**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**QUARTERLY REPORT UNDER SECTION 13OR 15 (d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended September 30, 2005**

 

**Commission File Number 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES,INC.**

(Exact name of registrant as specified 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**   | ** ** | ** **          |
| **Irvine, California**                   | ** ** | **92614**           |
| (Address of principal executive offices) |       | (Zip Code)          |

 

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

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15 (d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days:

 

Yes  ý                   No  o

 

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

 

Yes  ý                   No  o

 

Indicate by check mark whether the registrant is ashell company (as defined in Rule 12b-2 of the Exchange Act).

 

Yes  o                   No  ý

 

The numberof shares of Common Stock outstanding at October 31, 2005 was 10,160,212.

 

 

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CALIFORNIA COASTALCOMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED SEPTEMBER 30,2005

 

I N D E X

 
| Part I -  | Financial Information:                                             |                                                                      |
|----------------|--------------------------------------------------------------------|---------------------------------------------------------------------------|
|           |                                                               |                                                                      |   |
|           | Item 1 -                                                           | Consolidated Financial Statements                                         |   |
|           |                                                               |                                                                      |   |
|           |                                                               | Consolidated Balance Sheets -                                             |   |
|           |                                                               | September 30, 2005 and  December 31, 2004 (unaudited)           |   |
|           |                                                               |                                                                      |   |
|           |                                                               | Consolidated Statements of  Income -                                      |   |
|           |                                                               | Three and Nine Months Ended  September 30, 2005 and 2004 (unaudited) |   |
|           |                                                               |                                                                      |   |
|           |                                                               | Consolidated Statements of  Cash Flows -                                  |   |
|           |                                                               | Nine Months Ended  September 30, 2005 and 2004 (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 4 – Submission of  Matters to a Vote of Security Holders |                                                                      |
|           |                                                               |                                                                      |   |
|           | Item 6 - Exhibits                                                  |                                                                      |
|           |                                                               |                                                                      |   |
| SIGNATURE      |                                                               |

 

2

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PART I.  FINANCIAL INFORMATION

 

ITEM 1 – FINANCIALSTATEMENTS

 

 CALIFORNIA COASTAL COMMUNITIES,INC.

 

CONSOLIDATED BALANCESHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                              | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                                                              | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| **ASSETS**                                                                                                                              |       |                   |       |                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Cash and cash  equivalents                                                                                                              |       | $                      | 5.8        |                  | $          | 9.0 |   |
| Restricted cash                                                                                                                         |       | .6                     |       | 1.1                   |       |
| Real estate held  for current development or sale                                                                                       |       | 116.0                  |       | 49.9                  |       |
| Consolidated  real estate to be held for current development - not owned                                                                |       | —                 |       | 24.7                  |       |
| Land held for  future development or sale                                                                                               |       | 158.3                  |       | 156.4                 |       |
| Deferred tax  assets                                                                                                                    |       | 46.2                   |       | 3.6                   |       |
| Other assets                                                                                                                            |       | 1.7                    |       | 6.1                   |       |
|                                                                                                                                    |       |                   |       |                  |       |
|                                                                                                                                    |       | $                      | 328.6      |                  | $          | 250.8 |   |
|                                                                                                                                    |       |                   |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                           |       |                   |       |                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Liabilities:                                                                                                                            |       |                   |       |                  |       |
| Accounts payable  and accrued liabilities                                                                                               |       | $                      | 14.1       |                  | $          | 15.0 |   |
| Project debt                                                                                                                            |       | 81.4                   |       | 22.6                  |       |
| Consolidated  obligations related to real estate - not owned                                                                            |       | —                 |       | 24.7                  |       |
| Other  liabilities                                                                                                                      |       | 7.8                    |       | 9.3                   |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Total  liabilities                                                                                                                      |       | 103.3                  |       | 71.6                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Minority  interest                                                                                                                      |       | .3                     |       | .3                    |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Commitments and  contingencies                                                                                                          |       |                   |       |                  |       |
|                                                                                                                                    |       |                   |       |                  |       |
| Stockholders’  equity:                                                                                                             |       |                   |       |                  |       |
| Common  Stock—$.05 par value; 11,000,000 shares authorized; 10,160,212 and 10,130,212  shares issued and outstanding, respectively |       | .5                     |       | .5                    |       |
| Excess  Stock—$.05 par value; 11,000,000 shares authorized; no shares outstanding                                                  |       | —                 |       | —                |       |
| Capital in  excess of par value                                                                                                         |       | 191.6                  |       | 152.8                 |       |
| Retained  earnings                                                                                                                      |       | 34.6                   |       | 28.2                  |       |
| Accumulated  other comprehensive loss                                                                                                   |       | (1.7                   | )          | (2.6                  | )          |
| Total  stockholders’ equity                                                                                                        |       | 225.0                  |       | 178.9                 |       |
|                                                                                                                                    |       |                   |       |                  |       |
|                                                                                                                                    |       | $                      | 328.6      |                  | $          | 250.8 |   |

 

See the accompanying notes to consolidated financial statements.

 

3

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTSOF INCOME AND COMPREHENSIVE INCOME

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                                             | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                                             | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                                             | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Revenues                                                               |       | $                      | 24.4       |                   | $          | 28.4 |   | $ | 34.0 |   | $ | 37.2 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Costs of sales                                                         |       | 19.5                   |       | 22.4                   |       | 26.5 |   | 28.8 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Gross operating  profit                                                |       | 4.9                    |       | 6.0                    |       | 7.5 |   | 8.4 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Selling, general  and administrative expenses                          |       | 1.5                    |       | 1.7                    |       | 3.4 |   | 3.4 |   |
| Interest expense                                                       |       | .1                     |       | .1                     |       | .1 |   | .2 |   |
| Income from  unconsolidated joint ventures                             |       | (.1                    | )          | (.1                    | )          | (.1 | ) | (.3 | ) |
| Other expense,  net                                                    |       | .2                     |       | .6                     |       | .5 |   | .7 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Income before  income taxes                                            |       | 3.2                    |       | 3.7                    |       | 3.6 |   | 4.4 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Provision  (benefit) for income taxes                                  |       | 1.4                    |       | 1.1                    |       | (3.0 | ) | 1.3 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Minority  interest in income of consolidated joint venture, net of tax |       | .1                     |       | 1.3                    |       | .2 |   | 1.3 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Net income                                                             |       | 1.7                    |       | 1.3                    |       | 6.4 |   | 1.8 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Other  comprehensive income, net of income taxes:                      |       |                   |       |                   |       |   |   |   |   |
| Minimum pension  liability income tax benefit                          |       | —                 |       | —                 |       | .9 |   | — |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Comprehensive  income                                                  |       | $                      | 1.7        |                   | $          | 1.3 |   | $ | 7.3 |   | $ | 1.8 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Earnings per  common share:                                            |       |                   |       |                   |       |   |   |   |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                  |       | $                      | .17        |                   | $          | .13 |   | $ | .63 |   | $ | .18 |   |
| Diluted                                                                |       | $                      | .16        |                   | $          | .12 |   | $ | .61 |   | $ | .17 |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Common  equivalent shares:                                             |       |                   |       |                   |       |   |   |   |   |
|                                                                   |       |                   |       |                   |       |   |   |   |   |
| Basic                                                                  |       | 10.2                   |       | 10.1                   |       | 10.2 |   | 10.1 |   |
| Diluted                                                                |       | 10.5                   |       | 10.9                   |       | 10.5 |   | 10.8 |   |

 

See the accompanyingnotes to consolidated financial statements.

 

4

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTSOF CASH FLOWS

 

(in millions)

 

(unaudited)

 
| ** **                                                                 | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                 | ** ** | **September 30,** | ** ** |
| ** **                                                                 | ** ** | **2005**               | ** ** | **2004** | ** ** |
|                                                                       |       |                   |       |   |   |
| Cash flows from  operating activities:                                     |       |                   |       |   |   |
| Net income                                                                 |       | $                      | 6.4        |   | $ | 1.8 |   |
| Adjustments to  reconcile net income to cash used in operating activities: |       |                   |       |   |   |
| Non-cash  interest expense                                                 |       | .1                     |       | .2 |   |
| Non-cash  compensation expense                                             |       | —                 |       | .3 |   |
| Non-cash benefit  from reversal of deferred tax asset allowance            |       | (4.7                   | )          | — |   |
| Deferred taxes                                                             |       | 1.5                    |       | — |   |
| Gains on sales  of real estate held for current development or sale        |       | (7.6                   | )          | (8.4 | ) |
| Minority  interest in income of consolidated joint venture                 |       | .4                     |       | 1.3 |   |
| Proceeds from  asset sales, net                                            |       | 34.0                   |       | 37.0 |   |
| Investments in  real estate held for current development or sale           |       | (92.5                  | )          | (62.3 | ) |
| Investments in  land held for future development or sale                   |       | (1.9                   | )          | (2.0 | ) |
| Changes in  assets and liabilities:                                        |       |                   |       |   |   |
| Increase  (decrease) in deferred tax and other assets                      |       | 4.4                    |       | (1.7 | ) |
| (Decrease)  increase in accounts payable, accrued and other liabilities    |       | (2.5                   | )          | 3.6 |   |
|                                                                       |       |                   |       |   |   |
| Cash used in  operating activities                                         |       | (62.4                  | )          | (30.2 | ) |
|                                                                       |       |                   |       |   |   |
| Cash flows from  investing activities:                                     |       |                   |       |   |   |
| Release of  restricted cash                                                |       | .5                     |       | — |   |
| Cash provided by  investing activities:                                    |       | .5                     |       | — |   |
|                                                                       |       |                   |       |   |   |
| Cash flows from  financing activities:                                     |       |                   |       |   |   |
| Borrowings of  project debt                                                |       | 82.4                   |       | 45.4 |   |
| Repayments of project  debt                                                |       | (23.6                  | )          | (17.9 | ) |
| Proceeds from  exercise of stock options                                   |       | .3                     |       | .2 |   |
| Minority  interest distributions                                           |       | (.4                    | )          | (5.7 | ) |
|                                                                       |       |                   |       |   |   |
| Cash provided by  financing activities                                     |       | 58.7                   |       | 22.0 |   |
|                                                                       |       |                   |       |   |   |
| Net decrease in  cash and cash equivalents                                 |       | (3.2                   | )          | (8.2 | ) |
|                                                                       |       |                   |       |   |   |
| Cash and cash  equivalents - beginning of period                           |       | 9.0                    |       | 14.7 |   |
|                                                                       |       |                   |       |   |   |
| Cash and cash  equivalents - end of period                                 |       | $                      | 5.8        |   | $ | 6.5 |   |
|                                                                       |       |                   |       |   |   |
| Supplemental  disclosures of cash flow information:                        |       |                   |       |   |   |
| Cash paid during  the period for income taxes                              |       | $                      | .9         |   | $ | .4 |   |
| Cash paid during  the period for interest                                  |       | $                      | .8         |   | $ | .6 |   |

 

See the accompanying notes to consolidated financial statements.

