This Form 10-Q consists of 23 sequentially numbered pages.

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C. 20549**

 

**Form 10-Q**

 

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

 

**For the quarterly period ended September 30, 2004**

 

**Commission File Number 0-17189**

 

**CALIFORNIA COASTAL COMMUNITIES,INC.**

(Exact name of registrant as specified in its charter)

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

 

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

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 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 check markwhether the registrant is an accelerated filer (as defined in Rule 12b-2 of theAct).

 

| Yes | ý |   | No | o |   |
|-----|--------|--------|----|---|--------|

 

Thenumber of shares of Common Stock outstanding at November 1, 2004 was 10,130,212.

 

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

 

I N D E X

 
| Part I -  | Financial Information: |                                                                                                          |
|----------------|------------------------|---------------------------------------------------------------------------------------------------------------|
|           |                   |                                                                                                          |   |
|           | Item 1 -               | Consolidated Financial Statements                                                                             |   |
|           |                   |                                                                                                          |   |
|           |                   | Consolidated Balance Sheets  -  September 30, 2004 and December 31, 2003 (unaudited)                          |   |
|           |                   |                                                                                                          |   |
|           |                   | Consolidated  Statements of Operations -  Three and Nine Months Ended September 30, 2004 and 2003 (unaudited) |   |
|           |                   |                                                                                                          |   |
|           |                   | Consolidated  Statements of Cash Flows -  Nine Months Ended September 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 6 -               | Exhibits                                                                                                      |   |
|           |                   |                                                                                                          |   |
| SIGNATURE      |                   |                                                                                                          |

 

2

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PART I.  FINANCIAL INFORMATION

 

ITEM 1 – FINANCIAL STATEMENTS

 

CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATEDBALANCE SHEETS

 

(unaudited)

 

(in millions)

 
| ** **                                                                                                 | ** ** | **September 30,  2004** | ** ** | **December 31, 2003** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|-----------------------|------------|
|                                                                                                       |       |                         |       |                  |       |
| ASSETS                                                                                                     |       |                         |       |                  |       |
|                                                                                                       |       |                         |       |                  |       |
| Cash and cash  equivalents                                                                                 |       | $                            | 6.5        |                  | $          | 14.7 |   |
| Real estate held  for current development or sale                                                          |       | 61.2                         |       | 27.5                  |       |
| Land held for  future development                                                                          |       | 155.6                        |       | 153.6                 |       |
| Other assets                                                                                               |       | 4.0                          |       | 2.3                   |       |
|                                                                                                       |       |                         |       |                  |       |
|                                                                                                       |       | $                            | 227.3      |                  | $          | 198.1 |   |
|                                                                                                       |       |                         |       |                  |       |
| LIABILITIES AND  STOCKHOLDERS’ EQUITY                                                                 |       |                         |       |                  |       |
|                                                                                                       |       |                         |       |                  |       |
| Liabilities:                                                                                               |       |                         |       |                  |       |
| Accounts payable  and accrued liabilities                                                                  |       | $                            | 7.2        |                  | $          | 6.3 |   |
| Project debt                                                                                               |       | 37.9                         |       | 10.4                  |       |
| Other  liabilities                                                                                         |       | 8.8                          |       | 12.9                  |       |
|                                                                                                       |       |                         |       |                  |       |
| Total  liabilities                                                                                         |       | 53.9                         |       | 29.6                  |       |
|                                                                                                       |       |                         |       |                  |       |
| Minority  interest                                                                                         |       | .5                           |       | 3.9                   |       |
|                                                                                                       |       |                         |       |                  |       |
| Commitments and  contingencies                                                                             |       |                         |       |                  |       |
|                                                                                                       |       |                         |       |                  |       |
| Stockholders’  equity:                                                                                |       |                         |       |                  |       |
| Common  Stock—$.05 par value; 13,500,000 shares authorized; 10,130,212 shares issued  and outstanding |       | .5                           |       | .5                    |       |
| Excess  Stock—$.05 par value; 13,500,000 shares authorized; no shares outstanding                     |       | —                       |       | —                |       |
| Capital in  excess of par value                                                                            |       | 149.6                        |       | 143.1                 |       |
| Retained  earnings                                                                                         |       | 25.2                         |       | 23.4                  |       |
| Accumulated  other comprehensive loss                                                                      |       | (2.4                         | )          | (2.4                  | )          |
| Total  stockholders’ equity                                                                           |       | 172.9                        |       | 164.6                 |       |
|                                                                                                       |       |                         |       |                  |       |
|                                                                                                       |       | $                            | 227.3      |                  | $          | 198.1 |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

 

(in millions, except per share amounts)

 

(unaudited)

 
| ** **                                                 | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                                                 | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues                                                   |       | $                                     | 28.4       |                                 | $          | 8.4 |   | $ | 37.2 |   | $ | 21.5 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Costs of sales                                             |       | 22.4                                  |       | 6.8                                  |       | 28.8 |   | 17.7 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Gross operating  profit                                    |       | 6.0                                   |       | 1.6                                  |       | 8.4 |   | 3.8 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Selling, general  and administrative expenses              |       | 1.7                                   |       | .8                                   |       | 3.4 |   | 2.5 |   |
| Interest expense                                           |       | .1                                    |       | .1                                   |       | .2 |   | .2 |   |
| Income from  unconsolidated joint ventures                 |       | (.1                                   | )          | (.1                                  | )          | (.3 | ) | (.4 | ) |
| Other expense,  net                                        |       | .6                                    |       | (.1                                  | )          | .7 |   | .6 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Income before  income taxes                                |       | 3.7                                   |       | .9                                   |       | 4.4 |   | .9 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Provision for  income taxes                                |       | 1.1                                   |       | .4                                   |       | 1.3 |   | .3 |   |
| Minority  interest in income of consolidated joint venture |       | 1.3                                   |       | —                               |       | 1.3 |   | — |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Net income                                                 |       | $                                     | 1.3        |                                 | $          | .5 |   | $ | 1.8 |   | $ | .6 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Earnings per  common share – basic                    |       | $                                     | .13        |                                 | $          | .05 |   | $ | .18 |   | $ | .06 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Earnings per  common share – diluted                  |       | $                                     | .12        |                                 | $          | .05 |   | $ | .17 |   | $ | .06 |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Common  equivalent shares:                                 |       |                                  |       |                                 |       |   |   |   |   |
|                                                       |       |                                  |       |                                 |       |   |   |   |   |
| Basic                                                      |       | 10.1                                  |       | 10.1                                 |       | 10.1 |   | 10.1 |   |
| Diluted                                                    |       | 10.9                                  |       | 10.9                                 |       | 10.8 |   | 10.8 |   |

 

See the accompanying notes to consolidated financial statements.

