**FORM 10-Q**

 

**SECURITIES AND EXCHANGE COMMISSION**

 

**WASHINGTON,D.C. 20549**

 

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

 

**Forthe quarterly period ended June 30, 2004**

 

**Commissionfile number 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES, INC.**

(Exact name ofregistrant 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’stelephone number, including area code: **(949)250-7700**

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15 (d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days:

 

Yes ý                    No o

 

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

 

Yes ý                    No o

 

The number of shares ofCommon Stock outstanding at July 30, 2004 was 10,105,212.

 

 

----

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED JUNE 30, 2004

 

I N D E X

 
| Part I -  | Financial Information:                                        |                                                                                                    |
|----------------|---------------------------------------------------------------|---------------------------------------------------------------------------------------------------------|
|           |                                                          |                                                                                                    |   |
|           | Item 1 -                                                      | Consolidated Financial  Statements                                                                      |   |
|           |                                                          |                                                                                                    |   |
|           |                                                          | Consolidated Balance Sheets  -  June 30, 2004 and December 31, 2003 (unaudited)                         |   |
|           |                                                          |                                                                                                    |   |
|           |                                                          | Consolidated  Statements of Operations -  Three and Six Months Ended June 30, 2004 and 2003 (unaudited) |   |
|           |                                                          |                                                                                                    |   |
|           |                                                          | Consolidated  Statements of Cash Flows -  Six Months Ended June 30, 2004 and 2003 (unaudited)           |   |
|           |                                                          |                                                                                                    |   |
|           |                                                          | Notes to  Consolidated Financial Statements                                                             |   |
|           |                                                          |                                                                                                    |   |
|           | Item 2 -                                                      | Management’s Discussion and Analysis of  Financial Condition and Results of Operations             |   |
|           |                                                          |                                                                                                    |   |
|           | Item 3 -                                                      | Quantitative and Qualitative Disclosures About  Market Risk                                             |   |
|           |                                                          |                                                                                                    |   |
|           | Item 4 -                                                      | Evaluation of Disclosure Controls and Procedures                                                        |   |
|           |                                                          |                                                                                                    |   |
| Part II - | Other Information:                                            |                                                                                                    |
|           |                                                          |                                                                                                    |   |
|           | Item 1 -  Legal Proceedings                                   |                                                                                                    |
|           |                                                          |                                                                                                    |   |
|           | Item  4 - Submission of Matters to a Vote of Security Holders |                                                                                                    |
|           |                                                          |                                                                                                    |   |
|           | Item 6 - Exhibits and  Reports on Form 8-K                    |                                                                                                    |
|           |                                                          |                                                                                                    |   |
| SIGNATURE      |                                                          |                                                                                                    |

 

2

----

 

PART I.  FINANCIAL INFORMATION

 

ITEM 1 – FINANCIAL STATEMENTS

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED BALANCESHEETS

 

(unaudited)

 

(inmillions)

 
| ** **                                                                                                 | ** ** | **June 30,  2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
|                                                                                                       |       |                    |       |                  |       |
| ASSETS                                                                                                     |       |                    |       |                  |       |
|                                                                                                       |       |                    |       |                  |       |
| Cash  and cash equivalents                                                                                 |       | $                       | 4.4        |                  | $          | 14.7 |   |
| Real  estate held for current development or sale                                                          |       | 66.3                    |       | 27.5                  |       |
| Land  held for future development                                                                          |       | 155.0                   |       | 153.6                 |       |
| Other  assets                                                                                              |       | 2.0                     |       | 2.3                   |       |
|                                                                                                       |       |                    |       |                  |       |
|                                                                                                       |       | $                       | 227.7      |                  | $          | 198.1 |   |
|                                                                                                       |       |                    |       |                  |       |
| LIABILITIES  AND STOCKHOLDERS’ EQUITY                                                                 |       |                    |       |                  |       |
|                                                                                                       |       |                    |       |                  |       |
| Liabilities:                                                                                               |       |                    |       |                  |       |
| Accounts  payable and accrued liabilities                                                                  |       | $                       | 5.1        |                  | $          | 6.3 |   |
| Project  debt                                                                                              |       | 41.4                    |       | 10.4                  |       |
| Other  liabilities                                                                                         |       | 9.7                     |       | 12.9                  |       |
|                                                                                                       |       |                    |       |                  |       |
| Total  liabilities                                                                                         |       | 56.2                    |       | 29.6                  |       |
|                                                                                                       |       |                    |       |                  |       |
| Minority  interest                                                                                         |       | 3.9                     |       | 3.9                   |       |
|                                                                                                       |       |                    |       |                  |       |
| Commitments  and contingencies                                                                             |       |                    |       |                  |       |
|                                                                                                       |       |                    |       |                  |       |
| Stockholders’  equity:                                                                                |       |                    |       |                  |       |
| Common  Stock–$.05 par value; 13,500,000 shares authorized; 10,075,212 shares issued  and outstanding |       | .5                      |       | .5                    |       |
| Excess  Stock–$.05 par value; 13,500,000 shares authorized; no shares outstanding                     |       | —                  |       | —                |       |
| Capital  in excess of par value                                                                            |       | 145.6                   |       | 143.1                 |       |
| Retained  earnings                                                                                         |       | 23.9                    |       | 23.4                  |       |
| Accumulated  other comprehensive loss                                                                      |       | (2.4                    | )          | (2.4                  | )          |
| Total  stockholders’ equity                                                                           |       | 167.6                   |       | 164.6                 |       |
|                                                                                                       |       |                    |       |                  |       |
|                                                                                                       |       | $                       | 227.7      |                  | $          | 198.1 |   |

 

See theaccompanying notes to consolidated financial statements.

 

3

----

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATEDSTATEMENTS OF OPERATIONS

 

(in millions,except per share amounts)

 

(unaudited)

 
| ** **                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                    | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Revenues                                      |       | $                                | 3.2        |                           | $          | 9.2 |   | $ | 8.8 |   | $ | 13.1 |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Costs  of sales                               |       | 2.1                              |       | 7.6                            |       | 6.4 |   | 10.9 |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Gross  operating profit                       |       | 1.1                              |       | 1.6                            |       | 2.4 |   | 2.2 |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Selling,  general and administrative expenses |       | .8                               |       | .9                             |       | 1.7 |   | 1.7 |   |
| Interest  expense                             |       | —                           |       | —                         |       | .1 |   | .1 |   |
| Income  from unconsolidated joint ventures    |       | (.1                              | )          | (.2                            | )          | (.2 | ) | (.3 | ) |
| Other  expense, net                           |       | .1                               |       | .6                             |       | .1 |   | .7 |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Income  before income taxes                   |       | .3                               |       | .3                             |       | .7 |   | — |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Provision  (benefit) for income taxes         |       | .1                               |       | —                         |       | .2 |   | (.1 | ) |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Net  income                                   |       | $                                | .2         |                           | $          | .3 |   | $ | .5 |   | $ | .1 |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Earnings  per common share – basic       |       | $                                | .02        |                           | $          | .03 |   | $ | .05 |   | $ | .01 |   |
|                                          |       |                             |       |                           |       |   |   |   |   |
| Earnings  per common share – diluted     |       | $                                | .02        |                           | $          | .03 |   | $ | .05 |   | $ | .01 |   |

 

See theaccompanying notes to consolidated financial statements.

 

4

----

 

 CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

 

(unaudited)

 
| ** **                                                                 | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **2004**                       | ** ** | **2003** | ** ** |
|                                                                       |       |                           |       |   |   |
| Cash  flows from operating activities:                                     |       |                           |       |   |   |
| Net  income                                                                |       | $                              | .5         |   | $ | .1 |   |
| Adjustments  to reconcile net income to cash used in operating activities: |       |                           |       |   |   |
| Non-cash  interest expense                                                 |       | .1                             |       | .1 |   |
| Gains  on sales of real estate held for current development or sale        |       | (2.3                           | )          | (2.2 | ) |
| Proceeds  from home sales, net                                             |       | 8.7                            |       | 13.1 |   |
| Investments  in real estate held for current development or sale           |       | (45.2                          | )          | (25.3 | ) |
| Investments  in land held for future development                           |       | (1.4                           | )          | (.9 | ) |
| Changes  in assets and liabilities:                                        |       |                           |       |   |   |
| Decrease  (increase) in other assets                                       |       | .3                             |       | (.3 | ) |
| Decrease  in accounts payable, accrued and other liabilities, net          |       | (2.0                           | )          | (.7 | ) |
|                                                                       |       |                           |       |   |   |
| Cash  used in operating activities                                         |       | (41.3                          | )          | (16.1 | ) |
|                                                                       |       |                           |       |   |   |
| Cash  flows from financing activities:                                     |       |                           |       |   |   |
| Borrowings  of project debt                                                |       | 33.5                           |       | 14.3 |   |
| Minority  Interest                                                         |       | —                         |       | 3.9 |   |
| Repayments  of project debt                                                |       | (2.5                           | )          | (6.0 | ) |
|                                                                       |       |                           |       |   |   |
| Cash  provided by financing activities                                     |       | 31.0                           |       | 12.2 |   |
|                                                                       |       |                           |       |   |   |
| Net  decrease in cash and cash equivalents                                 |       | (10.3                          | )          | (3.9 | ) |
|                                                                       |       |                           |       |   |   |
| Cash  and cash equivalents - beginning of period                           |       | 14.7                           |       | 9.2 |   |
|                                                                       |       |                           |       |   |   |
| Cash  and cash equivalents - end of period                                 |       | $                              | 4.4        |   | $ | 5.3 |   |
|                                                                       |       |                           |       |   |   |
| Supplemental  disclosures of cash flow information:                        |       |                           |       |   |   |
| Cash  paid during the period for income taxes                              |       | $                              | (.4        | ) | $ | (.6 | ) |

 

See theaccompanying notes to consolidated financial statements.

