conditions**

 

Real estate and residential housing prices areaffected by inflation, which can cause increases in the price of land, rawmaterials and subcontracted labor. Unless these increased costs are recoveredthrough higher sales prices, gross margin from home sales would decrease. Ifinterest rates increase, construction and financing costs, as well as the costof borrowings, also would increase, which can also result in lower gross marginfrom home sales. The volatility of interest rates could have an adverse effecton the Company’s future operations and liquidity. Among other things, theseconditions may affect adversely the demand for housing and the availability ofmortgage financing and may reduce the credit facilities offered to the Company.

 

There can be no assurance regarding the continuedhealth of the southern California residential real estate market. While lowmortgage rates have sustained housing demand to date, any future increase inmortgage rates or significant loss of jobs in southern California would mostlikely slow demand for new homes. Increases in home mortgage interest ratesmake it more difficult for the Company’s customers to qualify for home mortgageloans, potentially decreasing home sales volume and prices. The tight supply ofnew homes in southern California has resulted in significant home priceincreases over the last five years. As a result, the affordability of new homeshas been declining and could further jeopardize future demand.

 

Most of the Company’s active homebuilding projects arelocated in the “Inland Empire” area of southern California, which includesRiverside and San Bernardino counties. The Inland Empire has experiencedsignificant population and job growth in the past decade. While continuedgrowth is expected, partially due to the limited supply of affordably pricedhousing in coastal areas such as Orange County, there can be no assurance thateconomic, demographic or other factors will not slow, diminish or cause suchgrowth to discontinue. The Company is continuing to pursue lot acquisitionopportunities throughout southern California.

 

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**Critical Accounting Policies**

** **

In the preparation of the Consolidated Financial Statements, theCompany applies accounting principles generally accepted in the United States.The application of generally accepted accounting principles may requiremanagement to make estimates and assumptions that affect the amounts reportedin the financial statements and accompanying results. Listed below are thosepolicies that the Company believes are critical and require the use of complexjudgment in their application. The Company’s critical accounting policiesinclude the evaluation of the impairment of long-lived assets and theevaluation of the probability of being able to realize the future benefitsindicated by its significant federal tax net operating losses, as discussedfurther in Note 2 to the Consolidated Financial Statements.

 

*Impairment of Long-Lived Assets*

 

The Company assesses the impairment of land held for future development(the Bolsa Chica project) and real estate held for current development or saleincluding long-lived assets in accordance with Statement of FinancialAccounting Standards (“SFAS”) No. 144, “Accounting for the Impairment orDisposal of Long-Lived Assets”. These assets are carried at cost, unless thecarrying amount of the parcel or subdivision is determined not to be fullyrecoverable, in which case the impaired real estate is written down to fairvalue. Given the significance of the carrying value of land held for futuredevelopment, the application of SFAS No. 144 in evaluating any potentialimpairment is critical to the Company’s consolidated financial statements, asdiscussed further in Note 2 to the Consolidated Financial Statements.

 

In accordance with SFAS No. 144, in developing estimated future cashflows for impairment testing, the Company has incorporated its own assumptionsregarding the entitlement prospects of land held for future development and itsown market assumptions including those regarding home prices, infrastructureand home-building costs regarding both land held for future development andreal estate held for current development or sale.  Additionally, as appropriate, the Company identifies alternativecourses of action to recover the carrying value of its long-lived assets andevaluates all likely alternatives under a probability-weighted approach assuggested in SFAS No. 144.

 

*Basis of Consolidation*

 

Certain wholly-owned subsidiaries of the Company are members in jointventures involved in the development and sale of residential projects andresidential loan production. The consolidated statements of the Company includethe accounts of the Company and all majority-owned and controlled subsidiariesand joint ventures. The financial statements of joint ventures in which theCompany generally has a controlling or majority economic interest (and thus arecontrolled by the Company) are consolidated with the Company’s financialstatements. Minority interest represents the equity interest of the Company’sjoint venture partner for one consolidated venture and is further described inNote 7 to the Consolidated Financial Statements. The Company’s investments inunconsolidated joint ventures are accounted for using the equity method whenthe Company does not have voting or economic control of the venture operations.

