**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

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

 

**For the quarterly period ended****June 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  incorporation or organization.) |       | (I.R.S. Employer  Identification No.) |
|                                                             |       |                                  |
| **6 Executive Circle, Suite 250  Irvine, California**       | ** ** | **92614**                             |
| (Address of principal executive offices)                         |       | (Zip Code)                            |

 

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

 

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 |
|-----|--------|----|---|

 

Thenumber of shares of Common Stock outstanding at July 29, 2005 was 10,160,212.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED JUNE 30, 2005

 

I N D E X

 
| Part I -  | Financial Information:     |                                                                                                     |
|----------------|----------------------------|----------------------------------------------------------------------------------------------------------|
|           |                       |                                                                                                     |   |
|           | Item 1 -                   | Consolidated Financial Statements                                                                        |   |
|           |                       |                                                                                                     |   |
|           |                       | Consolidated Balance Sheets -  June 30, 2005 and December 31, 2004 (unaudited)                 |   |
|           |                       |                                                                                                     |   |
|           |                       | Consolidated Statements of  Income -  Three and Six Months Ended June 30, 2005 and 2004 (unaudited) |   |
|           |                       |                                                                                                     |   |
|           |                       | Consolidated Statements of  Cash Flows -  Six Months Ended June 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 6 - Exhibits          |                                                                                                     |
|           |                       |                                                                                                     |   |
| SIGNATURE      |                       |

 

2

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PART I.  FINANCIAL INFORMATION

 

ITEM 1 – FINANCIALSTATEMENTS

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED BALANCESHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                                              | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| ** **                                                                                                                              | ** ** | **2005**          | ** ** | **2004**              | ** ** |
|                                                                                                                                    |       |              |       |                  |       |
| **ASSETS**                                                                                                                              |       |              |       |                  |       |
|                                                                                                                                    |       |              |       |                  |       |
| Cash and cash equivalents                                                                                                               |       | $                 | 5.4        |                  | $          | 9.0 |   |
| Restricted cash                                                                                                                         |       | .6                |       | 1.1                   |       |
| Real estate held for current development or sale                                                                                        |       | 101.9             |       | 49.9                  |       |
| Consolidated real estate to be held for current  development - not owned                                                                |       | —            |       | 24.7                  |       |
| Land held for future development or sale                                                                                                |       | 157.8             |       | 156.4                 |       |
| Deferred tax assets                                                                                                                     |       | 47.6              |       | 3.6                   |       |
| Other assets                                                                                                                            |       | 2.0               |       | 6.1                   |       |
|                                                                                                                                    |       |              |       |                  |       |
|                                                                                                                                    |       | $                 | 315.3      |                  | $          | 250.8 |   |
|                                                                                                                                    |       |              |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                           |       |              |       |                  |       |
|                                                                                                                                    |       |              |       |                  |       |
| Liabilities:                                                                                                                            |       |              |       |                  |       |
| Accounts payable and accrued liabilities                                                                                                |       | $                 | 10.3       |                  | $          | 15.0 |   |
| Project debt                                                                                                                            |       | 73.9              |       | 22.6                  |       |
| Consolidated obligations related to real estate -  not owned                                                                            |       | —            |       | 24.7                  |       |
| Other liabilities                                                                                                                       |       | 7.7               |       | 9.3                   |       |
|                                                                                                                                    |       |              |       |                  |       |
| Total liabilities                                                                                                                       |       | 91.9              |       | 71.6                  |       |
|                                                                                                                                    |       |              |       |                  |       |
| Minority interest                                                                                                                       |       | .1                |       | .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                                                                                                                       |       | 32.9              |       | 28.2                  |       |
| Accumulated other comprehensive loss                                                                                                    |       | (1.7              | )          | (2.6                  | )          |
| Total stockholders’ equity                                                                                                         |       | 223.3             |       | 178.9                 |       |
|                                                                                                                                    |       |              |       |                  |       |
|                                                                                                                                    |       | $                 | 315.3      |                  | $          | 250.8 |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTSOF INCOME

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                                | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                                | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Revenues                                                  |       | $                      | 3.1        |                 | $          | 3.2 |   | $ | 9.6 |   | $ | 8.8 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Costs of sales                                            |       | 2.2                    |       | 2.1                  |       | 7.0 |   | 6.4 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Gross operating profit                                    |       | .9                     |       | 1.1                  |       | 2.6 |   | 2.4 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Selling, general and administrative expenses              |       | .7                     |       | .8                   |       | 1.9 |   | 1.7 |   |
| Interest expense                                          |       | —                 |       | —               |       | — |   | .1 |   |
| Income from unconsolidated joint ventures                 |       | —                 |       | (.1                  | )          | — |   | (.2 | ) |
| Other expense, net                                        |       | .1                     |       | .1                   |       | .3 |   | .1 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Income before income taxes                                |       | .1                     |       | .3                   |       | .4 |   | .7 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Provision (benefit) for income taxes                      |       | .1                     |       | .1                   |       | (4.4 | ) | .2 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Minority interest in income of consolidated joint venture |       | —                 |       | —               |       | .1 |   | — |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Net income                                                |       | —                 |       | .2                   |       | 4.7 |   | .5 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Other comprehensive income, net of income taxes:          |       |                   |       |                 |       |   |   |   |   |
| Minimum pension liability income tax benefit              |       | —                 |       | —               |       | .9 |   | — |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Comprehensive income                                      |       | $                      | —     |                 | $          | .2 |   | $ | 5.6 |   | $ | .5 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Earnings per common share:                                |       |                   |       |                 |       |   |   |   |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Basic                                                     |       | $                      | —     |                 | $          | .02 |   | $ | .46 |   | $ | .05 |   |
| Diluted                                                   |       | $                      | —     |                 | $          | .02 |   | $ | .43 |   | $ | .05 |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Common equivalent shares:                                 |       |                   |       |                 |       |   |   |   |   |
|                                                      |       |                   |       |                 |       |   |   |   |   |
| Basic                                                     |       | 10.2                   |       | 10.1                 |       | 10.2 |   | 10.1 |   |
| Diluted                                                   |       | 10.9                   |       | 10.8                 |       | 10.9 |   | 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)