 

5

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 -Basis of Presentation**

 

Theaccompanying financial statements have been prepared by California CoastalCommunities, Inc. and its consolidated subsidiaries (the “Company”),without audit, pursuant to the rules and regulations of the Securities andExchange Commission. Certain information and footnote disclosures normallyincluded in financial statements prepared in accordance with generally acceptedaccounting principles have been condensed or omitted pursuant to such rules andregulations. The Company believes that these unaudited consolidated financialstatements reflect all material adjustments (consisting only of normalrecurring adjustments) and disclosures necessary for the fair presentation ofthe results of operations and statements of financial position when read inconjunction with the Financial Statements and Notes thereto included in theCompany’s Annual Report on Form 10-K for the year ended December 31, 2004,and the current year’s previously issued Quarterly Reports on Form 10-Q. Allinter company accounts and transactions have been eliminated.

 

Theresults for interim periods are not necessarily indicative of the results to beexpected for the full year. This report contains forward-looking statements.Readers are cautioned that any such forward-looking statements are notguarantees of future performance and involve risks and uncertainties thatactual events or results may differ materially from those described herein as aresult of various factors, including without limitation, the factors discussedgenerally in this report.

 

**Note 2 -Significant Accounting Policies**

 

*EarningsPer Common Share*

 

Theweighted-average number of common shares outstanding was 10.2 million for thethree and nine months ended September 30, 2005 and 10.1 million for thethree and nine months ended September 30, 2004.  Earnings per share, assuming dilution, arecomputed using the weighted-average number of common shares outstanding and thedilutive effect of potential common shares outstanding. For the three and ninemonths ended September 30, 2005 and 2004, the average market price of theCompany’s common stock exceeded the exercise price of outstanding stockoptions.  Therefore, diluted earnings pershare includes the dilutive effect of the weighted average number of commonshares from potential exercise of approximately 700,000 options.  The weighted average number of common shares,assuming dilution, was 10.5 million for the three and nine months ended September 30,2005, and 10.9 million and 10.8 million for the three and nine months ended September 30,2004 respectively.

 

*RealEstate*

 

Realestate held for current development or sale is carried at the lower of cost, orfair value, less costs to sell. Land held for future development is carried atcost, with write-downs to fair value only in the event that costs cannot berecovered from estimated undiscounted future cash flows, as described under “Impairmentof Long-Lived Assets.” The estimation process involved in the determination of fairvalue is inherently uncertain since it requires estimates as to future eventsand market conditions. Such estimation process assumes the Company’s ability tocomplete development and dispose of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions.Economic, market, environmental and political conditions may 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. Accordingly, theultimate values of the Company’s real estate properties are dependent uponfuture economic and market conditions, the availability of financing, and theresolution of political, environmental and other related issues.

 

Thecost of sales of multi-unit projects is generally computed using the relativesales value method. Interest cost is capitalized to real estate projects duringtheir development and construction period.

 

6

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*Impairmentof Long-Lived Assets*

 

TheCompany assesses the impairment of land held for future development and otherlong-lived assets in accordance with Statement of Financial AccountingStandards (“SFAS”) No. 144, “Accounting for the Impairment or Disposal ofLong-Lived Assets”, which requires that an impaired asset, for which costscannot be recovered from estimated undiscounted future cash flows, be writtendown to fair value. Long-lived assets are reviewed for impairment wheneverevents or changes in circumstances indicate that the carrying amount of anasset may not be recoverable. As provided by SFAS No. 144, impairment isevaluated by comparing an asset’s carrying value to the undiscounted estimatedcash flows expected from the asset’s operations and eventual disposition. Ifthe sum of the undiscounted estimated future cash flows is less than thecarrying value of the asset, an impairment loss is recognized based on the fairvalue of the asset. If impairment occurs, the fair value of an asset forpurposes of SFAS No. 144 is deemed to be the amount a willing buyerwould pay a willing seller for such asset in a current transaction. On September 2,1997, the Company completed its Recapitalization pursuant to court confirmationof a Prepackaged Plan of Reorganization, and the Company applied the principlesrequired by the American Institute of Certified Public Accountants Statement ofPosition (“SOP”) 90-7, “Financial Reporting by Entities in Reorganization Underthe Bankruptcy Code” (“Fresh-Start Reporting”), and the carrying value of realestate properties was adjusted to fair value. The Company has updated its analysis at each year-end since 1997, andhas noted no indications of impairment since that date. Since the undiscountedestimated future cash flows from the upper bench of the Bolsa Chica Mesa (the “UpperMesa”) and the Company’s pending sale of its 103-acre Lower Bench at BolsaChica exceed its carrying value, there has been no impairment.

 

Inaccordance with SFAS No. 144, in developing estimated future cash flowsfor impairment testing, the Company has incorporated its own assumptionsregarding the entitlement prospects of land held for future development and itsown market assumptions including those regarding home prices, infrastructureand home-building costs regarding both land held for future development (seeManagement’s Discussion and Analysis) and real estate held for currentdevelopment or sale.  Additionally, asappropriate, the Company identifies alternative courses of action to recoverthe carrying value of its long-lived assets and evaluates all likelyalternatives under a probability-weighted approach as described in SFAS No. 144.

 

*Consolidationof Variable Interest Entities*

 

AVariable Interest Entity (“VIE”) is created when (i) the equity investmentat risk is not sufficient to permit the entity from financing its activitieswithout additional subordinated financial support from other parties or (ii) equityholders either (a) lack direct or indirect ability to make decisions aboutthe entity, (b) are not obligated to absorb expected losses of the entityor (c) do not have the right to receive expected residual returns of theentity if they occur.  If an entity isdeemed to be a VIE, pursuant to Financial Interpretation FIN No. 46, “Consolidationof Variable Interest Entities – an interpretation of ARB No. 51.” (“FIN 46”),an enterprise that has the majority of the variability in gains and losses ofthe VIE is considered to be the primary beneficiary and must consolidate theVIE.  FIN 46 was effective immediatelyfor VIEs created after January 31, 2003.

 

Basedon the provisions of FIN 46, the Company has concluded that whenever it optionsland or lots from an entity and pays a non-refundable deposit, a VIE may becreated under condition (ii)(b) and (c) of the previousparagraph.  The Company may be deemed tohave provided subordinated financial support, which refers to variableinterests that will absorb some or all of an entity’s expected theoreticallosses if they occur.  For each VIEcreated with a significant nonrefundable option fee,  the Company will compute expected losses andresidual returns based on the probability of future cash flows as outlined inFIN 46.  If the Company is deemed to bethe primary beneficiary of the VIE, the VIE will be consolidated on the Company’sbalance sheet.  The fair value of the VIE’sreal estate will be reported as consolidated real estate to be held for currentdevelopment - not owned and the related theoretical liability will be reportedas consolidated obligations related to real estate - not owned.

 

TheCompany’s exposure to loss as the result of a purchase contract with a VIE islimited to the amount of the non-refundable option deposit, which is generally5% to 15% of the purchase price, not total assets on the balance sheet of theVIE.  Therefore, the Company believesthat consolidating the VIE does not reflect the economic realities or risks ofowning and developing land.  The Companyhas no material third party guarantees related to these contracts.  Creditors of these VIEs, if any, have norecourse against the Company.

 

DuringNovember 2004, the Company entered into an agreement to purchase land froma third party entity deemed to be a VIE, with the Company as the primarybeneficiary of the entity.  Because theCompany does not have access to the financial information of the VIE, the fairvalue of the optioned property less the cash deposit and

 

7

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consolidated obligations related to consolidated real estate - notowned of $24.7 million is reflected on the Company’s balance sheet as of December 31,2004.  During April 2005, theCompany completed the acquisition of land which was the subject of theagreement, and as such the land is included in Real estate held for currentdevelopment or sale as of September 30, 2005.  Not all of the Company’s deposits are withVIEs.  See Note 8 – Real Estate Matters.

 

*RecentAccounting Pronouncements*

 

In December 2004,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 123(revised 2004), “Share-Based Payment”. This Statement replaces SFAS 123, “Accounting for Stock-BasedCompensation” and supersedes APB 25. SFAS No. 123R addresses the accounting for share-based paymenttransactions in which an enterprise receives employee services in exchange for (a) equityinstruments of the enterprise or (b) liabilities that are based on thefair value of the enterprise’s equity instruments or that may be settled by theissuance of such equity instruments. SFAS No. 123R eliminates the ability to account for share-basedcompensation transactions using the intrinsic value method under APB 25, andgenerally would require instead that such transactions be accounted for using afair-value-based method.  The Company iscurrently evaluating SFAS No. 123R to determine which fair-value-basedmodel and transitional provision it will follow upon adoption.  SFAS No. 123R will be effective for theCompany beginning in the first quarter of 2006. The Company is evaluating the impact application of SFAS No. 123Rwill have on the Company’s results of operations.

 

In December 2004,the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets – Anamendment of APB 29, Accounting for Nonmonetary Transactions”.  This statement amends APB 29 to eliminate theexception for nonmonetary exchanges of similar productive assets and replacesit with a general exception for exchanges of nonmonetary assets that do nothave commercial substance.  A nonmonetaryexchange has commercial substance if the future cash flows of the entity areexpected to change significantly as a result of the exchange.  The Company will evaluate the effect, if any,of adopting SFAS 153.

 

In June 2005,the Emerging Issues Task Force (“EITF”) reached a final consensus on Issue No. 04-5,“Determining Whether a General Partner, or the General Partners as a Group,Controls a Limited Partnership or Similar Entity When the Limited Partners HaveCertain Rights”.  EITF No. 04-5affects the consolidation of entities in which a general partner or managingmember is presumed to control a partnership or limited liability company.  EITF No. 04-5 will be effective for theCompany beginning in the first quarter of 2006. The Company is evaluating the impact that the application of EITF No. 04-5will have on the Company’s financial statements.