 

*Income Taxes*

 

The Company accounts for income taxes on the liability method. Deferredincome taxes are determined based on the difference between the consolidatedfinancial statement and tax bases of assets and liabilities. The liabilitymethod requires an evaluation of the probability of being able to realize thefuture benefits indicated by deferred tax assets, such as tax net operatinglosses (“NOLs”). A valuation allowance related to the deferred tax asset isrecorded when uncertainties preclude the Company from determining that it ismore likely than not that some portion or all of the deferred tax asset will berealized. Given the significance of the Company’s historical federal tax NOLs,as discussed in Note 6 to the Consolidated Financial Statements, theapplication of the Company’s policy in evaluating the expected future benefitof NOLs is critical. In applying those policies, estimates and judgments affectthe amounts at which certain assets and liabilities are recorded. The Companyapplies its accounting policies on a consistent basis. As circumstances change,they are considered in the Company’s estimates and judgments, and futurechanges in circumstances could result in changes in amounts at which assets andliabilities are recorded.

 

*HomebuildingRevenues and Cost of Sales*

 

The Company’s homebuilding operation generatesrevenues from the sale of homes to homebuyers. The majority of these homes isdesigned to appeal to move-up homebuyers and the homes are generally offeredfor sale in advance of their construction. Sales contracts are usually subjectto certain contingencies such as the buyer’s ability to qualify for financing.Revenue from the sale of homes is recognized at closing when title passes tothe buyer, and the earnings process is complete. As a result, the Company’srevenue recognition process does not involve significant judgments orestimates. However, the Company does rely on certain projections and estimatesto determine the related construction costs and resulting gross marginsassociated with revenues recognized. The Company’s construction costs are comprisedof direct and allocated costs,

 

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including estimated costs for future warranties and indemnities. TheCompany’s estimates are based on historical results, adjusted for currentfactors.

 

*Litigation Reserves*

 

The Company and certain of its subsidiaries have been named asdefendants in various cases arising in the normal course of business andregarding disposed assets and businesses of the Company or former affiliates.The Company has reserved for costs expected to be incurred with respect tothese cases based upon information provided by its legal counsel.

 

**Recent AccountingPronouncements**

 

See discussion regarding recent accountingpronouncements in Note 2 to the Consolidated Financial Statements.

 

**Liquidity and CapitalResources**

 

The principal assets in the Company’s portfolio areresidential land which must be held over an extended period of time in order tobe developed to a condition that, in management’s opinion, will ultimatelymaximize the return to the Company. Consequently, the Company requiressignificant capital to finance its real estate development and homebuildingoperations. Historically, sources of capital have included bank lines ofcredit, specific property financings, asset sales and available internal funds.The Company is currently utilizing project debt and internally generated cashto fund construction of the Riverside, Chino and Rancho Santa Fe projects, andis utilizing internally generated cash to fund the North Corona project and theBolsa Chica project. The Company’s current homebuilding projects are expectedto generate approximately $30 million of cash during the next 24 months, basedon present economic conditions and market assumptions. The Company’s cash andcash equivalents as of March 31, 2004 were approximately $10.2 million.The Company believes that its cash and cash equivalents, future real estatesales proceeds, and funds available under its credit and joint ventureagreements will be sufficient to meet anticipated operating and capitalinvestment requirements, primarily project development costs for homebuildingprojects and the Bolsa Chica land development project, along with general andadministrative expenses and liabilities, for the next 12 months.

 

The Company is subject to the usual obligationsassociated with entering into contracts for the purchase of land and improvedhomesites. These purchase contracts typically require a cash deposit and thepurchase of properties under these contracts is generally contingent uponsatisfaction of certain requirements by the sellers, including obtainingapplicable property entitlements. The Company also utilizes option contractswith third-party land sellers and financial entities as a method of acquiringland in staged takedowns and minimizing the use of funds from other corporatefinancing sources. These option contracts also help to manage the financial andmarket risk associated with land holdings. Option contracts generally requirethe payment of a non-refundable cash deposit for the right to acquire lots overa specified period of time at predetermined prices. The Company has the rightat its discretion to terminate the obligations under these option agreements byforfeiting the cash deposit with no further financial responsibility. TheCompany may enter into land development and homebuilding joint ventures fromtime to time as a means of expanding its market opportunities, establishingstrategic alliances, managing its risk profile and leveraging the Company’scapital base. These joint ventures may obtain secured acquisition, developmentand construction financing, which minimizes the use of funds from othercorporate financing sources.