 
| ** **                                                                 | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                 | ** ** | **June 30,**    | ** ** |
| ** **                                                                 | ** ** | **2005**             | ** ** | **2004** | ** ** |
|                                                                       |       |                 |       |   |   |
| Cash flows from operating activities:                                      |       |                 |       |   |   |
| Net income                                                                 |       | $                    | 4.7        |   | $ | .5 |   |
| Adjustments to reconcile net income to cash used in  operating activities: |       |                 |       |   |   |
| Non-cash interest expense                                                  |       | —               |       | .1 |   |
| Non-cash benefit from reversal of deferred tax asset  allowance            |       | (4.7                 | )          | — |   |
| Gains on sales of real estate held for current  development or sale        |       | (2.6                 | )          | (2.3 | ) |
| Minority interest in income of consolidated joint  venture                 |       | .2                   |       | — |   |
| Proceeds from asset sales, net                                             |       | 9.6                  |       | 8.7 |   |
| Investments in real estate held for current  development or sale           |       | (59.0                | )          | (45.2 | ) |
| Investments in land held for future development or  sale                   |       | (1.4                 | )          | (1.4 | ) |
| Changes in assets and liabilities:                                         |       |                 |       |   |   |
| Decrease in deferred tax and other assets                                  |       | 4.2                  |       | .3 |   |
| Decrease in accounts payable, accrued and other  liabilities               |       | (6.3                 | )          | (2.0 | ) |
|                                                                       |       |                 |       |   |   |
| Cash used in operating activities                                          |       | (55.3                | )          | (41.3 | ) |
|                                                                       |       |                 |       |   |   |
| 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                                                 |       | 58.3                 |       | 33.5 |   |
| Repayments of project debt                                                 |       | (7.0                 | )          | (2.5 | ) |
| Proceeds from exercise of stock options                                    |       | .3                   |       | — |   |
| Minority interest distributions                                            |       | (.4                  | )          | — |   |
|                                                                       |       |                 |       |   |   |
| Cash provided by financing activities                                      |       | 51.2                 |       | 31.0 |   |
|                                                                       |       |                 |       |   |   |
| Net decrease in cash and cash equivalents                                  |       | (3.6                 | )          | (10.3 | ) |
|                                                                       |       |                 |       |   |   |
| Cash and cash equivalents - beginning of period                            |       | 9.0                  |       | 14.7 |   |
|                                                                       |       |                 |       |   |   |
| Cash and cash equivalents - end of period                                  |       | $                    | 5.4        |   | $ | 4.4 |   |
|                                                                       |       |                 |       |   |   |
| Supplemental disclosures of cash flow information:                         |       |                 |       |   |   |
| Cash paid during the period for income taxes                               |       | $                    | (.9        | ) | $ | (.4 | ) |

 

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 Report on Form 10-Q. Inter-companyaccounts 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 six months ended June 30, 2005 and 10.1 million for the threeand six months ended June 30, 2004. Earnings per share, assuming dilution, is computed using theweighted-average number of common shares outstanding and the dilutive effect ofpotential common shares outstanding. For the three and six months ended June 30,2005 and 2004, the average market price of the Company’s common stock exceededthe exercise price of outstanding stock options.  Therefore, the dilutive effect of theweighted average number of common shares from potential exercise of approximately700,000 options is reflected in the 10.9 million and 10.8 millionweighted-average common shares assuming dilution, respectively, in the relatedconsolidated statements of income.

 

*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 offair value is inherently uncertain since it requires estimates as to futureevents and market conditions. Such estimation process assumes the Company’sability to complete development and dispose of its real estate properties inthe ordinary course of business based on management’s present plans andintentions. Economic, market, environmental and political conditions may affectmanagement’s development and marketing plans. In addition, the implementationof such development and marketing plans could be affected by the availabilityof future financing for development and construction activities. Accordingly,the ultimate 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, as appropriate,the Company identifies alternative courses of action to recover the carryingvalue of its long-lived assets and evaluates all likely alternatives under aprobability-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 computeexpected losses and residual returns based on the probability of future cash flowsas outlined in FIN 46.  If the Company isdeemed to be the primary beneficiary of the VIE, the VIE will be consolidatedon the Company’s balance sheet.  The fairvalue of the VIE’s real estate will be reported as consolidated real estate tobe held for current development - not owned and the related theoreticalliability will be reported as 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 obligationsrelated to consolidated real estate - not owned of $24.7 million is reflectedon the Company’s balance sheet as of December 31, 2004.  During April 2005, the Company completedthe acquisition of land which was the subject of the agreement, and as such theland is included in Real estate held for current development or sale as of June 30,2005.  Not all of the Company’s depositsare with VIEs.  See Note 8 – Real EstateMatters.