 

5

----

 

CALIFORNIA COASTALCOMMUNITIES, INC.

 

NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 -Basis of Presentation**

 

The accompanyingfinancial statements have been prepared by California Coastal Communities, Inc.and its consolidated subsidiaries (the “Company”), without audit, pursuant tothe rules and regulations of the Securities and Exchange Commission. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations. The Companybelieves that these unaudited consolidated financial statements reflect allmaterial adjustments (consisting only of normal recurring adjustments) anddisclosures necessary for the fair presentation of the results of operationsand statements of financial position when read in conjunction with theFinancial Statements and Notes thereto included in the Company’s Annual Reporton Form 10-K for the year ended December 31, 2003, and the current year’spreviously issued Quarterly Report on Form 10-Q. The results for interimperiods are not necessarily indicative of the results to be expected for thefull year.

 

# **Note 2 – Significant Accounting Policies**

 

#### *EarningsPer Common Share*

 

For the three and six months endedJune 30, 2004 and 2003, the weighted-average common shares outstanding was 10.1million. 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 June30, 2004, the average market price of the Company’s common stock exceeded theexercise price of outstanding stock options. Therefore, the dilutive effect ofthe 774,996 common shares from potential exercise of options is reflected inthe 10.8 million weighted-average common shares assuming dilution. For thethree and six months ended June 30, 2003, the average market price of theCompany’s common stock exceeded the exercise price of outstanding stock optionsand did not exceed the exercise price of warrants then outstanding. Therefore,the dilutive effect of only the 754,996 common shares from potential exerciseof options is reflected in the 10.8 million weighted-average common sharesoutstanding assuming dilution in the statement of operations.

 

*Real Estate*

 

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

 

The cost of sales ofmulti-unit projects is generally computed using the relative sales valuemethod. Interest cost is capitalized to real estate projects during theirdevelopment and construction period.

 

*Impairment of Long-LivedAssets*

 

The Company assesses theimpairment of land held for future development and other long-lived assets inaccordance with Statement of Financial Accounting Standards (“SFAS”)No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets”,which requires an impaired asset, for which costs cannot be recovered fromestimated undiscounted future cash flows, be written down to fair value.Long-lived assets are reviewed for impairment whenever events or changes incircumstances indicate that the carrying amount of an asset may not berecoverable. As provided by SFAS No. 144, impairment is evaluated by comparingan asset’s carrying value to the undiscounted estimated cash flows expectedfrom the asset’s operations and eventual disposition. If the sum of theundiscounted estimated future cash flows

 

6

----

 

is less than the carrying value of the asset, animpairment loss is recognized based on the fair value of the asset. If animpairment occurs, the fair value of an asset for purposes of SFAS No. 144is deemed to be the amount a willing buyer would pay a willing seller for suchasset in a current transaction.

 

In accordance withSFAS No. 144, in developing estimated future cash flows for impairment testing,the Company has incorporated its own assumptions regarding the entitlementprospects of land held for future development and its own market assumptionsincluding those regarding home prices, infrastructure and home-building costsfor both land held for future development and real estate held for currentdevelopment or sale.  Additionally, asappropriate, the Company identifies alternative courses of action to recoverthe carrying value of its long-lived assets and evaluates all likelyalternatives under a probability-weighted approach as indicated in SFAS No.144.

### * *

### *Recent Accounting Pronouncements*

 

InJanuary 2003, the FASB issued FIN No. 46, “Consolidation of Variable InterestEntities” and in December 2003, issued Interpretation No. 46 (revised December2003) “Consolidation of Variable Interest Entities – An Interpretation of APBNo. 51.” In general, a variable interest entity is a corporation, partnership,trust, or any other legal structure used for business purposes that either (a)does not have equity investors with voting rights or (b) has equity investorsthat do not provide sufficient financial resources for the entity to supportits activities. FIN No. 46 requires certain variable interest entities to beconsolidated by the primary beneficiary of the entity if the investors in theentity do not have the characteristics of a controlling financial interest ordo not have sufficient equity at risk for the entity to finance its activitieswithout additional subordinated financial support from other parties. FIN No.46 (R) clarifies the application of Accounting Research Bulletin (“APB”) No.51, “Consolidated Financial Statements, “ to certain entities in which equityinvestors do not have the characteristics of a controlling financial interestor do not have sufficient equity at risk for the entity to finance itsactivities without subordinated financial support from other parties. TheCompany adopted all requirements of FIN No. 46 effective January 1, 2003,including those which apply immediately to variable interest entities createdafter January 31, 2003, and certain of the disclosure requirements applicablein all financial statements issued after January 31, 2003, regardless of whenthe variable interest entity was established and the consolidation requirementsapplicable to older entities in the first fiscal year or interim period endingafter December 15, 2003. FIN No. 46 (R) applies immediately to variableinterest entities created after December 31, 2003, and to variable interestentities in which an enterprise obtains an interest after that date. It appliesno later than the first reporting period ending after March 15, 2004, tovariable interest entities in which an enterprise holds a variable interest(other than special purpose) that it acquired before January 1, 2004.  FIN No. 46 (R) applies to public enterprisesas of the beginning of the applicable interim or annual period. The adoption ofFIN No. 46 and FIN No. 46 (R) did not have a material impact on the Company’sfinancial position or results of operations.

 

In May 2003, the FASB issued SFAS No. 150, “Accountingfor Certain Instruments with Characteristics of Both Liabilities and Equity”(“SFAS 150”), which establishes standards for how an issuer classifies andmeasures certain financial instruments with characteristics of both liabilitiesand equity. SFAS 150 requires that an issuer classify a financial instrumentthat is within its scope, which may have previously been reported as equity, asa liability or an asset in some circumstances. This statement is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003 for public companies. In October 2003, the FASB deferredimplementation of paragraphs 9 and 10 of SFAS 150 regarding parent companytreatment of minority interest for certain limited life entities. This deferralis for an indefinite period. As of June 30, 2004, the Company consolidated onejoint venture which is affected by this deferral (see Note 7). The adoption ofother provisions of SFAS 150 did not have a material effect on the Company’sfinancial statements.

 

**Note 3 - Land Held for FutureDevelopment**

 

The Company ownsapproximately 350 acres located in Orange County, California overlooking thePacific Ocean and the Bolsa Chica wetlands (which were sold by the Company tothe 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 42 acres of lowlands which were acquired by the Company in September 1997.

 

On June 30, 2004, the Company announced that it hasreached a preliminary agreement to sell a 103-acre parcel of the Bolsa ChicaMesa known as the “lower bench” to the State’s Wildlife Conservation Board(“WCB”) for $65 million. The sale remains subject to shareholder approval andto approval by the WCB at its next meeting on August 12, 2004.  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. However,there can be no assurances that WCB will grant final approval of the purchaseof the lower bench, or that a sale transaction will ever be completed.  The

 

7

----

 

Company has indicated that it will require Coastal Commission approvalof its development plan for the “upper bench” area of the Bolsa Chica Mesa, asdescribed below, prior to seeking shareholder approval.

 

The Company is currently pursuing approvalof permits for development of the approximately 105-acre upper bench of theBolsa Chica Mesa (“Upper Mesa”). During 2002, the County of Orange approved theCompany’s site plan and tentative tract map for development of 379single-family homes on the Upper Mesa. The Company submitted a Coastal Development Permit (“CDP”) applicationfor the planned community known as “Brightwater” to the Coastal Commission inNovember 2002, and the Coastal Commission is scheduled to hold a public hearingon the Company’s CDP application on August 12, 2004; however, there can be noassurance that further delays will not be encountered. The California CoastalCommission’s staff has released its report related to the Company’s CDP and hasrecommended that the Commission deny the permit application. However thatrecommendation is not binding on the Commission, and the Commission has oftenapproved development plans despite contrary staff recommendations. Therefore,the Company remains hopeful that the Commission will approve the CDP at theAugust 12 hearing. Ultimately, the Company does not believe that the CoastalCommission process will permanently prevent it from developing a plannedcommunity at Bolsa Chica; however, there can be no assurance in that regard, oras to (i) when development could commence, (ii) the number of acres or homesthe Company will be permitted to develop, or (iii) the absence of further litigation or administrative delay.

 

The Brightwater project iscurrently expected to offer a broad mix of home choices, averaging 2,900 squarefeet and ranging in size from 1,560 square feet to 4,450 square feet.Brightwater would also include 28 acres of parks, public trails and open spaceon the 105-acre Upper Mesa. With only 379 homes on approximately 77 acres ofthe Upper Mesa, the resulting low-density plan would equate to approximatelyfive homes per acre, which would be consistent and compatible with theneighboring Huntington Beach communities. In addition, the Company would offerto dedicate 51 acres of land on the Huntington Mesa to the County of Orange inorder to complete the Harriett M. Wieder Linear Park, a 105-acre plannedregional park. The 1,200-acre Bolsa Chica Wetlands are fully preserved andprotected in accordance with previous agreements with the State of Californiaand are not included in the Brightwater plan.