 

**Homebuilding**

 

*North Corona*. In July 2001, the Company acquired 83 finished lots in RiversideCounty, California near North Corona in the master-planned community known as“Providence Ranch”. The community of Providence Ranch and the adjacentcommunity of “Corona Valley”, are planned for a total of 2,600 homes, and arewell-located to serve the employment centers of the greater Los Angeles area,Orange County and the Ontario international airport. The Company commenced homeconstruction in October 2001, opened for sales in February 2002 andreleased 73 homes for sale during 2002 at an average price of approximately$298,000. During 2002 and 2003, 58 homes and 15 homes were delivered,respectively. As of May 6, 2004, the final phase of seven homes and the threemodels have been sold and are in escrow, with deliveries scheduled for thesecond quarter of 2004.

 

In October 2002, the Company acquired an additional 93 finishedlots in the Providence Ranch community. Construction of homes in this secondphase began during the first quarter of 2003. The Company sold these homes fromthe original model complex.  During2003, the Company delivered 71 homes at an average price of $367,000. Anadditional seven homes were delivered during the first quarter of 2004. As ofMay 6, 2004, all 15 of the remaining homes are in escrow, with deliveriesscheduled for the third quarter of 2004.

 

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*Riverside*. During the fourth quarter of 2002 and the first quarter of 2003, theCompany acquired a total of 24 finished lots near the city of Riverside, inRiverside County, in the master-planned community known as “Victoria Grove”.This well-established community is planned for a total of 855 homes. DuringApril 2004, the Company acquired 43 additional lots for a total project of67 homes known as “Jasper Ranch”. The Company began construction of homesduring the third quarter of 2003. The homes average 3,673 square feet. TheCompany opened for sales on these homes during June 2003. The Companydelivered the first phase of five homes during the fourth quarter of 2003 at anaverage price of approximately $468,000, and the second phase of six homesduring the first quarter of 2004, at an average price of approximately$458,000.  During April 2004, theCompany released 11 additional homes for sale at an average price of $602,000 andall 11 are in escrow, with deliveries currently scheduled for the fourthquarter of 2004.

 

*Chino. *In May 2003, through ajoint venture, the Company acquired 77 finished lots in Chino, California inSan Bernardino County. This infill site is part of a new community known as“The Reserve”, encompassing 244 homes. Construction of homes averagingapproximately 3,320 square feet began during the fourth quarter of 2003. TheCompany opened for home sales on February 28, 2004, and has released thefirst two phases aggregating 23 homes for sale at an average price of $537,000and expects to begin delivering homes during the summer of 2004.

 

In January 2004, the Company acquired 17additional finished lots in the City of Chino which are near, but not a part ofThe Reserve, and are not a part of the joint venture described above. TheCompany expects to begin construction of homes averaging 3,098 square feetduring the third quarter of 2004.

 

*RanchoSanta Fe.*  InOctober 2003, the Company entered into an agreement to acquire 32 lots ina luxury golf community known as Crosby Estates in the Rancho Santa Fe area ofCalifornia in San Diego County. The Company acquired eight of the lots duringthe fourth quarter of 2003 and presently expects to begin construction of homesaveraging approximately 3,369 square feet during the second quarter of 2004.

 

*Lancaster.*   The Company expects to acquire 104 lots inthe city of Lancaster in northern Los Angeles County in May 2004. The Companypresently expects to begin construction of homes averaging approximately 2,800square feet in mid-2004.

 

## **FinancialCondition**

## ** **

*March 31, 2004 Compared with December 31, 2003*

 

Cash flows from homebuilding operations for the firstquarter of 2004 primarily reflect a use of cash for investments in real estateand construction costs of $7.8 million and a $2.3 million decrease in accountspayable and accrued liabilities for payment of accrued construction,compensation and tax liabilities. Additional significant uses of cash includeapproximately $600,000 for investment in the Bolsa Chica Mesa project,primarily for consultants engaged in the entitlement process, and selling,general and administrative expenses of approximately $900,000. The primarysources of cash during the quarter were real estate sales proceeds of $5.6million from deliveries of 13 homes, and net borrowing under project debtfinancing of $2.2 million. These items, as well as other activity presented inthe Statements of Cash Flows, resulted in the $4.5 million decrease in cash andcash equivalents.

 

**Results of Operations**

 

The nature of the Company’s business, including its limited inventoryof buildable lots, is such that individual transactions often cause significantfluctuations in operating results from quarter-to-quarter and from year-to-year.

