**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

** **

**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                                                                                              | ** ** | ** **                                                                                                |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|
| **ý**                                                                                                                                                                                                                  | ** ** | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934**  |
| ** **                                                                                                                                                                                                                  | ** ** | ** **                                                                                                |
| **For the  quarterly period ended March 31, 2006**                                                                                                                                                                     |
| ** **                                                                                                                                                                                                                  | ** ** | ** **                                                                                                |
| **OR**                                                                                                                                                                                                                      |
| ** **                                                                                                                                                                                                                  | ** ** | ** **                                                                                                |
| **o**                                                                                                                                                                                                                       | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE   SECURITIES EXCHANGE ACT OF 1934** |
| ** **                                                                                                                                                                                                                  | ** ** | ** **                                                                                                |
| **For the  transition period from                 to               ** |
| ** **                                                                                                                                                                                                                  | ** ** | ** **                                                                                                |
| **Commission  file number: 0-17189**                                                                                                                                                                                        |

 

**CALIFORNIACOASTAL COMMUNITIES, INC.**

**(Exact name of registrant asspecified in its charter)**

 

| **Delaware**                              | ** ** | **02-0426634**       |
|-------------------------------------------|------------|----------------------|
| (State or  other jurisdiction of          |       | (I.R.S.  Employer    |
| incorporation  or organization)           |       | Identification  No.) |
|                                      |       |                 |
| **6  Executive Circle, Suite 250**   | ** ** | **92614**            |
| **Irvine,  California**                   |       | (Zip Code)           |
| (Address of  principal executive offices) | ** ** | ** **           |

 

Registrant’s telephone number, includingarea code:**(949) 250-7700**

 

Securities registered pursuant to Section 12(b) ofthe Act: **NONE**

 

Securities registered pursuant to Section 12(g) ofthe Act:

 

**Common Stock, par value $.05 per share**(Title of Class)

 

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. YES ý  NO o

 

Indicate by check mark whether the registrant isa large accelerated filer, an accelerated filer, or a non-accelerated filer.See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2of the Exchange Act. (Check one):

 

| **Large  accelerated filer  ****o** | ** ** | **Accelerated  filer ****ý** | ** ** | **Non-accelerated  filer ****o** |
|------------------------------------------|------------|----------------------------------------|------------|---------------------------------------|

 

Indicate by check mark whether the registrant isa shell company (as defined in Rule 12b-2 of the Act). YES o  NO ý

 

The number of shares of Common Stock outstandingas of May 1, 2006 was 10,161,462.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED MARCH 31,2006

 

I N D E X

 
| Cautionary Statement About Forward-Looking Statements |                   |
|-------------------------------------------------------|------------------------|
|                                                  |                   |   |
| Part I -                                         | Financial Information: |   |
|                                                  |                   |   |
|                                                  | Item  1 -              | Consolidated  Financial Statements |   |
|                                                  |                   |   |   |
|                                                  |                   | Consolidated Balance Sheets -  March 31, 2006 and December 31, 2005 (unaudited) |   |
|                                                  |                   |   |   |
|                                                  |                   | Consolidated Statements of Income -  Three Months Ended March 31, 2006 and 2005 (unaudited) |   |
|                                                  |                   |   |   |
|                                                  |                   | Consolidated Statements of Cash Flows -  Three Months Ended March 31, 2006 and 2005 (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 1A -              | Risk Factors That May Affect Results of Operations and Financial  Condition |   |
|                                                  |                   |   |   |
|                                                  | Item 6 -               | Exhibits |   |
|                                                  |                   |   |
| SIGNATURE                                             |                   |
|                                                       |                        |  |  |  |

 

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CAUTIONARYSTATEMENT ABOUT FORWARD-LOOKING STATEMENTS

 

This quarterly report on Form 10-Qcontains forward-looking statements within the meaning of Section 27A ofthe Securities Act of 1993 and Section 21E of the Securities Exchange Actof 1934 that relate to future events or our future financial performance. Inaddition, other statements we may make from time to time, such as pressreleases, oral statements made by Company officials and other reports that wefile with the Securities and Exchange Commission, may also contain suchforward-looking statements. Undue reliance should not be placed on thesestatements which involve known and unknown risks, uncertainties and otherfactors which may cause our actual results, performance or achievements tobe materially different from any future results, performances or achievementsexpressed or implied by the forward-looking statements. In some cases, you canidentify forward-looking statements by terminology such as “may”, “will”, “should”,“expects”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”,“continue”, or the negative of such terms or other comparable terminology.

 

These forward-looking statements include, butare not limited to:

 

•                  statementsabout our strategies, plans, objectives, goals, expectations and intentions;

•                  informationrelating to anticipated operating results, financial resources, changes inrevenues, changes in profitability, interest expense, growth and expansion,anticipated income to be realized from our investments in unconsolidatedentities;

•                  theimpact of demographic trends and supply constraints on the demand for andsupply of housing;

•                  housingmarket conditions in the geographic markets in which we operate;

•                  thenumber and types of homes and number of acres of land that we may developand sell;

•                  theability to deliver homes from backlog;

•                  thetiming and outcomes of regulatory approval processes or administrativeproceedings, which may result in delays in the land entitlement, development,construction, or the opening of new communities (including, but not limited toongoing administrative proceedings related to our joint venture near Oxnard,California);

•                  theability to secure materials and subcontractors;

•                  theability to produce the liquidity and capital necessary to expand and takeadvantage of opportunities in the future;

•                  ourability to realize the value of our net operating loss carry forwards;

•                  ourability to continue relationships with current or future partners;

•                  theeffectiveness and adequacy of our disclosure and internal controls;

•                  theimpact of recent accounting pronouncements; and

•                  stockmarket valuations.

 

Any or all of the forward-looking statementsincluded in this report and in any other reports or public statements made byus may turn out to be inaccurate. This can occur as a result of incorrectassumptions or as a consequence of known or unknown risks and uncertainties.Many factors mentioned in this report or in other reports or public statementsmade by us, such as government regulation and the competitive environment, willbe important in determining our future performance. Consequently, actualresults may differ materially from those that might be anticipated fromour forward-looking statements. You should not place undue reliance on any ofthese forward-looking statements because they are based on current expectationsor beliefs regarding future events or circumstances,  which involve known and unknown risks,uncertainties and other factors which may cause our actual results,performance or achievements to be materially different from any future results,performances or achievements expressed or implied by these forward-lookingstatements.

 

Although we believe that our strategies,plans, objectives, goals, expectations and intentions reflected in, orsuggested by these forward-looking statements are reasonable given currentinformation available to us, we can give no assurance that any of them will beachieved.

 

These forward-looking statements should beconsidered in light of the information included in this report and our otherfilings with the Securities and Exchange Commission, including, withoutlimitation, the Risk Factors, as well as the description of trends and otherfactors in Management’s Discussion and Analysis of Financial Condition andResults of Operations, set forth in our Form 10-K for the year ended December 31,2005. You should also read the following Management’s Discussion and Analysisof Financial Condition and Results of Operations in conjunction with theunaudited condensed consolidated financial statements and the related notesthat appear elsewhere in this report.

 

We assume no, and hereby disclaim any,obligation to update any of the foregoing or any other forward-lookingstatements. We nonetheless reserve the right to make such updates from time totime by press release, periodic report or other method of public disclosurewithout the need for specific reference to this Form 10-Q or any otherreport filed by us. No such update shall be deemed to indicate that otherstatements not addressed by such update remain correct or create an obligationto provide any other updates.

 

3

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PART I.FINANCIAL INFORMATION

 

ITEM 1 – FINANCIAL STATEMENTS

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATEDBALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                              | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| **ASSETS**                                                                                                                              |       |                     |       |                        |       |
| ** **                                                                                                                              |       |                     |       |                        |       |
| Cash and  cash equivalents                                                                                                              |       | $                        | 4.6        |                        | $          | 7.7 |   |
| Short-term  investments                                                                                                                 |       | 22.5                     |       | 30.3                        |       |
| Restricted  cash                                                                                                                        |       | 2.3                      |       | 2.3                         |       |
| Real estate  inventories                                                                                                                |       | 254.1                    |       | 253.6                       |       |
| Deferred tax  assets                                                                                                                    |       | 34.5                     |       | 35.4                        |       |
| Other assets                                                                                                                            |       | 1.1                      |       | 1.1                         |       |
|                                                                                                                                    |       |                     |       |                        |       |
|                                                                                                                                    |       | $                        | 319.1      |                        | $          | 330.4 |   |
|                                                                                                                                    |       |                     |       |                        |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                          |       |                     |       |                        |       |
| ** **                                                                                                                              |       |                     |       |                        |       |
| Liabilities:                                                                                                                            |       |                     |       |                        |       |
| Accounts  payable and accrued liabilities                                                                                               |       | $                        | 12.1       |                        | $          | 17.4 |   |
| Project debt                                                                                                                            |       | 50.2                     |       | 57.9                        |       |
| Other  liabilities                                                                                                                      |       | 7.9                      |       | 7.9                         |       |
|                                                                                                                                    |       |                     |       |                        |       |
| Total  liabilities                                                                                                                      |       | 70.2                     |       | 83.2                        |       |
|                                                                                                                                    |       |                     |       |                        |       |
| Minority  interest                                                                                                                      |       | —                   |       | .3                          |       |
|                                                                                                                                    |       |                     |       |                        |       |
| Commitments  and contingencies                                                                                                          |       |                     |       |                        |       |
|                                                                                                                                    |       |                     |       |                        |       |
| Stockholders’  equity:                                                                                                             |       |                     |       |                        |       |
| Common Stock—$.05  par value; 13,500,000 shares authorized; 10,160,212 and 10,130,212 shares  issued and outstanding, respectively |       | .5                       |       | .5                          |       |
| Excess  Stock—$.05 par value; 11,000,000 shares authorized; no shares outstanding                                                  |       | —                   |       | —                      |       |
| Capital in  excess of par value                                                                                                         |       | 191.7                    |       | 191.6                       |       |
| Retained  earnings                                                                                                                      |       | 58.5                     |       | 56.6                        |       |
| Accumulated  other comprehensive loss                                                                                                   |       | (1.8                     | )          | (1.8                        | )          |
| Total  stockholders’ equity                                                                                                        |       | 248.9                    |       | 246.9                       |       |
|                                                                                                                                    |       |                     |       |                        |       |
|                                                                                                                                    |       | $                        | 319.1      |                        | $          | 330.4 |   |