 

*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 Mesaand 43 acres of lowlands which were acquired by the Company 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.  The Company is working diligently to satisfythe various conditions necessary for the Coastal Commission to issue thepermit.  While it is difficult to predicthow long this will take, the Company currently expects to satisfy the conditionsfor issuance of the CDP by the end of 2005, begin grading during the first halfof 2006, begin building model homes in the second half of 2006 and startselling homes in the first half of 2007. However, there can be no assurance in that regard, or as to (i) whendevelopment could commence, or (ii) the absence of further administrativedelay.

 

During2002, the County of Orange approved a site plan and tentative tract map fordevelopment of 379 single-family homes on 77 acres of the Upper Mesa.  Subsequent modifications approved by theCoastal Commission reduced the development area by nine acres and 30homes.  As a result of the modificationsmade to the development plans by the Company and approved by the CoastalCommission, the County of Orange is in the process of amending their approvalsto reflect the modifications.

 

8

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Theplanned community at Bolsa Chica, known as “Brightwater” will offer a broad mixof home choices, averaging 2,800 square feet and ranging in size from 1,560square feet to 4,000 square feet.  Theplan also includes 37 acres of open space and conservation area on the 105-acreUpper Mesa.  With only 349 homes on 68acres of the Upper Mesa, the resulting low-density plan equates to approximately5 homes per acre, consistent and compatible with the neighboring HuntingtonBeach communities. In addition, the Company will offer to dedicate 51 acres ofland on the Huntington Mesa to the County of Orange to complete the Harriett M.Wieder Linear Park, a 105-acre planned regional park. The 1,200-acrestate-owned Bolsa Chica Wetlands are fully preserved and protected inaccordance with previous agreements with the State of California and are notincluded 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 remains subject to shareholder approval at the Company’s August 11,2005 Annual Meeting and 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 currently expects 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 its impairmentanalyses. In accordance with the Company’s policy described in Note 2 –Impairment of Long-Lived Assets, since the undiscounted estimated future cashflows from the proposed Upper Mesa development plan for 349 single-family homesand the pending sale of the Lower Bench to WCB are expected to exceed itscarrying value, 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 differ materiallyfrom 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.  The loans secured by firsttrust deeds bear an interest rate of prime plus three-fourths percent (7.0 % atJune 30, 2005).  During the sixmonths ended June 30, 2005, subsidiaries of Hearthside Homes, Inc.entered into five new first trust deed loan facilities aggregating $85.6million in conjunction with the acquisitions and development of a total of 210single family residential lots, including 27 acquired during 2004.  In addition, a subsidiary of Hearthside Homes, Inc.entered

 

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into one loan facilitysecured by a second trust deed which bears interest at 17%.  The following amounts were available andoutstanding under these loan facilities as of June 30, 2005 and December 31,2004 ($ in millions):

 
| ** **        | ** ** | ** **      | ** ** | ** **  | ** ** | ** **   | ** ** | **Outstanding at** | ** ** |
|-------------------|------------|-----------------|------------|-------------|------------|--------------|------------|--------------------|------------|
| ** **        | ** ** | **Amount**      | ** ** | **Number**  | ** ** | **Maturity** | ** ** | **June 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             |       | 17          |       | 8/11/05      |       | 5.8                |       | 1.7 |   |
| Rancho Santa Fe   |       | 5.2             |       | 8           |       | 8/19/05      |       | 3.7                |       | 1.6 |   |
| Lancaster         |       | 10.7            |       | 60          |       | 11/23/05     |       | 6.2                |       | 4.0 |   |
| Corona            |       | 21.1            |       | 83          |       | 11/24/05     |       | 12.8               |       | 11.4 |   |
| Rancho Santa Fe   |       | 3.9             |       | 6           |       | 12/13/05     |       | 1.2                |       | 1.1 |   |
| Riverside         |       | 7.9             |       | 15          |       | 3/27/06      |       | 6.3                |       | — |   |
| Rancho Santa Fe   |       | 15.4            |       | 18          |       | 3/27/06      |       | 5.9                |       | — |   |
| Ontario           |       | 11.7            |       | 26          |       | 4/19/06      |       | 2.8                |       | — |   |
| Lancaster         |       | 9.5             |       | 44          |       | 5/10/06      |       | 4.1                |       | — |   |
| Corona            |       | 41.1            |       | 151         |       | 1/15/07      |       | 16.9               |       | — |   |
|              |       |            |       |        |       |         |       | 65.7               |       | 22.6 |   |
|              |       |            |       |        |       |         |       |               |       |   |   |
| Second Trust Deed |       |            |       |        |       |         |       |               |       |   |   |
| Corona            |       | 10.5            |       | 151         |       | 1/15/07      |       | 8.2                |       | — |   |
|              |       |            |       |        |       |         |       |               |       |   |   |
|              |       |            |       |        |       |         |       | $                  | 73.9       |   | $ | 22.6 |   |
|                   |            |                 |            |             |            |              |            |                    |            |  |  |  |  |  |

 

Forthe three months ended June 30, 2005 and 2004, approximately $1.2 million and$300,000, respectively, of construction period interest incurred wascapitalized, and for the six months ended June 30, 2005 and 2004,approximately $1.6 million and $400,000, respectively, of construction periodinterest was capitalized.