 

On September 2, 1997, the Companycompleted a recapitalization pursuant to court confirmation of a PrepackagedPlan of Reorganization (the “Recapitalization”), and the Company applied theprinciples required by the American Institute of Certified Public Accountant’sStatement of Position (“SOP”) 90-7, “Financial Reporting by Entities inReorganization Under the Bankruptcy Code” (“Fresh-Start Reporting”), and thecarrying value of land held for development (Bolsa Chica) was adjusted to fairvalue. The fair value was determined in 1997 using discounted estimated cashflows expected from the asset’s operations and eventual disposition. Followingthe Coastal Commission’s November 2000 approval of suggested modifications tothe Bolsa Chica Local Coastal Program, which would limit development to onlythe Upper Mesa, an assessment of impairment was conducted by the Company forthe year ended December 31, 2000. The Company has updated its analysis at eachyear-end since 2000, and has noted no indicators of impairment since that date.Future costs incurred for capitalizable development activities for the BolsaChica project will increase the basis of the land. An estimate for these costshas been included in the Company’s estimated undiscounted cash flow forecastused in its impairment analyses. In accordance with the Company’s policydescribed in Note 2 – Impairment of Long-Lived Assets, since the estimatedundiscounted future cash flows from the Upper Mesa and the pending sale of thelower bench to WCB exceed its June 30, 2004 carrying value, the Companybelieves there has been no impairment.

 

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

 

8

----

 

**Note 4 - Project Debt**

 

In conjunction with the acquisitionof single-family residential lots, the Company’s homebuilding subsidiary,Hearthside Homes, Inc. and its subsidiaries, enter into construction loanagreements with a commercial bank. These loan facilities finance a portion ofthe land acquisition and the majority of the construction of infrastructure andhomes. The loans are secured by deeds of trust on individual projects andrequire principal repayments upon the delivery of homes. The loans bear aninterest rate of prime plus three-fourths percent (5.00% at June 30, 2004).During the six months ended June 30, 2004, Hearthside Homes, Inc. entered intoeight new loan facilities aggregating $66.4 million in conjunction with theacquisitions of a total of 253 single family residential lots. The followingamounts were available and outstanding under these loan facilities as of June30, 2004 and December 31, 2003 ($ in millions):

 
| ** **      | ** ** | ** **              | ** ** | ** **          | ** ** | ** **         | ** ** | **Outstanding at** | ** ** |
|-----------------|------------|-------------------------|------------|---------------------|------------|--------------------|------------|--------------------|------------|
| ** **      | ** ** | **Amount  of Facility** | ** ** | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|            |       |                    |       |                |       |               |       |               |       |   |   |
| Chino           |       | $                       | 15.4       |                | 56         |               | 8/29/04    |               | $          | 11.2 |   | $ | 10.4 |   |
| Chino           |       | 7.0                     |       | 21                  |       | 3/08/05            |       | 5.8                |       | — |   |
| Chino II        |       | 6.3                     |       | 17                  |       | 5/11/05            |       | 1.7                |       | — |   |
| Riverside       |       | 2.3                     |       | 13                  |       | 5/10/05            |       | 2.2                |       | — |   |
| Riverside       |       | 9.9                     |       | 41                  |       | 6/17/05            |       | 2.9                |       | — |   |
| Rancho Santa Fe |       | 5.2                     |       | 8                   |       | 5/19/05            |       | 1.6                |       | — |   |
| Rancho Santa Fe |       | 3.9                     |       | 6                   |       | 6/13/05            |       | 1.0                |       | — |   |
| Corona          |       | 21.1                    |       | 83                  |       | 5/24/05            |       | 11.1               |       | — |   |
| Lancaster       |       | 10.7                    |       | 104                 |       | 5/23/05            |       | 3.9                |       | — |   |
|            |       |                    |       |                |       |               |       | $                  | 41.4       |   | $ | 10.4 |   |
|                 |            |                         |            |                     |            |                    |            |                    |            |  |  |  |  |  |

 

For the six months ended June 30,2004 and 2003, approximately $400,000 and $100,000, respectively ofconstruction period interest was capitalized to projects in the construction stage.

 

**Note 5 – Other Liabilities**

 

Other liabilities were comprised of the following (inmillions):

 
| ** **                                          | ** ** | **June 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|------------------------|------------|
| Net deferred taxes and  other tax liabilities       |       | $                  | 1.3        |                   | $          | 3.6 |   |
| Accrued pensions                                    |       | 4.7                |       | 4.9                    |       |
| Home warranty  reserves                             |       | 1.2                |       | 1.2                    |       |
| Contingent  indemnity and environmental obligations |       | 3.3                |       | 4.1                    |       |
| Unamortized  discount                               |       | (.8                | )          | (.9                    | )          |
|                                                |       | $                  | 9.7        |                   | $          | 12.9 |   |

 

Contingent indemnity and environmental obligationsprimarily reflect (i) reserves before related discount (recorded pursuant toFresh-Start Reporting) for contingent indemnity obligations for businessesdisposed of by former affiliates and unrelated to the Company’s currentoperations, and (ii) the contingent liability of a subsidiary of the Companyfor PCB contamination on its 42-acre Bolsa Chica lowlands property as furtherdescribed below.

 

*Dresser Litigation*

 

In May 2002, Dresser Industries, Inc. (“Dresser”)filed litigation, captioned Dresser Industries, Inc. vs. California CoastalCommunities, Inc. and RESCO Holdings, Inc. (“RESCO”, a former affiliate), inthe 58th Judicial District Court of Jefferson County, Texas. Dresserseeks a declaratory judgment regarding the rights and obligations of theparties under a January 1988 purchase agreement. Under the agreement, Dresseracquired an engineering and construction business from The M.W. Kellogg Company(“Kellogg”), a corporation formerly affiliated with the Company. Kellogg andits parent company, Wheelabrator Technologies, Inc. (“Wheelabrator”, a formeraffiliate), agreed to indemnify Dresser against certain pre-closing claims. Ina subsequent transaction, Wheelabrator assigned certain assets and liabilitiesrelating to the January 1988 purchase agreement to the Company. Dresser alsoseeks unspecified damages for breach of the 1988 purchase agreement, along withattorney’s fees and costs. Dresser’s indemnity claims relate to several hundredlawsuits encompassing approximately 5,900 contested asbestos claims made bythird parties in connection with work in facilities in which the Dresser-acquiredengineering and construction business was allegedly connected.

 

9

----

 

The Company deniesDresser’s allegations and is vigorously defending itself in this case andrelated matters. The Company was not formed until September 1988 and, when itwas spun-off from Wheelabrator in December 1988, the Company agreed toindemnify Wheelabrator for its potential liabilities under the January 1988purchase agreement with Dresser, to the extent that any such liabilities arenot covered by insurance. However, the Company and RESCO contend that under theterms of the January 1988 purchase agreement, any contractual duty to indemnifyDresser for any third-party asbestos claims expired in March 1991. The Companyalso believes that it has a number of other meritorious defenses to thislitigation.

 

Currently, thislitigation is in the discovery process. The Company has participated in initialsettlement discussions in connection with a mediation which was ordered by theTexas court in advance of the trial. The trial has been postponed to October2004 in order to allow the mediation process to continue. However, there can beno assurance that a settlement can be reached before trial. Given thepreliminary nature of these proceedings, the Company is not able to assess itspotential exposure with any degree of accuracy. The Company’s litigationaccrual reflects its estimate for the minimum costs which are probable andestimable at this time.  However, defensecosts and damage awards in asbestos cases can involve amounts that would have amaterial adverse effect on the Company’s business, operations and financialcondition, in the event that the Company was required to provideindemnification to Dresser.

 

*LowlandRemediation*

 

In September 1997, theCompany acquired 42 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. While the State is negotiatingto acquire this property from the Company, no such agreement has been reachedto date and there can be no assurances that any agreement will ever be reached.However, in anticipation of entering into a purchase agreement, the Stateperformed limited soils sampling on this property and notified the Company in1999 that it had discovered contamination from a group of chemicals calledPCBs. The source of the contamination is presently unknown; however, theCompany has never conducted any development, business or operations on thisproperty. In January 2002, the State’s Department of Toxic Substances Control(“DTSC”) became the regulatory agency responsible for overseeing the Company’sefforts to remediate the contamination on this property. In July 2002, asubsidiary of the Company entered into a consent order with DTSC regardingremediation. The Company’s subsidiary prepared a Remedial Investigation (“RI”)Workplan, which was approved by DTSC in August 2003. During September andDecember 2003, the subsidiary performed soil sampling at the site according tothe RI Workplan to determine the nature and extent of contamination, andsubmitted an RI Report to DTSC in February 2004. As of June 30, 2004, thesubsidiary has accrued approximately $900,000 for environmental testing andremediation of this property. While the accrual reflects the estimate for theminimum costs which are probable and estimable, such accrual may not beadequate to satisfy the full amount of remediation that may be required by theDTSC. Until a remediation plan has been approved by DTSC, the Company cannotaccurately estimate how much, if any, additional costs may ultimately beincurred. There is no maximum limitation to the obligation of the Company’ssubsidiary to remediate under the DTSC consent order. Other parties, who haveyet to be identified, may be responsible for all or a portion of theseremediation costs. If any such party is subsequently identified, the Company’ssubsidiary may be entitled to seek reimbursement for some or all of its costs;however, there can be no assurance in that regard.

 

In May 2004, theCompany’s subsidiary received an invoice from DTSC seeking reimbursement for$793,216 of oversight and remediation costs incurred by DTSC with respect toPCBs found on neighboring residential properties. However, the Company’ssubsidiary contends, based upon advice of counsel, that it is not responsiblefor such costs because the Company did not develop or build the neighboringresidential properties, the Company did not generate the contamination, and thecontamination did not emanate from the Company’s property. Furthermore, theCompany’s subsidiary has also disputed such charges due to the fact that DTSCdid not bill the Company’s subsidiary on a timely basis as required by law. TheCompany’s subsidiary intends to vigorously defend itself in this matter.Therefore, the Company has not reserved for any of DTSC’s claims related tothese residential properties.