 

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

 

(in millions)

 

(unaudited)

 
| ** **                                                                        | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                        | ** ** | **2004**                             | ** ** | **2003** | ** ** |
|                                                                              |       |                                 |       |   |   |
| Cash flows from  operating activities:                                            |       |                                 |       |   |   |
| Net income                                                                        |       | $                                    | 1.8        |   | $ | .6 |   |
| Adjustments to  reconcile net income to cash used in operating activities:        |       |                                 |       |   |   |
| Non-cash  interest expense                                                        |       | .2                                   |       | .2 |   |
| Non-cash  compensation expense                                                    |       | .3                                   |       | — |   |
| Minority  interest in income of consolidated joint venture                        |       | 1.3                                  |       | — |   |
| Gains on sales  of real estate held for current development or sale               |       | (8.4                                 | )          | (3.8 | ) |
| Proceeds from  sales, net                                                         |       | 37.0                                 |       | 21.5 |   |
| Investments in  real estate held for current development or sale                  |       | (62.3                                | )          | (37.7 | ) |
| Investments in  land held for future development                                  |       | (2.0                                 | )          | (1.3 | ) |
| Changes in  assets and liabilities:                                               |       |                                 |       |   |   |
| Increase in  other assets                                                         |       | (1.7                                 | )          | (.6 | ) |
| Increase  (decrease) in accounts payable, accrued and other liabilities, net      |       | 3.6                                  |       | (.3 | ) |
|                                                                              |       |                                 |       |   |   |
| Cash used in  operating activities                                                |       | (30.2                                | )          | (21.4 | ) |
|                                                                              |       |                                 |       |   |   |
| Cash flows from  financing activities:                                            |       |                                 |       |   |   |
| Borrowings of  project debt                                                       |       | 45.4                                 |       | 22.8 |   |
| Repayments of  project debt                                                       |       | (17.9                                | )          | (9.2 | ) |
| Minority  interest contributions (distributions)                                  |       | (5.7                                 | )          | 3.9 |   |
| Proceeds from  exercise of stock options                                          |       | .2                                   |       | — |   |
|                                                                              |       |                                 |       |   |   |
| Cash provided by  financing activities                                            |       | 22.0                                 |       | 17.5 |   |
|                                                                              |       |                                 |       |   |   |
| Net decrease in  cash and cash equivalents                                        |       | (8.2                                 | )          | (3.9 | ) |
|                                                                              |       |                                 |       |   |   |
| Cash and cash  equivalents - beginning of period                                  |       | 14.7                                 |       | 9.2 |   |
|                                                                              |       |                                 |       |   |   |
| Cash and cash  equivalents - end of period                                        |       | $                                    | 6.5        |   | $ | 5.3 |   |
|                                                                              |       |                                 |       |   |   |
| Supplemental  disclosures of cash flow information:                               |       |                                 |       |   |   |
| Cash paid during  the period for income taxes                                     |       | $                                    | (.4        | ) | $ | (.6 | ) |
|                                                                              |       |                                 |       |   |   |
| Supplemental  disclosures of non-cash investing and financing activities:         |       |                                 |       |   |   |
| Utilization of  pre-reorganization net operating losses to offset tax liabilities |       | $                                    | .5         |   | $ | .3 |   |

 

See the accompanying notes to consolidated financial statements.

 

5

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CALIFORNIA COASTAL COMMUNITIES, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

**Note 1 -Basis of Presentation**

 

The accompanying financial statements have beenprepared by California Coastal Communities, Inc. and its consolidatedsubsidiaries (the “Company”), without audit, pursuant to the rules andregulations of the Securities and Exchange Commission. Certain information andfootnote disclosures normally included in financial statements prepared inaccordance with generally accepted accounting principles have been condensed oromitted pursuant to such rules and regulations. The Company believes that theseunaudited consolidated financial statements reflect all material adjustments(consisting only of normal recurring adjustments) and disclosures necessary forthe fair presentation of the results of operations and statements of financialposition when read in conjunction with the Financial Statements and Notesthereto included in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2003, and the current year’s previously issued Quarterly Reportson Form 10-Q. The results for interim periods are not necessarily indicative ofthe results to be expected for the full year.

 

# **Note 2– Significant Accounting Policies**

 

#### *EarningsPer Common Share*

#### * *

For the three and nine months endedSeptember 30, 2004 and 2003, the number of weighted-average common sharesoutstanding was 10.1 million. Earnings per share, assuming dilution, iscomputed using the weighted-average number of common shares outstanding and thedilutive effect of potential common shares outstanding. For the three and nine monthsended September 30, 2004, the average market price of the Company’s commonstock exceeded the exercise price of outstanding stock options. Therefore, thedilutive effect of the 719,996 and 774,996, respectively of common shares frompotential exercise of options is reflected in the 10.9 million and 10.8 millionweighted-average common shares assuming dilution, respectively. For the three andnine months ended September 30, 2003, the average market price of the Company’scommon stock also exceeded the exercise price of outstanding stock options andfor the three month period ending September 30, 2003, the average market pricealso exceeded the exercise price of 48,000 warrants then outstanding. Therefore,the dilutive of effect of the 754,996 common shares from potential exercise ofoptions then outstanding is reflected in both of the 2003 periods and thedilutive effect of the 48,000 warrants is reflected only in the three monthperiod, resulting in the 10.9 million and 10.8 million weighted-average commonshares outstanding assuming dilution, respectively, in the statement ofoperations.

 

*Real Estate*

 

Realestate held for current development or sale is carried at the lower of cost, orfair value less costs to sell. Land held for future development is carried atcost, with write-downs to fair value only in the event that costs cannot berecovered from estimated undiscounted future cash flows, as described under “Impairmentof Long-Lived Assets.” The estimation process involved in the determination offair value is inherently uncertain since it requires estimates as to futureevents and market conditions. Such estimation process assumes the Company’sability to complete development and dispose of its real estate properties inthe ordinary course of business based on management’s present plans andintentions. Economic, market, environmental and political conditions may affectmanagement’s development and marketing plans. In addition, the implementationof such development and marketing plans could be affected by the availabilityof future financing for development and construction activities. Accordingly,the ultimate values of the Company’s real estate properties are dependent uponfuture economic and market conditions, the availability of financing, and theresolution of political, environmental and other related issues.

 

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

 

6

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events or changes in circumstances indicate that the carrying amount ofan asset may not be recoverable. As provided by SFAS No. 144, impairment isevaluated by comparing an asset’s carrying value to the undiscounted estimatedcash flows expected from the asset’s operations and eventual disposition. Ifthe sum of the undiscounted estimated future cash flows is less than thecarrying value of the asset, an impairment loss is recognized based on the fairvalue of the asset. If an impairment occurs, the fair value of an asset forpurposes of SFAS No. 144 is deemed to be the amount a willing buyer wouldpay a willing seller for such asset in a current transaction.

 

Inaccordance with SFAS No. 144, in developing estimated future cash flows forimpairment testing, the Company has incorporated its own assumptions regardingthe entitlement prospects of land held for future development and its ownmarket assumptions including those regarding home prices, infrastructure andhome-building costs for both land held for future development and real estateheld for current development or sale. Additionally, as appropriate, the Company identifies alternative coursesof action to recover the carrying value of its long-lived assets and evaluatesall likely alternatives under a probability-weighted approach as indicated inSFAS No. 144.

 

### *RecentAccounting 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’s  financial position or results of operations.

 

In May 2003, the FASBissued SFAS No. 150, “Accounting for Certain Instruments with Characteristicsof Both Liabilities and Equity” (“SFAS 150”), which establishes standards forhow an issuer classifies and measures certain financial instruments with characteristicsof both liabilities and equity. SFAS 150 requires that an issuer classify afinancial instrument that is within its scope, which may have previously beenreported as equity, as a liability or an asset in some circumstances. Thisstatement is effective for financial instruments entered into or modified afterMay 31, 2003, and otherwise is effective at the beginning of the first interimperiod beginning after June 15, 2003 for public companies. In October 2003, theFASB deferred implementation of paragraphs 9 and 10 of SFAS 150 regardingparent company treatment of minority interest for certain limited lifeentities. This deferral is for an indefinite period. As of September 30, 2004,the Company consolidated one joint venture which is affected by this deferral(see Note 7). The adoption of other provisions of SFAS 150 did not have amaterial effect on the Company’s financial statements.

 

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

 

The Company ownsapproximately 351 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’s holdingsinclude 208 acres on a mesa north of the Bolsa Chica wetlands (“Bolsa ChicaMesa”), approximately 100 acres on, or adjacent to, the Huntington Mesa and 43acres of lowlands which were acquired by the Company in September 1997.