 

**Note 5 -Other Liabilities**

 

Otherliabilities were comprised of the following (in millions):

 
| ** **                                         | ** ** | **June 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 |       | 2.0               |       | 3.5                   |       |
| Unamortized discount                               |       | (.6               | )          | (.7                   | )          |
|                                               |       | $                 | 7.7        |                  | $          | 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) thecontingent liability of a subsidiary of the Company for PCB contamination onits 43-acre Bolsa 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 Company settled this litigation with Dresser and the Company paid $1.33million, its share of the settlement, which is the

 

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amount of the Company’s litigationaccrual as of December 31, 2004. The Company and RESCO did not admit fault or liability with respect toDresser’s claims, but settled the matter in order to avoid the continued costand 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 their 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.  As of June 30, 2005, the subsidiary hasaccrued approximately $700,000 for environmental testing and remediation ofthis property. While the accrual reflects the estimate for the minimum costswhich are probable and estimable, such accrual may not be adequate to satisfythe full amount of remediation that may be required by the DTSC.

 

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 will deposit the $1.7 million into escrow,with up to $1 million of such funds to be utilized to fund remediation of theproperty as required by the RAW.  Afterremediation has been completed to the satisfaction of DTSC, SLC will completetheir acquisition of this property from the Company’s subsidiary and theCompany’s subsidiary will receive the remaining balance of the escrowed funds.  The remediation work is scheduled to begin inAugust 2005 and to be completed by the end of 2005.

 

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 four additional invoices for an aggregateadditional $94,000 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 theresidential properties. Furthermore, the Company’s subsidiary has also disputedsuch charges 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. Therefore, theCompany has not accrued for any of DTSC’s $887,000 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):

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

 

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**Note 6 -Income Taxes**

 

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

 
| ** **                                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                               | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                                               | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Current tax                                              |       | $                      | —     |                 | $          | — |   | $ | .1 |   | $ | — |   |
| Deferred tax                                             |       | .1                     |       | .1                   |       | .2 |   | .3 |   |
| Reversal of valuation allowances on deferred tax  assets |       | —                 |       | —               |       | (4.7 | ) | — |   |
| Reduction in contingent tax liabilities                  |       | —                 |       | —               |       | — |   | (.1 | ) |
| Provision (benefit) for income taxes                     |       | $                      | .1         |                 | $          | .1 |   | $ | (4.4 | ) | $ | .2 |   |

 

As aresult of the California Coastal Commission’s approval of the Company’sdevelopment plan for the Bolsa Chica Upper Mesa on April 14, 2005, theCompany has concluded that it is more likely than not that it will utilize allof its deferred tax assets, including NOLs, to offset future taxable income.  Therefore, during the six months ended June 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 six months ended June 30, 2005, areversal 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 inthe Company, it has experienced a three-year cumulative ownership shift ofapproximately 40% as of July 25, 2005.

 

Thefederal NOLs available as of June 30, 2005 were approximately $170 million.The amount of federal NOLs which expire if not utilized is zero, $10 million,$8 million, $21 million, $11 million and $120 million for 2005, 2006, 2007,2008, 2009 and thereafter, respectively.

 

In October 1999,in response to an unsolicited written consent from a majority of itsstockholders, the Company amended its certificate of incorporation in order toprotect the ability of the Company to utilize its tax loss carryforwards. Sincethe Company’s use of its NOLs would be severely restricted if it experiences anownership change of more than 50%, the Company’s majority stockholdersrequested that the Board of Directors enact the amendments, which weredetermined to be in the best interest of the Company and its stockholders. Theamendments prohibit future purchases of the Company’s common stock by personswho would become new 5% holders, and also prohibit current holders of over 5%from increasing their positions, except in certain permissible circumstanceswhich would not jeopardize the Company’s ability to use its NOLs. While theseamendments reduced the Company’s risk of an ownership change occurring due tothe acquisition of shares by 5% stockholders, the risk remains that anownership change could result from the sale of shares by existing 5%stockholders. During August 2004, the Company announced that it would notapprove further purchases in the foreseeable future.  However, since the calculation of thecumulative ownership shift is based on a rolling three years, the Company’sBoard of Directors will re-evaluate such requests in the future.

 

**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 is currently constructing and selling homes. Hearthside Homes, Inc.(one of the Company’s principal subsidiaries) is the managing member of theChino LLC, manages its operations and contributed capital of approximately$400,000 (approximately 10%) to the venture. Minority interest represents thenon-managing member’s equity interest in the venture including a capitalcontribution 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

 

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distributions ofapproximately $7.6 million were made to the non-managing member, repaying allof its initial capital contribution, plus all $600,000 of accumulated preferredreturn and $3.1 million in profit distributions, in conjunction with thedelivery of the first 65 homes.  Duringthe six months ended June 30, 2005, additional distributions of $450,000 weremade to the non-managing member and the Company recorded minority interest inincome of consolidated joint venture of $100,000, 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 marketrisk associated with land holdings. Option contracts generally require thepayment of a non-refundable cash deposit of 5% to 15% of the purchase price forthe right 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 June 30, 2005:

 
| Total number of projects                                                       |   | 1      |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
|                                                                           |   |   |   |
| Total number of lots                                                           |   | 102    |   |
|                                                                           |   |   |   |
| Total forfeited deposits if lots are not purchased  (included in other assets) |   | $      | 1.2    |   |
|                                                                           |   |   |   |
| Total remaining purchase price                                                 |   | $      | 10.1   |   |

 

The Company currently expects to complete the purchaseduring the third quarter of 2005.  In July 2005,the Company entered into an agreement to purchase an additional 77 lots inLancaster, California.