 

**Note 3 -Land Held for Future Development or Sale**

 

TheCompany owns approximately 351 acres located in Orange County, California overlookingthe Pacific Ocean and the Bolsa Chica wetlands (which were sold by the Companyto the State of California in 1997), surrounded by the City of Huntington Beachand approximately 35 miles south of downtown Los Angeles. The Company’sholdings include 208 acres on a mesa north of the Bolsa Chica wetlands (“BolsaChica Mesa”), approximately 100 acres on, or adjacent to, the Huntington Beachmesa (“Huntington Mesa”) and 43 acres of lowlands which were acquired by theCompany in September 1997.

 

On April 14,2005, the Company obtained approval from the California Coastal Commission fora Coastal Development Permit (“CDP”) to build 349 homes on 68 acres of itsapproximately 105-acre upper bench of the Bolsa Chica Mesa (“Upper Mesa”), subjectto satisfying the Coastal Commission’s permit conditions.  On October 5, 2005, the County of Orangeapproved modifications to the Company’s site plan and on October 18, 2005approved the tentative tract map for 349 homes. This approval was necessary to comply with the California CoastalCommission’s conditions of approval for a CDP. The Company is workingdiligently to satisfy the various conditions necessary for the CoastalCommission to issue the CDP.  The Companyis striving to: (i) satisfy the conditions for issuance of the CDP by theend of 2005, (ii) begin grading during the second quarter of 2006, (iii) beginbuilding model homes during the third quarter of 2006, and (iv) startselling homes during the first quarter of 2007. However, there can be no assurance in that regard, or as to the absenceof further administrative delay.

 

Theplanned community on the Upper Mesa, known as “Brightwater,” will offer a broadmix of home choices, averaging 2,800 square feet and ranging in size from 1,600square feet to 4,000 square feet.  Theplan also includes 37 acres of open space and conservation area.  With only 349 homes on 68 acres of the UpperMesa, the resulting low-density plan equates to approximately 5 homes per acre,consistent and compatible with the neighboring Huntington

 

8

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Beach communities. In addition, the Company will offer to dedicate 51acres of land on the Huntington Mesa to the County of Orange to complete theHarriett M. Wieder Linear Park. The 1,200-acre state-owned Bolsa Chica Wetlandsare fully preserved and protected in accordance with previous agreements withthe State of California and are not included in the Brightwater plan.

 

On August 12,2004, an agreement to sell a 103-acre parcel of the Bolsa Chica Mesa known asthe “Lower Bench” to the State’s Wildlife Conservation Board (“WCB”) for $65million was approved by the WCB.  Thesale was approved by the Company’s stockholders at the August 11, 2005Annual Meeting, subject to the issuance of the CDP prior to the outside closingdate of December 31, 2005. If the proposed sale is completed, WCB’spurchase of the property will be funded with bond proceeds authorized byvoter-approved Proposition 50, which was passed in November 2002.  The Company is striving to satisfy theconditions for issuance of the CDP by the end of 2005; however, there can be noassurances that the CDP will be issued before December 31, 2005 or thatthe sale will be completed.

 

On September 2,1997, the Company completed a recapitalization pursuant to court confirmationof a Prepackaged Plan of Reorganization (the “Recapitalization”), and theCompany applied the principles required by the American Institute of CertifiedPublic Accountant’s Statement of Position (“SOP”) 90-7, “Financial Reporting byEntities in Reorganization Under the Bankruptcy Code” (“Fresh-Start Reporting”),and the carrying value of land held for development (Bolsa Chica) was adjustedto fair value.  The fair value wasdetermined in 1997 using discounted estimated cash flows expected from theasset’s operations and eventual disposition. The Company has updated its analysis at each year-end since 1997, andhas noted no indicators of impairment since that date. Future costs incurredfor capitalizable development activities for the Bolsa Chica project willincrease the basis of the land. An estimate for these costs has been includedin the Company’s estimated undiscounted cash flow forecast used in itsimpairment analyses. In accordance with the Company’s policy described in Note2 – Impairment of Long-Lived Assets, since the undiscounted estimated futurecash flows from the Upper Mesa development plan for 349 single-family homes andthe pending sale of the Lower Bench to WCB are expected to exceed its carryingvalue, the Company believes there has been no impairment.

 

Theestimation process involved in the determination of value is inherentlyuncertain since it requires estimates as to future events and marketconditions. Such estimation process assumes the Company’s ability to completedevelopment and disposition of its real estate properties in the ordinarycourse of business based on management’s present plans and intentions.Economic, market, environmental and political conditions may 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 theCompany’s Upper Mesa project is dependent upon satisfying the CoastalCommission’s conditions of approval, market conditions and economic factors.Accordingly, the amount ultimately realized from such project may differmaterially from current estimates and the project’s carrying value.

 

**Note 4 –Project Debt**

 

Inconjunction with the acquisition of single-family residential lots, the Company’shomebuilding subsidiary, Hearthside Homes, Inc. and its subsidiaries,enter into construction loan agreements with commercial banks.  These loan facilities finance a portion ofthe land acquisition and the majority of the construction of infrastructure andhomes.  The loans are secured by deeds oftrust on individual projects and require principal repayments upon the deliveryof homes.  Each loan facility requires aguaranty of project completion and an environmental indemnity.  The loans secured by first trust deeds bearan interest rate of prime plus three-fourths percent (7.5 % at September 30,2005).  During the nine months ended September 30,2005, subsidiaries of Hearthside Homes, Inc. entered into seven new firsttrust deed loan facilities aggregating $108.1 million in conjunction with theacquisitions and development of a total of 312 single family residential lots,including 27 acquired during 2004.  Inaddition, a subsidiary of Hearthside Homes, Inc. entered into one loanfacility secured by a second trust deed which bears interest at 17%.  The following

 

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amounts were availableand outstanding under these loan facilities as of September 30, 2005 and December 31,2004 ($ in millions):

 
| ** **        | ** ** | ** **      | ** ** | ** **  | ** ** | ** **   | ** ** | **Outstanding at**     | ** ** |
|-------------------|------------|-----------------|------------|-------------|------------|--------------|------------|------------------------|------------|
| ** **        | ** ** | **Amount**      | ** ** | **Number**  | ** ** | **Maturity** | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
| ** **        | ** ** | **of Facility** | ** ** | **of Lots** | ** ** | **Date**     | ** ** | **2005**               | ** ** | **2004** | ** ** |
|              |       |            |       |        |       |         |       |                   |       |   |   |
| First Trust Deeds |       |            |       |        |       |         |       |                   |       |   |   |
| Riverside         |       | $               | 2.3        |        | —     |         | Repaid     |                   | $          | — |   | $ | 2.3 |   |
| Chino             |       | 9.6             |       | —      |       | Repaid       |       | —                 |       | .5 |   |
| Chino II          |       | 6.3             |       | —      |       | Repaid       |       | —                 |       | 1.7 |   |
| Rancho Santa Fe   |       | 5.2             |       | 6           |       | 11/19/05     |       | 3.5                    |       | 1.6 |   |
| Lancaster         |       | 10.7            |       | 60          |       | 11/23/05     |       | 3.9                    |       | 4.0 |   |
| Corona            |       | 21.1            |       | 83          |       | 11/24/05     |       | 17.2                   |       | 11.4 |   |
| Rancho Santa Fe   |       | 3.9             |       | 6           |       | 12/13/05     |       | 1.9                    |       | 1.1 |   |
| Riverside         |       | 7.9             |       | 15          |       | 3/27/06      |       | .7                     |       | — |   |
| Rancho Santa Fe   |       | 15.4            |       | 18          |       | 3/27/06      |       | 7.3                    |       | — |   |
| Ontario           |       | 11.7            |       | 26          |       | 4/19/06      |       | 3.5                    |       | — |   |
| Lancaster         |       | 9.5             |       | 44          |       | 5/10/06      |       | 7.3                    |       | — |   |
| Rancho Santa Fe   |       | 1.8             |       | 2           |       | 9/13/06      |       | 1.7                    |       | — |   |
| Corona            |       | 41.1            |       | 151         |       | 1/7/07       |       | 18.4                   |       | — |   |
| Beaumont          |       | 20.7            |       | 102         |       | 2/17/07      |       | 7.4                    |       | — |   |
|              |       |            |       |        |       |         |       | 72.8                   |       | 22.6 |   |
| Second Trust Deed |       |            |       |        |       |         |       |                   |       |   |   |
| Corona            |       | 10.5            |       | 151         |       | 1/7/07       |       | 8.6                    |       | — |   |
|              |       |            |       |        |       |         |       |                   |       |   |   |
|              |       |            |       |        |       |         |       | $                      | 81.4       |   | $ | 22.6 |   |
|                   |            |                 |            |             |            |              |            |                        |            |  |  |  |  |  |

 

Forthe three months ended September 30, 2005 and 2004, approximately $1.5million and $500,000, respectively, of construction period interest incurredwas capitalized, and for the nine months ended September 30, 2005 and2004, approximately $3.1 million and $900,000, respectively, of constructionperiod interest was capitalized.

 

**Note 5 -Other Liabilities**

 

Otherliabilities were comprised of the following (in millions):

 
| ** **                                         | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|----------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                         | ** ** | **2005**               | ** ** | **2004**              | ** ** |
| Accrued pensions and benefits                      |       | $                      | 4.8        |                  | $          | 4.9 |   |
| Home warranty reserves                             |       | 1.5                    |       | 1.6                   |       |
| Contingent indemnity and environmental obligations |       | 2.1                    |       | 3.5                   |       |
| Unamortized discount                               |       | (.6                    | )          | (.7                   | )          |
|                                               |       | $                      | 7.8        |                  | $          | 9.3 |   |

 

Contingentindemnity and environmental obligations primarily reflect (i) reservesbefore related discount (recorded pursuant to Fresh-Start Reporting) forcontingent indemnity obligations for businesses disposed of by formeraffiliates and unrelated to the Company’s current operations, and (ii) theliability of a subsidiary of the Company for PCB contamination on its 43-acreBolsa Chica lowlands property as further described below.

 

*DresserLitigation*

 

In May 2002,Dresser Industries, Inc. (“Dresser”) filed litigation, captioned DresserIndustries, Inc. vs. California Coastal Communities, Inc. and RESCOHoldings, Inc. (“RESCO”, a former affiliate), in the 58th JudicialDistrict Court of Jefferson County, Texas. Dresser sought a declaratory judgment regarding the rights andobligations of the parties under a January 1988 purchase agreement.Dresser’s indemnity claims related to several hundred lawsuits encompassingapproximately 5,900 contested asbestos claims made by third parties inconnection with work in facilities in which the Dresser-acquired engineeringand construction business was allegedly connected. The Company denied Dresser’sallegations and vigorously defended itself in this case and relatedmatters.  On April 6, 2005, RESCOand the

 

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Company settled this litigation with Dresser and the Company paid $1.33million, its share of the settlement, which is the amount of the Company’slitigation accrual as of December 31, 2004.  The Company and RESCO did not admit fault orliability with respect to Dresser’s claims, but settled the matter in order toavoid the continued cost and uncertainty of litigation.