 

OnAugust 12, 2004, an agreement to sell a 103-acre parcel of the Bolsa Chica Mesaknown as the “lower bench” to the State’s Wildlife Conservation Board (“WCB”)for $65 million was approved by the WCB.  The sale remains subject to shareholderapproval and the terms of the agreement include an outside closing date of June30, 2005.  If the proposed sale iscompleted, WCB’s purchase of the property will be funded with

 

7

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bond proceeds authorized by voter-approved Proposition 50, which waspassed in November 2002. However, there can be no assurances that a saletransaction will ever be completed.  TheCompany has indicated that it will require Coastal Commission approval of adevelopment plan for the “upper bench” area of the Bolsa Chica Mesa prior toseeking shareholder approval.

 

The Company is currently pursuingapproval of permits for development of the approximately 105-acre upper benchof the Bolsa Chica Mesa (“Upper Mesa”). During 2002, the County of Orangeapproved the Company’s site plan and tentative tract map for development of 379single-family homes on the Upper Mesa. The Company submitted a Coastal Development Permit (“CDP”) applicationfor the planned community,  known as “Brightwater”,to the Coastal Commission in November 2002. On October 13, 2004, the CoastalCommission held a public hearing on the Company’s CDP application. Followingcompletion of the public hearing, the Company withdrew its CDP application inorder to have additional time to work with Commissioners and their staff in aneffort to develop changes to the project which would be acceptable to theCommission.  Therefore, the Company currentlyexpects that the Commission will hold another hearing on a revised CDPapplication during the first quarter of 2005; however, there can be noassurance that further delays will not be encountered. Ultimately, the Companydoes not believe that the Coastal Commission process will permanently preventit from developing 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 oradministrative delay.

 

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 capitalizabledevelopment activities for the Bolsa Chica project will increase the basis ofthe land. An estimate for these costs has been included in the Company’sestimated undiscounted cash flow forecast used in its impairment analyses.  Although changes will be proposed to thedevelopment plan for 379 single-family homes on the Upper Mesa, the revised estimatedundiscounted future cash flows from the Upper Mesa and the proceeds which wouldbe received if the pending sale of the lower bench to WCB is completed, areexpected to exceed its September 30, 2004 carrying value.  Therefore, in accordance with the Company’spolicy described in Note 2 – Impairment of Long-Lived Assets, 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.

 

**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 (5.50% at September 30,2004). During the nine months ended September 30, 2004, Hearthside Homes, Inc.entered into nine new loan facilities aggregating $76.0 million in conjunctionwith the acquisitions and development of a total of 253 single familyresidential lots.  One of these loans wasrepaid during the three months ended September 30, 2004.  The following amounts were available andoutstanding under these loan facilities as of September 30, 2004 and December31, 2003 ($ in millions):

 

8

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| ** **      | ** ** | ** **              | ** ** | ** **          | ** ** | ** **         | ** ** | **Outstanding at**      | ** ** |
|-----------------|------------|-------------------------|------------|---------------------|------------|--------------------|------------|-------------------------|------------|
| ** **      | ** ** | **Amount  of Facility** | ** ** | **Number  of Lots** | ** ** | **Maturity  Date** | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
| Chino           |       | $                       | 15.4       |                | 12         |               | 11/29/04   |                    | $          | 3.6 |   | $ | 10.4 |   |
| Chino           |       | 9.6                     |       | 29                  |       | 7/29/05            |       | 7.2                     |       | — |   |
| Chino II        |       | 6.3                     |       | 17                  |       | 5/11/05            |       | 1.7                     |       | — |   |
| Riverside       |       | 2.3                     |       | 13                  |       | 5/10/05            |       | 2.3                     |       | — |   |
| Riverside       |       | 9.9                     |       | 41                  |       | 6/17/05            |       | 5.3                     |       | — |   |
| 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            |       | 11.3                    |       | — |   |
| Lancaster       |       | 10.7                    |       | 104                 |       | 5/23/05            |       | 3.9                     |       | — |   |
|            |       |                    |       |                |       |               |       | $                       | 37.9       |   | $ | 10.4 |   |
|                 |            |                         |            |                     |            |                    |            |                         |            |  |  |  |  |  |

 

Construction period interest wascapitalized to projects in the amount of approximately $500,000 and $900,000 forthe three and nine months ended September 30, 2004, respectively, andapproximately $200,000 and $500,000, respectively for the three and nine monthsended September 30, 2003.

 

**Note 5 – Other Liabilities**

 

Other liabilities werecomprised of the following (in millions):

 
| ** **                                                 | ** ** | **September 30,  2004** | ** ** | **December 31,  2003** | ** ** |
|------------------------------------------------------------|------------|-------------------------|------------|------------------------|------------|
| Net deferred  taxes and other tax liabilities (see Note 6) |       | $                       | —     |                   | $          | 3.6 |   |
| Accrued pensions                                           |       | 4.6                     |       | 4.9                    |       |
| Home warranty  reserves                                    |       | 1.4                     |       | 1.2                    |       |
| Contingent  indemnity and environmental obligations        |       | 3.5                     |       | 4.1                    |       |
| Unamortized  discount                                      |       | (.7                     | )          | (.9                    | )          |
|                                                       |       | $                       | 8.8        |                   | $          | 12.9 |   |

 

Contingent indemnity andenvironmental obligations primarily reflect (i) reserves before relateddiscount (recorded pursuant to Fresh-Start Reporting) for contingent indemnityobligations for businesses disposed of by former affiliates and unrelated tothe Company’s current operations, and (ii) the contingent liability of asubsidiary of the Company for PCB contamination on its 43-acre Bolsa Chicalowlands property as further described below.

 

*Dresser Litigation*

 

In May2002, Dresser Industries, Inc. (“Dresser”) filed litigation, captioned DresserIndustries, Inc. vs. California Coastal Communities, Inc. and RESCO Holdings,Inc. (“RESCO”, a former affiliate), in the 58th Judicial DistrictCourt of Jefferson County, Texas. Dresser seeks a declaratory judgmentregarding the rights and obligations of the parties under a January 1988purchase agreement. Under the agreement, Dresser acquired an engineering andconstruction business from  The M.W.Kellogg Company (“Kellogg”), a corporation formerly affiliated with theCompany. Kellogg and its parent company, Wheelabrator Technologies, Inc. (“Wheelabrator”,a former affiliate of the Company), agreed to indemnify Dresser against certainpre-closing claims. In a subsequent transaction, Wheelabrator assigned certainassets and liabilities relating to the January 1988 purchase agreement to theCompany. Dresser also seeks unspecified damages for breach of the 1988 purchaseagreement, along with attorney’s fees and costs. Dresser’s indemnity claimsrelate to several hundred lawsuits encompassing approximately 5,900 contestedasbestos claims made by third parties in connection with work in facilities inwhich the Dresser-acquired engineering and construction business was allegedlyconnected.

 

TheCompany denies Dresser’s allegations and is vigorously defending itself in thiscase and related matters. The Company was not formed until September 1988 and,when it was 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.

 

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InSeptember 2004, RESCO and the Company reached an agreement in principle withDresser to settle this litigation, subject to negotiation of a definitivesettlement agreement.  The Company’sshare of the settlement is $1.33 million, which is included in the Company’slitigation accrual, reflecting its estimate for the minimum costs which are probableand estimable at this time.  However, inthe event that final settlement is not accomplished and the Company is requiredto provide indemnification to Dresser, defense costs and damage awards inasbestos cases can involve amounts that would have a material adverse effect onthe Company’s business, operations and financial condition.