 

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 Notes 3 and 5 for a discussion of othercontingencies.

 

*CorporateIndemnification Matters*

 

TheCompany and its former affiliates have, through a variety of transactionseffected since 1986, disposed of several assets and businesses, many of whichare unrelated to the Company’s current operations. By operation of law orcontractual indemnity provisions, the Company may have retained liabilitiesrelating to certain of these assets and businesses. There is generally nomaximum obligation or amount of indemnity provided for such liabilities. Aportion of such liabilities is supported by insurance or by indemnities fromcertain of the Company’s previously affiliated companies. The Company believesits consolidated balance sheet reflects adequate reserves for these matters.

 

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ITEM 2–                                            MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS

 

**Overview**

 

The Company is a residential land development andhomebuilding company with properties owned or controlled in six Southern Californiacounties (Ventura, Los Angeles, San Bernardino, Riverside, Orange and San Diego).The principal activities of the Company and its consolidated subsidiariesinclude: (i) obtaining zoning and other entitlements for land it owns orcontrols through purchase options and improving the land for residentialdevelopment; and (ii) designing, constructing and selling single-familyhomes in Southern California. Once the residential land owned by the Company isentitled, the Company may build homes, sell unimproved land to other developersor homebuilders, sell improved land to homebuilders, or participate in jointventures with other developers, investors or homebuilders to finance and constructinfrastructure and homes. During the remainder of 2005, the Company will focusits immediate efforts to (i) satisfy the conditions required to completethe process of obtaining a Coastal Development Permit (“CDP”) from theCalifornia Coastal Commission (“Coastal Commission”) to build 349 homes on theupper bench of the Bolsa Chica Mesa (“Upper Mesa”), as further described inNote 3 to the Company’s Consolidated Financial Statements; and (ii) continueto expand 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 2007.  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 four-year 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 Oxnard project, up toapproximately 543 additional single-family lots would be available forhomebuilding operations, however, these numbers are subject to change duringthe course of the entitlement process.

 

Bolsa Chica is the Company’s principal asset,representing 50% of total assets at June 30, 2005. On April 14, 2005,the Company obtained approval from the Coastal Commission for a CoastalDevelopment Permit (“CDP”) to build 349 homes on 68 acres of its approximately105-acre upper bench of the Bolsa Chica Mesa (“Upper Mesa”), subject tosatisfying the Coastal Commission’s permit conditions.  The Company is working diligently to satisfythe various conditions necessary for the Coastal Commission to issue thepermit.  While it is difficult to predicthow long this will take, the Company currently expects to satisfy theconditions for issuance of the CDP by the end of 2005, begin grading during thefirst half of 2006, begin building model homes in the second half of 2006 andstart selling homes in the first half of 2007. However, there can be no assurance in that regard, or as to (i) whendevelopment could commence, or (ii) the absence of further administrativedelay.

 

During 2002, the County of Orange approved a site planand tentative tract map for development of 379 single-family homes on 77 acresof the Upper Mesa.  Subsequentmodifications approved by the Coastal Commission reduced the development areaby nine acres and 30 homes.  As a resultof the modifications made to the development plans by the Company and approvedby the Coastal Commission, the County of Orange is in the process of amendingtheir approvals to reflect the modifications.

 

The planned community at Bolsa Chica, known as “Brightwater”will offer a broad mix of home choices averaging 2,800 square feet and rangingin size from 1,560 square feet to 4,000 square feet.  The plan also includes 37 acres of open spaceand conservation area on the 105-acre Upper Mesa. With only 349 homes on 68acres of the Upper Mesa, the resulting low-density plan equates toapproximately 5 homes per acre, consistent and compatible with the neighboringHuntington Beach communities. In addition, the Company will offer to dedicate51 acres of land on the Huntington Mesa to the County of Orange to complete theHarriett M. Wieder Linear Park, a 105-acre planned regional park. The 1,200-acrestate-owned Bolsa Chica Wetlands are fully preserved and protected inaccordance with previous agreements with the State of California and are notincluded in the Brightwater plan.

 

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 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 remains subject to shareholder approval at the Company’s August 11,2005 Annual Meeting and 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 Companycurrently expects to satisfy the conditions for issuance of the CDP by the end of2005; however, there can be no assurances that the CDP will be issued before December 31,2005 or that the sale will be completed.

 

The following facts and assumptions were utilized bythe Company in evaluating the potential value which is expected to be derivedfrom development of the Bolsa Chica 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 currently expects tobegin grading during the first half of 2006, begin building model homes in thesecond half of 2006 and start selling homes in the first half of 2007.