 

10

----

 

*HomeWarranty Reserve*

 

The Company provides ahome warranty reserve to reflect its contingent liability for productliability. The Company generally records a provision as homes are delivered,based upon historical and industry experience, subject to certain minimums. Thehome warranty reserve activity is presented below (in millions):

 
| ** **                      | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------|------------|--------------------------------|------------|
| ** **                      | ** ** | **2004**                       | ** ** | **2003** | ** ** |
|                            |       |                           |       |   |   |
| Balance at  beginning of period |       | $                              | 1.2        |   | $ | 1.2 |   |
| Provision                       |       | .1                             |       | .1 |   |
| Payments                        |       | (.1                            | )          | (.1 | ) |
| Balance at end  of period       |       | $                              | 1.2        |   | $ | 1.2 |   |

 

**Note 6 – Income Taxes**

 

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

 
| ** **                               | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **2004**                         | ** ** | **2003**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current tax                              |       | $                                | —     |                           | $          | — |   | $ | — |   | $ | — |   |
| Deferred tax                             |       | .1                               |       | .1                             |       | .3 |   | — |   |
| Reduction in  contingent tax liabilities |       | —                           |       | (.1                            | )          | (.1 | ) | (.1 | ) |
| Provision  (benefit) for income taxes    |       | $                                | .1         |                           | $          | — |   | $ | .2 |   | $ | (.1 | ) |

 

Deferred tax benefits resulting from reductions in thedeferred tax asset valuation allowance on net operating losses  (“NOLs”) are recorded when the Companyconcludes that it is more likely than not that it will utilize additional NOLsto offset taxable income. Increases in the deferred tax asset valuationallowance on NOLs are recorded when the Company determines that it cannotconclude that it is more likely than not that it will utilize additional NOLsto offset taxable income. During the three and six months ended June 30, 2004,reductions in valuation allowance on federal pre-Reorganization NOLs ofapproximately $2.4 million and $2.5 million, respectively were recorded.Pursuant to Fresh Start Reporting, the reductions in valuation allowancerelated to pre-Reorganization NOLs were reflected by increasing the Company’scapital in excess of par value.

 

The Internal Revenue Code (the“Code”) generally limits the availability of NOLs if an ownership change occurswithin any three-year period under Section 382. If the Company were toexperience an ownership change of more than 50%, the use of all remaining NOLswould generally be subject to an annual limitation equal to the value of theCompany’s equity before the ownership change, multiplied by the long-termtax-exempt rate. The federal NOLs available as of June 30, 2004 wereapproximately $176 million. The amount of federal NOLs which expire if not utilizedis zero, $1 million, $20 million, $8 million, $19 million and $128 million for2004, 2005, 2006, 2007, 2008 and thereafter, respectively.

 

##### **In October 1999, in response to anunsolicited written consent from a majority of its stockholders, the Companyamended its certificate of incorporation in order to protect the ability of theCompany to utilize its tax loss carryforwards. Since the Company’s use of itsNOLs would be severely restricted if it experiences an ownership change of 50%or more, the Company’s majority stockholders requested that the Board ofDirectors enact the amendments, which were determined to be in the bestinterest of the Company and its stockholders. The amendments prohibit futurepurchases of the Company’s common stock by persons who would become new 5%holders, and also prohibit current holders of over 5% from increasing theirpositions, except in certain permissible circumstances which would notjeopardize the Company’s ability to use its NOLs. While these amendmentsreduced the Company’s risk of an ownership change occurring due to theacquisition of shares by 5% stockholders, the risk remains that an ownershipchange could result from the sale of shares by existing 5% stockholders. TheCompany estimates that after giving effect to various transactions bystockholders who hold a 5% or greater interest in the Company, it hasexperienced a three-year cumulative ownership shift of approximately 38% as of August3, 2004.**

 

11

----

 

**Note 7 – Minority Interest**

 

In April 2003, theCompany entered into a Limited Liability Company (“Chino LLC”) joint ventureagreement for the purpose of designing, constructing and selling 77 homes inChino, California. The Chino LLC acquired the 77 lots in May 2003 and iscurrently constructing and selling homes. Hearthside Homes, Inc. (one of theCompany’s principal subsidiaries) is the managing member of the Chino 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%), as adjusted forthe member’s allocation of profits and losses. Profits and losses are generallyallocated 50% to each member, after a 10% preferred return on invested capital.The losses of the non-managing member are limited to the amount of its capitalcontribution of approximately $4.0 million. During July 2004, a capital distributionof $400,000 was made to the non-managing member, following the delivery of thefirst 11 homes.

 

**Note 8 –Commitments and Contingencies**

 

*Corporate Indemnification Matters*

 

The Company and its formeraffiliates have, through a variety of transactions effected since 1986,disposed of several assets and businesses, many of which are unrelated to theCompany’s current operations. By operation of law or contractual indemnityprovisions, the Company may have retained liabilities relating to certain ofthese assets and businesses.  There isgenerally no maximum obligation or amount of indemnity provided for suchliabilities. A portion of such liabilities are supported by insurance or byindemnities from certain of the Company’s previously affiliated companies. TheCompany believes its balance sheet reflects adequate reserves for thesematters; however there can be no assurance in that regard. See Note 5.

 

*Legal Proceedings*

 

See Note 5 for adiscussion of pending litigation filed against the Company by Dresser.

 

There are various otherlawsuits and claims pending against the Company and certain subsidiaries. Inthe opinion of the Company’s management, ultimate liability, if any, will nothave a material adverse effect on the Company’s financial condition or resultsof operations.

 

12

----

 

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

 

**General**

### * *

The Company is a residential landdevelopment and homebuilding company with properties located primarily insouthern California. The principal activities of the Company and itsconsolidated subsidiaries include: (i) obtaining zoning and otherentitlements for land it owns or controls through purchase options and improvingthe land for residential development; and (ii) designing, constructing andselling single-family residential homes in southern California. Once theresidential land owned by the Company is entitled, the Company may build homes,sell unimproved land to other developers or homebuilders, sell improved land tohomebuilders, or participate in joint ventures with other developers, investorsor homebuilders to finance and construct infrastructure and homes. During theremainder of 2004, the Company will focus its immediate efforts to(i) obtain approval from the California Coastal Commission (“CoastalCommission”) for development permits to build 379 homes on the upper bench ofthe Bolsa Chica Mesa (“Upper Mesa”), as further described in Note 3 to theCompany’s Consolidated Financial Statements; and (ii)  continue to expandits profitable homebuilding operations. However, the Company may also considerother strategic and joint venture opportunities; and there can be no assurancethat the Company will accomplish, in whole or in part, all or any of thesestrategic goals.

 

Over the last four years (2000 –2003), the Company has generated gross margins from homebuilding activities andcash flows on assets other than Bolsa Chica. The Company currently has on-goingsouthern California projects in Riverside County near the cities of NorthCorona and Riverside, in San Bernardino County in the city of Chino, in LosAngeles County in the city of Lancaster, and in San Diego County in the area ofRancho Santa Fe. These homebuilding projects are expected to generate cashflows and gross margins through mid-2006. While the Company acquired 253additional single-family residential lots during the first half of 2004, theCompany’s inventory of entitled land available for homebuilding projectsremains limited. Given this limited inventory of buildable lots, the Company iscontinuing to pursue residential lot acquisition opportunities. Due to delaysin approvals for homebuilding at Bolsa Chica, continuation of homebuildingoperations beyond mid-2006 is dependent upon acquisition of suitable, entitledresidential lots within the southern California area or Coastal Commissionapproval of the Company’s development plan for 379 homes on the Bolsa ChicaUpper Mesa.

 

**Bolsa Chica**

 

Bolsa Chica is the Company’sprincipal asset, representing 68% of total assets at June 30, 2004. It hasrequired and continues to require significant investments for entitlement andland development activities. As discussed in Note 3 to the consolidatedfinancial statements, the Company has faced various delays in implementing itsplans for residential development on the Bolsa Chica Mesa.

 

On June 30, 2004, the Company announced that it hasreached a preliminary agreement to sell a 103-acre parcel of the Bolsa ChicaMesa known as the “lower bench” to the State’s Wildlife Conservation Board(“WCB”) for $65 million. The sale remains subject to shareholder approval andto approval by the WCB at its next meeting on August 12, 2004. If the proposedsale is completed, WCB’s purchase of the property will be funded with bondproceeds authorized by voter-approved Proposition 50, which was passed inNovember 2002. However, there can be no assurances that WCB will grant finalapproval of the purchase of the lower bench, or that a sale transaction willever be completed.  The Company hasindicated that it will require Coastal Commission approval of its developmentplan for the “upper bench” area of the Bolsa Chica Mesa, as described below,prior to seeking shareholder approval.

 

The Company is currently pursuingapproval of development permits for the Upper Mesa. During 2002, the County ofOrange approved the Company’s site plan and tentative tract map for developmentof 379 single-family homes on the Upper Mesa. The Company submitted a CoastalDevelopment Permit (“CDP”) application for Brightwater to the CoastalCommission in November 2002, and the Coastal Commission is scheduled to hold apublic hearing on the Company’s CDP application on August, 12 2004; however,there can be no assurance that further delays will not be encountered. TheCalifornia Coastal Commission’s staff has released its report related to theCompany’s CDP and has recommended that the Commission deny the permitapplication. However that recommendation is not binding on the Commission, andthe Commission has often approved development plans despite contrary staffrecommendations. Therefore, the Company remains hopeful that the Commissionwill approve the CDP at the August 12 hearing. Ultimately, the Company does notbelieve that the Coastal Commission process will permanently prevent it fromdeveloping a planned community at Bolsa Chica; however, there can be noassurance in that regard, or as to (i) when development could commence, (ii)the number of acres or homes the Company will be permitted to develop, or (iii)the absence of further litigation or administrative delay.