 

*Lowland  Remediation*

 

In September 1997, theCompany acquired 43 acres in the Bolsa Chica lowlands with the intent ofselling it to the State of California in connection with their plannedrestoration of 1,000 acres of adjacent wetlands. 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’s effortsto remediate the contamination on this property. In July 2002, a subsidiary ofthe Company entered into a consent order with DTSC regarding remediation. TheCompany’s subsidiary prepared a Remedial Investigation (“RI”) Workplan, whichwas approved by DTSC in August 2003. During September and December 2003, thesubsidiary performed soil sampling at the site according to the RI Workplan todetermine the nature and extent of contamination, and submitted an RI Report toDTSC in February 2004. As of September 30, 2004, the subsidiary has accruedapproximately $900,000 for environmental testing and remediation of thisproperty. While the accrual reflects the estimate for the minimum costs whichare probable and estimable, such accrual may not be adequate to satisfy thefull amount of remediation that may be required by the DTSC.  A draft Remedial Action Workplan (“RAW”) hasbeen prepared and is subject to public comments until November 18, 2004.  Until the RAW has been approved by DTSC, theCompany cannot accurately estimate how much, if any, additional costs mayultimately be incurred. There is no maximum limitation to the obligation of theCompany’s subsidiary to remediate under the DTSC consent order. Other parties,who have yet 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, the Company’ssubsidiary received an invoice from DTSC seeking reimbursement for $793,216 ofoversight and remediation costs incurred by DTSC with respect to PCBs found onneighboring residential properties.  InAugust 2004, the Company’s subsidiary received a similar invoice for anadditional $38,302.  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 neighboring residentialproperties, 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 applicablelaw. The Company’s subsidiary intends to vigorously defend itself in thismatter. Therefore, the Company has not accrued for any of DTSC’s claims relatedto these residential properties.

 

*Home Warranty Reserve*

 

The Company provides ahome warranty reserve to reflect its contingent obligation 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):

 
| ** **                      | ** ** | **Nine Months Ended  September 30,** | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **2004**                             | ** ** | **2003** | ** ** |
| Balance at  beginning of period |       | $                                    | 1.2        |   | $ | 1.2 |   |
| Provision                       |       | .3                                   |       | .1 |   |
| Payments                        |       | (.1                                  | )          | (.1 | ) |
| Balance at end  of period       |       | $                                    | 1.4        |   | $ | 1.2 |   |

 

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**Note 6 – Income Taxes**

 

Thefollowing is a summary of the tax provision (benefit):

 
| ** **                               | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------|------------|---------------------------------------|------------|--------------------------------------|------------|
| ** **                               | ** ** | **2004**                              | ** ** | **2003**                             | ** ** | **2004** | ** ** | **2003** | ** ** |
| Current tax                              |       | $                                     | —     |                                 | $          | .1 |   | $ | — |   | $ | — |   |
| Deferred tax                             |       | 1.1                                   |       | .4                                   |       | 1.4 |   | .4 |   |
| Reduction in  contingent tax liabilities |       | —                                |       | (.1                                  | )          | (.1 | ) | (.1 | ) |
| Provision  (benefit) for income taxes    |       | $                                     | 1.1        |                                 | $          | .4 |   | $ | 1.3 |   | $ | .3 |   |

 

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.  The taxprovisions for three and nine months ended September 30, 2004 reflect a$300,000 benefit for a reduction in valuation allowance on post-reorganizationstate NOLs.  During the three and ninemonths ended September 30, 2004, reductions in valuation allowance on federal pre-ReorganizationNOLs of approximately $3.5 million and $6.0 million, respectively, wererecorded, as the Company determined that the utilization of these NOLs is “morelikely than not” based on forecasted earnings. Pursuant to Fresh StartReporting, the reductions in valuation allowance related to pre-ReorganizationNOLs were reflected by increasing the Company’s capital in excess of par value.

 

The Internal Revenue Code (the “Code”)generally limits the availability of NOLs if an ownership change occurs withinany three-year period under Section 382. If the Company were to experience anownership change of more than 50%, the use of all remaining NOLs wouldgenerally be subject to an annual limitation equal to the value of the Company’sequity before the ownership change, multiplied by the long-term tax-exemptrate. The federal NOLs available as of September 30, 2004 were approximately$175 million. The amount of federal NOLs which expire if not utilized is zero, $1million, $20 million, $8 million, $19 million and $127 million for 2004, 2005,2006, 2007, 2008 and thereafter, respectively.

 

In October 1999, in response to an unsolicited writtenconsent from a majority of its stockholders, the Company amended itscertificate of incorporation in order to protect the ability of the Company toutilize its tax loss carryforwards. Since the Company’s use of its NOLs wouldbe severely restricted if it experiences an ownership change of 50% or more,the Company’s majority stockholders requested that the Board of Directors enactthe amendments, which were determined to be in the best interest of the Companyand its stockholders. The amendments prohibit future purchases of the Company’scommon stock by persons who would become new 5% holders, and also prohibitcurrent holders of over 5% from increasing their positions, except in certainpermissible circumstances which would not jeopardize the Company’s ability touse its NOLs. While these amendments reduced the Company’s risk of an ownershipchange occurring due to the acquisition of shares by 5% stockholders, the riskremains that an ownership change could result from the sale of shares byexisting 5% stockholders. The Company estimates that after giving effect tovarious transactions by stockholders who hold a 5% or greater interest in theCompany, it has experienced a three-year cumulative ownership shift ofapproximately 39% as of October 31, 2004.

 

**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%), net ofdistributions and as adjusted for the member’s allocation of profits andlosses. Profits and losses are generally allocated 50% to each member, after a10% preferred return on invested capital.    During the three months ended September 30, 2004,capital distributions of approximately $5.7 million were made to thenon-managing member, repaying all of its initial capital contribution, plus all$600,000 of accumulated preferred return and $1.2 million in profitdistributions, following the delivery of the first 35 homes.  During the three months ended September 30,2004, the Company recorded an expense for minority interest in income ofconsolidated joint venture of $1.3 million, net of income tax benefit of $1.0million.

 

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**Note 8 – Commitments and Contingencies**

 

*CorporateIndemnification 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 is generallyno maximum obligation or amount of indemnity provided for such liabilities. Aportion of such liabilities are supported by insurance or by indemnities fromcertain of the Company’s previously affiliated companies. The Company believesits balance sheet reflects adequate reserves for these matters; however therecan 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.

 

*Other*

* *

See Notes 3 and 5 for adiscussion of other contingencies.

 

 

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

 

**General**

 

TheCompany is a residential land development and homebuilding company withproperties located primarily in southern California. The principal activitiesof the Company and its consolidated subsidiaries include: (i) obtainingzoning and other entitlements for land it owns or controls through purchase optionsand improving the land for residential development; and (ii) designing,constructing and selling single-family residential homes in southernCalifornia. Once the residential land owned by the Company is entitled, theCompany may build homes, sell unimproved land to other developers orhomebuilders, sell improved land to homebuilders, or participate in jointventures with other developers, investors or homebuilders to finance andconstruct infrastructure and homes. During the remainder of 2004 and throughout2005, the Company will focus its immediate efforts to (i) obtain approvalfrom the California Coastal Commission (“Coastal Commission”) for a CoastalDevelopment Permit (“CDP”) to build homes on the approximately 105-acre upperbench of the Bolsa Chica Mesa (“Upper Mesa”), as further described in Note 3 tothe Company’s Consolidated Financial Statements; and (ii)  continue toexpand its profitable homebuilding operations. However, the Company may alsoconsider other strategic and joint venture opportunities; and there can be noassurance that the Company will accomplish, in whole or in part, all or any ofthese strategic goals.