•                  New home prices approximate $580 persquare foot, including view and other premiums, in the local residential market(coastal Huntington Beach). Approximately 60 homes are expected to haveunobstructed views of the Pacific Ocean and/or the Bolsa Chica Wetlands.

•                  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 12% during the first six monthsof 2005.  While demand continues toexceed 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 8% of the sales price of homes.

 

Given the facts and circumstances described above, theCompany currently believes that the eventual development of the Upper Mesa andthe pending sale of the Lower Bench will result in realization of an amountthat is substantially in excess of the $157.8 million book value presentlyreflected in the Company’s consolidated financial statements.  From time to time, the Company has receivedoutside appraisals on an “as developed basis” which have supported the Company’sbeliefs, although there can be no assurance that those beliefs will be validated.

 

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 mortgageinterest rates, and other real estate risks such as the general demand forhousing and the supply of competitive products. Real estate properties do notconstitute liquid assets and, at any given time, it may be difficult to sell aparticular property 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.

 

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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 five years and the related decline inthe affordability of new homes in Southern California, (ii) the state ofthe national economy and the possiblity of a recession in the future, (iii) theState of California’s budget deficit, and (iv) the volatility in the stockmarket, collectively may exert recessionary pressures on the California economyand may have a negative impact on the Southern California housing market.

 

While low mortgage rates have sustained housing demandto date, any significant future increase in mortgage rates or significant lossof jobs in Southern California would most likely slow demand for new homes.Increases in home mortgage interest rates could make it more difficult for theCompany’s customers to qualify for home mortgage loans, potentially decreasinghome sales volume and prices. The tight supply of new homes in SouthernCalifornia has resulted in significant home price increases over the last fiveyears. As a result, the affordability of new homes has been declining and couldjeopardize future demand.  The percentageof home buyers 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 hasincorporated its own assumptions regarding the entitlement prospects of landheld for future development and its own market assumptions including thoseregarding home prices, infrastructure and home-building costs regarding bothland held for future development and real estate held for current developmentor sale.  Additionally, as appropriate,the Company identifies alternative courses of action to recover the carryingvalue of its long-lived assets and evaluates all likely alternatives under aprobability-weighted approach as described in SFAS No. 144.

 

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*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 the Companyinclude the accounts of the Company and all majority-owned and controlledsubsidiaries and joint ventures. The financial statements of joint ventures inwhich 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.

 

*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 is

 

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utilizing internally generated cash and project debt to fundconstruction of its homebuilding projects. The Company’s current and pendinghomebuilding projects, which are primarily in the “Inland Empire” area of SouthernCalifornia (Riverside and San Bernardino counties) and Lancaster innortheastern Los Angeles County, are currently expected to generateapproximately $49.0 million of positive cash flows during the next 30 months,after net investments in new projects to acquire 179 lots, based on presenteconomic conditions and market assumptions. The Company’s unrestricted cash andcash equivalents as of June 30, 2005 were approximately $5.4 million. TheCompany believes that its cash and cash equivalents, future real estate salesproceeds, and funds available under its credit agreements will be sufficient tomeet anticipated operating and capital investment requirements, primarilyproject development costs for homebuilding projects, and the Oxnard and Bolsa Chicaland development projects, along with general and administrative expenses, forthe next 12 months.

 

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 June 30, 2005:

 
| Total number of projects                                                       |   | 1      |   |
|--------------------------------------------------------------------------------|--------|--------|--------|
|                                                                           |   |   |   |
| Total number of lots                                                           |   | 102    |   |
|                                                                           |   |   |   |
| Total forfeited deposits if lots are not purchased  (included in other assets) |   | $      | 1.2    |   |
|                                                                           |   |   |   |
| Total remaining purchase price                                                 |   | $      | 10.1   |   |

 

The Company currently expects to complete the purchaseduring the third quarter of 2005.  In July 2005,the Company entered into an agreement to purchase an additional 77 lots inLancaster, California.

 

 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 543 of the single-familylots and 490 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 completed duringthe second 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 aLimited Liability Company (“Oxnard LLC”) joint venture agreement with a majorfinancial partner to pursue the Oxnard development opportunity. The Companyassigned the land

 

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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 June 30,2005, the non-managing member had made an aggregate of approximately $3.5million 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. Totalcontributions of the non-managing member are generally limited to $5 million.After payment of a 10% preferred return on invested capital to each member,first tier profits are generally allocated 75% to the non-managing member and25% to the managing member and second tier profits and losses over $5 millionare generally allocated 50% to each member. The first $5 million of losses aregenerally allocated 80% to the non-managing member and 20% to the managingmember.  While the Company exerts a largedegree of influence over the venture, the non-managing member does have variousparticipating rights such as approval rights with regard to major businessdecisions.  In addition, the Company isnot the primary beneficiary of the entity; therefore, the venture is notconsolidated.

 

**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 255 lots during the first half of 2005, which increasedinventory in existing markets, and entered into agreements to acquire 102 lotsin Beaumont in Riverside County and an additional 77 lots in Lancaster.  Although home prices in Southern Californiahave increased 20% to 30% annually over the last few years, the Company doesnot expect appreciation to continue at that rate, but rather expects modestincreases of less than 20% over the next year. While the 14 home deliveries for the first half of 2005 are less thanthe 20 homes delivered in the first half of 2004, homebuilding revenues andmargins for 2005 exceeded first half 2004 results.  The record rainfall during the last quarterof 2004 and the first quarter of 2005 negatively impacted the Company’sconstruction schedule and contributed to the Company’s low number of homedeliveries during the first half of 2005. The Company expects a more robust second half, as in recent prior years.  The Company’s active homebuilding projectsare 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 10 additional homes (some with views) during the first half of 2005at an average price of $723,000 and delivered an additional six homes during July 2005.  As of August 2, 2005, all of the eightremaining homes (none with views) are in escrow at an average price of $680,000.