 

See the accompanying notes toconsolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATEDSTATEMENTS OF INCOME

 

(in millions, except per shareamounts)

 

(unaudited)

 
| ** **                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                 | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Revenues:                                                  |       |                                             |       |   |   |
| Homebuilding                                               |       | $                                                | 27.9       |   | $ | 6.5 |   |
| Costs of  sales:                                           |       |                                             |       |   |   |
| Homebuilding                                               |       | 23.2                                             |       | 4.8 |   |
|                                                       |       |                                             |       |   |   |
| Gross  operating profit                                    |       | 4.7                                              |       | 1.7 |   |
|                                                       |       |                                             |       |   |   |
| Selling,  general and administrative expenses              |       | 1.7                                              |       | 1.2 |   |
| Other  (income) expense, net                               |       | (.3                                              | )          | .2 |   |
|                                                       |       |                                             |       |   |   |
| Income  before income taxes                                |       | 3.3                                              |       | .3 |   |
|                                                       |       |                                             |       |   |   |
| Provision  (benefit) for income taxes                      |       | 1.4                                              |       | (4.5 | ) |
|                                                       |       |                                             |       |   |   |
| Minority  interest in income of consolidated joint venture |       | —                                           |       | .1 |   |
|                                                       |       |                                             |       |   |   |
| Net income                                                 |       | 1.9                                              |       | 4.7 |   |
|                                                       |       |                                             |       |   |   |
| Other  comprehensive income, net of income taxes:          |       |                                             |       |   |   |
| Minimum  pension liability income tax benefit              |       | —                                           |       | .9 |   |
|                                                       |       |                                             |       |   |   |
| Comprehensive  income                                      |       | $                                                | 1.9        |   | $ | 5.6 |   |
|                                                       |       |                                             |       |   |   |
| Net earnings  per common share:                            |       |                                             |       |   |   |
|                                                       |       |                                             |       |   |   |
| Basic                                                      |       | $                                                | .19        |   | $ | .46 |   |
|                                                       |       |                                             |       |   |   |
| Diluted                                                    |       | $                                                | .18        |   | $ | .43 |   |
|                                                       |       |                                             |       |   |   |
| Common  equivalent shares:                                 |       |                                             |       |   |   |
|                                                       |       |                                             |       |   |   |
| Basic                                                      |       | 10.2                                             |       | 10.2 |   |
|                                                       |       |                                             |       |   |   |
| Diluted                                                    |       | 10.5                                             |       | 10.9 |   |

 

See the accompanyingnotes to consolidated financial statements.

 

5

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

 

(in millions)

 

(unaudited)

 
| ** **                                                                                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                                 | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Cash flows  from operating activities:                                                     |       |                                             |       |   |   |
| Net income                                                                                 |       | $                                                | 1.9        |   | $ | 4.7 |   |
| Adjustments  to reconcile net income to cash used in operating activities:                 |       |                                             |       |   |   |
| Non-cash  benefit from reversal of deferred tax asset allowance                            |       | —                                           |       | (4.7 | ) |
| Gains on  sales of real estate inventories                                                 |       | (4.7                                             | )          | (1.7 | ) |
| Stock-based  compensation expense                                                          |       | .1                                               |       | — |   |
| Deferred  taxes                                                                            |       | .9                                               |       | — |   |
| Minority  interest in income of consolidated joint venture                                 |       | —                                           |       | .2 |   |
| Proceeds  from asset sales, net                                                            |       | 27.7                                             |       | 6.5 |   |
| Investments  in real estate inventories                                                    |       | (23.5                                            | )          | (8.7 | ) |
| Investments  in land held for future development or sale                                   |       | —                                           |       | (.4 | ) |
| Changes in  assets and liabilities:                                                        |       |                                             |       |   |   |
| Decrease  (increase) in other assets                                                       |       | .1                                               |       | (.2 | ) |
| Decrease in  accounts payable, accrued and other liabilities                               |       | (5.3                                             | )          | (4.2 | ) |
|                                                                                       |       |                                             |       |   |   |
| Cash used in  operating activities                                                         |       | (2.8                                             | )          | (8.5 | ) |
|                                                                                       |       |                                             |       |   |   |
| Cash flows  from investing activities:                                                     |       |                                             |       |   |   |
| Sales of  short-term investments                                                           |       | 26.5                                             |       | — |   |
| Purchases of  short-term investments                                                       |       | (18.7                                            | )          | — |   |
| Investments  in unconsolidated joint ventures                                              |       | (.1                                              | )          | — |   |
|                                                                                       |       |                                             |       |   |   |
| Cash  provided by investing activities                                                     |       | 7.7                                              |       | — |   |
|                                                                                       |       |                                             |       |   |   |
| Cash flows  from financing activities:                                                     |       |                                             |       |   |   |
| Borrowings  of project debt                                                                |       | 1.2                                              |       | 18.2 |   |
| Repayments  of project debt                                                                |       | (8.9                                             | )          | (3.3 | ) |
| Proceeds  from exercise of stock options                                                   |       | —                                           |       | .3 |   |
| Minority  interest distributions                                                           |       | (.3                                              | )          | (.4 | ) |
|                                                                                       |       |                                             |       |   |   |
| Cash (used  in) provided by financing activities                                           |       | (8.0                                             | )          | 14.8 |   |
|                                                                                       |       |                                             |       |   |   |
| Net  (decrease) increase in cash and cash equivalents                                      |       | (3.1                                             | )          | 6.3 |   |
|                                                                                       |       |                                             |       |   |   |
| Cash and  cash equivalents - beginning of period                                           |       | 7.7                                              |       | 9.0 |   |
|                                                                                       |       |                                             |       |   |   |
| Cash and  cash equivalents - end of period                                                 |       | $                                                | 4.6        |   | $ | 15.3 |   |
|                                                                                       |       |                                             |       |   |   |
| Supplemental  disclosures of cash flow information:                                        |       |                                             |       |   |   |
| Cash paid  (refunds received) during the period for income taxes, net of refunds  received |       | $                                                | 4.6        |   | $ | (.8 | ) |

 

See the accompanying notes toconsolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 - Basis of Presentation**

 

The accompanying financial statements have beenprepared by California Coastal Communities, Inc. and its consolidatedsubsidiaries (the “Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. The Company believes thatthese unaudited consolidated financial statements reflect all materialadjustments (consisting only of normal recurring adjustments) and disclosuresnecessary for the fair presentation of the results of operations and statementsof financial position when read in conjunction with the Financial Statementsand Notes thereto included in the Company’s Annual Report on Form 10-K forthe year ended December 31, 2005. Intercompany accounts and transactionshave been eliminated. Certain prior year amounts have been reclassified to conform tothe current year presentation.

 

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 differmaterially from those described herein as a result of various factors,including without limitation, the factors discussed generally in this report.

 

**Note 2 - Significant Accounting Policies**

 

*Consolidation of Variable Interest Entities*

 

A Variable Interest Entity (“VIE”) is createdwhen (i) the equity investment at risk is not sufficient to permit theentity to finance its activities without additional subordinated financialsupport from other parties or (ii) equity holders either (a) lackdirect or indirect ability to make decisions about the entity, (b) are notobligated to absorb expected losses of the entity or (c) do not have theright to receive expected residual returns of the entity if they occur. If anentity is deemed to be a VIE, pursuant to Financial Interpretation FIN No. 46,“Consolidation of Variable Interest Entities – an interpretation of ARB No. 51”(“FIN 46”), an enterprise that has the majority of the variability in gains andlosses of the VIE is considered to be the primary beneficiary and mustconsolidate the VIE. FIN 46 was effective immediately for VIEs created after January 31,2003.

 

Based on the provisions of FIN 46, theCompany has concluded that whenever it options land or lots from an entity andpays a non-refundable deposit, a VIE may be created under condition (ii)(b) and(c) of the previous paragraph. The Company may be deemed to haveprovided subordinated financial support, which refers to variable intereststhat will absorb some or all of an entity’s expected theoretical losses if theyoccur. For each VIE created with a significant nonrefundable option fee, theCompany will compute expected losses and residual returns based on theprobability of future cash flows as outlined in FIN 46. If the Company isdeemed to be the primary beneficiary of the VIE, the VIE will be consolidatedon the Company’s balance sheet.

 

The Company’s exposure to loss as the resultof a purchase contract with a VIE is limited to the amount of thenon-refundable option deposit, which is generally 5% to 15% of the purchaseprice, not total assets on the balance sheet of the VIE. Therefore, the Companybelieves that consolidating the VIE does not reflect the economic realities orrisks of owning and developing land. The Company has no material third partyguarantees related to these contracts. Creditors of these VIEs, if any, have norecourse against the Company.

 

As of March 31, 2006, the Company has no depositswith VIEs. See Note 7 – Real Estate Matters.

 

*Real Estate*

 

Real estate inventories primarilyconsists of homes under construction and lots under development and are carriedat the lower of cost or fair value less costs to sell. The estimation processinvolved in the determination of fair value is inherently uncertain since itrequires estimates as to future events and market conditions. Such estimationprocess assumes the Company’s ability to complete development and dispose ofits real estate properties in the ordinary course of business based onmanagement’s present plans and intentions. Economic, market, and environmentalconditions may affect management’s

 

7

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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.Accordingly, the ultimate values of the Company’s real estate properties aredependent upon future economic and market conditions, and the availability offinancing.

 

The cost of sales of multi-unit projects isgenerally computed using the relative sales value method. Interest and othercarrying costs are capitalized to real estate projects during their developmentand construction period.

 

*Impairment of Long-Lived Assets*

 

The Company assesses the impairment of realestate inventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets”, which requires that an impairedasset, for which costs cannot be recovered from estimated undiscounted futurecash flows, be written down to fair value. Long-lived assets are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. As provided by SFAS No. 144,impairment is evaluated by comparing an asset’s carrying value to theundiscounted estimated cash flows expected from the asset’s operations andeventual disposition. If the sum of the undiscounted estimated future cashflows is less than the carrying value of the asset, an impairment loss isrecognized based on the fair value of the asset. If impairment occurs, the fairvalue of an asset for purposes of SFAS No. 144 is deemed to be theamount a willing buyer would pay a willing seller for such asset in a currenttransaction.