 

Since 2000, the Company hasgenerated gross margins from homebuilding activities and cash flows on assetsother than Bolsa Chica. The Company currently has on-going southern Californiaprojects in Riverside County near the cities of North Corona and Riverside, inSan Bernardino County in the city of Chino, in Los Angeles County in the cityof Lancaster, and in San Diego County in the area of Rancho Santa Fe. Thesehomebuilding projects are expected to generate cash flows and gross marginsthrough mid-2006. While the Company acquired 259 additional single-familyresidential lots during the first nine months of 2004, the Company’s inventoryof entitled land available for homebuilding projects remains limited. Giventhis limited inventory of buildable lots, the Company is continuing to pursueresidential lot acquisition opportunities. Due to current levels of landinventory and delays in approvals for homebuilding at Bolsa Chica, continuationof homebuilding operations beyond mid-2006 is dependent upon acquisition of additionalsuitable, entitled residential lots within the southern California area orCoastal Commission approval of a development plan for the Bolsa Chica UpperMesa. There can be no assurance that such acquisitions will be made or suchapproval will be obtained.

 

**Bolsa Chica**

 

Bolsa Chica is the Company’sprincipal asset, representing 68% of total assets at September 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.

 

OnAugust 12, 2004, an agreement to sell a 103-acre parcel of the Bolsa Chica Mesaknown as the “lower bench” to the State’s Wildlife Conservation Board (“WCB”)for $65 million was approved by the WCB. The sale remains subject to shareholder approval and the terms of theagreement include an outside closing date of June 30, 2005. 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 a sale transaction willever be completed. The Company has indicated that it will require CoastalCommission approval of a development plan for the Upper Mesa, prior to seekingshareholder 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 CDPapplication for the planned community known as “Brightwater” to the CoastalCommission in November 2002. On October 13, 2004, the Coastal Commission held apublic hearing on the Company’s CDP application.  Following completion of the public hearing,the Company withdrew its CDP application in order to have additional time towork with the Commissioners and their staff in an effort to develop changes tothe project which would be acceptable to the Commission.  Therefore, the Company currently expects thatthe Commission will hold another hearing on a revised CDP application during thefirst quarter of 2005; however, there can be no assurance that further delayswill not be encountered. Ultimately, the Company does not believe that theCoastal Commission process will permanently prevent it from developing aplanned community at Bolsa Chica; however, there can be no assurance in thatregard, or as to (i) when development could commence, (ii) the number of acresor homes the Company will be permitted to develop, or (iii) the absence offurther litigation or administrative delay.

 

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If the Coastal Commission approves aCDP for the Upper Mesa, the Company would then reevaluate its projectedprofitability as it relates to recorded deferred tax asset valuation allowanceon NOLs as required by SFAS No. 109. Such re-evaluation may result inmanagement concluding that it is more likely than not that the Company willrealize its deferred tax assets, which would result in a reversal of all or aportion of the related  valuationallowance.

 

The Company’s valuationallowance on federal NOLs as of September 30, 2004 is approximately $45.9 million.Recognition of tax benefits from reductions in valuation allowancesattributable to any utilization or future potential utilization ofpre-Reorganization NOLs would be excluded from results of operations andcredited to capital in excess of par value. The portion of the federalvaluation allowance attributable to federal pre-Reorganization NOLs isapproximately $41.3 million as of September 30, 2004. Therefore, the Companywould expect to reflect a tax benefit of $4.6 million in its statement of operationsfor reversal of valuation allowance on post-Reorganization NOLs and creditcapital in excess of par value in the amount of $41.3 million for reversal ofvaluation allowance on pre-Reorganization NOLs if it concludes that it is morelikely than not that all the NOLs will ultimately be utilized to offsetoperating income generated from the disposition of the Bolsa Chica property.  Preservation of the Company’s NOLs isdependent upon the enforcement of certain transfer restrictions on the Company’scommon stock.  These restrictions are setforth in the Company’s charter documents and stock transfers are monitored forcompliance purposes.

 

Uponcompletion of the Recapitalization in September 1997 as discussed in Note 3 tothe Consolidated Financial Statements included in this Quarterly Report, the Companyapplied the accounting principles required by Fresh-Start Reporting and thecarrying value of land held for development (Bolsa Chica) was adjusted to fairvalue as of September 2, 1997. The fair value was determined in 1997 usingdiscounted estimated cash flows expected from the asset’s operations andeventual disposition. 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. Although changes will be proposed to the development planfor 379 single-family homes on the Upper Mesa, the revised estimatedundiscounted future cash flows from the Upper Mesa and the proceeds which wouldbe received if the pending sale of the lower bench to the WCB is completed, areexpected to exceed its September 30, 2004 carrying value.  Therefore, in accordance with the Company’spolicy described in Note 2 to the Consolidated Financial Statements –Impairment of Long-Lived Assets, the Company believes there has been noimpairment.

 

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 a CDPapplication for the Upper Mesa and several alternative outcomes for the lower benchin its probability-weighted approach to evaluating the recoverability of thecarrying 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 on the Upper Mesa if the Company would grant aconservation easement over the lower bench. During the October 13, 2004 public hearing, the Coastal Commissionreaffirmed that it would allow substantial development on the Upper Mesa.  Therefore, the Company believes that it is likelythat the Commission will eventually allow reasonable development on the UpperMesa.  The Company currently anticipatesseeking approval of its CDP during the first quarter of 2005.  If the Company is permitted to reasonablydevelop the Upper Mesa, the Company believes it would recover substantiallymore from the Upper Mesa development than the $155.6  million carrying value for the entire BolsaChica Mesa as of September 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.

 

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

 

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the development and disposition of its real estate properties in theordinary course of business based on management’s present plans and intentions.Economic, market, environmental and political conditions may affect management’sdevelopment and marketing plans. In addition, the implementation of suchdevelopment and marketing plans could be affected by the availability of futurefinancing for development and construction activities. The development of theCompany’s Upper Mesa project is dependent upon various governmental approvalsand economic factors. Accordingly, the amount ultimately realized from suchproject may differ materially from current estimates and the project’s carryingvalue.

 

**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 adversely affect the demand for housing and the availabilityof mortgage financing and may reduce the credit facilities offered to theCompany.

 

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 futureincrease in mortgage rates or significant loss of jobs in southern Californiawould most likely slow demand for new homes. Increases in home mortgageinterest rates make it more difficult for the Company’s customers to qualifyfor home mortgage loans, potentially decreasing home sales volume and prices.

 

The tight supply of new homes insouthern California has resulted in significant home price increases over thelast five years. As a result, the affordability of new homes has been decliningand could further jeopardize future demand. The significant price increases over the last twelve months haverecently slowed down 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 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 net operatinglosses, as discussed further in Notes 2 and 6 to the Consolidated FinancialStatements.

 

*Impairmentof Long-Lived Assets*

 

The Company assesses theimpairment of land held for future development (the Bolsa Chica project) andreal estate held for current development or sale including long-lived assets inaccordance with Statement of Financial Accounting Standards (“SFAS”) No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”. These assets are carriedat cost, unless the carrying amount of the parcel or subdivision is determinednot to be fully recoverable, in which case the impaired real estate is writtendown to fair value. Given the significance of the carrying value of land heldfor future development, the application of SFAS No. 144 in evaluating anypotential impairment is critical to the Company’s consolidated financialstatements, as discussed further in Note 2 to the Consolidated FinancialStatements.