 

*LowlandRemediation*

 

In September 1997,the Company acquired 43 acres in the Bolsa Chica lowlands with the intent ofselling it to the State of California in connection with its plannedrestoration of 1,000 acres of adjacent wetlands.  In anticipation of entering into a purchaseagreement, the State performed limited soils sampling on this property andnotified the Company in 1999 that it had discovered contamination from a groupof chemicals called PCBs.  The source ofthe contamination is presently unknown; however, the Company has neverconducted any development, business or operations on this property.  In January 2002, the State’s Departmentof Toxic Substances Control (“DTSC”) became the regulatory agency responsiblefor overseeing the Company’s efforts to remediate the contamination on thisproperty.  In July 2002, asubsidiary of the Company entered into a consent order with DTSC regardingremediation.  The Company’s subsidiaryprepared a Remedial Investigation (“RI”) Workplan, which was approved by DTSCin August 2003.  During 2003, thesubsidiary performed soil sampling at the site according to the RI Workplan todetermine the nature and extent of contamination, and submitted an RI Report toDTSC in February 2004.  A RemedialAction Workplan (“RAW”) was approved by DTSC in December 2004.  The removal of contaminated soil wascompleted during September 2005 and the DTSC has acknowledged completionof the remedial activities.  As of September 30,2005 the subsidiary has accrued approximately $900,000 for environmentaltesting and remediation of this property. The accrual reflects the estimate ofcharges for the recently completed remediation, including approximately $800,000to be paid out of the escrow described below.

 

In July 2005,the Company’s subsidiary entered into an agreement with the State LandsCommission (“SLC”) to sell this property to the SLC for $1.7 million.  SLC deposited the $1.7 million into escrow, withup to $1 million of such funds to be utilized to fund the Company’s subsidiary’sobligation to remediate the property as required by the RAW.  The DTSC’s final acceptance of the remediationwork is expected by the end of 2005. After the final acceptance by the DTSC,SLC is expected to complete their acquisition of this property from the Company’ssubsidiary and the Company’s subsidiary is expected to receive the remainingbalance of the escrowed funds which are estimated to be approximately $900,000.

 

In May 2004,the Company’s subsidiary received an invoice from DTSC seeking reimbursementfor $793,000 of oversight and remediation costs incurred by DTSC with respectto PCBs found on neighboring residential properties.  Since receiving the original invoice, theCompany’s subsidiary has received five additional invoices for an aggregateadditional $108,000 including accrued interest. However, the Company’s subsidiary contends, based upon advice ofcounsel, that it is not responsible for such costs because the Company did notdevelop or build the neighboring residential properties, the Company did notgenerate the contamination, the contamination did not emanate from the Company’sproperty and the 43-acre site should not be part of the same site as the residentialproperties. Furthermore, the Company’s subsidiary has also disputed suchcharges due to the fact that DTSC did not bill the Company’s subsidiary inaccordance with the requirements of the applicable law. The Company’ssubsidiary intends to vigorously defend itself in this matter, and the Companyhas not accrued for any of DTSC’s $901,000 of claims related to theseresidential properties.

 

*HomeWarranty Reserve*

 

TheCompany provides a home warranty reserve to reflect its contingent obligationfor product liability. The Company generally records a provision as homes aredelivered, based upon historical and industry experience, subject to certainminimums. The home warranty reserve activity is presented below (in millions):

 
| ** **                     | ** ** | **Nine Months Ended**  | ** ** |
|--------------------------------|------------|------------------------|------------|
| ** **                     | ** ** | **September 30,** | ** ** |
| ** **                     | ** ** | **2005**               | ** ** | **2004** | ** ** |
| Balance at beginning of period |       | $                      | 1.6        |   | $ | 1.2 |   |
| Provision                      |       | .2                     |       | .3 |   |
| Payments                       |       | (.3                    | )          | (.1 | ) |
| Balance at end of period       |       | $                      | 1.5        |   | $ | 1.4 |   |

 

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**Note 6 -Income Taxes**

 

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

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| ** **                                               | ** ** | **September 30,** | ** ** | **September 30,** | ** ** |
| ** **                                               | ** ** | **2005**               | ** ** | **2004**               | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current tax                                              |       | $                      | (.1        | )                      | $          | — |   | $ | — |   | $ | — |   |
| Deferred tax                                             |       | 1.5                    |       | 1.1                    |       | 1.7 |   | 1.4 |   |
| Reversal of  valuation allowances on deferred tax assets |       | —                 |       | —                 |       | (4.7 | ) | — |   |
| Reduction in  contingent tax liabilities                 |       | —                 |       | —                 |       | — |   | (.1 | ) |
| Provision  (benefit) for income taxes                    |       | $                      | 1.4        |                   | $          | 1.1 |   | $ | (3.0 | ) | $ | 1.3 |   |

 

As aresult of the California Coastal Commission’s approval of the Company’s developmentplan for the Upper Mesa on April 14, 2005, the Company has concluded thatit is more likely than not that it will utilize all of its deferred tax assets,including NOLs, to offset future taxable income.  Therefore, during the nine months ended September 30,2005, the Company recorded a reversal of valuation allowances on post-reorganizationNOLs and other deferred tax assets of approximately $4.7 million, which isreflected in the tax benefit.  Pursuantto Fresh Start Reporting, also during the nine months ended September 30, 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.

 

TheInternal Revenue Code (the “Code”) generally limits the availability of NOLs ifan ownership change occurs within any three-year period under Section 382.If the Company were to experience an ownership change of more than 50%, the useof all remaining NOLs would generally be subject to an annual limitation equalto the value of the Company’s equity before the ownership change, multiplied bythe long-term tax-exempt rate. The Company estimates that after giving effectto various transactions by stockholders who hold a 5% or greater interest in theCompany, it has experienced a three-year cumulative ownership shift ofapproximately 40% as of October 21, 2005.

 

Thefederal NOLs available as of September 30, 2005 were approximately $168 million.The amount of federal NOLs which expire if not utilized is zero, $12 million,$8 million, $21 million, $11 million and $116 million for  2005, 2006, 2007, 2008, 2009 and thereafter,respectively.

 

In October 1999the Company’s certificate of incorporation was amended in order to protect theability of the Company to utilize its NOLs. Since the Company’s use of its NOLswould be severely restricted if it experiences an ownership change of more than50%, the amendment prohibits future purchases of the Company’s common stock bypersons who would become new 5% holders, and also prohibits current holders ofover 5% from increasing their positions, except in certain permissiblecircumstances which would not jeopardize the Company’s ability to use its NOLs.While these amendments reduced the Company’s risk of an ownership changeoccurring due to the acquisition of shares by 5% stockholders, the risk remainsthat an ownership change could result from the sale of shares by existing 5%stockholders.

 

**Note 7 –Minority Interest**

 

In April 2003,the Company entered into a Limited Liability Company (“Chino LLC”) jointventure agreement for the purpose of designing, constructing and selling 77homes in Chino, California. The Chino LLC acquired the 77 lots in May 2003and began construction during the fourth quarter of 2003.  The Company delivered 65 homes during 2004,eight homes during the first nine months of 2005, and the remaining four homesduring the fourth quarter of 2005.  HearthsideHomes, Inc. (one of the Company’s principal subsidiaries) is the managingmember of the Chino LLC, manages its operations and contributed capital ofapproximately $400,000 (approximately 10%) to the venture. Minority interestrepresents the non-managing member’s equity interest in the venture including acapital contribution of approximately $4.0 million (approximately 90%), net ofdistributions and as adjusted for the member’s allocation of profits andlosses. Profits and losses are generally allocated 50% to each member, after a10% preferred return on invested capital. During the year ended December 31,2004, capital distributions of approximately $7.6 million were made to thenon-managing member, repaying all of its initial capital contribution, plus all$600,000 of accumulated

 

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preferred return and $3.1million in profit distributions, in conjunction with the delivery of the first65 homes.  During the nine months ended September 30,2005, additional distributions of $425,000 were made to the non-managing memberand the Company recorded minority interest in income of consolidated jointventure of $200,000, net of income tax benefit.

 

**Note 8 -Commitments and Contingencies**

 

*RealEstate Matters*

 

TheCompany is subject to the usual obligations associated with entering intocontracts for the purchase of land and improved home sites. The purchase ofproperties under these contracts is generally contingent upon satisfaction ofcertain requirements by the sellers, including obtaining applicable propertyentitlements. The Company also utilizes option contracts with third-party landsellers and financial entities as a method of acquiring land in stagedtakedowns and minimizing the use of funds from other corporate financingsources. These option contracts also help to manage the financial and market riskassociated with land holdings. Option contracts generally require the paymentof a non-refundable cash deposit of 5% to 15% of the purchase price for theright to acquire lots over a specified period of time (usually one to twoyears) at predetermined prices. The Company has the right at its discretion toterminate its obligations under these land purchase and option agreements byforfeiting the cash deposit with no further financial responsibility.  Summary information regarding the Company’sland option deposits is as follows as of September 30, 2005:

 
| Total number of  projects                                                      |   | 1      |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
|                                                                           |   |   |   |
| Total number of lots                                                           |   | 77     |   |
|                                                                           |   |   |   |
| Total forfeited deposits if lots are not purchased  (included in other assets) |   | $      | .5     |   |
|                                                                           |   |   |   |
| Total remaining purchase price                                                 |   | $      | 8.5    |   |

 

The Company currently expects to complete the purchaseof 77 lots in Lancaster, California during the fourth quarter of 2005.

 

TheCompany has outstanding performance and surety bonds, for the benefit of cityand county jurisdictions, related principally to its obligations for site improvementsat various projects.  The Company doesnot believe that draws upon these bonds, if any, will have a material effect onthe Company’s financial position, results of operations or cash flows.

 

*LegalProceedings*

 

See Note 5 for a discussion of settled litigationfiled against the Company by Dresser.

 

There are various other lawsuits and claims pendingagainst the 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.