 

In accordance with SFAS No. 144, in developingestimated future cash flows for impairment testing, the Company hasincorporated its own market assumptions including those regarding home prices,infrastructure, home-building costs and financing costs regarding real estateinventories. 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 asdescribed in SFAS No. 144.

 

*Earnings Per Common Share*

 

Earnings per common share is accounted for inaccordance with SFAS No. 128, “Earnings Per Share”. Basic earnings percommon share is computed using the weighted-average number of common sharesoutstanding for the period. The weighted-average number of common sharesoutstanding was 10.2 million for the three months ended March 31, 2006 and2005. The weighted average number of common shares, assuming dilution, was 10.5million and 10.9 million for the three months ended March 31, 2006 and2005, respectively. Diluted earnings per common share is computed using theweighted-average number of common shares outstanding and the dilutive effect ofpotential common shares outstanding. For the three months ended March 31,2006 and 2005, the average market price of the Company’s common stock exceededthe exercise price of outstanding stock options. Therefore, diluted earningsper share includes the dilutive effect of the weighted average number of commonshares from potential exercise of approximately 700,000 options.

 

The table below sets forth the reconciliation of thedenominator of the earnings per share calculation (in millions):

 
| ** **                                                  | ** ** | **March 31,** | ** ** |
|-------------------------------------------------------------|------------|--------------------|------------|
| ** **                                                  | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Shares used  in computing basic earnings per common share   |       | 10.2               |       | 10.2 |   |
| Dilutive  effect of stock options                           |       | .3                 |       | .7 |   |
| Shares used  in computing diluted earnings per common share |       | 10.5               |       | 10.9 |   |

 

*Recent Accounting Pronouncements*

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(revised 2004), “Share-Based Payment” (“SFAS 123(R)”). This Statement replacesSFAS 123, “Accounting for Stock-Based Compensation” and supersedes AccountingPrinciples Board (“APB”) Opinion No. 25. “Accounting for Stock Issued toEmployees.”  SFAS 123(R) addresses theaccounting for share-based payment transactions in which an enterprise receivesemployee services in exchange for (a) equity instruments of the enterpriseor (b) liabilities that are based on the fair value of the enterprise’sequity instruments or that may be settled by the issuance of such equityinstruments. SFAS 123(R) eliminates the ability to account for share-basedcompensation transactions using the intrinsic value method under APB No. 25,and generally would require instead that such transactions be accounted forusing a fair-value-based method. The Company adopted SFAS 123(R) in the firstquarter of 2006

 

8

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usingthe modified prospective method, which requires that compensation is recognizedon or after the required effective date for the portion of outstanding awardsfor which the requisite service has not yet been rendered, based on thegrant-date fair value of those awards calculated under SFAS 123 for eitherrecognition or pro forma disclosures. The Company previously adopted the fairvalue recognition provisions of SFAS 123 in 2003. The adoption of SFAS 123(R)did not have a material impact on the Company’s consolidated financialposition, results of operations, or cash flows.

 

In December 2004, the FASB issued SFAS No. 153,“Exchanges of Nonmonetary Assets – An amendment of APB 29, Accounting forNonmonetary Transactions” (“SFAS 153”). This statement amends APB No. 29to eliminate the exception for nonmonetary exchanges of similar productiveassets and replaces it with a general exception for exchanges of nonmonetaryassets that do not have commercial substance. A nonmonetary exchange hascommercial substance if the future cash flows of the entity are expected tochange significantly as a result of the exchange. This statement was effectivebeginning in the Company’s first quarter of 2006. The adoption of SFAS 153 didnot have a material impact on the Company’s consolidated financial position,results of operations, or cash flows.

 

In May 2005, the FASB issued SFAS No. 154,“Accounting Changes and Error Corrections” (“SFAS 154”). This statementreplaces APB Opinion No. 20, “Accounting Changes” and SFAS No. 3, “ReportingAccounting Changes in Interim Financial Statements,” and changes therequirements for the accounting for and reporting of a change in accountingprinciple. SFAS 154 requires retrospective application of changes in accountingprinciple to prior periods’ financial statements unless it is impracticable todetermine the period-specific effects or the cumulative effect of the change.This statement was effective beginning in the Company’s first quarter of 2006.The adoption of SFAS 154 did not have a material impact on the Company’sconsolidated financial position, results of operations, or cash flows.

 

In June 2005, the Emerging Issues TaskForce (“EITF”) reached a final consensus on Issue No. 04-5, “DeterminingWhether a General Partner, or the General Partners as a Group, Controls aLimited Partnership or Similar Entity When the Limited Partners Have CertainRights” (“EITF 04-5”). EITF 04-5 affects the consolidation of entities in whicha general partner or managing member is presumed to control a partnership orlimited liability company. EITF 04-5 was effective for the Company beginning inthe first quarter of 2006. The adoption of EITF 04-5 did not have a materialimpact on the Company’s consolidated financial position, results of operations,or cash flows upon initial adoption. EITF 04-5 may materially impact theCompany’s consolidated financial position, results of operations, or cash flowsin future periods should the Company form new limited partnerships ormodify existing limited partnerships such that the Company is deemed to controlthe limited partnership. Under those circumstances, the Company may berequired by EITF 04-5 to consolidate the limited partnership. 

 

**Note 3 – Real Estate Inventories**

 

Real estate inventories primarily consist ofhomes under construction and lots under development in communities in fiveSouthern California counties. At March 31, 2006, real estate inventoriesinclude 889 lots and homes under construction, and five completed homes.Approximately $132.8 million of real estate inventories at March 31, 2006reflects the 105-acre parcel of land on a mesa north of the Bolsa Chicawetlands (“Upper Mesa”), which is planned for 356 homes as discussed below. Inaddition, the balance includes approximately 51 acres nearby which have beenoffered for dedication to the County of Orange for inclusion in the Harriet M.Weider Linear Park in conjunction with the development of the Upper Mesa, and51 additional acres which are subject to a conservation easement. The Companycapitalizes direct carrying costs including interest and property taxes, aswell as direct construction costs, to real estate inventories.

 

The planned community on the UpperMesa, known as “Brightwater,” will offer a broad mix of home choices, averaging2,850 square feet and ranging in size from 1,700 square feet to 4,100 squarefeet. The plan also includes 37 acres of open space and conservation area. With349 homes permitted on 68 acres of the Upper Mesa, the resulting low-densityplan equates to approximately five homes per acre, consistent and compatiblewith the neighboring Huntington Beach communities. In addition, the Company ownsland adjacent to the planned Brightwater development, on which it intends toprocess permits to build seven additional homes which will be included in theBrightwater community. The Company expects to (i) begin grading in June 2006,(ii) begin building model homes during the fourth quarter of 2006, (iii) startselling homes during the second quarter of 2007, and (iv) begin deliveringhomes during the fourth quarter of 2007. However, there can be no assurance inthat regard, or as to the absence of further administrative or constructiondelay.

 

The estimation process involved inthe determination of value is inherently uncertain since it requires estimatesas to future events and market conditions. Such estimation process assumes theCompany’s ability to complete development and

 

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disposition of its real estate properties in theordinary course of business based on management’s present plans and intentions.Economic, and market 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 amount ultimatelyrealized from such project may differ materially from current estimatesand the project’s carrying value.

 

Capitalized interest is allocated to realestate inventories when incurred and charged to cost of sales when the relatedproperty is delivered. Certain information regarding interest follows (inmillions):

 
| ** **                                 | ** ** | **March 31,** | ** ** |
|--------------------------------------------|------------|--------------------|------------|
| ** **                                 | ** ** | **2006**           | ** ** | **2005** | ** ** |
| Capitalized  interest, beginning of period |       | $                  | 6.1        |   | $ | 1.3 |   |
| Interest  incurred and capitalized         |       | 1.1                |       | .5 |   |
| Charged to  cost of sales                  |       | (1.1               | )          | (.1 | ) |
| Capitalized  interest, end of period       |       | $                  | 6.1        |   | $ | 1.7 |   |

 

 **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 commercialbanks. These loan facilities finance a portion of the land acquisition and themajority of the construction of infrastructure and homes. Each loan facilityrequires a guaranty of project completion and an environmental indemnity. Theloans secured by first trust deeds bear an interest rate of prime plusthree-fourths percent (8.5% at March 31, 2006), and some of these loanfacilities have a minimum interest rate ranging from 5.75% to 7.5%. During thethree months ended March 31, 2006, Hearthside Homes, Inc. enteredinto no new loan facilities. The following amounts were available andoutstanding under these loan facilities as of March 31, 2006 and December 31,2005 ($ in millions):

 
| ** **       | ** ** | ** **                   | ** ** | ** **               | ** ** | ** **         | ** ** | **Outstanding at**  | ** ** |
|------------------|------------|------------------------------|------------|--------------------------|------------|--------------------|------------|--------------------------|------------|
| ** **       | ** ** | **Amount  of Facility** | ** ** | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
| Rancho Santa  Fe |       | $                            | 15.4       |                     | 18         |               | 3/27/06    |                     | $          | — |   | $ | 8.5 |   |
| Lancaster        |       | 9.5                          |       | 10                       |       | 5/10/06            |       | —                   |       | .2 |   |
| Rancho Santa  Fe |       | 1.8                          |       | 2                        |       | 9/13/06            |       | 1.7                      |       | 1.7 |   |
| Ontario          |       | 11.7                         |       | 26                       |       | 10/19/06           |       | 4.7                      |       | 4.6 |   |
| Corona           |       | 1.9                          |       | 4                        |       | 10/26/06           |       | 1.8                      |       | 1.8 |   |
| Corona           |       | 14.8                         |       | 36                       |       | 10/26/06           |       | 7.2                      |       | 7.0 |   |
| Lancaster        |       | 1.0                          |       | 3                        |       | 11/17/06           |       | 1.0                      |       | 1.0 |   |
| Lancaster        |       | 10.5                         |       | 36                       |       | 11/17/06           |       | 3.6                      |       | 3.6 |   |
| Corona           |       | 41.1                         |       | 151                      |       | 1/7/07             |       | 19.2                     |       | 18.8 |   |
| Beaumont         |       | 20.7                         |       | 102                      |       | 2/17/07            |       | 7.8                      |       | 7.6 |   |
| Lancaster        |       | 17.7                         |       | 77                       |       | 7/1/07             |       | 3.2                      |       | 3.1 |   |
|             |       |                         |       |                     |       |               |       |                     |       |   |   |
|             |       |                         |       |                     |       |               |       | $                        | 50.2       |   | $ | 57.9 |   |
|                  |            |                              |            |                          |            |                    |            |                          |            |  |  |  |  |  |