 

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

 

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and its own market assumptions including those regarding home prices,infrastructure and home-building costs regarding both land held for futuredevelopment and real estate held for current development or sale.  Additionally, as appropriate, the Companyidentifies alternative courses of action to recover the carrying value of itslong-lived assets and evaluates all likely alternatives under aprobability-weighted approach as suggested in SFAS No. 144.

 

*Basis ofConsolidation*

 

Certain wholly-ownedsubsidiaries of the Company are members in joint ventures involved in thedevelopment and sale of residential projects and residential loan production.The consolidated statements of the Company include the accounts of the Companyand all majority-owned and controlled subsidiaries and joint ventures. Thefinancial statements of joint ventures in which the Company generally has acontrolling or majority economic interest (and thus are controlled by theCompany) are consolidated with the Company’s financial statements. Minorityinterest represents the equity interest of the Company’s joint venture partnerfor one consolidated venture and is further described in Note 7 to theConsolidated Financial Statements. The Company’s investments in unconsolidatedjoint ventures are accounted for using the equity method when the Company doesnot have voting or economic control of the 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*

 

TheCompany’s homebuilding operation generates revenues from the sale of homes tohomebuyers. The majority of these homes are designed to appeal to move-uphomebuyers and the homes are generally offered for sale in advance of theirconstruction. Sales contracts are usually subject to certain contingencies suchas the buyer’s ability to qualify for financing. Revenue from the sale of homesis recognized at closing when title passes to the buyer, and the earningsprocess is complete. As a result, the Company’s revenue recognition processdoes not involve significant judgments or estimates. However, the Company doesrely on certain projections and estimates to determine the related constructioncosts and resulting gross margins associated with revenues recognized. TheCompany’s construction costs are comprised of direct and allocated costs,including estimated costs for future warranties and indemnities. The Company’sestimates are based on historical results, adjusted for current factors.

 

*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**

 

Seediscussion regarding recent accounting pronouncements in Note 2 to theConsolidated Financial Statements.

 

**Liquidity and Capital Resources**

 

Theprincipal assets in the Company’s portfolio are residential land which must beheld over an extended period of time in order to be developed to a conditionthat, in management’s opinion, will ultimately maximize the return to theCompany. Consequently, the Company requires significant capital to finance itsreal estate development and homebuilding operations. Historically, sources ofcapital have included specific property financings, asset sales and availableinternal funds. The Company is utilizing internally generated cash to fund theBolsa Chica project, and is currently utilizing project debt and internallygenerated cash to fund acquisition and construction of all other homebuilding projects.The Company’s current homebuilding projects are expected to generateapproximately $39 million of cash during the next 24 months, based on

 

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present economic conditions and market assumptions.The Company’s cash and cash equivalents as of September 30, 2004 wereapproximately $6.5 million. The Company believes that its cash and cashequivalents, future real estate sales proceeds, and funds available under itscredit and joint venture agreements will be sufficient to meet anticipatedoperating and capital investment requirements, primarily project developmentcosts for homebuilding projects and the Bolsa Chica and Oxnard  land development projects, along with generaland administrative expenses and liabilities, for the next 12 months.

 

TheCompany is subject to the usual obligations associated with entering intocontracts for the purchase of land and improved homesites. These purchase contractstypically require a cash deposit and the purchase of properties under thesecontracts is generally contingent upon satisfaction of certain requirements bythe sellers or the Company, including obtaining applicable propertyentitlements. The Company also utilizes option contracts with third-party landsellers and financial entities as a method of acquiring land in stagedtakedowns and minimizing the use of funds from other corporate financingsources. These option contracts also help to manage the financial and marketrisk associated with land holdings. Option contracts generally require thepayment of a non-refundable cash deposit for the right to acquire lots over aspecified period of time at predetermined prices. The Company has the right atits discretion to terminate the obligations under these option agreements byforfeiting the cash deposit with no further financial responsibility. TheCompany may enter into land development and homebuilding joint ventures fromtime to time as a means of expanding its market opportunities, establishingstrategic alliances, managing its risk profile and leveraging the Company’scapital base. These joint ventures may obtain secured acquisition, developmentand construction financing, which minimizes the use of funds from othercorporate financing sources.

 

**Homebuilding**

 

TheCompany’s homebuilding operations have been rebuilding lot inventory during thefirst nine months of 2004, completing acquisitions of 259 single-familyresidential lots during that period.  The53 home deliveries during the third quarter exceeded the 24 deliveries in the thirdquarter of 2003 and deliveries on a year-to-date basis of 73 also exceeds the66 deliveries during the comparable prior year period.  In addition, the Company expects to deliver 55homes during the fourth quarter.  Whilethe 128 home deliveries projected for the full year 2004 are less than the 154homes delivered in 2003, homebuilding revenues and margins for 2004 areexpected to exceed 2003 results.

 

*NorthCorona*.  In July 2001,the Company acquired 83 finished lots in Riverside County, California nearNorth Corona in the master-planned community known as “Providence Ranch”. Thecommunity of Providence Ranch and the adjacent community of “Corona Valley”,are planned for a total of 2,600 homes, and are well-located to serve theemployment centers of the greater Los Angeles area, Orange County and theOntario international airport. The Company commenced home construction inOctober 2001, opened for sales in February 2002 and released 73 homes for saleduring 2002 at an average price of approximately $298,000. During 2002 and2003, 58 homes and 15 homes were delivered, respectively. During the ninemonths ended September 30, 2004, all 10 homes in the final phase were deliveredat an average price of $445,000, including three homes during the third quarterof 2004, which completed the project.

 

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 22 homes weredelivered during the first nine months of 2004 at an average price of $440,000,including 15 homes during the third quarter, which completed the project.

 

*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 of2003 at 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 41 additional homes for sale at an average priceof $645,000 and as of November 1, 2004, 36 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 69 homes for sale at an average price of $590,000. As ofNovember 1, 2004, 44 homes have been delivered and an additional 20 are inescrow.

 

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InJanuary 2004, the Company acquired 17 additional finished lots in the City ofChino which are near, but not a part of The Reserve, and are not a part of thejoint venture described above. The Company expects to begin construction ofhomes averaging 2,990 square feet during the fourth quarter of 2004.

 

*Rancho SantaFe.*  In October 2003, the Company entered into anagreement to acquire 32 lots in a luxury golf community known as Crosby Estatesin the Rancho Santa Fe area of California in San Diego County. The Companyacquired eight of the lots during the fourth quarter of 2003 and six additionallots each in June and September of 2004, and began construction of model homesaveraging approximately 3,370 square feet during the third quarter of 2004.

 

*Lancaster.*   The Companyacquired 104 lots in the city of Lancaster in northern Los Angeles County duringMay 2004. The Company began construction of model homes averaging approximately2,800 square feet during the third quarter of 2004.  In 2004, the Company also purchased an optionto acquire an additional 70 lots in Lancaster, which is expected to occurduring the second quarter of 2005.

 

*Corona.*  The Companyacquired 83 lots in North Corona in May 2004. The Company expects to begin construction of homes averaging 3,250square feet during the fourth 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 800 single-family detached lots and approximately 200 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 ofconsummating the purchase transactions. The option-holder has the right in itssole discretion to terminate the obligations under these option agreements byforfeiting the cash deposits with no further financial responsibility.