 

*CorporateIndemnification 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 DISCUSSION AND ANALYSIS OFFINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

**Overview**

 

The Company is a residential land development andhomebuilding company with properties owned or controlled  in six Southern California counties (Ventura,Los Angeles, San Bernardino, Riverside, Orange and San Diego). The principalactivities of the Company and its consolidated subsidiaries include: (i) obtainingzoning and other entitlements for land it owns or controls through purchaseoptions and improving the land for residential development; and (ii) designing,constructing and selling single-family homes in Southern California. Once theresidential land owned by the Company is entitled, the Company may build homes,sell unimproved land to other developers or homebuilders, sell improved land tohomebuilders, or participate in joint ventures with other developers, investorsor homebuilders to finance and construct infrastructure and homes. During theremainder of 2005, the Company will focus its immediate efforts to (i) satisfythe conditions required to complete the process of obtaining a CoastalDevelopment Permit (“CDP”) from the California Coastal Commission (“CoastalCommission”) to build 349 homes on 68 acres of its approximately 105-acre upperbench of the Bolsa Chica Mesa (“Upper Mesa”), as further described in Note 3 tothe Company’s Consolidated Financial Statements; and (ii) continue toexpand its profitable homebuilding operations. However, the Company may alsoconsider other strategic and joint venture opportunities; and there can be noassurance that the Company will accomplish, in whole or in part, all or any ofthese strategic goals.

 

The Company currently has on-going Southern Californiaprojects in Riverside County near the cities of North Corona and Riverside, inthe cities of Chino and Ontario in San Bernardino County, in the city ofLancaster in northern Los Angeles County, and in the Rancho Santa Fe area inSan Diego County.  These homebuildingprojects are currently expected to generate cash flows and gross operatingmargins through mid-2008.  With the April 14,2005 Coastal Commission approval of 349 homes on the Upper Mesa, the Company’sinventory of entitled land available for homebuilding projects represents approximatelya three-year (2006-2008) supply at levels at or above recent years.  The Company is continuing to pursueresidential lot acquisition opportunities throughout Southern California,including increasing lot inventory in existing successful submarkets andexpansion into additional submarkets.  Inaddition, if the Company obtains entitlements for its project in Oxnard,California, up to approximately 550 additional single-family lots would beavailable for homebuilding operations, however, these numbers are subject tochange during the course of the entitlement process.

 

Bolsa Chica is the Company’s principal asset,representing 48% of total assets at September 30, 2005. On April 14,2005, the Company obtained approval from the Coastal Commission for a CDP tobuild 349 homes on the Upper Mesa, subject to satisfying the Coastal Commission’spermit conditions.  On October 5,2005, the County of Orange approved modifications to the Company’s site planand on October 18, 2005 approved the tentative tract map for 349homes.  This approval was necessary tocomply with the California Coastal Commission’s conditions of approval for aCDP. The Company is working diligently to satisfy the various conditionsnecessary for the Coastal Commission to issue the permit.  The Company is striving to: (i) satisfythe conditions for issuance of the CDP by the end of 2005, (ii) begingrading during the second quarter of 2006, (iii) begin building modelhomes during the third quarter of 2006, and (iv) start selling homes duringthe first quarter of 2007.  However,there can be no assurance in that regard, or as to the absence of furtheradministrative delay.

 

The planned community on the Upper Mesa, known as “Brightwater,”will offer a broad mix of home choices averaging 2,800 square feet and rangingin size from 1,600 square feet to 4,000 square feet.  The plan also includes 37 acres of open spaceand conservation area. With only 349 homes on 68 acres of the Upper Mesa, theresulting low-density plan equates to approximately 5 homes per acre,consistent and compatible with the neighboring Huntington Beach communities. Inaddition, the Company will offer to dedicate 51 acres of land on the HuntingtonMesa to the County of Orange to complete the Harriett M. Wieder Linear Park.The 1,200-acre state-owned Bolsa Chica Wetlands are fully preserved andprotected in accordance with previous agreements with the State of Californiaand are not included in the Brightwater plan.

 

On August 12, 2004, an agreement to sell a 103-acreparcel of the Bolsa Chica Mesa known as the “Lower Bench” to the State’sWildlife Conservation Board (“WCB”) for $65 million was approved by theWCB.  The sale was approved by the Company’sstockholders at the August 11, 2005 Annual Meeting, subject to the issuanceof the CDP prior to the outside closing date of December 31, 2005. If theproposed sale is completed, WCB’s purchase of the property will be funded withbond proceeds authorized by voter-approved Proposition 50, which was passed in

 

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November 2002. The Company is striving to satisfy the conditionsfor issuance of the CDP by the end of 2005; however, there can be no assurancesthat the CDP will be issued before December 31, 2005 or that the sale willbe completed.

 

The following facts and assumptions were utilized bythe Company in evaluating the potential value which is expected to be derivedfrom development of the Upper Mesa:

 

•                  The Upper Mesa development planencompasses 349 homes aggregating approximately 980,000 square feet.

•                  Following the Coastal Commission’sapproval on April 14, 2005, the Company currently expects it may take untilthe end of 2005 to satisfy the Commission’s permit conditions, which are apre-requisite to issuance of a CDP.

•                  Following receipt of a CDP, the UpperMesa development is projected to take approximately six months forinfrastructure and two to three years for home construction.

•                  The Company is striving to begingrading during the second quarter of 2006, begin building model homes duringthe third quarter of 2006, and start selling homes during the first quarter of2007.

•                  As of June 2005, new home pricesapproximated $580 per square foot, including view and other premiums, in thelocal residential market (coastal Huntington Beach). Approximately 60 homes areexpected to have unobstructed views of the Pacific Ocean and/or the Bolsa ChicaWetlands.

•                  The finished lot component of homeprices ranges from 60% to 65%.

•                  Costs to improve the lots from theirraw condition to finished lots approximate $120,000 per lot.

•                  Home prices in the coastal HuntingtonBeach area (as well as other Orange County coastal areas) appreciatedapproximately 20% during 2004 and approximately 14% during the first ninemonths of 2005.  While demand continuesto exceed the supply of housing, pressure for continued appreciation of homeprices may be reduced by any significant increases in interest rates and/orreduced affordability.

•                  Generally, homebuilders expect toearn a gross profit of at least 8% of the sales price of homes at the time theland is purchased.

 

Real estate held for current development or sale andland held for future development (real estate properties) are carried at fairvalue as of September 2, 1997, following adoption of Fresh-Start Reportingas discussed in Note 2 to the Consolidated Financial Statements, as adjusted bysubsequent activity. The Company’s real estate properties are subject to anumber of uncertainties which can affect the values of those assets. Theseuncertainties include litigation or appeals of regulatory approvals (asdiscussed above) and availability of adequate capital, financing and cash flow.In addition, future values may be adversely affected by increases in propertytaxes, increases in the costs of labor and materials and other developmentrisks, changes in general economic conditions, including higher mortgage interestrates, and other real estate risks such as the general demand for housing andthe supply of competitive products. Real estate properties do not constituteliquid assets and, at any given time, it may be difficult to sell a particularproperty for an appropriate price.

 

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

 

Real estate and residential housing prices areaffected by inflation, which can cause increases in the price of land, rawmaterials and subcontracted labor. Unless these increased costs are recoveredthrough higher sales prices, gross margin from home sales would decrease. Ifinterest rates increase, construction and financing costs would also increase,which can also result in lower gross margin from home sales. The volatility ofinterest rates could have an adverse effect on the Company’s future operationsand liquidity. Among other things, these conditions may affect adversely thedemand for housing and the availability of mortgage financing and may reducethe credit facilities offered to the Company.

 

There can be no assurance regarding the continuedhealth of the Southern California residential real estate market.  In particular, (i) the significantincreases in home prices over the last six years and the related decline in theaffordability of new homes in Southern California, (ii) the state of thenational economy, continued increases in interest rates by the Federal ReserveBoard and the possibility of a recession in the future, (iii) the State ofCalifornia’s budget deficit, and (iv) the volatility in the stock market,collectively may exert recessionary pressures on the California economy and mayhave a negative impact on the Southern California housing market.

 

While low mortgage rates have sustained housing demandto date, interest rates have been rising and any significant future increase inmortgage rates or significant loss of jobs in Southern California would mostlikely slow demand for new homes. Increases in home mortgage interest ratescould make it more difficult for the Company’s customers to qualify for homemortgage loans, potentially decreasing home sales volume and prices. The tightsupply of available homes in Southern California has resulted in significanthome price increases over the last six years. As a result,

 

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the affordability of new homes has been declining and could jeopardizefuture demand.  The percentage of homebuyers utilizing variable-rate and/or interest only mortgages to affordSouthern California new home prices has been increasing.  These buyers may be more sensitive toincreases in interest rates and may encounter difficulty in making increasedmortgage payments on their homes in the future. This could have negative consequences on the demand for new homes if itresults in reduced buyer confidence and an increase in secondary market homesavailable for sale, competing with sales of new homes.

 

Most of the Company’s active homebuilding projects arelocated in the “Inland Empire” area of Southern California, which includesRiverside and San Bernardino counties. None of the Company’s projectsexperienced any direct impact from the Southern California landslides in early2005. The Inland Empire has experienced significant population and job growthin the past decade. While continued population growth and demand for new homesare expected to continue, partially due to the limited supply of affordablypriced housing in coastal areas such as Orange County, there can be noassurance that economic, demographic or other factors will not slow, diminishor cause such growth to diminish or cease. The Company is continuing to pursueland development and lot acquisition opportunities throughout SouthernCalifornia.

 

**CriticalAccounting Policies**

 

In the preparation of the Consolidated FinancialStatements, the Company applies accounting principles generally accepted in theUnited States. The application of generally accepted accounting principles mayrequire management to make estimates and assumptions that affect the amountsreported in the financial statements and accompanying results. Listed below arethose policies that the Company believes are critical and require the use ofcomplex judgment in their application. In particular, the Company’s criticalaccounting policies include the evaluation of the impairment of long-livedassets and the evaluation of the probability of being able to realize thefuture benefits indicated by its significant federal tax net operating losses,as discussed further in Notes 2 and 6 to the Consolidated Financial Statements.

 

*Impairmentof Long-Lived Assets*

 

The Company assesses the impairment of land held forfuture development (the Bolsa Chica project) and real estate held for currentdevelopment or sale including long-lived assets in accordance with Statement ofFinancial Accounting Standards (“SFAS”) No. 144, “Accounting for theImpairment or Disposal of Long-Lived Assets”. These assets are carried at cost,unless the carrying amount of the parcel or subdivision is determined not to befully recoverable, in which case the impaired real estate is written down tofair value. Given the significance of the carrying value of land held forfuture development, the application of SFAS No. 144 in evaluating anypotential impairment is critical to the Company’s consolidated financialstatements, as discussed further in Notes 2 and 3 to the Consolidated FinancialStatements.