 

13

----

 

The planned community on the UpperMesa, known as “Brightwater”, is currently expected to offer a broad mix ofhome choices, averaging 2,900 square feet and ranging in size from 1,560 squarefeet to 4,450 square feet. Brightwater would also include 28 acres of parks,public trails and open space on the 105-acre Upper Mesa. With only 379 homes onapproximately 77 acres of the Upper Mesa, the resulting low-density plan wouldequate to approximately 5 homes per acre, which is consistent and compatiblewith the neighboring Huntington Beach communities. In addition, the Companywould offer to dedicate 51 acres of land on the Huntington Mesa to the Countyof Orange in order to complete the Harriett M. Wieder Linear Park, a 105-acreplanned regional park. The 1,200-acre Bolsa Chica Wetlands are fully preservedand protected in accordance with previous agreements with the State ofCalifornia and are not included in the Brightwater plan.

 

If the WCB approves thepurchase of the lower bench at a price of $65 million and if the CoastalCommission approves the CDP for the Upper Mesa, the Company would thenreevaluate its projected profitability as it relates to recorded deferred taxasset valuation allowance on NOLs as required by SFAS No. 109. Suchre-evaluation may result in management concluding that it is more likely thannot that the Company will realize its deferred tax assets, which would resultin a reversal of all or a portion of the related valuation allowance.

 

The Company’s valuation allowance on federal NOLs asof June 30, 2004 is approximately $49.4 million.  Recognition of tax benefits from reductionsin valuation allowances attributable to any utilization or future potentialutilization of pre-Reorganization NOLs would be excluded from results ofoperations and credited to capital in excess of par value.  The portion of the federal valuationallowance attributable to federal pre-Reorganization NOLs is approximately$44.8 million as of June 30, 2004. Therefore, the Company would expect toreflect a tax benefit of $4.6 million in its statement of operations forreversal of valuation allowance on post-Reorganization NOLs and credit capitalin excess of par value in the amount of $44.8 million for reversal of valuationallowance on pre-Reorganization NOLs if it concludes that it is more likelythan not that all the NOLs will ultimately be utilized to offset operatingincome generated from the disposition of the Bolsa Chica property.

 

Upon completion of theRecapitalization in September 1997 as discussed in Note 3 to the ConsolidatedFinancial Statements included in this Quarterly Report, the Company applied theaccounting principles required by Fresh-Start Reporting and the carrying valueof land held for development (Bolsa Chica) was adjusted to fair value as ofSeptember 2, 1997. The fair value was determined in 1997 using discountedestimated cash flows expected from the asset’s operations and eventualdisposition. Following the November 2000 Coastal Commission action, anassessment of impairment was conducted by the Company for the year endedDecember 31, 2000. The Company updated its analysis at each year-end since2000, and has noted no indicators of impairment since that date. Future costsincurred for capitalizable development activities for the Bolsa Chica projectwill increase the basis of the land. An estimate for these costs has beenincluded in the Company’s estimated undiscounted cash flow forecast used in itsimpairment analyses. In accordance with the Company’s policy described in Note2 to the Consolidated Financial Statements – Impairment of Long-Lived Assets,since the estimated undiscounted future cash flows from the Upper Mesa and thepending sale of the lower bench to the WCB exceed its June 30, 2004 carryingvalue, the Company believes there has been no impairment.

 

In evaluating therecoverability of the carrying value of Bolsa Chica, the Company considered thecurrent status of development planning for the Upper Mesa.  A tentative tract map and site plan for theUpper Mesa have been approved by the County of Orange. The Company alsoevaluated the likelihood of obtaining Coastal Commission approval for its CDPapplication for the Upper Mesa and several alternative outcomes for the lowerbench in its probability-weighted approach to evaluating the recoverability ofthe carrying value of this asset under SFAS No. 144.

 

The Company’s applicationfor a CDP from the Coastal Commission relates only to the Upper Mesa, where theCoastal Commission has previously approved residential development in fourprevious public hearings (1986, 1996, 1997 and 2000). The Coastal Commissionindicated in its 2000 public hearing on Bolsa Chica, that it would allowsubstantial development (up to 1,235 homes) on the Upper Mesa if the Companywill grant a conservation easement over the lower bench.  Therefore, the Company believes that it islikely that the Commission will allow reasonable development on the Upper Mesain the future. Furthermore, the Company believes that it will eventually bepermitted to reasonably develop the Upper Mesa, and that the Company wouldrecover substantially more from the Upper Mesa development than the $155.0million carrying value for the entire Bolsa Chica Mesa as of June 30, 2004.

 

Given that the Companyhas no debt which is secured by any of the Bolsa Chica property, and itscurrent homebuilding operations are providing cash flow, the Company expects tobe able to continue pursuing reasonable development as long as necessary untilit succeeds in obtaining permits for development on the Upper Mesa.Alternatively, if the Company’s CDP is not approved, the Company expects tovigorously oppose any challenges to reasonable development of the UpperMesa.  Furthermore, as discussed above,any value recovered from the lower bench would add to the ultimate proceedsfrom disposal of this class of assets.

 

14

----

 

The following facts andassumptions were utilized by the Company in evaluating the potential valuewhich could be derived from development of the Bolsa Chica Upper Mesa:

 

•      The Upper Mesa CDP application encompasses 379homes aggregating approximately 1.1 million square feet.

•      Following receipt of a CDP, the Upper Mesadevelopment is projected to take approximately six months for infrastructureand two to three years for home construction.

•      New home prices approximate $400 per square foot,before view and other premiums, in the local residential market (coastalHuntington Beach).

•      View, size and location premiums for the UpperMesa could range from 5% to 25% of base home prices.

•      The finished lot component of home prices rangesfrom 40% to 60%, based on knowledge of the market place and discussions withadvisors to the Company.

•      Costs to improve the lots from their rawcondition to finished lots approximate $100,000 per lot.

•      Home prices in the coastal Huntington Beach area(as well as other Orange County coastal areas) appreciated approximately 20%during 2003 and continued to appreciate during the first half of 2004. Whiledemand continues to exceed the supply of housing, pressure for continuedappreciation of home prices has been reduced by declining affordability.

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

 

The estimation processinvolved in the determination of value is inherently uncertain because itrequires estimates as to future events and market conditions. Such estimationprocess assumes the Company’s ability to complete development and dispose ofits real estate properties in the ordinary course of business based onmanagement’s present plans and intentions. Economic, market, environmental andpolitical conditions may affect management’s development and marketing plans.In addition, the implementation of such development and marketing plans couldbe affected by the availability of future financing for development andconstruction activities. The development of the Company’s Bolsa Chica Mesaproject is dependent upon various governmental approvals and economic factors.Accordingly, the amount ultimately realized from such project may differmaterially from current estimates and the project’s carrying value.

 

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

 

Real estate and residential housingprices are affected by inflation, which can cause increases in the price ofland, raw materials and subcontracted labor. Unless these increased costs arerecovered through higher sales prices, gross margin from home sales woulddecrease. If interest rates increase, construction and financing costs, as wellas the cost of borrowings, also would increase, which can also result in lowergross margin from home sales. The volatility of interest rates could have anadverse effect on the Company’s future operations and liquidity. Among otherthings, these conditions may affect adversely the demand for housing and theavailability of mortgage financing and may reduce the credit facilities offeredto the Company.

 

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

 

Most of the Company’s activehomebuilding projects are located in the “Inland Empire” area of southernCalifornia, which includes Riverside and San Bernardino counties. The InlandEmpire has experienced significant population and job growth in the pastdecade. While continued growth is expected, partially due to the limited supplyof affordably priced housing in coastal areas such as Orange County, there canbe no assurance that economic, demographic or other factors will not slow,diminish or cause such growth to discontinue. The Company is continuing topursue lot acquisition opportunities throughout southern California.

 

**CriticalAccounting Policies**

 

In the preparation of theConsolidated Financial Statements, the Company applies accounting principlesgenerally accepted in the United States. The application of generally acceptedaccounting principles may require management to make estimates and assumptionsthat affect the amounts reported in the financial statements and accompanyingresults. Listed below are those policies that the Company believes are criticaland require the use of

 

15

----

 

complex judgment in their application. The Company’scritical accounting policies include the evaluation of the impairment oflong-lived assets and the evaluation of the probability of being able torealize the future benefits indicated by its significant federal tax netoperating losses, as discussed further in Note 2 to the Consolidated FinancialStatements.

 

*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 the Impairmentor Disposal of Long-Lived Assets”. These assets are carried at cost, unless thecarrying amount of the parcel or subdivision is determined not to be fullyrecoverable, in which case the impaired real estate is written down to fairvalue. Given the significance of the carrying value of land held for futuredevelopment, the application of SFAS No. 144 in evaluating any potentialimpairment is critical to the Company’s consolidated financial statements, asdiscussed further in Note 2 to the Consolidated Financial Statements.

 

In accordance with SFASNo. 144, in developing estimated future cash flows for impairment testing, theCompany has incorporated its own assumptions regarding the entitlementprospects of land held for future development and its own market assumptionsincluding those regarding home prices, infrastructure and home-building costsregarding both land held for future development and real estate held forcurrent development or sale. Additionally, as appropriate, the Company identifies alternative coursesof action to recover the carrying value of its long-lived assets and evaluatesall likely alternatives under a probability-weighted approach as suggested inSFAS No. 144.

 

*Basis ofConsolidation*

 

Certain wholly-owned subsidiaries of the Company aremembers in joint ventures involved in the development and sale of residentialprojects and residential loan production. The consolidated statements of theCompany include the accounts of the Company and all majority-owned andcontrolled subsidiaries and joint ventures. The financial statements of jointventures in which the Company generally has a controlling or majority economicinterest (and thus are controlled by the Company) are consolidated with theCompany’s financial statements. Minority interest represents the equityinterest of the Company’s joint venture partner for one consolidated ventureand is further described in Note 7 to the Consolidated Financial Statements. TheCompany’s investments in unconsolidated joint ventures are accounted for usingthe equity method when the Company does not have voting or economic control ofthe venture operations.