 

During October 2003, theCompany entered into a Limited Liability Company (“Oxnard LLC”) joint ventureagreement with a major financial partner to pursue the Oxnard developmentopportunity. The Company assigned the land purchase option contracts to theOxnard LLC.  Hearthside Homes, Inc. (theCompany’s homebuilding subsidiary) is the managing member of the Oxnard LLC,and has contributed $500,000 to the venture. The non-managing member also madean initial contribution of $500,000 to the venture. Capital contributions of upto an additional $4 million are to be made by the non-managing member. As of September30, 2004, the non-managing member had made an aggregate of approximately $2.3million of additional contributions. Under the Oxnard LLC operating agreement,if contributions in excess of $5 million are required and approved by themembers, the next $1 million would be contributed equally by the members. Totalcontributions of the non-managing member are generally limited to $5 million.After payment of a 10% preferred return on invested capital to each member,first tier profits are generally allocated 75% to the non-managing member and25% to the managing member and second tier profits and losses over $5 millionare generally allocated 50% to each member. The first $5 million of losses aregenerally allocated 80% to the non-managing member and 20% to the managingmember.  While the Company exerts a largedegree of control over the venture, the non-managing member does have variousapproval rights with regard to major business decisions, and therefore theoperations of the venture are not consolidated.

 

**Financial Condition**

 

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

 

Cashflows from homebuilding operations for the first nine months of 2004 primarilyreflect uses of cash for land acquisitions of 259 single-family residentiallots in Chino, Riverside, Corona, Lancaster and Rancho Santa Fe, California aggregating$30.3 million and homebuilding construction costs of $32.0 million, largelyfinanced by net borrowing under project debt financing of $27.5 million,including borrowing under nine new credit facilities. Additional cash wasprovided by home sales proceeds, net of $36.9 million from deliveries of 73homes and a $900,000 increase in accounts payable and accrued liabilities forconstruction costs and compensation liabilities.  Additional significant uses of cash include $2.0million for investment in the Bolsa Chica Mesa project, primarily forconsultants engaged in the entitlement process, selling, general andadministrative expenses of approximately $3.1 million and a $700,000 netdecrease in other liabilities for payment of legal fees, environmental costs,and funding the Company’s pension plans,

 

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partially offset by an accrual increase for apending settlement of litigation.  Theseitems, as well as other activity presented in the Statements of Cash Flows,resulted in an $8.2 million decrease in cash and cash equivalents.

 

Theremaining $3.6 million decrease in other liabilities primarily reflectsrecognition of tax benefits for expected utilization of pre-ReorganizationNOLs, which increased capital in excess of par value (see Note 6).

 

**Resultsof Operations**

 

Thenature of the Company’s business, including its limited inventory of buildablelots, is such that individual transactions often cause significant fluctuationsin operating results from quarter-to-quarter and from year-to-year.

 

*ThreeMonths Ended September 30, 2004 Compared with the Three Months Ended September30, 2003*

 

The Company reported revenues of $28.4million and gross operating profit of  $6.0million for the third quarter of 2004, compared with $8.4 million in revenuesand gross operating profit of $1.6 million for the third quarter of 2003.Revenues in the current period reflect deliveries of 53 homes, including 35 atthe Chino Reserve project and 18 at the North Corona project. The comparableperiod of the prior year reflects deliveries of 24 homes at the Riverside “Harvest”project. The current quarter’s gross margin from homebuilding of 21.1% ishigher than the prior period gross margin of 19.0% due to price appreciationand the higher profitability of homes at the Chino and North Corona projectscompared with the Riverside project.

 

The $900,000 increase in selling,general and administrative expenses during the third quarter of 2004, ascompared with the third quarter of 2003, primarily reflects an increase inaccrued incentive compensation corresponding to the significantly improvedoperating results and non-cash compensation expense of approximately $300,000recorded pursuant to the grant and vesting of certain stock options.

 

The increase in other expense, netreflects an additional accrual for a pending settlement of litigation relatedto a former affiliate (see Note 5).

 

*NineMonths Ended September 30, 2004 Compared with the Nine Months Ended September30, 2003*

 

The Company reported revenues of $37.2million and gross operating profit of $8.4 million for the first nine months of2004, compared with $21.5 million in revenues and gross operating profit of $3.8million for the first nine months of 2003. Revenues for the first nine monthsof 2004 reflect deliveries of 73 homes, including 35 at the Chino Reserveproject, 32 at the Providence Ranch project and six homes at the Company’sRiverside (Jasper Ranch) project and a $100,000 land sale. The comparableperiod of the prior year reflects deliveries of an aggregate of 66 homes at theRiverside, North Corona and Yucaipa projects. The homebuilding gross margin forthe first nine months of 2004 of 22.4% is higher than the prior period grossmargin of 17.7% due to home price appreciation experienced over the past yearand higher profitability of the Riverside, Chino and North Corona projects ascompared with the North Corona and Yucaipa projects.

 

The $100,000 decrease in incomefrom unconsolidated joint ventures to $300,000 for the first nine months of 2004from $400,000 for the first nine months of 2003 primarily reflects the absenceof income from a homebuilding joint venture in San Diego which completed its finalhome deliveries during 2002.

 

The $100,000increase in other expense, net primarily reflects the increase in thelitigation accrual discussed above, partially offset by the absence in 2004 of itemsrecorded in the 2003 period.  The 2003 periodincluded an accrual of approximately $700,000 for estimated environmentalremediation costs for the 43-acre Bolsa Chica lowland remediation (see Note 5) andincome of approximately $300,000 from recovery of the value of water rightscertificates, related to a completed project, which had been reserved.

 

During the three months endedSeptember 30, 2004, the Company recorded a tax benefit of $300,000 for the reversalof a valuation allowance on post-Reorganization state NOLs. During each of thenine months ended September 30, 2004 and 2003, the Company recorded a taxbenefit of approximately $100,000 in connection with the resolution ofoutstanding tax matters in two and eight states, respectively.  These events have eliminated the Company’sexposure.

 

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*Payments Under ContractualObligations*

 

The Company has enteredinto certain contractual obligations to make future payments for project debtand lease agreements. A summary of the payments due under specified contractualobligations, aggregated by category of contractual obligation, for specifiedtime periods is presented below as of  September 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     |       | $                          | 37.9       |   | $ | 37.9 |   | — |   | — |   | — |   |
| Operating leases |       | .5                         |       | .2 |   | .3 |   | — |   | — |   |
| Total            |       | $                          | 38.4       |   | $ | 38.1 |   | $ | .3 |   | — |   | — |   |
|                  |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

The Company’s purchasecontracts which are made in the normal course of its homebuilding business forland acquisition and construction subcontracts are generally cancelable atwill. Other contractual obligations including the Company’s other taxliabilities, accrued benefit liability for a frozen retirement plan and otheraccrued pensions, home warranty reserves and contingent indemnity andenvironmental obligations are estimated based on various factors. Payments arenot due as of a given date, but rather are dependent upon the incurrence ofprofessional services, the lives of annuitants and other factors. The estimationprocess involved in the determination of carrying values of these obligationsis inherently uncertain since it requires estimates as to future events andcontingencies. The Company has provided additional disclosure in itsConsolidated Financial Statements in Notes 5 and 6.

 

**Safe Harbor, Statement Under thePrivate Securities Litigation Act of 1995**

 

Certain information included inthis Report and other materials filed or to be filed by the Company with theSecurities and Exchange Commission (as well as information included in oral orwritten statements made by the Company or on the Company’s behalf), may containforward-looking statements about current and expected performance trends,growth plans, business goals and other matters. These statements may becontained in the Company’s filings with the Securities and Exchange Commission,in press releases, in other written communications, and in oral statements madeby or with the approval of one of the Company’s authorized officers. Thesestatements involve known and unknown risks, uncertainties and other factorswhich may cause the Company’s actual results, performance or achievements to bematerially different from any future results, performances or achievementsexpressed 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 terms or othercomparable terminology. These statements, and any other statements that are nothistorical facts, are forward-looking statements within the meaning of thePrivate Securities Litigation Reform Act of 1995, as codified in Section 27A ofthe Securities Act of 1933 and Section 21E of the Securities Exchange Act of1934, as amended from time to time (the “Act”).