 

**Note 5 - Other Liabilities**

 

Other liabilities were comprised of thefollowing (in millions):

 
| ** **                                          | ** ** | **March 31,  2006** | ** ** | **December 31,  2005** | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|-----------------------------|------------|
| Accrued  pensions and benefits                      |       | $                        | 4.7        |                        | $          | 4.8 |   |
| Home  warranty reserves                             |       | 2.2                      |       | 2.1                         |       |
| Contingent  indemnity and environmental obligations |       | 1.5                      |       | 1.5                         |       |
| Unamortized  discount                               |       | (.5                      | )          | (.5                         | )          |
|                                                |       | $                        | 7.9        |                        | $          | 7.9 |   |

 

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Contingent indemnity and environmental obligationsprimarily reflect reserves before related discount (recorded pursuant toFresh-Start Reporting) for contingent indemnity obligations for businessesdisposed of by former affiliates and unrelated to the Company’s currentoperations.

 

*Home Warranty Reserve*

 

The Company provides a home warranty reserve toreflect its contingent obligation for product liability. The Company generallyrecords a provision as homes are delivered, based upon historical and industryexperience, for the items listed in the homeowner warranty manual, which doesnot include items that are covered by manufacturers’ warranties or items thatare not installed by the Company’s employees or contractors. The home warrantyreserve activity is presented below (in millions):

 
| ** **                      | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------|------------|--------------------------------------------------|------------|
| ** **                      | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
|                            |       |                                             |       |   |   |
| Balance at  beginning of period |       | $                                                | 2.1        |   | $ | 1.6 |   |
| Provision                       |       | .2                                               |       | .1 |   |
| Payments                        |       | (.1                                              | )          | (.1 | ) |
| Balance at  end of period       |       | $                                                | 2.2        |   | $ | 1.6 |   |

 

**Note 6 - Income Taxes**

 

The following is a summary of thetax provision (benefit):

 
| ** **                                              | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                              | ** ** | **2006**                                         | ** ** | **2005** | ** ** |
| Current  taxes                                          |       | $                                                | .5         |   | $ | .1 |   |
| Deferred  taxes                                         |       | .9                                               |       | .1 |   |
| Reversal of  valuation allowance on deferred tax assets |       | —                                           |       | (4.7 | ) |
| Provision  (benefit) for income taxes                   |       | $                                                | 1.4        |   | $ | (4.5 | ) |

 

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 future taxable income. As a result of the California CoastalCommission’s approval of the Company’s development plan for the Bolsa ChicaUpper Mesa on April 14, 2005, the Company concluded that it is more likelythan not that it will utilize all of its deferred tax assets. Therefore, duringthe three months ended March 31, 2005, the Company recorded a reversal ofvaluation allowance on post-reorganization NOLs and other deferred tax assetsof approximately $4.7 million, which is reflected in the tax benefit. Pursuantto Fresh Start Reporting, also during the three months ended March 31,2005, a reversal of valuation allowance on federal Pre-reorganization NOLs ofapproximately $38.5 million was reflected by increasing the Company’s capitalin 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 the Company’sequity before the ownership change, multiplied by the long-term tax-exemptrate. The Company estimates that after giving effect to various transactions bystockholders who hold a 5% or greater interest in the Company, it hasexperienced a three-year cumulative ownership shift of approximately 40% as of April 25,2006.

 

The federal NOLs available as of March 31, 2006were approximately $124 million. The amount of federal NOLs which expire if notutilized is zero for 2006, 2007 and 2008 and $8 million, $49 million, and $67million for 2009, 2010 and thereafter, respectively.

 

In October 1999, in response to an unsolicitedwritten consent from a majority of its stockholders, the Company amended itscertificate of incorporation in order to protect the ability of the Company toutilize its tax loss carryforwards. Since the Company’s use of its NOLs wouldbe severely restricted if it experiences an ownership change of more than

 

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50%, the Company’s majority stockholders requested that the Board ofDirectors enact the amendments, which were determined to be in the bestinterest of the Company and its stockholders. The amendments prohibit futurepurchases of the Company’s common stock by persons who would become new 5%holders, and also prohibit current holders of over 5% from increasing theirpositions, except in certain permissible circumstances which would notjeopardize the Company’s ability to use its NOLs. While these amendmentsreduced the Company’s risk of an ownership change occurring due to theacquisition of shares by 5% stockholders, the risk remains that an ownershipchange could result from the sale of shares by existing 5% stockholders. TheCompany’s Board of Directors evaluates requests to purchase any amounts inexcess of 5% of the Company’s common stock and authorizes such transactionswhich are not expected to jeopardize the Company’s ability to use its NOLs.

 

**Note 7 - Commitments and Contingencies**

 

*Real Estate Matters*

 

The Company is subject to the usualobligations associated with entering into contracts for the purchase of landand improved home sites. The purchase of properties under these contracts isgenerally contingent upon satisfaction of certain requirements by the sellers,including obtaining applicable property entitlements. The Company also utilizesoption contracts with third-party land sellers and financial entities as amethod of acquiring land in staged takedowns and minimizing the use of fundsfrom other corporate financing sources. These option contracts also help tomanage the financial and market risk associated with land holdings. Optioncontracts generally require the payment of a non-refundable cash deposit of 5%to 15% of the purchase price for the right to acquire lots over a specifiedperiod of time (usually one to two years) at predetermined prices. The Companyhas the right at its discretion to terminate its obligations under these landpurchase and option agreements by forfeiting the cash deposit with no furtherfinancial responsibility. As of March 31, 2006 and December 31, 2005,the Company had no land option deposits. However, our unconsolidated Oxnardjoint venture does have land deposits (discussed below).

 

In February 2003, the Company enteredinto two option contracts to acquire land adjacent to the City of Oxnard inVentura County, California aggregating approximately 168 acres. The Company isin the process of developing a land plan for the area, which also includes an additional149 acres owned by other landowners, with the intention of entitling theproperty for residential development and annexing it into Oxnard. During October 2003,the Company entered into a limited liability company joint venture agreementwith a major financial partner to pursue the Oxnard development opportunity.The Company assigned the land purchase option contracts to the Oxnard limitedliability company. Hearthside Homes, Inc., the Company’s homebuildingsubsidiary, is the managing member of the Oxnard joint venture, and made aninitial contribution of $500,000. The non-managing member also made an initialcontribution of $500,000 to the joint venture and, as of December 31,2005, had made an aggregate of $4 million of first tier additional contributions.The members have agreed to provide a second tier of additional capitalcontributions of up to $2 million, as necessary, to complete the business plan.For contributions in excess of $5 million, the first $500,000 is to becontributed equally by the Company and the Company’s partner. At ourdiscretion, the Company could continue to contribute equally to the next$500,000. Thereafter, the next $1 million is to be contributed equally betweenthe members. During the fourth quarter of 2005 and the first quarter of 2006,the members each contributed approximately $160,000 and $100,000, respectively,of the additional $2 million. The Company expects to make additional aggregatecapital contributions of approximately $675,000 to the joint venture during thenext 15 months, bringing the Company’s total expected investment in the projectto $1.4 million.

 

The Company has outstanding performance and suretybonds, for the benefit of city and county jurisdictions, related principally toits obligations for site improvements at various projects. The Company does notbelieve that draws upon these bonds, if any, will have a material effect on theCompany’s financial position, results of operations or cash flows.

 

*Legal Proceedings*

 

There are various lawsuits and claims pending againstthe Company and certain subsidiaries. In the opinion of the Company’smanagement, ultimate liability, if any, will not have a material adverse effecton the Company’s financial condition or results of operations.

 

See Note 5 for a discussion of other contingencies.

 

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*Corporate Indemnification Matters*

 

The Company and its former affiliates have, through avariety of transactions effected since 1986, disposed of several assets andbusinesses, many of which are unrelated to the Company’s current operations. Byoperation of law or contractual indemnity provisions, the Company may haveretained liabilities relating to certain of these assets and businesses. Thereis generally no maximum obligation or amount of indemnity provided for suchliabilities. A portion of such liabilities is supported by insurance or byindemnities from certain of the Company’s previously affiliated companies. TheCompany believes its consolidated balance sheet reflects adequate reserves forthese matters.

 

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ITEM 2 - MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**Overview of California Coastal Communities, Inc.**

 

We are a residential land development andhomebuilding company with properties owned or controlled in six SouthernCalifornia counties (Los Angeles, Orange, Riverside, San Bernardino, San Diegoand Ventura). Our principal activities include:

 

•                  obtainingzoning and other entitlements for land we own or control through purchaseoptions or joint ventures;

 

•                  improvingthe land for residential development; and

 

•                  designing,constructing and selling single-family homes in Southern California.

 

Once our residential land is entitled, we may buildhomes, sell unimproved land to other developers or homebuilders, sell improvedland to homebuilders, or participate in joint ventures with other developers,investors or homebuilders to finance and construct infrastructure and homes.The majority of these homes are designed to appeal to move-up homebuyers andare generally offered for sale in advance of their construction. During thenext 12 months, we will focus our primary efforts to:

 

•                  begingrading and building model homes for our Brightwater project located on 105acres of the Bolsa Chica mesa in Orange County, California in accordance withthe Coastal Development Permit for 349 homes issued by the California CoastalCommission in December 2005;

 

•                  completethe entitlement process for a 168-acre joint venture project near Oxnard,California; and

 

•                  increasedeliveries, revenues and profitability of our homebuilding operationsthroughout Southern California.