 

In accordance with SFAS No. 144, in developingestimated future cash flows for impairment testing, the Company has incorporatedits own assumptions regarding the entitlement prospects of land held for futuredevelopment and its own market assumptions including those regarding homeprices, infrastructure and home-building costs regarding both land held forfuture development and real estate held for current development or sale.  Additionally, as appropriate, the Companyidentifies alternative courses of action to recover the carrying value of itslong-lived assets and evaluates all likely alternatives under a probability-weightedapproach as described in SFAS No. 144.

 

*Basis ofConsolidation*

 

Certain wholly-owned subsidiaries of the Company aremembers in joint ventures involved in the development and sale of residentialprojects and residential loan production. The consolidated statements of theCompany include the accounts of the Company and all majority-owned andcontrolled subsidiaries and joint ventures. The financial statements of jointventures in which the Company generally has a controlling or majority economic interest(and thus are controlled by the Company) are consolidated with the Company’sfinancial statements. Minority interest represents the equity interest of theCompany’s joint venture partner for one consolidated venture and is furtherdescribed in Note 7 to the Consolidated Financial Statements. The Company’sinvestments in unconsolidated joint ventures are accounted for using the equitymethod when the Company does not have voting or economic control of the ventureoperations, as further discussed in Land Development - Unconsolidated JointVenture below.

 

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*IncomeTaxes*

 

The Company accounts 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 (“NOLs”). A valuation allowance related to the deferred tax asset isrecorded when it is more likely than not that some portion or all of thedeferred tax asset will not be realized. Given the significance of the Company’shistorical federal tax NOLs, as discussed in Note 6 to the ConsolidatedFinancial Statements, the application of the Company’s policy in evaluating theexpected future benefit of NOLs is critical. In applying those policies,estimates and judgments affect the amounts at which certain assets andliabilities are recorded. The Company applies its accounting policies on aconsistent basis. As circumstances change, they are considered in the Company’sestimates and judgments, and future changes in circumstances could result inchanges in amounts at which assets and liabilities are recorded.

 

*HomebuildingRevenues and Cost of Sales*

 

The Company’s homebuilding operation generatesrevenues from the sale of homes to homebuyers. The majority of these homes aredesigned to appeal to move-up homebuyers and the homes are generally offeredfor sale in advance of their construction. Sales contracts are usually subjectto certain contingencies such as the buyer’s ability to qualify for financing.Revenue from the sale of homes is recognized at closing when title passes tothe buyer, and the earnings process is complete. As a result, the Company’srevenue recognition process does not involve significant judgments orestimates. However, the Company does rely on certain projections and estimatesto determine the related construction costs and resulting gross marginsassociated with revenues recognized. The cost of sales is recorded based upontotal estimated costs within a subdivision and allocated using the relativesales value method. The Company’s construction costs are comprised of directand allocated costs, including estimated costs for future warranties andindemnities. The Company’s estimates are based on historical results, adjustedfor current factors.

 

*LitigationReserves*

 

The Company and certain of its subsidiaries have beennamed as defendants in various cases arising in the normal course of businessand regarding disposed assets and businesses of the Company or formeraffiliates (see Notes 5 and 8 to the Consolidated Financial Statements). TheCompany has reserved for costs expected to be incurred with respect to thesecases based upon information provided by its legal counsel. There can be noassurance that total litigation costs actually incurred will not exceed theamount of such reserve.

 

**RecentAccounting Pronouncements**

 

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

 

**Liquidityand Capital Resources**

 

The principal assets in the Company’s portfolio areresidential land which must be held over an extended period of time in order tobe developed to a condition that, in management’s opinion, will ultimatelymaximize the return to the Company. Consequently, the Company requiressignificant capital to finance its real estate development and homebuildingoperations. Historically, sources of capital have included loan facilitiessecured by specific projects, asset sales and available internal funds. TheCompany is utilizing internally generated cash to fund its Bolsa Chica landdevelopment project and joint venture contributions to fund the Oxnard landdevelopment project.   The Company isutilizing internally generated cash and project debt to fund construction ofits homebuilding projects. The Company’s current and pending homebuildingprojects, (excluding Bolsa Chica) which are primarily in the “Inland Empire”area of Southern California (Riverside and San Bernardino counties) andLancaster in northeastern Los Angeles County, are currently expected togenerate approximately $59.0 million of positive cash flows during the next threeyears, after net investments in new projects to acquire 77 lots, based onpresent economic conditions and market assumptions. However, any adverse changein such conditions or assumptions would adversely impact the amount of theCompany’s cash flows. The Company’s unrestricted cash and cash equivalents asof September 30, 2005 were approximately $5.8 million. The Companybelieves that its cash and cash equivalents, future real estate sales proceeds,and funds available under its credit agreements will be sufficient to meetanticipated operating and capital investment requirements, primarily projectdevelopment costs for homebuilding projects, and the Oxnard and Bolsa Chicaland development projects, along with general and administrative expenses, forthe next 12 months.

 

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The Company is subject to the usual obligationsassociated with entering into contracts for the purchase of land and improvedhome sites. The purchase of properties under these contracts is generallycontingent upon satisfaction of certain requirements by the sellers, includingobtaining applicable property entitlements. The Company also utilizes optioncontracts with third-party land sellers and financial entities as a method ofacquiring land in staged takedowns and minimizing the use of funds from othercorporate financing sources. These option contracts also help to manage thefinancial and market risk associated with land holdings. Purchase and 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.

 

Summary information regarding the Company’s landoption deposits is as follows as of September 30, 2005:

 
| Total number of  projects                                                      |   | 1      |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
|                                                                           |   |   |   |
| Total number of  lots                                                          |   | 77     |   |
|                                                                           |   |   |   |
| Total forfeited  deposits if lots are not purchased (included in other assets) |   | $      | .5     |   |
|                                                                           |   |   |   |
| Total remaining  purchase price                                                |   | $      | 8.5    |   |

 

The Company currently expects to complete the purchaseof 77 lots in Lancaster, California during the fourth quarter of 2005.

 

 The Company mayenter into land development and homebuilding joint ventures from time to timeas a means of expanding its market opportunities, establishing strategicalliances, managing its risk profile and leveraging the Company’s capital base.These joint ventures may obtain secured acquisition, development andconstruction financing, which minimize the use of funds from other corporatefinancing sources.

 

**LandDevelopment - Unconsolidated Joint Venture**

 

*Oxnard.*  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 anadditional 149 acres owned by other landowners, with the intention of entitlingthe property for residential development and annexing it to the City of Oxnard.The Company currently expects that the residential development plan willinclude approximately 700 single-family detached lots and approximately 800 attachedfamily residential units; however, these numbers are subject to change duringthe course of the entitlement process. Approximately 550 of the single-familylots and 339 of the attached units would be developed on the 168 acres ofoptioned land expected to be purchased by the Company.  The option contracts allow for two years,plus up to three additional years through the exercise of extensions, for theCompany to complete these entitlement activities in advance of consummating thepurchase transactions. The entitlement process is expected to be completedduring the third quarter of 2006; however, delays could be encountered.  During January and July 2005, thefirst and second six-month option extensions were exercised.  The option-holder has the right in its solediscretion to terminate the obligations under these option agreements byforfeiting the cash deposits with no further financial responsibility.

 

During October 2003, the Company entered into ajoint venture agreement with a major financial partner to form a limitedliability company (“Oxnard LLC”) to pursue the Oxnard development opportunity.The Company assigned the land purchase option contracts to the Oxnard LLC.  Hearthside Homes, Inc. (the Company’shomebuilding subsidiary) is the managing member of the Oxnard LLC, and hascontributed $500,000 to the venture. The non-managing member also made aninitial contribution of $500,000 to the venture. Capital contributions of up toan additional $4 million are to be made by the non-managing member. As of September 30,2005, the non-managing member had made an aggregate of approximately $3.9million of additional contributions. Under the Oxnard LLC operating agreement,if contributions in excess of $5 million are required and approved by themembers, the next $1 million would be contributed equally by the members.  Total contributions of the non-managing memberare generally limited to $5 million. After payment of a 10% preferred return oninvested capital to each member, first tier profits are generally allocated 75%to the non-managing member and 25% to the managing member and second tierprofits and losses over $5 million are generally allocated 50% to each member.The first $5 million of losses are generally allocated 80% to the non-managingmember and 20% to the managing member. While the Company exerts a large degree of influence over

 

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the venture, the non-managing member does have various participatingrights such as approval rights with regard to major business decisions.  In addition, the Company is not the primarybeneficiary of the entity; therefore, the venture is not consolidated.

 

**Homebuilding**

 

The Company acquired 265 single-family residentiallots during 2004, increasing lot inventory in Riverside and San BernardinoCounties and expanding into northern Los Angeles County and returning to theSan Diego County market.  The Companyalso acquired an additional 357 lots during the first nine months of 2005, whichincreased inventory in existing markets, and entered into an agreement toacquire an additional 77 lots in Lancaster. Although home prices in Southern California have increased 20% to 30% annuallyover the last few years, the Company does not expect appreciation to continueat that rate, but rather expects modest increases of less than 20% over thenext year.  While the 59 home deliveriesfor the first nine months of 2005 are less than the 73 homes delivered in thefirst nine months of 2004, per unit homebuilding revenues and margins for 2005exceeded the nine-month 2004 results.  Therecord rainfall during the last quarter of 2004 and the first quarter of 2005negatively impacted the Company’s construction schedule and contributed tothe Company’s lower number of home deliveries during the first nine months of2005.  The Company expects a robust fourthquarter, as in recent prior years.  TheCompany’s active homebuilding projects are described below.

 

*Riverside.*  During 2003 and 2004, the Company acquired 67lots for a project known as “Jasper Ranch” near the city of Riverside, inRiverside County, in the master-planned community known as “Victoria Grove”.The Company began construction of homes averaging 3,673 square feet during thethird quarter of 2003 and opened for sales on these homes during June 2003.The Company delivered the first phase of five homes during the fourth quarterof 2003 at an average price of approximately $468,000, and an additional 38homes during 2004, at an average price of approximately $612,000. The Companydelivered 21 additional homes (some with views) during the first nine months of2005 at an average price of $695,000 and delivered an additional two homesduring October 2005.  As of November 1,2005, the remaining home is held for sale.