 

These forward-looking statementsinclude, but are not limited to, (1) statements about the Company’s plans,objectives, goals, expectations and intentions; (2) the number and types ofhomes and number of acres of land that the Company may develop and sell; (3)the timing and outcomes of litigation, regulatory approval processes oradministrative proceedings (including, but not limited to ongoingadministrative proceedings related to the Company’s principal asset, the BolsaChica Mesa); (4) the completion of the pending $65 million sale of the lowerbench of the Bolsa Chica Mesa to the State of California’s Wildlife ConservationBoard; (5) the expected home deliveries and revenues; (6) the expectation ofcontinued favorable housing market conditions over the next 24 months,including measured increases in mortgage interest rates; (7) the housing marketconditions in the geographic markets in which the Company operates; (8)expected average sales prices; (9) the intention to continue to utilize jointventure vehicles; (10) the effectiveness and adequacy of the Company’sdisclosures and internal controls; and (11) other statements contained hereinthat are not historical facts.

 

In connection with the “safe harbor”provisions of the Act, the Company is filing the following summary to identifyimportant factors, risks and uncertainties that could cause actual results todiffer materially from those projected in forward-looking statements made bythe Company, or on its behalf. These cautionary statements are to be used as areference in connection with any forward-looking statements. The factors, risksand uncertainties identified in these cautionary statements are in addition tothose contained in any other cautionary statements, written or oral, which maybe made or otherwise addressed in connection with a forward-looking statementor contained in any of the Company’s subsequent filings with the placing ofundue reliance on forward-looking statements. Although the Company believesthat the assumptions underlying forward-looking statements are reasonable, any ofthe assumptions could be incorrect, and there can be no assurance that

 

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forward-looking statements will prove to beaccurate. Forward-looking statements speak only as of the date on which theyare made. The Company does not undertake any obligation to modify or revise anyforward-looking statement to take into account or otherwise reflect subsequentevents, or circumstances arising after the date that the forward-lookingstatement was made.

 

The following risk factors mayaffect the Company’s operating results and the environment within which itconducts business. If the Company’s projections and estimates regarding thesefactors differ materially from what actually occurs, the Company’s actualresults could vary significantly from any results expressed or implied byforward-looking statements. These risk factors include, but are not limited to,(1) changes in general economic, demographic, geopolitical or public safetyconditions which affect consumer behavior and spending for residential realestate, including the ongoing ramifications of the September 11, 2001 terroristattacks and the governmental response thereto, including the continuing armedconflict in Iraq or in other countries; (2) local and general economic andmarket conditions, including consumer confidence,  employment rates, interest rates, the cost andavailability of mortgage financing, and stock market, home and land valuations;(3) the Company’s ability to acquire residential lots in order to continuehomebuilding operations; (4) the adequacy of capital, financing and cash flowrequired to continue the Company’s operations and land development activities;(5)  the Company’s ability to continuerelationships with current or future partners; (6) the Company’s ability toexpend resources to comply with environmental regulations and local permittingrequirements; (7) the effect of certain costs, contractual obligations and taxliabilities, both known and unknown, on the Company’s business, results ofoperations and financial condition; (8) the cost and availability of constructionfinancing and corporate debt and equity capital; (9) the demand forsingle-family homes; (10) cancellations of purchase contracts by homebuyers;(11) the cyclical and competitive nature of the Company’s business; (12) delaysin 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 the Company’sproperties; (17) the Company’s ability to estimate cash flow projections due touncertainties in valuing real property; (18) the future condition of the real estatemarket in southern California; (19) general economic and business conditions; (20)interest rate changes and the availability to homebuyers of permanent mortgages;(21) the relative stability of debt and equity markets; (22) competition; (23)the availability and cost of raw materials used by the Company in itshomebuilding operations; (24) shortages and the cost of labor; (25) weatherrelated slowdowns; (26) slow growth and no growth initiatives or moratoria; (27)governmental regulation, including the interpretation of tax, labor andenvironmental laws; (28) changes in consumer confidence and preferences; (29)accounting changes; (30) other risks discussed in the Company’s past and futurefilings with the Securities and Exchange Commission; and (31) other factorsover which the Company has little 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.

 

**Prohibition Against Becoming a 5%Stockholder and No Further Acquisitions by Current 5% or Greater Stockholders**

 

Unless the Company has previously consented inwriting (i) no stockholder holding less than 5% of the outstanding shares ofthe Company’s Common Stock may acquire additional shares of Common Stock in anamount that would take such shareholder to 5% or more; and (ii) no current 5%or greater stockholder may acquire any additional shares.  The foregoing prohibition is contained in theCompany’s charter documents, in order to preserve the tax benefits of theCompany’s $175 million of NOLs.  Allacquisitions of the Company’s Common Stock in violation of its charterprohibitions are null and void, and the Company is empowered to effectivelyrescind such acquisitions.  The Companywill not entertain requests for permission to exceed the limitations on stockacquisitions in the foreseeable future, because the Company’s board ofdirectors has determined that such acquisitions could jeopardize the Company’sability to preserve and use its NOLs.

 

ITEM 3  -  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

TheCompany utilizes project debt financing for acquisition, development andconstruction of homes. The interest rates on the Company’s project debtapproximate the current rates available for secured real estate financing withsimilar terms and maturities, and as a result, their carrying amountsapproximate fair value. While changes in interest rates generally do not impactthe fair market value of the debt instrument, they do affect the Company’searnings and cash

 

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

 

ITEM 4 -  EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES

 

TheCompany maintains disclosure controls and procedures that are designed toensure that information relating to the Company (including its consolidatedsubsidiaries) required to be disclosed in the Company’s periodic filings withthe Securites and Exchange Commission (“SEC”) is recorded, processed,summarized and reported within the time periods specified in the SEC’s rulesand forms, and that such information is accumulated and communicated to theCompany’s management, including its Chief Executive Officer and Chief FinancialOfficer, as appropriate, to allow timely decisions regarding requireddisclosure.  In designing and evaluatingthe disclosure controls and procedures, management recognizes that any controlsand procedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement is required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures.

 

As of September 30, 2004,the end of the quarter covered by this report, the Company carried out anevaluation, under the supervision and with the participation of the Company’smanagement, including the Chief Executive Officer and Chief Financial Officer,of the effectiveness of the design and operation of the Company’s disclosurecontrols and procedures. Based on the foregoing, the Company’s Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures were effective at the reasonable assurance level.  Although the Company’s disclosure controls andprocedures have been designed to provide reasonable assurance of achievingtheir objectives, there can be no assurance that such disclosure controls andprocedures will always achieve their stated goals under all circumstances.

 

There have been nosignificant changes that occurred during the quarter covered by this report inthe Company’s internal control over financial reporting identified inconnection with the evaluation referenced above that has materially affected,or is reasonable likely to materially affect, the Company’s internal controlover financial reporting.

 

PART II- OTHER INFORMATION

 

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 6 -                EXHIBITS

 

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

 

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

 

32.1         Section 906Certificate of Raymond J. Pacini, Chief Executive Officer of California CoastalCommunities, Inc.*

 

32.2         Section 906Certificate of Sandra G. Sciutto, Chief Financial Officer of California CoastalCommunities, Inc.*

 

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*              Thesecertifications are being furnished solely to accompany this report pursuant to18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 ofthe Securities Exchange Act of 1934, as amended, and are not to be incorporatedby reference into any filing of the Company, whether made before or after thedate hereof, regardless of any general incorporation language in such filing.

 

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**SIGNATURE**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theregistrant has caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

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

 

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