 

However, we are also considering other strategic opportunities asdiscussed below; and there can be no assurance that we will accomplish, inwhole or in part, all or any of these strategic goals.

 

Our total revenues for the three months endedMarch 31, 2006 and 2005 were $27.9 million and $6.5 million, respectively.For the three months ended March 31, 2006 and 2005, we delivered 49 and 10homes, respectively. Our total assets as of March 31, 2006 and December 31,2005 were $319.1 million and $330.4 million, respectively. Over the last tenyears, we have delivered over 1,900 homes to families throughout SouthernCalifornia.

 

We were formed in 1988 and our executiveoffices are located at 6 Executive Circle, Suite 250, Irvine, California92614. Our telephone number is (949) 250-7700.

 

**Strategic Alternatives**

 

The Board of Directors and management of theCompany have always been and continue to be committed to enhancing value forall stockholders. In that regard, we continue to evaluate strategicalternatives. From time to time we have considered the various strategicalternatives available to us with respect to our businesses, assets, operationsand available cash. We have engaged investment bankers and other advisors forthis purpose, with a view towards assessing alternatives which would enhancethe value of our current businesses, create additional business opportunities,or otherwise maximize the value of our Company for our stockholders. Includedin this process has been an exploration of merger, acquisition and dispositionpossibilities; analysis of equity and debt financings; open market and otherrepurchases of our stock; dividends to our stockholders; and combinations ofthese alternatives.

 

Prior to obtaining the Coastal DevelopmentPermit for our Brightwater project in December 2005, we have historicallymaintained a minimal amount of leverage. We currently have $50 million ofproject-specific debt against $249 million of book equity and a $377 millionequity market capitalization as of March 31, 2006. The Bolsa Chica

 

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Mesa is unencumbered by debt. We are in the process of seeking debtfinancing for our Brightwater project which may also provide additionalcash that could be available for a potential special dividend to ourstockholders, open market or other repurchases of our stock, or combinations ofthese alternatives. We will continue to evaluate our strategy to maximize valueto our stockholders.

 

**Our Current and Future Homesites**

 

We currently have on-going SouthernCalifornia homebuilding projects in:

 

•                  RiversideCounty near the cities of Corona and North Corona, and in the City of Beaumont;

 

•                  SanBernardino County in the City of Ontario;

 

•                  NorthernLos Angeles County in the City of Lancaster; and

 

•                  SanDiego County in the Rancho Santa Fe area.

 

We expect to begin grading our Brightwaterdevelopment project during May 2006 and plan to process permits for sevenhomes on adjacent parcels, which would bring the total unit count up to 356.The following chart describes our current projects, their location and our lotinventories as of March 31, 2006:

 

| **Project**         | ** ** | **Location**                    | ** ** | **Lot  Inventory** | ** ** |
|---------------------|------------|---------------------------------|------------|--------------------|------------|
| Chandler Ranch      |       | North Corona                    |       | 45                 |       |
| Alisal at Ontario   |       | Ontario                         |       | 26                 |       |
| Woodhaven           |       | Beaumont                        |       | 102                |       |
| Hearthside Lane     |       | Corona                          |       | 151                |       |
|                | * *   | *Subtotal – Inland Empire* |       | 324                |       |
| Alisal at Lancaster |       | Lancaster                       |       | 39                 |       |
| Lancaster II        |       | Lancaster                       |       | 72                 |       |
| Quartz Hill         |       | Lancaster                       |       | 77                 |       |
|                | * *   | *Subtotal - Lancaster*          |       | 188                |       |
| Cancion             |       | Rancho Santa Fe                 |       | 26                 |       |
| Brightwater         |       | Bolsa Chica                     |       | 356                |       |
|                |       |                            |       | 894                |       |

 

These homebuilding projects are currentlyexpected to generate cash flows and gross operating margins through mid-2009.Up to approximately 555 additional single-family lots would be available forhomebuilding operations if we obtain entitlements for our Oxnard project;however, the exact number of homes will be dependent upon the final outcome ofthe entitlement process.

 

*Brightwater at Bolsa Chica*

 

The Bolsa Chica upper mesa is the largestproperty in our portfolio, representing 42% of our total assets as of March 31,2006. The Bolsa Chica upper mesa is one of the last large undeveloped coastalproperties in Southern California, and is located in Orange County,approximately 35 miles south of downtown Los Angeles. Bolsa Chica is borderedon the north and east by residential development in the City of HuntingtonBeach and Huntington Harbor, to the south by open space and the Bolsa Chicawetlands, and to the west by open space, Pacific Coast Highway, Bolsa ChicaState Beach, and the Pacific Ocean. Our holdings include 68 acres ofdevelopable land on the Bolsa Chica upper mesa planned for a residentialcommunity known as Brightwater, 37 acres of open space and conservation area inthe planned community, five acres in the City of Huntington Beach which arecurrently zoned agricultural, and approximately 104 non-developable acres on,or adjacent to, the Huntington Mesa. We are analyzing development alternativesfor the 5-acre Huntington Beach parcel and expect to submit a proposed siteplan to the City of Huntington Beach later this year.

 

On December 15, 2005, we received apermit from the California Coastal Commission for development of the 349-homeBrightwater residential community, which will offer a broad mix of home choicesaveraging 2,850 square feet and ranging in size from 1,700 square feet to 4,100square feet. We currently expect to:

 

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•                  begingrading in June 2006,

 

•                  beginbuilding model homes during the fourth quarter of 2006, and

 

•                  startselling homes during the second quarter of 2007.

 

However, there can be no assurance in that regard, or as to the absenceof any delays.

 

Our Brightwater plan also includes 37 acresof open space and conservation area. With 349 homes on 68 acres of the uppermesa, the resulting low-density plan equates to approximately five homes peracre, consistent and compatible with the neighboring Huntington Beachcommunities. In addition, we own land adjacent to the planned Brightwaterdevelopment, for which we intend to process permits to build seven additionalhomes which would be included in the Brightwater community. Approximately 51acres of land on the Huntington Mesa have been offered for dedication to theCounty of Orange for inclusion in the Harriet M. Weider Linear Park inconjunction with the development of Brightwater.

 

During the first quarter of 2005, followingthe Coastal Commission’s conditional approval of our permit to developBrightwater, we concluded that it is more likely than not that we will utilizeall of our deferred tax assets, including net operating losses, to offsetfuture taxable income. As a result, we recorded a $4.7 million reversal ofvaluation allowance on post-reorganization net operating losses and otherdeferred tax assets and a $38.5 million reversal of valuation allowance onfederal pre-reorganization net operating losses. See Note 6 in our ConsolidatedFinancial Statements.

 

We used the following facts and assumptionsin evaluating the value that we expect to receive from the Brightwaterdevelopment project:

 

•                  TheBrightwater development permit provides for 349 homes aggregating approximately995,000 square feet.

 

•                  Weown land adjacent to Brightwater, for which we intend to process permits tobuild seven additional homes which would be included in the Brightwatercommunity.

 

•                  Developmentat Brightwater is projected to take approximately six months forinfrastructure, approximately eight months to build 14 model homes, and two tothree years for home construction.

 

•                  Weare currently planning to: (i) begin grading during June 2006, (ii) beginbuilding model homes during the fourth quarter of 2006, (iii) startselling homes during the second quarter of 2007, and (iv) start deliveringhomes in the fourth quarter of 2007.

 

•                  Asof January 2006, new home prices approximated $650 per square foot,including view and other premiums, in the local residential market (coastalHuntington Beach).

 

•                  Thefinished lot component of home prices ranges from 60% to 65%.

 

•                  Coststo improve the lots from their raw condition to finished lots, includingbuilding permits and city fees, approximate $140,000 per lot.

 

•                  Homeprices in the coastal Huntington Beach area (as well as other Orange Countycoastal areas) appreciated approximately 20% during 2005. While demandcontinues to exceed the supply of housing, pressure for continued appreciationof home prices may be reduced by any significant increases in interestrates.

 

The estimation process involved in thedetermination of value is inherently uncertain because it requires estimates asto future events and market conditions. This estimation process assumes ourability to complete development and disposition of our real estate propertiesin the ordinary course of business based on management’s present plans andintentions. Economic, market, and environmental conditions may affect ourdevelopment and marketing plans. In addition, the implementation of suchdevelopment and marketing plans could be affected by the availability of futurefinancing for development and construction activities. The development ofBrightwater is dependent upon various economic factors. Accordingly, the amountultimately realized from the Brightwater project may differ materiallyfrom our current estimates and the project’s carrying value.

 

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*Oxnard Land Development - UnconsolidatedJoint Venture*

 

In February 2003, we entered into twooption contracts to acquire land adjacent to the City of Oxnard in VenturaCounty, California aggregating approximately 168 acres. We are in the processof developing a land plan for the area, which also includes an additional 149acres owned by other landowners, with the intention of entitling the propertyfor residential development and annexing it into Oxnard. We currently expectthe residential development plan to include approximately 800 single-familydetached lots and approximately 750 attached family residential units(townhomes, condominiums, and apartments); however, these numbers are subjectto change during the course of the entitlement process. Approximately 555 ofthe single-family lots and 490 of the attached units would be developed on the168 acres of optioned land that we currently expect to purchase. The optioncontracts give us two years, plus up to three additional years through theexercise of extensions, to complete these entitlement activities beforepurchasing the land. We have the right to terminate these option agreements byforfeiting the cash deposits. We are striving to obtain approval of our planfrom the Oxnard City Council by the end of 2006 and approval of annexation intothe City of Oxnard from the Local Agency Formation Commission in the first halfof 2007; however, delays could be encountered. We exercised six-monthextensions in January and July 2005, and in January 2006.