 

*Chino.*  In May 2003, through a consolidatedjoint venture, the Company acquired 77 finished lots in Chino, California inSan Bernardino County. This infill site is part of a new community known as “TheReserve”, encompassing 244 homes. Construction of homes averaging approximately3,320 square feet began during the fourth quarter of 2003. The Company openedfor home sales in February 2004, delivered 65 homes at an average price of$593,000 during 2004, delivered eight homes during the first nine months of2005 at an average price of $600,000 and as of November 1, 2005, the finalfour homes were delivered.

 

During January 2004, the Company acquired 17additional finished lots in the City of Chino which are near, but not a part ofThe Reserve, and are not a part of the joint venture described above. TheCompany began construction of homes averaging 2,990 square feet during thefourth quarter of 2004.  The Companyopened for sales at this project during January 2005 and delivered all 17homes during the third quarter of 2005 at an average price of $568,000.

 

*Corona.*  The Company acquired 83 lots in North Coronain May 2004.  Following constructionof infrastructure, during April 2005, the Company began construction of homesaveraging 3,160 square feet.  The Companyopened for sales during the third quarter of 2005 and as of November 1,2005, 43 homes have been released for sale and 39 are in escrow at an averageprice of $593,000.

 

*Rancho Santa Fe.*  In October 2003, the Company enteredinto an agreement to acquire 32 lots in a luxury golf community known as CrosbyEstates in the Rancho Santa Fe area of California in San Diego County. TheCompany acquired eight of the lots during the fourth quarter of 2003, 18additional lots during 2004 and the final six lots during March 2005.  Two model homes were recently completedaveraging approximately 3,370 square feet. Of the 24 homes released for sale as of November 1, 2005, 16 homesare in escrow at an average price of $1,290,000.

 

*Lancaster.*   The Company acquired 104 lots in the city ofLancaster in northern Los Angeles County during May 2004. The Companybegan construction of model homes averaging approximately 2,800 square feetduring the third quarter of 2004.  TheCompany opened for sales of the first phase in January 2005, and hasreleased a total of 78 homes.  TheCompany delivered the first 13 homes of this project during the third quarterof 2005, five homes in October and as of November 1, 2005, 59 ofthese homes are in escrow at an average price of $410,000.  During April 2005, the Company acquiredan additional 72 lots in Lancaster, which will be marketed through the existingmodel homes.

 

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*Ontario.  *DuringApril 2005, the Company acquired 26 lots in the City of Ontario inRiverside County, California.  This smallcommunity of homes, planned to average 3,380 square feet, is an infill sitesituated very close to the Company’s projects in the City of Chino.  The project is currently scheduled forconstruction to start during the fourth quarter of 2005.

 

**FinancialCondition**

 

*September 30,2005 Compared with December 31, 2004*

 

Cash flows from homebuilding operations for the first ninemonths of 2005 primarily reflect a use of cash for investments in real estateand construction costs of $92.5 million, including acquisitions of an aggregateof 357 lots.   Additional significant uses of cash includeapproximately $1.9 million for investment in the Bolsa Chica Mesa project,primarily for consultants engaged in the entitlement process, and selling,general and administrative expenses of approximately $3.4 million. The primarysources of cash during the period were real estate sales proceeds of $34.0million from deliveries of 59 homes, and net borrowing under project debtfinancing of $58.8 million. These items, as well as other activity presented inthe Statements of Cash Flows, resulted in a $3.2 million decrease in cash andcash equivalents.

 

The $66.1 million increase in real estate held forcurrent development or sale reflects the purchase of the 357 lots describedabove, including six lots in the Rancho Santa Fe area of San Diego County, 26in Ontario, 151 in Corona, 72 in Lancaster and 102 in Beaumont, along with projectconstruction costs, partially offset by reductions to real estate recorded uponthe deliveries of 59 homes.

 

Accounts payable and accrued liabilities decreased by$900,000, to a balance of $14.1 million as of September 30, 2005,primarily reflecting payment of accrued liabilities for profit-based incentivecompensation in the first quarter of 2005.

 

The $38.8 million increase in capital in excess of parvalue primarily reflects the reversal of $38.5 million of valuation reserves onpre-Reorganization federal NOLs expected to be utilized in the future as aresult of the development of the Upper Mesa (see Note 6 to the ConsolidatedFinancial Statements).  An increase ofapproximately $300,000 for issuance of common stock pursuant to optionexercises, and the related state tax effect, is also reflected in capital inexcess of par value.

 

**Resultsof Operations**

 

The nature of the Company’s business, including itslimited inventory of buildable lots, is such that the number, location and specificmarket conditions of active selling communities over any given time period maycause significant fluctuations in operating results from quarter-to-quarter andfrom year-to-year.

 

* Three Months Ended September 30, 2005Compared with the Three Months Ended September 30, 2004*

 

The Company reported revenues of $24.4 million andgross operating profit of $4.9 million for the third quarter of 2005, comparedwith $28.4 million in revenues and gross operating profit of $6.0 million forthe same period of 2004. Revenues in the current period reflect an aggregate of45 homes delivered, including deliveries of 11 homes at the “Jasper Ranch” projectin Riverside, 21 homes at the Chino projects and 13 homes at the Lancasterproject.  The comparable period of theprior year reflects an aggregate of 53 deliveries, including 18 homes at aNorth Corona project and 35 homes at the Chino project.

 

The average price of homes delivered increased to $542,000in the third quarter of 2005 from $536,000 during the third quarter of 2004,while the current quarter gross margin of 20.1% is slightly less than the priorperiod homebuilding gross margin of 21.1%. The changes primarily reflect varying levels of price appreciationrelated to variations in the holding periods for the land underlying the homesdelivered.  The Company generated $1.1 millionless in gross operating profit from home sales during the third quarter of 2005compared with the same period of 2004, while delivering eight fewer homes (45vs. 53).

 

Selling, general and administrative expenses duringthe third quarter of 2005 are $200,000 less than the third quarter of 2004,primarily reflecting the absence in 2005 of non-cash compensation expenserecorded in 2004 pursuant to the vesting of certain stock options.

 

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*Nine Months Ended September 30, 2005 Comparedwith Nine Months Ended September 30, 2004*

 

The Company reported revenues of $34.0 million andgross operating profit of $7.5 million for the first nine months of 2005compared with $37.2 million in revenues and gross operating profit of $8.4million for the first nine months of 2004. Although the Company’s revenues during the current nine-month periodwere lower than the prior nine-month period, the average revenue per homeincreased by $68,000 to $576,000.  Revenuesin the first nine months of 2005 reflect deliveries of 59 homes, including 25homes at the Company’s Chino projects, 21 homes at the Company’s Riverside(Jasper Ranch) project, and 13 homes at the Lancaster project.  The comparable period of the prior yearreflects an aggregate of 73 homes including six homes at the Jasper Ranchproject, 32 homes at the North Corona project, 35 homes at the Chino projectand a $100,000 land sale.  Thehomebuilding gross margin for the first nine months of 2005 of 22.1% is comparableto the prior period gross margin of 22.4%, while the per unit average grossmargin increased by $13,000 to $127,000.

 

The $100,000 of income from unconsolidated jointventures for the first nine months of 2005 compared with $300,000 for the firstnine months of 2004 primarily reflects fewer home loans made through theCompany’s joint venture during the first nine months of 2005 as compared withthe first nine months of 2004.  Thisreduced volume correlates to fewer home deliveries during the current yearperiod and a significantly reduced number of refinance loans generated.

 

During the quarter ended March 31,2005, the Company recorded reversals of valuation allowances on post-ReorganizationNOLs of $4.7 million following the Coastal Commission’s approval of thedevelopment plan for 349 homes on the Upper Mesa (see Note 6), which isreflected for the nine months ended September 30, 2005.  During the nine months ended September 30,2004, the Company recorded a tax benefit of approximately $100,000 inconnection with the reduction in reserves for contingent tax liabilities tozero, due to the resolution of outstanding tax matters in two states.

 

*Payments Under ContractualObligations*

 

The Company has entered into certain contractualobligations to make future payments for items such as project debt and leaseagreements.  A summary of the paymentsdue under specified contractual obligations, aggregated by category ofcontractual obligation, for specified time periods is presented below as of September 30,2005 (in millions):

 
| ** **       | ** ** | **Payments due by period** | ** ** |
|------------------|------------|----------------------------|------------|
| ** **       | ** ** | ** **                 | ** ** | **Less** | ** ** | ** ** | ** ** | ** ** | ** ** | **More** | ** ** |
| ** **       | ** ** | ** **                 | ** ** | **than 1** | ** ** | **1-3** | ** ** | **3-5** | ** ** | **than 5** | ** ** |
| ** **       | ** ** | **Total**                  | ** ** | **year** | ** ** | **years** | ** ** | **years** | ** ** | **years** | ** ** |
|             |       |                       |       |   |   |   |   |   |   |   |   |
| Project debt     |       | $                          | 81.4       |   | $ | 65.4 |   | $ | 16.0 |   | — |   | — |   |
| Operating leases |       | .3                         |       | .2 |   | .1 |   | — |   | — |   |
| Total            |       | $                          | 81.7       |   | $ | 65.6 |   | $ | 16.1 |   | — |   | — |   |

 

The Company’s purchase contracts which are made in thenormal course of its homebuilding business for land acquisition andconstruction subcontracts are generally cancelable at will. Other contractualobligations including the Company’s other tax liabilities, accrued benefitliability for a frozen retirement plan and other accrued pensions, homewarranty reserves and contingent indemnity and environmental obligations areestimated based on various factors. Payments are not due as of a given date,but rather are dependent upon the incurrence of professional services, thelives of annuitants and other factors. The estimation process involved in thedetermination of carrying values of these obligations is inherently uncertainsince it requires estimates as to future events and contingencies. The Companyhas provided additional disclosure in its Consolidated Financial Statements in Notes5 and 6 – Other Liabilities.

 

**ForwardLooking Statements**

 

This quarterly report on Form 10-Q containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934 that relate to future events or the Company’s future financialperformance.  In addition, otherstatements the Company may make from time to time, such as press releases, oralstatements made by Company officials and other reports the Company files withthe Securities and Exchange Commission, may also contain such forward-lookingstatements.  Undue reliance should not beplaced on these statements which involve known and unknown risks, uncertaintiesand other factors which may cause the Company’s

 

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actual results, performance or achievements to be materially differentfrom any future results, performances or achievements expressed or implied bythe forward-looking statements.  In somecases, you can identify forward-looking statements by terminology such as “may”,“will”, “should”, “expects”, “plans”, “anticipates”, “believes”, “estimates”, “predicts”,“potential”, “continue”, or the negative of such terms or other comparableterminology.