 

*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, and delivered 65 homes at an averageprice of $593,000 during 2004, and delivered four homes during the firstquarter of 2005 at an average price of $577,000.  As of August 2, 2005, all of theremaining eight homes are currently in escrow at an average price of $631,000

 

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 thefirst two homes during July 2005. All of the remaining 15 homes are in escrow as of August 2, 2005 atan average price of $566,000.

 

*Corona.*  The Company acquired 83 lots in North Coronain May 2004.  Following constructionof infrastructure, during April 2005, the Company began construction of homesaveraging 3,250 square feet.  The Companyis currently constructing model homes and expects to open for sales during thethird quarter of 2005.

 

*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. Three phases of six homes each have been released for sale and as of August 2,2005, 14 of the 18 homes are in escrow at an average price of $1,239,000.

 

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*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 65 homes.  TheCompany delivered the first five homes of this project during July 2005and as of August 2, 2005, 54 of these homes are in escrow at an averageprice of $396,000.  During April 2005,the Company acquired an additional 72 lots in Lancaster, which will be marketedthrough the existing model homes.

 

*Ontario.  *DuringApril 2005, the Company acquired 26 lots in the City of Ontario inRiverside County, California.  This smallcommunity of homes, planned to average 3,415 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 third quarter of 2005.

 

**FinancialCondition**

 

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

 

Cash flows from homebuilding operations for the first halfof 2005 primarily reflect a use of cash for investments in real estate andconstruction costs of $59.0 million, reflecting acquisitions of an aggregate of255 lots, and a $6.3 million decrease in accounts payable and accruedliabilities for payment of accrued construction, compensation and taxliabilities. Additional significant uses of cash include approximately $1.4million for investment in the Bolsa Chica Mesa project, primarily forconsultants engaged in the entitlement process, and selling, general andadministrative expenses of approximately $1.9 million. The primary sources ofcash during the period were real estate sales proceeds of $9.6 million fromdeliveries of 14 homes, and net borrowing under project debt financing of $51.3million. These items, as well as other activity presented in the Statements ofCash Flows, resulted in a $3.6 million decrease in cash and cash equivalents.

 

The $52.0 million increase in real estate held forcurrent development or sale reflects the purchase of the 255 lots describedabove, including six lots in the Rancho Santa Fe area of San Diego County, 26in Ontario, 151 in Corona and 72 in Lancaster, along with project constructioncosts, partially offset by reductions to real estate recorded upon thedeliveries of 14 homes.

 

Accounts payable and accrued liabilities decreased by$4.7 million, to a balance of $10.3 million as of June 30, 2005, primarilyreflecting payment of accrued liabilities for profit-based incentivecompensation, income taxes and $2.7 million due to land sellers forparticipations in homebuilding profits.

 

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 Bolsa Chica Upper Mesa (see Note 6 to theConsolidated Financial Statements).  An increaseof approximately $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 June 30, 2005 Comparedwith the Three Months Ended June 30, 2004*

 

The Company reported revenues of $3.1 million andgross operating profit of $900,000 for the second quarter of 2005, compared with$3.2 million in revenues and gross operating profit of approximately $1.1million for the same period of 2004. Revenues in the current period reflectdeliveries of four homes at the “Jasper Ranch” project in Riverside. Thecomparable period of the prior year reflects deliveries of seven homes at aNorth Corona project. The current quarter’s gross margin of 29.0% is slightlyless than the prior period gross margin of 34.4%, primarily due to varyinglevels of price appreciation related to variations in the holding period oflots for homes delivered.

 

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The average price of homes delivered increasedsignificantly from $443,000 in the second quarter of 2004 to $775,000 duringthe second quarter of 2005, while the current quarter gross margin of 29.0% isslightly less than the prior period homebuilding gross margin of 32.3%.  The changes primarily reflect the largerhomes at the Riverside project (Jasper Ranch), and varying levels of priceappreciation related to variations in the holding periods for the landunderlying the homes delivered.  Aquarter-to-quarter comparison is not meaningful due to the low number of homedeliveries during the recent quarter and variations in product mix.  The Company generated $100,000 less in grossoperating profit from home sales during the second quarter of 2005 comparedwith the same period of 2004, while delivering three fewer homes (four vs.seven).

 

Selling, general and administrative expenses duringthe second quarter of 2005, are slightly less than the second quarter of 2004,primarily reflecting lower selling expenses corresponding to a comparable numberof projects currently selling.