 

During October 2003, we entered into alimited liability company joint venture agreement with a major financialpartner to pursue the Oxnard development opportunity. We assigned the landpurchase option contracts to the Oxnard limited liability company. HearthsideHomes, Inc., our homebuilding subsidiary, is the managing member of theOxnard joint venture, and made an initial contribution of $500,000. Thenon-managing member also made an initial contribution of $500,000 to the jointventure and, as of December 31, 2005, had made an aggregate of $4 millionof first tier additional contributions. The members have agreed to provide asecond tier of additional capital contributions of up to $2 million, asnecessary, to complete the business plan. For contributions in excess of $5million, the first $500,000 is to be contributed equally by us and our partner.At our discretion, we could continue to contribute equally to the next$500,000. Thereafter, the next $1 million is to be contributed equally betweenus. During the fourth quarter of 2005 and the first quarter of 2006, we eachcontributed approximately $160,000 and $100,000, respectively, of theadditional $2 million. We expect to make additional aggregate capitalcontributions of approximately $675,000 to the joint venture during the next 15months, bringing our total expected investment in the project to $1.4 million.After payment of a 10% preferred return on invested capital to us and ourpartner, first tier profits are generally allocated 75% to our partner and 25%to us and second tier profits and losses over $5 million are generallyallocated on a 50/50 basis. The first $5 million of losses are generallyallocated 80% to our partner and 20% to us. While we exert a large degree ofinfluence over the joint venture, our partner does have various substantiveparticipating rights such as approval rights with regard to the majority ofbusiness decisions, including approval of project budgets.

 

*Homebuilding*

 

We acquired no single-familyresidential lots during the first quarter of 2006. Although home prices inSouthern California have increased 20% to 30% annually over the last few years,we do not expect appreciation to continue at that rate, but rather expectmodest, if any, increases over the next year. We delivered 49 homes during thefirst quarter of 2006, compared to 10 deliveries during the comparable periodin 2005. The record rainfall during the fourth quarter of 2004 and the firstquarter of 2005 negatively impacted our construction schedule andcontributed to our lower number of home deliveries in the first quarter of2005.

 

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Our homebuilding projects are described below:

 

 
| ** **          | ** ** | ** **      | ** ** | **Land  Acquisition** | ** ** | **Commenced  Construction** | ** ** | **Commenced  Sales** | ** ** | **Deliveries  Quarter Ended   March 31,** | ** ** |
|---------------------|------------|-----------------|------------|-----------------------|------------|-----------------------------|------------|----------------------|------------|------------------------------------------------|------------|
| ** **          | ** ** | **Location**    | ** ** | ** **            | **2006**   | ** **                  | **2005**   |
| Completed Projects  |       | Various         |       | n/a                   |       | n/a                         |       | n/a                  |       | 1                                              |       | 10 |   |
|                |       |            |       |                  |       |                        |       |                 |       |                                           |       |   |   |
| Active  Projects    |       |            |       |                  |       |                        |       |                 |       |                                           |       |   |   |
| Chandler Ranch      |       | North Corona    |       | 2004                  |       | 2005                        |       | 2005                 |       | 38                                             |       | — |   |
| Cancion             |       | Rancho Santa Fe |       | 2003-2005             |       | 2005                        |       | 2005                 |       | —                                         |       | — |   |
| Alisal at Lancaster |       | Lancaster       |       | 2004                  |       | 2004                        |       | 2005                 |       | 10                                             |       | — |   |
| Alisal at Ontario   |       | Ontario         |       | 2005                  |       | 2005                        |       | 2006                 |       | —                                         |       | — |   |
| Woodhaven           |       | Beaumont        |       | 2005                  |       | 2005                        |       | 2006                 |       | —                                         |       | — |   |
| Hearthside Lane     |       | Corona          |       | 2005                  |       | 2005                        |       | 2006                 | (a)        | —                                         |       | — |   |
| Quartz Hill         |       | Lancaster       |       | 2005                  |       | 2006                        | (a)        | 2006                 | (a)        | —                                         |       | — |   |
| Brightwater         |       | Bolsa Chica     |       | 1970                  |       | 2006                        | (a)        | 2007                 | (a)        | —                                         |       | — |   |
|                |       |            |       |                  |       |                        |       |                 |       | 49                                             |       | 10 |   |

 

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(a) Pending

 

*Rancho Santa Fe.*In October 2003, we entered into an agreementto acquire 32 lots in a luxury golf community known as Crosby Estates in theRancho Santa Fe area of San Diego County in California. We acquired the lotsduring the period from October 2003 to March 2005. During 2005, twomodel homes averaging approximately 3,370 square feet were completed and sixhomes were delivered at an average price of $1,223,000. As of April 24,2006, 22 homes are in escrow at an average price of $1,396,000, and threeadditional homes are under construction and held for sale.

 

*Lancaster.*We acquired 104 lots in the City of Lancaster in northernLos Angeles County during May 2004. We began construction of model homesaveraging approximately 2,800 square feet during the third quarter of 2004 andopened for home sales in January 2005. During 2005, we delivered 55 homesat an average price of $406,000. We delivered 10 homes during the first quarterof 2006 at an average price of $417,000 and, as of April 24, 2006, 25homes are in escrow at an average price of $445,000, and nine homes are underconstruction and held for sale. In April 2005, we acquired an additional72 unentitled lots in Lancaster. We are completing the entitlement process andplans for the project and expect to begin construction during the fourthquarter of 2006.

 

In December 2005, we acquired77 additional lots in an area known as Quartz Hill in the City of Lancaster.The homes in this community will be on 10,000 square foot lots and will average3,642 square feet. We expect to begin construction of models and open for salesduring the second quarter of 2006.

 

*Corona.*We acquired 83 lots in North Corona in May 2004.Following construction of infrastructure, during April 2005, we beganconstruction of homes averaging 3,160 square feet. We opened for sales duringthe third quarter of 2005 and delivered 38 homes during the first quarter of2006 at an average price of $603,000 and delivered two homes in early April. Asof April 24, 2006, nine homes are in escrow at an average price of$607,000, and seven additional homes are under construction and have beenreleased for sale.

 

During April 2005, we acquired151 lots in Corona. Following construction of infrastructure, construction ofhomes averaging 3,583 square feet on lots of approximately 7,200 square feet isexpected to begin during the second quarter of 2006.

 

*Ontario.*During April 2005, we acquired 26 lots in theCity of Ontario in Riverside County, California. This small community of homes,planned to average 3,380 square feet, is an infill site situated very close tothe projects we recently completed in the City of Chino. Constructionbegan during the fourth quarter of 2005, and we opened for sales during March 2006.As of April 24, 2006, four homes are in escrow at an average price of$693,000, and nine additional homes are under construction and have beenreleased for sale.

 

*Beaumont*. We acquired 102 lots in the City of Beaumontduring the third quarter of 2005. Following construction of infrastructure,construction of homes averaging 2,500 square feet began during the firstquarter of 2006, and sales commenced during March 2006. As of April 24,2006, 10 homes are under construction and have been released for sale.

 

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**Impact of Inflation; ChangingPrices and Economic Conditions**

 

Real estate and residential housingprices are affected by inflation, which can cause increases in the price ofland, raw materials and subcontracted labor. Unless these increased costs arerecovered through higher sales prices, gross margin from home sales woulddecrease. If interest rates increase, construction and financing costs wouldalso increase, which can also result in lower gross margin from home sales. Thevolatility of interest rates could have an adverse effect on our futureoperations and liquidity. Among other things, these conditions may affectadversely the demand for housing and the availability of mortgage financing andmay reduce the credit facilities we offer.

 

In general, while these priceincreases have been greater than the general rate of inflation in our housingmarkets, they have not had a significant adverse effect on the sale of ourhomes. A significant risk faced by the housing industry generally is thatrising home costs, including land and interest costs, will substantiallyoutpace increases in the income of potential purchasers. Inflation has a lessershort-term effect on us because we generally negotiate fixed-price contractswith our subcontractors and material suppliers for the construction of ourhomes. These prices are generally applicable for a specified number of homes.

 

There can be no assurance regardingthe continued health of the Southern California residential real estate market.In particular, (i) the significant increases in home prices over the lastsix years and the related decline in the affordability of new homes in SouthernCalifornia, (ii)  the state of the national economy, continued increasesin interest rates by the Federal Reserve Board and the possibility of arecession in the future, and (iii) the volatility in the stock market,collectively may exert recessionary pressures on the California economyand may have a negative impact on the Southern California housing market.

 

While low mortgage rates havesustained housing demand to date, interest rates have been rising and anysignificant future increase in mortgage rates or significant loss of jobs inSouthern California would most likely slow demand for new homes. Increases inhome mortgage interest rates make it more difficult for our customers toqualify for home mortgage loans, potentially decreasing home sales volume andprices. The tight supply of available homes in Southern California has resultedin significant home price increases over the last six years. As a result, theaffordability of new homes has been declining and could jeopardize future demand.The percentage of home buyers utilizing variable-rate and/or interest onlymortgages to afford Southern California new home prices has been increasing.These buyers may be more sensitive to increases in interest rates and may encounterdifficulty in making increased mortgage payments on their homes in the future.This could have negative consequences on the demand for new homes if it resultsin reduced buyer confidence and an increase in secondary market homes availablefor sale, competing with sales of new homes.

 

Approximately 36% (based on numberof lots) of our active homebuilding projects are located in the “Inland Empire”area of Southern California, which includes Riverside and San Bernardinocounties; however, in 2006 we will also be actively developing our 349-homeBrightwater community adjacent to Huntington Beach, California. The InlandEmpire has experienced significant population and job growth in the pastdecade. While continued population growth and demand for new homes are expectedto continue, partially due to the limited supply of affordably priced housingin coastal areas such as Orange County, there can be no assurance thateconomic, demographic or other factors will not slow, diminish or cause suchgrowth to diminish or cease.

 

During the year ended December 31,2005, the homebuilding environment remained strong due to a positivesupply/demand relationship in Southern California, as well as relatively lowinterest rates. We have seen signs that the housing market in SouthernCalifornia has slowed during the first quarter of 2006. For the first quarterof 2006, our net new orders decreased by 35 homes compared with the same periodlast year (29 for the first quarter of 2006 compared with 64 for the firstquarter of 2005). The decrease was partially due to one less active sellingcommunity as well as a return to a more moderate level of orders from recordfirst quarter orders last year. At the same time, however, backlog as ofquarter end was comparable (60 as of March 31, 2006 compared with 61 as ofMarch 31, 2005). Although the homebuilding business historically has beencyclical, it has not undergone an economic down cycle in a number of years.Further, during 2005, home prices rose significantly in all of our markets.This has led some people to assert that the prices of land, new homes and thestock prices of homebuilding companies may be inflated and may declineif the demand for new homes weakens. A decline in the prices for new homescould adversely affect both our revenues and margins. A decline in our stockprice could make raising capital through stock issuances more difficult andexpensive.