 

*Three Months Ended March 31, 2004 Compared with the Three MonthsEnded March 31, 2003*

 

The Company reported revenues of $5.6 million andgross operating profit of approximately $1.3 million for the first quarter of2004, compared with $3.9 million in revenues and gross operating profit ofapproximately $600,000 for the first quarter of 2003. Revenues in the currentperiod reflect deliveries of 13 homes, including six homes at the “ JasperRanch” project in Riverside and seven homes at the North Corona project. Thecomparable period of the prior year also reflects deliveries of 13 homes,including two homes at the Company’s Yucaipa project, one home at the NorthCorona project and the first 10 homes at a smaller Riverside project known as“Harvest”. The current quarter’s gross margin of 23.2% is higher than the priorperiod gross margin of 15.4%, due to price appreciation, particularly at theRiverside Jasper Ranch project.

 

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The $100,000 increase in selling, general andadministrative expenses during the first quarter of 2004, as compared with thefirst quarter of 2003, primarily reflects an increase in accrued incentivecompensation corresponding to the improved operating results.

 

During the three months ended March 31, 2004, theCompany recorded a $100,000 tax benefit from a reduction in contingent taxliabilities, partially offsetting the tax provision on income for the period.

 

*PaymentsUnder Contractual Obligations*

 

The Company has entered into certain contractual obligations to makefuture payments for items such as project debt and lease agreements.  A summary of the payments due underspecified contractual obligations, aggregated by category of contractualobligation, for specified time periods is presented below as of March 31,2004 (in millions):

 
|             |   |      |   | **Payments  due by period** |   |
|------------------|--------|-----------|--------|-----------------------------|--------|
|             |   | **Total** |   | **Less  than 1year**        |   | **1-3years** |   | **3-5years** |   | **More  than 5years** |   |
| Project debt     |   | $         | 12.6   |                        | $      | 12.6 |   | — |   | — |   | —- |   |
| Operating leases |   | .4        |   | .2                          |   | .2 |   | — |   | — |   |
| Total            |   | $         | 13.0   |                        | $      | 12.8 |   | $ | .2 |   | — |   | — |   |
|                  |        |           |        |                             |        |  |  |  |  |  |  |  |  |  |

 

The Company’s purchase contracts which are made in the normal course ofits homebuilding business for land acquisition and construction subcontractsare generally cancelable at will. Other contractual obligations including theCompany’s other tax liabilities, accrued benefit liability for a frozenretirement plan and other accrued pensions, home warranty reserves andcontingent indemnity and environmental obligations are estimated based onvarious factors. Payments are not due as of a given date, but rather aredependent upon the incurrence of professional services, the lives of annuitantsand other factors. The estimation process involved in the determination ofcarrying values of these obligations is inherently uncertain since it requiresestimates as to future events and contingencies. The Company has providedadditional disclosure in its Consolidated Financial Statements in Notes 5 and6.

 

**SafeHarbor, Statement Under the Private Securities Litigation Act of 1995**

 

Certain of the foregoing information and theinformation following this Item 2 contains forward-looking statements thatrelate to future events or the Company’s future financial performance.  These statements involve known and unknownrisks, uncertainties and other factors which may cause the Company’s actualresults, performance or achievements to be materially different from any futureresults, performances or achievements expressed or implied by theforward-looking statements.  In somecases, you can identify forward-looking statements by terminology such as“may”, “will”, “should”, “expects”, “plans”, “anticipates”, “believes”,“estimates”, “predicts”, “potential”, “continue”, or the negative of such termsor other comparable terminology.  Theseforward-looking statements include, but are not limited to, (1) statementsabout the Company’s plans, objectives, goals, expectations and intentions; (2)the number and types of homes and number of acres of land that the Company maydevelop and sell; (3) the timing and outcomes of litigation, regulatoryapproval processes or administrative proceedings (including, but not limited toongoing administrative proceedings related to the Company’s principal asset,the Bolsa Chica Mesa); (4) the Company’s ability to continue relationships withcurrent or future partners; (5) the Company’s ability to expend resources tocomply with environmental regulations and local permitting requirements; (6)the effect of certain costs, contractual obligations and tax liabilities, bothknown and unknown, on the Company’s business, results of operations andfinancial condition; (7) the condition and adequacy of the Company’sproperties; (8) the Company’s ability to estimate cash flow projections due touncertainties in valuing real property; (9) the Company’s ability to acquireresidential lots in order to continue homebuilding operations; (10) theadequacy of capital, financing and cash flow required to continue the Company’soperations and land development activities; (11) the future condition of thereal estate market in southern California; (12) the possible negotiation of asale transaction with the State of California and the ability to realize asales price for the Bolsa Chica Mesa that is substantially in excess of bookvalue; (13) general economic and business conditions; (14) interest ratechanges; (15) the relative stability of debt and equity markets; (16)competition; (17) the availability and cost of raw materials used by theCompany in its homebuilding operations; (18) shortages and the cost of labor;(19) weather related slowdowns; (20) slow growth and no growth initiatives ormoratoria; (21) governmental regulation, including the interpretation of tax,labor and environmental laws; (22) changes in consumer confidence and preferences;(23) accounting changes; (24) terrorist acts and other acts of war; (25) otherfactors over which the Company has little or no control; and (26) otherstatements contained herein that are not historical facts.