 

*IncomeTaxes*

 

The Company accounts forincome taxes on the liability method. Deferred income taxes are determinedbased on the difference between the consolidated financial statement and taxbases of assets and liabilities. The liability method requires an evaluation ofthe probability of being able to realize the future benefits indicated bydeferred tax assets, such as tax net operating losses (“NOLs”). A valuationallowance related to the deferred tax asset is recorded when uncertaintiespreclude the Company from determining that it is more likely than not that someportion or all of the deferred tax asset will be realized. Given thesignificance of the Company’s historical federal tax NOLs, as discussed aboveand in Note 6 to the Consolidated Financial Statements, the application of theCompany’s policy in evaluating the expected future benefit of NOLs is critical.In applying those policies, estimates and judgments affect the amounts at whichcertain assets and liabilities are recorded. The Company applies its accountingpolicies on a consistent basis. As circumstances change, they are considered inthe Company’s estimates and judgments, and future changes in circumstancescould result in changes in amounts at which assets and liabilities arerecorded.

 

*HomebuildingRevenues and Cost of Sales*

 

The Company’s homebuilding operationgenerates revenues from the sale of homes to homebuyers. The majority of thesehomes is designed to appeal to move-up homebuyers and the homes are generallyoffered for sale in advance of their construction. Sales contracts are usuallysubject to certain contingencies such as the buyer’s ability to qualify forfinancing. Revenue from the sale of homes is recognized at closing when titlepasses to the buyer, and the earnings process is complete. As a result, theCompany’s revenue recognition process does not involve significant judgments orestimates. However, the Company does rely on certain projections and estimatesto determine the related construction costs and resulting gross marginsassociated with revenues recognized. The Company’s construction costs arecomprised of direct and allocated costs, including estimated costs for futurewarranties and indemnities. The Company’s estimates are based on historicalresults, adjusted for current factors.

 

16

----

 

*LitigationReserves*

 

The Company and certainof its subsidiaries have been named as defendants in various cases arising inthe normal course of business and regarding disposed assets and businesses ofthe Company or former affiliates. The Company has reserved for costs expectedto be incurred with respect to these cases based upon information provided byits legal counsel.

 

**Recent Accounting Pronouncements**

 

See discussion regarding recentaccounting pronouncements in Note 2 to the Consolidated Financial Statements.

 

**Liquidity and Capital Resources**

 

The principal assets in theCompany’s portfolio are residential land which must be held over an extendedperiod of time in order to be developed to a condition that, in management’sopinion, will ultimately maximize the return to the Company. Consequently, theCompany requires significant capital to finance its real estate development andhomebuilding operations. Historically, sources of capital have includedspecific property financings, asset sales and available internal funds. TheCompany is utilizing internally generated cash to fund the North Corona projectand the Bolsa Chica project, and is currently utilizing project debt andinternally generated cash to fund acquisition and construction of all other homebuildingprojects. The Company’s current homebuilding projects are expected to generateapproximately $39 million of cash during the next 24 months, based on presenteconomic conditions and market assumptions. The Company’s cash and cashequivalents as of June 30, 2004 were approximately $4.4 million. The Companybelieves that its cash and cash equivalents, future real estate sales proceeds,and funds available under its credit and joint venture agreements will besufficient to meet anticipated operating and capital investment requirements,primarily project development costs for homebuilding projects and the BolsaChica and Oxnard land development projects, along with general andadministrative expenses and liabilities, for the next 12 months.

 

The Company is subject to the usualobligations associated with entering into contracts for the purchase of landand improved homesites. These purchase contracts typically require a cashdeposit and the purchase of properties under these contracts is generallycontingent upon satisfaction of certain requirements by the sellers or theCompany, including obtaining applicable property entitlements. The Company alsoutilizes option contracts with third-party land sellers and financial entitiesas a method of acquiring land in staged takedowns and minimizing the use offunds from other corporate financing sources. These option contracts also helpto manage the financial and market risk associated with land holdings. Optioncontracts generally require the payment of a non-refundable cash deposit forthe right to acquire lots over a specified period of time at predeterminedprices. The Company has the right at its discretion to terminate theobligations under these option agreements by forfeiting the cash deposit withno further financial responsibility. The Company may enter into landdevelopment and homebuilding joint ventures from time to time as a means ofexpanding its market opportunities, establishing strategic alliances, managingits risk profile and leveraging the Company’s capital base. These jointventures may obtain secured acquisition, development and constructionfinancing, which minimizes the use of funds from other corporate financingsources.

 

**Homebuilding**

 

The Company’s homebuildingoperations have been focused on rebuilding lot inventory during the first sixmonths of 2004, completing acquisitions of 253 single-family residential lotsduring that period. While home deliveries have not been as numerous as in theprior year’s first half, the Company expects to have a much more robust secondhalf, as it did in the second half of 2003 when it delivered 112 homes. Whilethe approximately 140 home deliveries projected for the full year 2004 issomewhat less than the 154 homes delivered in 2003, homebuilding revenues andmargins for 2004 are expected to exceed 2003 results.

 

*North Corona*.  In July 2001, the Company acquired 83finished lots in Riverside County, California near North Corona in themaster-planned community known as “Providence Ranch”. The community of ProvidenceRanch and the adjacent community of “Corona Valley”, are planned for a total of2,600 homes, and are well-located to serve the employment centers of thegreater Los Angeles area, Orange County and the Ontario international airport.The Company commenced home construction in October 2001, opened for sales inFebruary 2002 and released 73 homes for sale during 2002 at an average price ofapproximately $298,000. During 2002 and 2003, 58 homes and 15 homes weredelivered, respectively. During the three months ended June 30, 2004, seven ofthe 10 homes in the final phase were delivered at an average price of $430,500,two additional homes were delivered during July and the final home is inescrow, with delivery scheduled during the third quarter of 2004.

 

17

----

 

In October 2002, theCompany acquired an additional 93 finished lots in the Providence Ranchcommunity. Construction of homes in this second phase began during the firstquarter of 2003. The Company sold these homes from the original modelcomplex.  During 2003, the Companydelivered 71 homes at an average price of $367,000. An additional seven homeswere delivered during the first quarter of 2004. As of August 2, 2004, theremaining 15 homes are in escrow at an average price of $446,000, withdeliveries scheduled during the third quarter of 2004.

 

*Riverside*.  During the fourth quarter of 2002 and thefirst quarter of 2003, the Company acquired a total of 24 finished lots nearthe city of Riverside, in Riverside County, in the master-planned communityknown as “Victoria Grove”. This well-established community is planned for atotal of 855 homes. During April 2004, the Company acquired 43 additional lotsfor a total project of 67 homes known as “Jasper Ranch”. The Company beganconstruction of homes during the third quarter of 2003. The homes average 3,673square feet. The Company opened for sales on these homes during June 2003. TheCompany delivered the first phase of five homes during the fourth quarter of 2003at an average price of approximately $468,000, and the second phase of sixhomes during the first quarter of 2004, at an average price of approximately$458,000. The Company has released 32 additional homes for sale at an averageprice of $619,000 and as of August 2, 2004, 28 are in escrow, with deliveriescurrently scheduled to begin during the fourth quarter of 2004.

 

*Chino. *In May 2003, through a consolidated joint venture, the Company acquired 77finished lots in Chino, California in San Bernardino County. This infill siteis part of a new community known as “The Reserve”, encompassing 244 homes.Construction of homes averaging approximately 3,320 square feet began duringthe fourth quarter of 2003. The Company opened for home sales on February 28,2004, and has released the 69 homes for sale at an average price of $570,000.  As of August 2, 2004, 11 homes have beendelivered and an additional 45 are in escrow.

 

In January 2004, the Companyacquired 17 additional finished lots in the City of Chino which are near, butnot a part of The Reserve, and are not a part of the joint venture describedabove. The Company expects to begin construction of homes averaging 3,098square feet during the third quarter of 2004.

 

*Rancho Santa Fe.*  In October2003, the Company entered into an agreement to acquire 32 lots in a luxury golfcommunity known as Crosby Estates in the Rancho Santa Fe area of California inSan Diego County. The Company acquired eight of the lots during the fourthquarter of 2003 and six additional lots in June 2004, and expects to beginconstruction of homes averaging approximately 3,369 square feet during thethird quarter of 2004.

 

*Lancaster.*  The Company acquired 104 lots in the city ofLancaster in northern Los Angeles County during May 2004. The Company presentlyexpects to begin construction of homes averaging approximately 2,800 squarefeet during the third quarter of 2004.

 

*Corona.*  The Companyacquired 83 lots in North Corona in May 2004. The Company presently expects to begin construction of homes averaging3,038 square feet during the third quarter of 2004.

 

**Land Development - UnconsolidatedJoint Venture**

 

*Oxnard.*  In February 2003, the Company entered intotwo option contracts to acquire land adjacent to the City of Oxnard in VenturaCounty, California aggregating approximately 168 acres. The Company is in theprocess of developing a land plan for the site, which includes an additional149 acres owned by other landowners, with the intention of entitling theproperty for residential development and annexing it to the City of Oxnard. TheCompany currently expects that the residential development plan will includeapproximately 700 single-family detached lots and approximately 441 attachedfamily residential units; however, these numbers are subject to change duringthe course of the entitlement process. The option contracts allow for twoyears, plus up to three additional years through the exercise of extensions,for the Company to complete these entitlement activities in advance of consummatingthe purchase transactions. 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.