 

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**Critical Accounting Policies**

 

In the preparation of the ConsolidatedFinancial Statements, we applied accounting principles generally accepted inthe United States of America. The application of generally accepted accountingprinciples may require management to make estimates and assumptions thataffect the amounts reported in the financial statements and accompanyingresults. Listed below are those policies and estimates that we believe arecritical and require the use of complex judgment in their application. Inparticular, our critical accounting policies and estimates include the evaluationof the impairment of long-lived assets and the evaluation of the probability ofbeing able to realize the future benefits indicated by our significant federaltax net operating losses, as discussed further in Notes 2 and 6 to theConsolidated Financial Statements.

 

*Impairment of Long-Lived Assets*

 

We assess the impairment of real estateinventories and other long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets,” which requires that an impairedasset, for which costs cannot be recovered from estimated undiscounted futurecash flows, be written down to fair value. Long-lived assets are reviewed forimpairment whenever events or changes in circumstances indicate that thecarrying amount of an asset may not be recoverable. As provided by SFAS No. 144,impairment is evaluated by comparing an asset’s carrying value to theundiscounted estimated cash flows expected from the asset’s operations andeventual disposition. If the sum of the undiscounted estimated future cashflows is less than the carrying value of the asset, an impairment loss isrecognized based on the fair value of the asset. If impairment occurs, the fairvalue of an asset for purposes of SFAS No. 144 is deemed to be the amounta willing buyer would pay a willing seller for such asset in a currenttransaction. These assets are carried at cost, unless the carrying amount ofthe parcel or subdivision is determined not to be fully recoverable, in whichcase the impaired real estate is written down to fair value. Given thesignificance of the carrying value of real estate inventories, the applicationof SFAS No. 144 in evaluating any potential impairment is critical to ourconsolidated financial statements, as discussed further in Note 2 to theConsolidated Financial Statements.

 

The Bolsa Chica property is our largestasset. Prior to the December 2005 receipt of our Brightwater permit, theproperty was included in land held for future development or sale. In December 2005,we sold approximately 146 acres of the property to the State. Beginning in December 2005,the remaining portion consisting of approximately 214 acres is included in realestate inventories.

 

In accordance with SFAS No. 144, in developingestimated future cash flows for impairment testing, we incorporated our ownmarket assumptions including those regarding home prices, infrastructure,home-building costs, and financing costs regarding real estate inventories.Additionally, as appropriate, we identify alternative courses of action torecover the carrying value of our long-lived assets and evaluate all likelyalternatives under a probability-weighted approach as described in SFAS No. 144.

 

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 our ability tocomplete development and disposition of our real estate properties in theordinary course of business based on management’s present plans and intentions.Economic, market, and environmental conditions may affect management’sdevelopment and marketing plans. In addition, the implementation of suchdevelopment and marketing plans could be affected by the availability of futurefinancing for development and construction activities. The development of ourBrightwater project is dependent upon various economic factors. Accordingly,the amount ultimately realized from such project may differ materially fromcurrent estimates and the project’s carrying value.

 

*Basis of Consolidation*

 

Certain of our wholly-owned subsidiaries aremembers in joint ventures involved in the development and sale of residentialprojects and residential loan production. Our consolidated statements include ouraccounts and all of our majority-owned and controlled subsidiaries and jointventures. The financial statements of joint ventures in which we generally havea controlling or majority economic interest (and thus are controlled by us) areconsolidated with our financial statements. Minority interest represents theequity interest of our joint venture partner for one consolidated venture. Ourinvestments in unconsolidated joint ventures are accounted for using the equitymethod when we do not have voting or economic control of the ventureoperations.

 

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*Income Taxes*

 

We account for income taxes on the liabilitymethod. Deferred income taxes are determined based on the difference betweenthe financial 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. A valuation allowance related to the deferred tax asset is recordedwhen it is more likely than not that some portion or all of the deferred taxasset will not be realized. Given the significance of our historical federaltax net operating losses, as discussed in Note 6 to the Consolidated FinancialStatements, the application of our policy in evaluating the expected futurebenefit of net operating losses is critical. In applying those policies,estimates and judgments affect the amounts at which certain assets and liabilitiesare recorded. We apply our accounting policies on a consistent basis. Ascircumstances change, they are considered in our estimates and judgments, andfuture changes in circumstances could result in changes in amounts at whichassets and liabilities are recorded.

 

We remain subject to the general rules ofSection 382, which limit the availability of net operating losses if anownership change occurs. If we were to experience another ownership change, theamount of net operating losses available would generally be limited to anannual amount equal to (i) the value of our equity immediately before theownership change, multiplied by the long-term tax-exempt rate (4.26% as of April 2006)plus (ii) recognized built-in-gains, defined as those gains recognizedwithin five years of the ownership change subject to an overall limitation ofthe net unrealized built-in gains existing as of the ownership change date. Webelieve we have net unrealized built-in gains sufficient to allow utilizationof the entire net operating loss, assuming that we are able to recognize thesegains within the five-year time limitation. We estimate that as of April 25,2006, we have experienced a three-year cumulative ownership shift ofapproximately 40%, as computed in accordance with Section 382.

 

*Homebuilding Revenues and Cost ofSales*

 

Our homebuilding operationgenerates revenues from the sale of homes to homebuyers. The majority of thesehomes are designed to appeal to move-up homebuyers and the homes are generallyoffered for sale in advance of their construction. Sales contracts are usuallysubject to certain contingencies such as the buyer’s ability to qualify forfinancing. Revenue from the sale of homes is recognized at closing when titlepasses to the buyer, and the earnings process is complete. As a result, ourrevenue recognition process does not involve significant judgments orestimates. However, we do rely on certain projections and estimates todetermine the related construction costs and resulting gross margins associatedwith revenues recognized. The cost of sales is recorded based upon totalestimated costs within a subdivision and allocated using the relative salesvalue method. Our construction costs are comprised of direct and allocatedcosts, including estimated costs for future warranties and indemnities. Ourestimates are based on historical results, adjusted for current factors.

 

*Litigation Reserves*

 

We and certain of our subsidiaries have beennamed as defendants in various cases arising in the normal course of businessand regarding assets and businesses disposed of by us or our former affiliates.See Notes 5 and 7 to the Consolidated Financial Statements. We have reservedfor costs expected to be incurred with respect to these cases based uponinformation provided by our legal counsel. There can be no assurance that totallitigation costs actually incurred will not exceed the amount of such reserve.

 

**Recent Accounting Pronouncements**

 

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

 

**Results of Operations**

 

The nature of our business, including our limitedinventory of buildable lots, is such that status of each project often causessignificant fluctuations in operating results from quarter-to-quarter andyear-to-year.

 

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*Three Months Ended March 31, 2006Compared with the Three Months Ended March 31, 2005*

 

The Company reported revenues of $27.9 million andgross operating profit of $4.7 million for the first quarter of 2006, comparedwith $6.5 million in revenues and gross operating profit of approximately $1.7million for the first quarter of 2005. Revenues in the current period reflectdeliveries of 49 homes, including 38 homes at the “Chandler Ranch” project inNorth Corona, 10 homes at the “Alisal” project in Lancaster, and one home atthe “Jasper Ranch” project in Riverside. The comparable period of the prioryear reflects deliveries of 10 homes, including six homes at the Riversideproject and four homes at the Chino project. The current quarter’s gross marginof 16.8% is lower than the prior period gross margin of 26.2% due to the lowerprofitability of the Lancaster and North Corona (Chandler Ranch) homesdelivered during the current quarter as compared with the Riverside (JasperRanch) and Chino homes delivered during the comparable period of the prioryear. This decrease reflects the lower price level of homes in Lancastercompared with homes in the Inland Empire, a higher-end product delivered at ourChino and Jasper Ranch projects in 2005, and lower levels of price appreciationresulting from shorter holding periods for the land underlying the homesdelivered during the three months ended March 31, 2006.

 

The $500,000 increase in selling, general andadministrative expenses during the first quarter of 2006, as compared with thefirst quarter of 2005, primarily reflects an increased accrual for incentivebonuses related to the increased profitability of our homebuilding business.

 

The $500,000 increase in other (income) expense duringthe first quarter of 2006 compared with the first quarter of 2005 primarilyreflects interest income on short-term investments during the 2006 period.

 

During the three months ended March 31, 2005, theCompany recorded a reversal of valuation allowance on post-reorganization NOLsof $4.7 million following the Coastal Commission’s approval of the developmentplan for 349 homes on the Bolsa Chica Upper Mesa (see Note 6).

 

*Payments Under Contractual Obligations*

 

We have entered into certain contractual obligationsto make future payments for items such as project debt and lease agreements. Asummary of the payments due under specified contractual obligations, aggregatedby category of contractual obligation, for specified time periods is presentedbelow as of March 31, 2006 (in millions):

 
| ** **       | ** ** | **Payments due by period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | **Total**                  | ** ** | **Less  than 1** | ** ** | **1-3  years** | ** ** | **4-5  years** | ** ** | **More  than 5  years** | ** ** |
|             |       |                       |       |   |   |   |   |   |   |   |   |
| Project debt     |       | $                          | 50.2       |   | $ | 47.0 |   | $ | 3.2 |   | — |   | — |   |
| Operating leases |       | .2                         |       | .2 |   | — |   | — |   | — |   |
| Total            |       | $                          | 50.4       |   | $ | 47.2 |   | $ | 3.2 |   | — |   | — |   |

 

Our purchase contracts which are made in the normalcourse of our homebuilding business for land acquisition and constructionsubcontracts are generally cancelable at will. Other contractual obligationsincluding our 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. We have provided additionaldisclosure in Item 1. “Legal Proceedings” and in Note 5 to our ConsolidatedFinancial Statements.