 

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ITEM 3 -QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company utilizes project debt financing foracquisition, development and construction of homes. The interest rates on theCompany’s project debt approximate the current rates available for secured realestate financing with similar terms and maturities, and as a result, theircarrying amounts approximate fair value. While changes in interest ratesgenerally do not impact the fair market value of the debt instrument, they do affectthe Company’s earnings and cash flows. Holding the Company’s variable rate debtbalance constant as of March 31, 2004, each one point percentage increasein interest rates would result in an increase in variable rate interestincurred for 2004 of approximately $100,000.

 

ITEM 4 - EVALUATIONOF DISCLOSURE CONTROLS AND PROCEDURES

 

As of the end of the period covered by this report,the Company carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures.  The Company’s disclosure controls andprocedures are designed to ensure that information required to be disclosed bythe Company in its periodic filings with the Securities and Exchange Commission(“SEC”) is recorded, processed and reported within the time periods specifiedin the SEC’s rules and forms.  Based onthe foregoing, the Company’s Chief Executive Office and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures were effectivein timely alerting them to material information relating to the Company(including its consolidated subsidiaries) required to be included in theCompany’s periodic SEC filings.  Therehave been no significant changes in the Company’s internal controls or in otherfactors that could significantly affect the internal controls subsequent to thedate the Company completed its evaluation.

 

PART II - OTHER INFORMATION

 

ITEM 1 -                                                 Legal Proceedings

 

See Note 5 to the Consolidated Financial Statements above, and “Item 1- Business - Corporate Indemnification Matters” and “Item 3 - LegalProceedings” in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003.

 

ITEM 6 -                                                 Exhibitsand Reports on Form 8-K

 

(a)                  Exhibits:

 

31.1*                    Section 302 Certificate ofRaymond J. Pacini, Chief Executive Officer of California Coastal Communities,Inc.

 

31.2*                    Section 302 Certificate ofSandra G. Sciutto, Chief Financial Officer of California Coastal Communities,Inc.

 

32.1*                    Section 906 Certificate ofRaymond J. Pacini, Chief Executive Officer of California Coastal Communities,Inc.**

 

32.2*                    Section 906 Certificate ofSandra G. Sciutto, Chief Financial Officer of California Coastal Communities,Inc.**

 

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*                                         Filedherewith.

 

**                                  Thesecertifications are being furnished solely to accompany this report pursuant to18 U.S.C. Section 1350, and are not being filed for purposes ofSection 18 of the Securities Exchange Act of 1934, as amended, and are notto be incorporated by reference into any filing of the Company, whether madebefore or after the date hereof, regardless of any general incorporationlanguage in such filing.

 

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(b)                 Reports on Form8-K:

 

Current report on Form 8-K dated March 9, 2004,attaching a press release reporting fourth quarter and year end results, a copyof which was attached.

 

**SIGNATURE**

 

Pursuant to the requirements of Section 13 or 15(d) of theSecurities Exchange Act of 1934, the registrant has caused this report to besigned on its behalf by the undersigned, thereunto duly authorized.

 

 
| Date:  May 7, 2004 | CALIFORNIA COASTAL COMMUNITIES, INC. |
|-------------------------|--------------------------------------|
|                    |                                 |   |
|                    |                                 |   |
|                    | By:                                  | /s/ Sandra G. Sciutto |   |
|                    |                                 | SANDRA G. SCIUTTO |
|                    |                                 | Senior Vice President and  Chief Financial Officer |

 

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