 

18

----

 

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 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 an initialcontribution of $500,000 to the venture. Capital contributions of up to anadditional $4 million are to be made by the non-managing member. As of June 30,2004, the non-managing member had made an aggregate of approximately $1.9million of additional contributions. Under the Oxnard LLC operating agreement,if contributions in excess of $5 million are required and approved by themembers, the next $1 million would be contributed equally by the members. 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 will exert alarge degree of control over the venture, the non-managing member does havevarious approval rights with regard to major business decisions, and thereforethe operations of the venture are not consolidated.

 

## ** Financial Condition**

 

*June 30,2004 Compared with December 31, 2003*

 

Cash flows from homebuildingoperations for the first six months of 2004 primarily reflect a use of cash forland acquisitions of 253 single-family residential lots in Chino, Riverside,Corona, Lancaster and Rancho Santa Fe, California aggregating $28.5 million andhomebuilding construction costs of $16.7 million, largely financed by netborrowing under project debt financing of $31.0 million, including borrowingunder eight new facilities. Additional cash was provided by home sales proceedsof $8.7 million from deliveries of 20 homes. Additional significant uses ofcash include approximately $1.4 million for investment in the Bolsa Chica Mesaproject, primarily for consultants engaged in the entitlement process, selling,general and administrative expenses of approximately $1.7 million, a $1.2million decrease in accounts payable and accrued liabilities for payment ofaccrued construction, compensation and tax liabilities and a $.8 milliondecrease in other liabilities for payment of legal fees, environmental costs,and funding the Company’s pension plans. These items, as well as other activitypresented in the Statements of Cash Flows, resulted in the $10.3 milliondecrease in cash and cash equivalents.

 

The remaining $2.4 million decreasein other liabilities primarily reflects recognition of tax benefits forexpected utilization of pre-Reorganization NOLs, which increased capital inexcess of par value (see Note 6).

 

**Results of Operations**

 

The nature of theCompany’s business, including its limited inventory of buildable lots, is suchthat individual transactions often cause significant fluctuations in operatingresults from quarter-to-quarter and from year-to-year.

 

*ThreeMonths Ended June 30, 2004 Compared with the Three Months Ended June 30, 2003*

 

The Company reported revenues of$3.2 million and gross operating profit of  $1.1 million for the second quarter of 2004,compared with $9.2 million in revenues and gross operating profit of $1.6million for the second quarter of 2003. Revenues in the current period reflectdeliveries of seven homes, all at the North Corona project and a $100,000 landsale. The comparable period of the prior year reflects deliveries of 29 homes,including  14 homes at the North Coronaproject, 14 homes at the Riverside project known as “Harvest” and the finalhome at the Yucaipa project. The current quarter’s gross margin fromhomebuilding of 32.3% is higher than the prior period gross margin of 17.4% dueto price appreciation, and reflects current quarter deliveries of homes on lotspurchased in 2001.

 

The $100,000 decrease in selling,general and administrative expenses during the second quarter of 2004, ascompared with the first quarter of 2003, primarily reflects a decrease inaccrued incentive compensation corresponding to the reduced operating results.

 

The improvement in other expense,net reflects the absence in 2004 of an accrual of approximately $700,000 forestimated environmental remediation costs for Bolsa Chica lowland remediationrecorded in the 2003 period.

 

*SixMonths Ended June 30, 2004 Compared with the Six Months Ended June 30, 2003*

 

The Company reported revenues of$8.8 million and gross operating profit of $2.4 million for the first half of2004, compared with $13.1 million in revenues and gross operating profit of$2.2 million for the first half of 2003. Revenues in the first half of 2004reflect deliveries of 20 homes, including six homes at the Company’s Riverside(Jasper Ranch) project and 14 homes at the North Corona project and the$100,000 land sale. The comparable period of the prior year reflects deliveriesof an aggregate of 42 homes at the Riverside (Harvest), North Corona andYucaipa projects. The homebuilding gross margin for the first half of 2004 of26.4% is higher than the prior period gross margin of 16.8% due to home priceappreciation experienced over the past year and higher profitability of theRiverside project as compared to the Yucaipa project.

 

19

----

 

The $100,000 decrease in incomefrom unconsolidated joint ventures to $200,000 for the first half of 2004 from$300,000 for the first half of 2003 primarily reflects fewer home loans madethrough the Company’s joint venture during the first half of 2004 as comparedwith the first half of 2003. This reduced volume correlates to fewer homedeliveries during the current year period.

 

The improvement in otherexpense, net reflects the absence in 2004 of an accrual of approximately$700,000 for estimated environmental remediation costs for Bolsa Chica lowlandremediation recorded in the 2003 period (see Note 5).

 

During each of the six months endedJune 30, 2004 and 2003, the Company recorded a tax benefit of approximately$100,000 in connection with reductions in reserves for contingent taxliabilities. The reductions in tax reserves in 2004 and 2003 were due to theresolution of outstanding tax matters in two and eight states, respectively.These events reduced the Company’s exposure in each period.

 

*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 ofJune 30, 2004 (in millions):

 
| ** **       | ** ** | ** ** | ** ** | **Payments due by period** | ** ** |
|------------------|------------|------------|------------|----------------------------|------------|
| ** **       | ** ** | **Total**  | ** ** | **Less  than 1  year**     | ** ** | **1-3  years** | ** ** | **3-5  years** | ** ** | **More  than 5  years** | ** ** |
|             |       |       |       |                       |       |   |   |   |   |   |   |
| Project debt     |       | $          | 41.4       |                       | $          | 41.4 |   | — |   | — |   | —- |   |
| Operating leases |       | .5         |       | .2                         |       | .3 |   | — |   | — |   |
| Total            |       | $          | 41.9       |                       | $          | 41.6 |   | $ | .3 |   | — |   | — |   |
|                  |            |            |            |                            |            |  |  |  |  |  |  |  |  |  |

 

The Company’s purchase contracts which are made in thenormal course of its homebuilding business for land acquisition andconstruction subcontracts are generally cancelable at will. Other contractualobligations including the Company’s other tax liabilities, accrued benefitliability for a frozen retirement plan and other accrued pensions, homewarranty reserves and contingent indemnity and environmental obligations areestimated based on various factors. Payments are not due as of a given date,but rather are dependent upon the incurrence of professional services, thelives of annuitants and other factors. The estimation process involved in thedetermination of carrying values of these obligations is inherently uncertainsince it requires estimates as to future events and contingencies. The Companyhas provided additional disclosure in its Consolidated Financial Statements inNotes 5 and 6.

 

**Safe Harbor, Statement Underthe Private Securities Litigation Act of 1995**

 

Certaininformation included in this Report and other materials filed or to be filed bythe Company with the Securities and Exchange Commission (as well as informationincluded in oral or written statements made by the Company or on the Company’sbehalf), may contain forward-looking statements about current and expectedperformance trends, growth plans, business goals and other matters. Thesestatements may be contained in the Company’s filings with the Securities andExchange Commission, in press releases, in other written communications, and inoral statements made by or with the approval of one of the Company’s authorizedofficers. These statements involve known and unknown risks, uncertainties andother factors which may cause the Company’s actual results, performance orachievements to be materially different from any future results, performancesor achievements expressed or implied by the forward-looking statements.  In some cases, you can identifyforward-looking statements by terminology such as “may”, “will”, “could”,“should”, “would”, “expects”, “plans”, “anticipates”, “believes”, “estimates”,“predicts”, “projects”, “potential”, “continue”, or the negative of such termsor other comparable terminology. These statements, and any other statementsthat are not historical facts, are forward-looking statements within themeaning of the Private Securities Litigation Reform Act of 1995, as codified inSection 27A of the Securities Act of 1933 and Section 21E of the SecuritiesExchange Act of 1934, as amended from time to time (the “Act”).

 

Theseforward-looking statements include, but are not limited to, (1) statementsabout the Company’s plans, objectives, goals, expectations and intentions; (2)the number and types of homes and number of acres of land that the Company maydevelop and sell; (3) the timing and outcomes of litigation, regulatoryapproval processes or administrative proceedings (including, but not limited toongoing administrative proceedings related to the Company’s principal asset,the Bolsa Chica Mesa); (4) the completion of the $65 million sale of the lowerbench of the Bolsa Chica Mesa to the State of

 

20

----

 

California’s Wildlife Conservation Board; (5) theexpected home deliveries and revenues; (6) the expectation of continuedfavorable housing market conditions in 2004, including measured increases inmortgage interest rates; (7) the housing market conditions in the geographicmarkets in which the Company operates; (8) expected average sales prices; (9)the intention to continue to utilize joint venture vehicles; (10) theeffectiveness and adequacy of the Company’s disclosures and internal controls;and (11) other statements contained herein that are not historical facts.

 

Inconnection with the “safe harbor” provisions of the Act, the Company is filingthe following summary to identify important factors, risks and uncertaintiesthat could cause actual results to differ materially from those projected inforward-looking statements made by the Company, or on its behalf. Thesecautionary statements are to be used as a reference in connection with anyforward-looking statements. The factors, risks and uncertainties identified inthese cautionary statements are in addition to those contained in any othercautionary statements, written or oral, which may be made or otherwiseaddressed in connection with a forward-looking statement or contained in any ofthe Company’s subsequent filings with the placing of undue reliance onforward-looking statements. Although the Company believes that the assumptionsunderlying forward-looking statements are reasonable, any of the assumptionscould be incorrect, and there can be no assurance that forward-lookingstatements will prove to be accurate. Forward-looking statements speak only asof the date on which they are made. The Company does not undertake anyobligation to modify or revise any forward-looking statement to take intoaccount or otherwise reflect subsequent events, or circumstances arising afterthe date that the forward-looking statement was made.