 

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**Liquidity and Capital Resources**

 

Year-over-year changes in theprincipal components of our liquidity and capital resources are as follows (inmillions, except percentages):

 

| ** **                                       | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                       | ** ** | **2006**                               | ** ** | **2005** | ** ** |
| Cash and cash equivalents                        |       | $                                      | 4.6        |   | $ | 15.3 |   |
| Short-term investments                           |       | 22.5                                   |       | — |   |
| Cash used in operating activities                |       | (2.8                                   | )          | (8.5 | ) |
| Cash provided by investing activities            |       | 7.7                                    |       | — |   |
| Cash (used in) provided by financing  activities |       | (8.0                                   | )          | 14.8 |   |
|                                                  |            |                                        |            |  |  |  |  |

 

The principal assets in ourportfolio are residential land which must be held over an extended period oftime in order to be developed to a condition that, in management’s opinion,will ultimately maximize our return. Consequently, we require significantcapital to finance our real estate development and homebuilding operations.Historically, sources of capital have included loan facilities secured byspecific projects, asset sales and available internal funds. We are currentlyutilizing internally generated cash to fund our Brightwater development atBolsa Chica and, along with joint venture contributions, to fund the Oxnardland development project. We expect to obtain construction financing forinfrastructure and homebuilding activities at Brightwater during the thirdquarter of 2006. We expect to make aggregate additional capital contributionsof approximately $675,000 to the Oxnard joint venture during the next 15months, bringing our total expected investment in the project to $1.4 million.We are utilizing internally generated cash and project debt to fund constructionof our homebuilding projects. Our current and pending homebuilding projects(excluding Brightwater), which are primarily in the “Inland Empire” area ofSouthern California (Riverside and San Bernardino counties) and Lancaster innortheastern Los Angeles County, are currently expected to generateapproximately $90 million of positive cash flows over the next three years,based on present economic conditions and market assumptions. However, anyadverse change in such conditions or assumptions would adversely impact theamount of our cash flows. Our unrestricted cash and cash equivalents andshort-term investments as of March 31, 2006 were $27.1 million. We believethat our cash and cash equivalents, short-term investments, future real estatesales proceeds, and funds available under our current and future creditagreements will be sufficient to meet anticipated operating and capitalinvestment requirements, primarily project development costs for homebuildingprojects, and the Oxnard and Brightwater land development projects, along withgeneral and administrative expenses, for at least the next 12 months.

 

Also see “Strategic Alternatives”above for a discussion of a potential special dividend and/or stockrepurchases.

 

We are subject to the usual obligationsassociated with entering into contracts for the purchase of land and improvedhomesites. The purchase of properties under these contracts is generallycontingent upon satisfaction of certain requirements by the sellers, includingobtaining applicable property entitlements. We also utilize 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. Purchase and option contractsgenerally require the payment of a non-refundable cash deposit of 5% to 15% ofthe purchase price for the right to acquire lots over a specified period oftime (usually one to two years) at predetermined prices. We have the right atour discretion to terminate our obligations under these land purchase andoption agreements by forfeiting the cash deposit with no further financialresponsibility. As of March 31, 2006, we have no consolidated land optiondeposits. However, our unconsolidated Oxnard joint venture does have landdeposits.

 

We may enter into landdevelopment and homebuilding joint ventures from time to time as a means ofexpanding our market opportunities, establishing strategic alliances, managingour risk profile and leveraging our capital base. These joint ventures may obtainsecured acquisition, development and construction financing, which minimize theuse of funds from other corporate financing sources.

 

*March 31, 2006 Compared with December 31,2005*

 

Cash used in homebuilding operations of $2.8 millionfor the first quarter of 2006 primarily reflects real estate sales proceeds of$27.7 million from deliveries of 49 homes, offset by uses of cash forinvestments in real estate inventories and construction costs of $23.5 millionand a $5.3 million decrease in accounts payable discussed below.

 

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Additional significant uses of cash include approximately $8.9 millionfor repayments of project debt financing to reduce the negative arbitragebetween costs of project debt and interest income on short-term investments.The primary sources of cash during the quarter were net sales of short-term investmentsof $7.8 million and borrowing under project debt financing of $1.2 million.These items, as well as other activity presented in the Statements of CashFlows, resulted in a $3.1 million decrease in cash and cash equivalents.

 

The $900,000 decrease in deferred tax assets primarilyreflects the usage of $300,000 of federal Pre-reorganization net operatinglosses (“NOLs”) and $600,000 related to amounts not deductible until paid.

 

Accounts payable and accrued liabilities decreased by$5.3 million, to a balance of $12.1 million as of March 31, 2006,primarily reflecting $4.6 million of payments for federal alternative minimumtax and state income taxes.

 

**Off Balance Sheet Financing**

 

In the ordinary course of business, we enterinto land option contracts in order to procure land for the construction ofhomes. The use of such option agreements allows us to reduce the risksassociated with land ownership and development; reduce our financialcommitments, including interest and other carrying costs; and minimize landinventories. Under such land option contracts, we will fund a specified optiondeposit or earnest money deposit in consideration for the right to purchaseland in the future, usually at a predetermined price. Our liability isgenerally limited to forfeiture of the nonrefundable deposits, letters ofcredit and other nonrefundable amounts incurred. As of March 31, 2006, wehave no consolidated land option deposits and no material third partyguarantees.

 

We alsoacquire land and conduct residential construction activities throughparticipation in joint ventures in which we hold less than a controllinginterest. Through joint ventures, we reduce and share our risk and also reducethe amount invested in land, while increasing our access to potential futurehome sites. The use of joint ventures also, in some instances, enables us toacquire land which we might not otherwise obtain or access on as favorableterms, without the participation of a strategic partner. While we view the useof unconsolidated joint ventures as beneficial to our homebuilding activities,we do not view them as essential to those activities.

 

Our investmentin unconsolidated joint ventures totaled $800,000 and $600,000 at March 31,2006 and 2005, respectively. These joint ventures had total assets of $5.6million and $4.3 million as of March 31, 2006 and 2005, respectively,which included land deposits of $1.6 million and $1.1 million, respectively. Incertain instances, we may provide varying levels of guarantees on debt ofunconsolidated joint ventures. As of March 31, 2006, we provide noguarantees on debt of unconsolidated joint ventures.

 

Under therequirements of FASB Interpretation No. 46(R), “Consolidation of VariableInterest Entities” (“FASB Interpretation No. 46(R)”), certain of our landoption contracts may create a variable interest for us, with the landseller being identified as a VIE. In compliance with FASB Interpretation No. 46(R),we analyzed our land option contracts and other contractual arrangements andhave consolidated the fair value of certain VIEs from which we are purchasingland under option contracts.

 

ITEM 3 - QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

We utilize project debt financingfor acquisition, development and construction of homes. The interest rates onour 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 doaffect our earnings and cash flows. Holding our variable rate debt balanceconstant as of March 31, 2006, each one point percentage increase ininterest rates would result in an increase in variable rate interest incurredfor 2006 of approximately $500,000.

 

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ITEM 4 -  EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

 

*Conclusion Regarding the Effectiveness ofDisclosure Controls and Procedures*

 

No matter how well a control system isconceived and operated, it can provide only reasonable, not absolute, assurancethat the objectives of the control system are met. In addition, the design of acontrol system must reflect the fact that there are resource constraints andthe benefits of controls must be considered relative to costs. Therefore, nocost-effective control systems and no evaluation of controls can provideabsolute assurance that all control issues and instances of misstatements due toerror or fraud, if any, within our company have been detected.

 

*Evaluation of Disclosure Controls andProcedures*

 

Our chief executive officer and chieffinancial officer, with the assistance of management, evaluated theeffectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) as of theend of the period covered by this report (the “Evaluation Date”). Based on thatevaluation, our chief executive officer and chief financial officer concludedthat, as of the Evaluation Date, our disclosure controls and procedures wereeffective to ensure that information required to be disclosed in our reportsunder the Exchange Act, is recorded, processed, summarized and reported withinthe time periods specified in the SEC’s rules and forms, and that suchinformation is accumulated and communicated to management, including our chiefexecutive officer and chief financial officer, as appropriate to allow timelydecisions regarding required disclosure.

 

*Changes in Internal Controls*

 

There have been no significant changes in ourinternal control over financial reporting during the three months ended March 31,2006 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

PART II -OTHER INFORMATION

 

ITEM 1 -                                                 LEGALPROCEEDINGS

 

See Note 7 to the Consolidated Financial Statementsabove, and “Item 1 - Business - Corporate Indemnification Matters” and “Item 3- Legal Proceedings” in our Annual Report on Form 10-K for the year ended December 31,2005.

 

ITEM 1A -                                       RISK FACTORSTHAT MAY AFFECT RESULTS OF OPERATIONS AND FINANCIAL CONDITION

 

There has not been any material change in the riskfactors disclosure from that contained in our Form 10-K for the fiscalyear ended December 31, 2005; however, the risks and uncertaintiesdescribed in the Form 10-K are not the only ones facing us. Other eventsthat we do not currently anticipate or that we currently deem immaterial also may affectour results of operations and financial condition.

 

ITEM 6 -                                                 EXHIBITS

 

31.1                           Section 302Certificate of Raymond J. Pacini, Chief Executive Officer of California CoastalCommunities, Inc.

 

31.2                           Section 302Certificate of Sandra G. Sciutto, Chief Financial Officer of California CoastalCommunities, Inc.

 

32                                    Section 906Certificate of Raymond J. Pacini, Chief Executive Officer and Sandra G.Sciutto, Chief Financial Officer of California Coastal Communities, Inc.*

 

*                                         Thesecertifications are being furnished solely to accompany this report pursuant to18 U.S.C. Section 1350, and are not being filed for purposes of Section 18of the Securities Exchange Act of 1934, as amended, and are not to beincorporated by reference into any filing of the Company, whether made beforeor after the date hereof, regardless of any general incorporation language insuch filing.

 

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**SIGNATURE**

 

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

 

 
| Date:   May 5, 2006 | CALIFORNIA COASTAL COMMUNITIES, INC. |
|-------------------------------|-------------------------------------------|
|                          |                                      |
|                          |                                      |
|                          | By:                                       | * /s/  Sandra G. Sciutto* | * * |
|                          |                                      | SANDRA G. SCIUTTO |
|                          |                                      | Senior Vice President and |
|                          |                                      | Chief Financial Officer |

 

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