 

*Six Months Ended June 30, 2005 Compared withSix Months Ended June 30, 2004*

 

The Company reported revenues of $9.6 million andgross operating profit of $2.6 million for the first half of 2005 compared with$8.8 million in revenues and gross operating profit of $2.4 million for thefirst half of 2004.  Revenues in thefirst half of 2005 reflect deliveries of 14 homes, including 10 homes at theCompany’s Chino project and four homes at the Company’s Riverside (JasperRanch) project.  The comparable period ofthe prior year reflects an aggregate of 20 homes including six homes at theJasper Ranch project, 14 homes at the North Corona project and a $100,000 landsale.  The homebuilding gross margin forthe first half of 2005 of 27.1% is higher than the prior period gross margin of26.4% due to home price appreciation experienced over the selling period forthe homes delivered in 2005 and higher profitability of the Riverside and Chinoprojects as compared to the North Corona project.

 

The absence of income from unconsolidated jointventures for the first half of 2005 compared with $200,000 for the first halfof 2004 primarily reflects fewer home loans made through the Company’s jointventure during the first half of 2005 as compared with the first half of2004.  This reduced volume correlates tofewer home deliveries during the current year period.

 

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 Bolsa Chica Upper Mesa (see Note 6),which is reflected for the six months ended June 30, 2005.  During the six months ended June 30,2004, the Company recorded a tax benefit of approximately $100,000 inconnection with the reduction in reserves for contingent tax liabilities to zero,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 June 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     |       | $                          | 73.9       |   | $ | 48.8 |   | $ | 25.1 |   | — |   | — |   |
| Operating leases |       | .3                         |       | .2 |   | .1 |   | — |   | — |   |
| Other            |       | —                     |       | — |   | — |   | — |   | — |   |
| Total            |       | $                          | 74.2       |   | $ | 49.0 |   | $ | 25.2 |   | — |   | — |   |

 

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

 

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obligations is inherently uncertain since it requires estimates as tofuture events and contingencies. The Company has provided additional disclosurein its Consolidated Financial Statements in Notes 5 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, other statementsthe Company may make from time to time, such as press releases, oral statementsmade by Company officials and other reports the Company files with theSecurities 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 actual results, performance orachievements to be materially different from any future results, performances orachievements expressed or implied by the forward-looking statements.  In some cases, you can identifyforward-looking statements by terminology such as “may”, “will”, “should”, “expects”,“plans”, “anticipates”, “believes”, “estimates”, “predicts”, “potential”, “continue”,or the negative of such terms or other comparable terminology.

 

These forward-looking statements include, 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 involve knownand unknown risks, uncertainties, assumptions and other factors, many of whichare out of our control and difficult to forecast, that may cause actual resultsto differ materially from those that may be described or implied. Such factorsinclude but are not limited to: (1) the future condition of the realestate market in Southern California affecting local and general economic andmarket conditions, including consumer confidence, employment rates, interestrates, the cost and availability of mortgage financing, and stock market, homeand land valuations; (2) the ability to react to increases or decreases indemand for housing and to rapidly take advantage of local market opportunitiesas they arise; (3) the sufficiency of our capital resources and ability toaccess additional capital; (4) the Company’s ability to expend resourcesto comply with environmental regulations and local permitting requirements; (5) theeffect of certain costs, contractual obligations and tax liabilities, bothknown and unknown, on the Company’s business, results of operations andfinancial condition; (6) the condition and adequacy of the Company’sproperties; (7) the Company’s ability to estimate cash flow projectionsdue to uncertainties in valuing real property; (8) the Company’s abilityto acquire residential lots in order to continue homebuilding operations; (9) delaysin the land entitlement and other approval processes, development,construction, or the opening of new home communities; (10) the adequacy ofcapital, financing and cash flow required to continue the Company’s operationsand land development activities; (11) the cyclical and competitive nature ofthe homebuilding business; (12) the availability and cost of raw materials usedby the Company in its homebuilding operations; (13) homebuilding litigation andwarranty claims; (14) shortages and the cost of labor; (15) adverse weather conditionsand natural disasters; (16) governmental regulation, including “slow growth,” “nogrowth” or similar initiatives or moratoria, the interpretation of tax, laborand environmental laws;  (17) the impacton economic conditions of terrorist attacks or the outbreak or escalation ofarmed conflict involving the United States; (18) other risks discussed in ourfilings with the Securities and Exchange Commission, including in our mostrecent Annual Report on Form 10-K; and (19) other factors over which theCompany 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,periodic report 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.

 

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**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 $170 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.

 

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 ratesgenerally do not impact the fair market value of the debt instrument, they doaffect the Company’s earnings and cash flows. Holding the Company’s variablerate debt balance constant as of June 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

 

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, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management is required to apply its judgment inevaluating the cost-benefit relationship of possible controls and procedures.

 

As of June 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 and procedureswere 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.

 

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.

 

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 6 - EXHIBITS

 
| 10.1   |   | Employment  Contract between Hearthside Homes, Inc., a subsidiary of the Registrant  and Mr. Michael J. Rafferty, dated as of August 8, 2005. |
|--------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                         |
| 10.2   |   | Employment  Contract between Hearthside Homes, Inc., a subsidiary of the Registrant,  and Mr. John W. Marshall, dated as of August 8, 2005.   |
|   |   |                                                                                                                                                         |
| 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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*                                         Thiscertification is being furnished solely to accompany this report pursuant to 18U.S.C. Section 1350, and is not being filed for purposes of Section 18of the Securities Exchange Act of 1934, as amended, and is not to beincorporated by reference into any filing of the Company, whether made beforeor after the date hereof, regardless of any general incorporation language insuch filing.

 

**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: August 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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