 

The followingrisk factors may affect the Company’s operating results and the environmentwithin which it conducts business. If the Company’s projections and estimatesregarding these factors differ materially from what actually occurs, theCompany’s actual results could vary significantly from any results expressed orimplied by forward-looking statements. These risk factors include, but are notlimited to, (1) changes in general economic, demographic, geopolitical orpublic safety conditions which affect consumer behavior and spending forresidential real estate, including the ongoing ramifications of the September11, 2001 terrorist attacks and the governmental response thereto, including thecontinuing armed conflict in Iraq or in other countries; (2) local and generaleconomic and market conditions, including consumer confidence,  employment rates, interest rates, the costand availability of mortgage financing, and stock market, home and landvaluations; (3) the Company’s ability to acquire residential lots in order tocontinue homebuilding operations; (4) the adequacy of capital, financing andcash flow required to continue the Company’s operations and land developmentactivities; (5)  the Company’s ability tocontinue relationships with current or future partners; (6) the Company’sability to expend resources to comply with environmental regulations and localpermitting requirements; (7) the effect of certain costs, contractualobligations and tax liabilities, both known and unknown, on the Company’s business,results of operations and financial condition; (8) the cost and availability ofconstruction financing and corporate debt and equity capital; (9) the demandfor single-family homes; (10) cancellations of purchase contracts byhomebuyers; (11) the cyclical and competitive nature of the Company’s business;(12) delays in the land entitlement and other approval processes, development,construction, or the opening of new home communities; (13) future businessdecisions and the Company’s ability to successfully implement its operational,growth and other strategies; (14) risks relating to acquisitions; (15)litigation and warranty claims; (16) the condition and adequacy of theCompany’s properties; (17) the Company’s ability to estimate cash flowprojections due to uncertainties in valuing real property; (18) the futurecondition of the real estate market in southern California; (19) generaleconomic and business conditions; (20) interest rate changes; (21) the relativestability of debt and equity markets; (22) competition; (23) the availabilityand cost of raw materials used by the Company in its homebuilding operations;(24) shortages and the cost of labor; (25) weather related slowdowns; (26) slowgrowth and no growth initiatives or moratoria; (27) governmental regulation,including the interpretation of tax, labor and environmental laws; (28) changesin consumer confidence and preferences; (29) accounting changes; (30) otherrisks discussed in the Company’s past and future filings with the Securitiesand Exchange Commission; and (31) other factors over which the Company haslittle or no control.

 

The Company assumes no, and herebydisclaims any, obligation to update any of the foregoing or any otherforward-looking statements. The Company nonetheless reserves the right to makesuch updates from time to time by press release, periodic report or othermethod of public disclosure without the need for specific reference to thisReport. No such update shall be deemed to indicate that other statements notaddressed by such update remain correct or create an obligation to provide anyother updates.

 

ITEM3  -  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

The Company utilizes project debtfinancing for acquisition, development and construction of homes. The interestrates on the Company’s project debt approximate the current rates available forsecured real estate financing with similar terms and maturities, and as aresult, their carrying amounts approximate fair value. While changes ininterest rates generally do not impact the fair market value of the debtinstrument, they do affect the Company’s earnings and cash

 

21

----

 

flows. Holding the Company’s variable rate debtbalance constant as of June 30, 2004, each one point percentage increase ininterest rates would result in an increase in variable rate interest incurredfor 2004 of approximately $400,000.

 

ITEM4 -  EVALUATION OFDISCLOSURE CONTROLS AND PROCEDURES

 

As of the end of the period covered by this report,the Company carried out an evaluation, under the supervision and with theparticipation of the Company’s management, including the Chief ExecutiveOfficer and Chief Financial Officer, of the effectiveness of the design andoperation of the Company’s disclosure controls and procedures. The Company’sdisclosure controls and procedures are designed to ensure that informationrequired to be disclosed by the Company in its periodic filings with theSecurities and Exchange Commission (“SEC”) is recorded, processed and reportedwithin the time periods specified in the SEC’s rules and forms. Based on theforegoing, the Company’s Chief Executive Officer and Chief Financial Officerconcluded that the Company’s disclosure controls and procedures were effectivein timely alerting them to material information relating to the Company(including its consolidated subsidiaries) required to be included in theCompany’s periodic SEC filings. There have been no significant changes in theCompany’s internal controls or in other factors that could significantly affectthe internal controls subsequent to the date the Company completed itsevaluation.

 

PART II - OTHERINFORMATION

 

ITEM 1 -                Legal Proceedings

 

See Note 5 to theConsolidated Financial Statements above, and “Item 1 - Business - CorporateIndemnification Matters” and “Item 3 - Legal Proceedings” in the Company’sAnnual Report on Form 10-K for the year ended December 31, 2003.

 

 

ITEM  4 -               Submission of Matters to a Vote ofSecurity Holders

 

The Annual Meeting of the Company’sstockholders was held on May 27, 2004. A quorum of common stock was present inperson or by proxy. The following proposals were approved by the requisite voteof the Company’s stockholders entitled to vote, as follows:

 

Proposal No. 1: *The Director Proposal*.  The Company’s director proposal recommendedelection of five directors to a one-year term. Set forth below is a table ofhow the votes were cast for each nominee, which constituted the affirmativevotes for all nominees, by the holders of approximately 98.7% of theoutstanding Common Stock represented in person or by proxy at the annualMeeting.

 
| **Name**               | ** ** | **Votes Cast “For Nominee”** | ** ** | **Votes “Withheld”** |
|------------------------|------------|----------------------------------------|------------|--------------------------------|
|                   |       |                                   |       |                           |
| Geoffrey W. Arens      |       | 9,857,657                              |       | 103,009                        |
| Phillip R. Burnaman II |       | 9,834,857                              |       | 125,809                        |
| Raymond J. Pacini      |       | 9,857,434                              |       | 103,232                        |
| Thomas W. Sabin, Jr.   |       | 9,836,873                              |       | 123,793                        |
| J. Thomas Talbot       |       | 9,836,657                              |       | 124,015                        |

 

Proposal No. 2:  *The Stock Plan Proposal*.  The holders of Common Stock cast 7,175,048votes for and 964,680 votes against the Company’s proposal to amend theCompany’s Amended and Restated 1993 Stock Option/Stock Issuance Plan, toincrease the number of shares of Common Stock issuable thereunder by anadditional 150,000 shares for a total of 909,984 shares that will be issuableunder the Plan, and to extend the term of the Plan to December 31, 2013.  Such votes constituted the affirmative votefor the Stock Plan Proposal by the holders of approximately 72% of theoutstanding Common Stock represented in person or by proxy at the AnnualMeeting. There were 26,252 abstentions and 1,794,686 broker non-votes by theholders of shares of Common Stock with respect to the Stock Plan Proposal.

 

Proposal No. 3:  *The Authorized SharesProposal*.  The holders ofCommon Stock cast 9,007,272 votes for and 952,098 votes against the Company’sproposal to amend the Company’s Amended and Restated Certificate ofIncorporation

 

22

----

 

to increase the number of authorized shares of Common Stock that theCompany has the authority to issue from ll million shares to 13.5 millionshares, with a corresponding increase in the number of shares of Excess Stock,par value $0.05 per share from 11 million shares to 13.5 million shares.  Such votes constituted the affirmative votefor the Authorized Shares Proposal by the holders of approximately 90.4% of theoutstanding Common Stock represented in person or by proxy at the AnnualMeeting. There were 1,296 abstentions and no broker non-votes by the holders ofshares of Common Stock with respect to the Authorized Shares Proposal.

 

Proposal No. 4:  *The Auditor Proposal*.  The holders of Common Stock cast 9,935,636votes for and 23,556 votes against the Company’s proposal to ratify theappointment of Deloitte & Touche LLP as the Company’s independent auditorsfor the fiscal year ending December 31, 2004. Such votes constituted theaffirmative vote for the Auditor Proposal by the holders of approximately 99.7%of the outstanding Common Stock represented in person or by proxy at the AnnualMeeting. There were 1,474 abstentions and no broker non-votes by the holders ofshares of Common Stock with respect to the Auditor Proposal.

 

ITEM6 -                Exhibits and Reports on Form 8-K

 

(a)     Exhibits:

 

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

 

31.2         Section302 Certificate of Sandra G. Sciutto, Chief Financial Officer of CaliforniaCoastal Communities, Inc.

 

32.1         Section906 Certificate of Raymond J. Pacini, Chief Executive Officer of CaliforniaCoastal Communities, Inc.*

 

32.2         Section906 Certificate of Sandra G. Sciutto, Chief Financial Officer of CaliforniaCoastal Communities, Inc.*

 

----

*              These certificationsare being furnished solely to accompany this report pursuant to 18 U.S.C.Section 1350, and are not being filed for purposes of Section 18 of theSecurities Exchange Act of 1934, as amended, and are not to be incorporated byreference into any filing of the Company, whether made before or after the datehereof, regardless of any general incorporation language in such filing.

 

(b)     Reports on Form 8-K:

 

CurrentReport on Form 8-K dated May 7, 2004, reporting that the Registrant hadannounced in a press release, a copy of which was attached, that it had decidedto postpone the hearing before the California Coastal Commission on itssubsidiary’s application for a Coastal Development Permit to build 379 homes onthe upper bench of its Bolsa Chica mesa property and attaching a press releasereporting first quarter results.

 

CurrentReport on Form 8-K dated June 30, 2004, reporting that the Registrant hadannounced in a press release that it had reached a preliminary agreement tosell 103 acres of its 208-acre Bolsa Chica Mesa property.

 

23

----

 

**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 4, 2004 | CALIFORNIA COASTAL  COMMUNITIES, INC. |
|----------------------------|---------------------------------------|
|                       |                                  |
|                       |                                  |
|                       | By:                                   | /s/ Sandra G. Sciutto |   |
|                       |                                  | SANDRA G. SCIUTTO |
|                       |                                  | Senior Vice President  and |
|                       |                                  | Chief Financial Officer |

 

24

----