 

These forward-looking statements include, but are notlimited to: (1) statements about the Company’s strategies, plans,objectives, goals, expectations and intentions; (2) the impact ofdemographic trends and supply constraints on the demand for and supply ofhousing; (3) housing market conditions in the geographic markets in whichwe operate; (4) the number and types of homes and number of acres of landthat the Company may develop and sell; (5) the timing and outcomes ofregulatory approval processes or administrative proceedings, which may resultin delays in the land entitlement, development, construction, or the opening ofnew communities (including, but not limited to ongoing administrativeproceedings related to the Company’s principal asset, the Bolsa Chica Mesa); (6) theCompany’s ability to realize the value of its net operating loss carryforwards; (7) the completion of the pending $65 million sale of the lowerbench of the Bolsa Chica Mesa to the State of California’s WildlifeConservation Board; (8) the Company’s ability to continue relationshipswith current or future partners; (9) the effectiveness and adequacy of theCompany’s disclosure and internal controls; and (10) the impact of recentaccounting pronouncements.

 

Forward-looking statements are based on currentexpectations or beliefs regarding future events or circumstances, and youshould not place undue reliance on these statements. Such statements involveknown and unknown risks, uncertainties, assumptions and other factors, many ofwhich are out of our control and difficult to forecast, that may cause actualresults to differ materially from those that may be described or implied. Suchfactors include but are not limited to: (1) the future condition of thereal estate market in Southern California affecting local and general economicand market conditions, including consumer confidence, employment rates,interest rates, the cost and availability of mortgage financing, and stockmarket, home and land valuations; (2) the ability to react to increases ordecreases in demand for housing and to rapidly take advantage of local marketopportunities as they arise; (3) the sufficiency of our capital resourcesand ability to access additional capital; (4) the Company’s ability toexpend resources to comply with environmental regulations and local permittingrequirements; (5) the effect of certain costs, contractual obligations andtax liabilities, both known and unknown, on the Company’s business, results ofoperations and financial condition; (6) the condition and adequacy of theCompany’s properties; (7) the Company’s ability to estimate cash flowprojections due to uncertainties in valuing real property; (8) the Company’sability to acquire residential lots in order to continue homebuildingoperations; (9) delays in the land entitlement and other approvalprocesses, development, construction, or the opening of new home communities; (10) theadequacy of capital, financing and cash flow required to continue the Company’soperations and land development activities; (11) the cyclical and competitivenature of the homebuilding business; (12) the availability and cost of rawmaterials used by the Company in its homebuilding operations; (13) homebuildinglitigation and warranty claims; (14) shortages and the cost of labor; (15)adverse weather conditions and natural disasters; (16) governmental regulation,including “slow growth,” “no growth” or similar initiatives or moratoria, theinterpretation of tax, labor and environmental laws;  (17) the impact on economic conditions ofterrorist attacks or the outbreak or escalation of armed conflict involving theUnited States; (18) other risks discussed in our filings with the Securitiesand Exchange Commission, including in our most recent Annual Report on Form 10-K;and (19) other factors over which the Company has little or no control.

 

The Company assumes no, and hereby disclaims any,obligation to update any of the foregoing or any other forward-lookingstatements.  The Company nonethelessreserves the right to make such updates from time to time by press release, periodicreport or other method of public disclosure without the need for specificreference to this report.  No such updateshall be deemed to indicate that other statements not addressed by such updateremain correct or create an obligation to provide any other updates.

 

**ProhibitionAgainst Becoming a 5% Stockholder and No Further Acquisitions by Current 5% orGreater Stockholders**

 

Unless the Company has previously consented in writing(i) no stockholder holding less than 5% of the outstanding shares of theCompany’s Common Stock may acquire additional shares of Common Stock in anamount that would take such shareholder to 5% or more; and (ii) no current5% or greater stockholder may acquire any additional shares.  The foregoing prohibition is contained in theCompany’s charter documents, in order to preserve the tax benefits of theCompany’s $168 million of NOLs.  Allacquisitions of the Company’s Common Stock in violation of its charterprohibitions are null and void, and the Company is empowered to effectivelyrescind such acquisitions.  The Company mayentertain requests for permission to exceed the limitations on stockacquisitions in the future, if the Company’s board of directors determines thatsuch acquisitions would not jeopardize the Company’s ability to preserve anduse its NOLs.

 

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ITEM 3 - QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company utilizes project debt financing foracquisition, development and construction of homes. The interest rates on theCompany’s project debt approximate the current rates available for secured realestate financing with similar terms and maturities, and as a result, theircarrying amounts approximate fair value. While changes in interest rates generallydo not impact the fair market value of the debt instrument, they do affect theCompany’s earnings and cash flows. Holding the Company’s variable rate debtbalance constant as of September 30, 2005, each one point percentageincrease in interest rates would result in an increase in variable rateinterest incurred for 2005 of approximately $700,000.

 

ITEM 4 - EVALUATION OFDISCLOSURE CONTROLS AND PROCEDURES

 

**General**

 

The Company maintains disclosure controls andprocedures that are designed to ensure that information relating to the Company(including its consolidated subsidiaries) required to be disclosed in theCompany’s periodic filings with the Securities and Exchange Commission (“SEC”)is recorded, processed, summarized and reported within the time periodsspecified in the SEC’s rules and forms, and that such information isaccumulated and communicated to the Company’s management, including its ChiefExecutive Officer and Chief Financial Officer, as appropriate, to allow timelydecisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures,management recognizes that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving thedesired control objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

**Effectiveness of Disclosure Controls andProcedures**

 

As of September 30, 2005, the end of the quartercovered by this report, the Company carried out an evaluation, under thesupervision and with the participation of the Company’s management, includingthe Chief Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of the Company’s disclosure controls andprocedures. Based on the foregoing, the Company’s Chief Executive Officer andChief Financial Officer concluded that the Company’s disclosure controls andprocedures were effective at the reasonable assurance level.  Although the Company’s disclosure controlsand procedures have been designed to provide reasonable assurance of achievingtheir objectives, there can be no assurance that such disclosure controls andprocedures will always achieve their stated goals under all circumstances.

 

**Changes in Internal Control over FinancialReporting**

 

There have been no significant changes that occurredduring the quarter covered by this report in the Company’s internal controlover financial reporting identified in connection with the evaluationreferenced above that has materially affected, or is reasonable likely tomaterially affect, the Company’s internal control over financial reporting.  Changes to certain financial processes,information technology systems and other components of internal control overfinancial reporting may occur in the future and will be evaluated bymanagement.

 

PART II -OTHER INFORMATION

 

ITEM 1 - LEGALPROCEEDINGS

 

See Note 5 to the Consolidated Financial Statementsabove, and “Item 1 - Business - Corporate Indemnification Matters” and “Item 3- Legal Proceedings” in the Company’s Annual Report on Form 10-K/A for theyear ended December 31, 2004.

 

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ITEM 4 - SUBMISSION OFMATTERS TO A VOTE OF SECURITY HOLDERS

 

The Annual Meeting of the Company’sstockholders was held on August 11, 2005. A quorum of common stock waspresent in person or by proxy. The following proposals were approved by therequisite vote of the Company’s stockholders entitled to vote, as follows:

 

ProposalNo. 1:  *The DirectorProposal*.  The Company’sdirector proposal recommended election of four directors to a one-year term.Set forth below is a table of how the votes were cast for each nominee, whichconstituted the affirmative votes for all nominees, by the holders of at least 98.6%of the outstanding Common Stock represented in person or by proxy at the AnnualMeeting.

 
| **Name**                   | ** ** | **Votes Cast “For Nominee”** | ** ** | **Votes “Withheld”** | ** ** |
|----------------------------|------------|----------------------------------------|------------|--------------------------------|------------|
|                       |       |                                   |       |                           |       |
| Geoffrey W.  Arens         |       | 9,563,423                              |       | 115,176                        |       |
| Phillip R.  Burnaman II    |       | 9,560,279                              |       | 118,320                        |       |
| Raymond J.  Pacini         |       | 9,564,879                              |       | 113,720                        |       |
| Thomas W.  Sabin, Jr. |       | 9,542,344                              |       | 136,255                        |       |

 

ProposalNo. 2:     *The BolsaChica Lower Bench Sale Proposal*. The holders of Common Stock cast 8,608,145 votes “for” and 4,927 votes “against”the Company’s proposal to sell the 103-acre Lower Bench of the Bolsa Chica Mesafor $65 million, subject to receipt of a Coastal Development Permit from theCoastal Commission for Upper Bench development. Such votes constituted the affirmative vote “for” the Bolsa Chica LowerBench Sale Proposal by the holders of approximately 88.9% of the outstandingCommon Stock represented in person or by proxy at the Annual Meeting. Therewere 456 abstentions and 1,065,071 broker non-votes by the holders of shares ofCommon Stock with respect to the Bolsa Chica Lower Bench Sale Proposal.

 

ProposalNo. 3:  *The AuditorProposal*.   The holders ofCommon Stock cast 9,674,727 votes “for” and 2,111 votes “against” the Company’sproposal to ratify the appointment of Deloitte & Touche, LLP as theCompany’s independent registered public accounting firm for the fiscal yearending December 31, 2005. Such votes constituted the affirmative vote “for”the Auditor Proposal by the holders of approximately 99.9% of the outstandingCommon Stock represented in person or by proxy at the Annual Meeting. Therewere 1,408 abstentions and 353 broker non-votes by the holders of shares ofCommon Stock with respect to the Auditor Proposal.

 

ITEM 6 - EXHIBITS

 
|   | 31.1   | Certification of  the CEO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                              |
|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                   |
|   | 31.2   | Certification of  the CFO pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                              |
|   |   |                                                                                                                                   |
|   | 32.1   | Certification  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes- Oxley Act of 2002. * |

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*              This certification is being furnished solely toaccompany this report pursuant to 18 U.S.C. Section 1350, and is not beingfiled for purposes of Section 18 of the Securities Exchange Act of 1934,as amended, and is not to be incorporated by reference into any filing of theCompany, whether made before or after the date hereof, regardless of anygeneral incorporation language in such 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:  November 8, 2005 | CALIFORNIA  COASTAL COMMUNITIES, INC. |
|------------------------------|---------------------------------------|
|                         |                                  |
|                         |                                  |
|                         | By:                                   | */s/  Sandra G. Sciutto* |   |
|                         |                                  | SANDRA G.  SCIUTTO |
|                         |                                  | Senior Vice  President and |
|                         |                                  | Chief Financial  Officer |

 

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