MAXXAM INC - 10-K Annual Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

FORM 10-K

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ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934

FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001 COMMISSION FILE NUMBER 1-3924

MAXXAM INC.
(Exact name of Registrant as Specified in its Charter)

DELAWARE 95-2078752
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)

5847 SAN FELIPE, SUITE 2600 77057
HOUSTON, TEXAS (Zip Code)
(Address of Principal Executive Offices)

Registrant's telephone number, including area code: (713) 975-7600

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Securities registered pursuant to Section 12(b) of the Act:

NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
--------------------- ------------------------------------
Common Stock, $.50 par value.......... American

Number of shares of common stock outstanding at April 11, 2002: 6,527,671
Securities registered pursuant to Section 12(g) of the Act: None.

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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes /X/ No / /

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of Registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. /X/

Based upon the April 11, 2002 American Stock Exchange closing price of
$12.78 per share, the aggregate market value of the Registrant's outstanding
voting stock held by non-affiliates is approximately $46.7 million.

DOCUMENTS INCORPORATED BY REFERENCE:

Certain portions of Registrant's definitive proxy statement, to be filed with
the Securities and Exchange Commission pursuant to Regulation 14A not later than
120 days after the close of the Registrant's fiscal year, are incorporated by
reference under Part III.
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TABLE OF CONTENTS

PART I

List of Defined Terms
Item 1. Business
General
Aluminum Operations
Forest Products Operations
Real Estate Operations
Racing Operations

Item 2. Properties

Item 3. Legal Proceedings

Item 4. Submission of Matters to a Vote of Security Holders

PART II

Item 5. Market for Registrant's Common Equity and Related Stockholder Matters

Item 6. Selected Financial Data

Item 7. Management's Discussion and Analysis of Financial Condition and Results
of Operations

Item 7A. Quantitative and Qualitative Disclosures About Market Risk

Item 8. Financial Statements and Supplementary Data
Report of Independent Public Accountants
Consolidated Balance Sheet
Consolidated Statement of Operations
Consolidated Statement of Stockholders' Equity (Deficit)
Consolidated Statement of Cash Flows
Notes to Consolidated Financial Statements

Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure

PART III

Items 10-13. To be filed with the Registrant's definitive proxy statement

PART IV

Item 14. Exhibits, Financial Statement Schedules, and Reports on Form 8-K

LIST OF DEFINED TERMS

Set forth below is a list of all terms used and defined in this Report and
the Consolidated Financial Statements and the pages on which they first appear.

Term
- --------------------------------
$100 Preference Stock
1984 Plan
1994 Director Plan
1994 Omnibus Plan
Acquiring Person
AKW
Alpart
AMT Price
Anglesey
Bear Creek lawsuit
BOF
BPA
Britt
Britt Agreement
CARIFA
CDF
CEQA
CERCLA
CESA
Class A Preferred Stock
Code
Common Stock
Company
Court
Custodial Trust Agreement
CWA
DIP Facility
Drexel
Elk River Timberlands
Environmental Laws
Environmental Plans
EPA
EPIC-SYP/Permits lawsuit
Equity Fund Partnership
ERF lawsuit
ESA
FASB
FDIC
FDIC action
FDIC Counterclaim
Federated
FHLBB
FireRock, LLC
Forest Practice Act
GIS
GPS
Grizzly Creek Grove
HCP
Headwaters Agreement
Headwaters Timberlands
Hydro
Intercompany Note
Junior Preferred Stock
KACC
Kacc 10 7/8 Senior Notes
KACC 9 7/8 Senior Notes
KACC Notes
KACC Senior Subordinated Notes
Kahn lawsuit
Kaiser
KJBC
Lakepointe Assets
Lakepointe Notes
LIFO
LME Prices
London Facility
LTSY
MAXXAM
MAXXAM Parent
MGHI
MGHI Notes
MGI
NLRB
North Coast Water Board
Notice
Old growth
OTS
OTS action
Pacific Lumber
Pacific Lumber Credit Agreement
Palco Companies
Palmas
Permits
QAL
Racing Act
Racing Commission
Redeemable Preference Stock
Required Liquidity Amount
Respondents
Rights
Salmon Creek
SAR Account
Scotia LLC
Scotia LLC Line of Credit
Scotia LLC Timber
Scotia LLC Timber Rights
Scotia LLC Timberlands
Series A Right
Series B Right
SFAS No. 133
SFAS No. 141
SFAS No. 142
SFAS No. 143
SFAS No. 144
SFAS No. 66
SHRP, Ltd.
SunRidge Canyon LLC
SYP
take
THPs
Timber Notes
Timber Notes Indenture
TMDLs
UFG
ULPs
USAT
USWA
USWA lawsuit
Valco
VRA
Water Board
Wrigley lawsuit
young growth

ITEM 1. BUSINESS

GENERAL

MAXXAM Inc. and its subsidiaries are collectively referred to herein as
the "COMPANY" or "MAXXAM" unless otherwise indicated or the context indicates
otherwise. The Company is a holding company and, as such, conducts substantially
all of its operations through its subsidiaries. The Company operates in four
principal industries:

- - Aluminum, through its majority owned subsidiary, Kaiser Aluminum
Corporation ("KAISER") (62% owned as of December 31, 2001), an integrated
aluminum producer. Kaiser, through its wholly owned principal operating
subsidiary, Kaiser Aluminum & Chemical Corporation ("KACC"), operates
in several principal aspects of the aluminum industry--the mining of
bauxite, the refining of bauxite into alumina, the production of primary
aluminum from alumina and the manufacture of fabricated (including
semi-fabricated) aluminum products. As of December 31, 2001, a substantial
portion of the Company's consolidated assets, liabilities, revenues,
results of operations and cash flows were attributable to Kaiser. On
February 12, 2002, Kaiser, KACC and 13 of KACC's wholly owned subsidiaries
filed separate voluntary petitions in the United States Bankruptcy Court
for the District of Delaware (the "COURT") for reorganization under
Chapter 11 of the United States Bankruptcy Code (the "CODE"). On March 15,
2002, two additional wholly owned subsidiaries of KACC filed petitions in
the Court. Kaiser, KACC and the 15 subsidiaries of KACC that have filed
petitions are collectively referred to herein as the "DEBTORS" and the
Chapter 11 proceedings of these entities are collectively referred to
herein as the "CASES." For purposes of this Report, the term "FILING DATE"
shall mean, with respect to any particular Debtor, the date on which such
Debtor filed its Case. See "--Aluminum Operations--Reorganization
Proceedings" and Notes 1 and 9 to the Consolidated Financial Statements.

- - Forest products, through MAXXAM Group Inc. ("MGI") and MGI's wholly owned
subsidiaries, The Pacific Lumber Company ("PACIFIC LUMBER") and Britt
Lumber Co., Inc. ("BRITT"). MGI operates in several principal aspects of
the lumber industry -- the growing and harvesting of redwood and
Douglas-fir timber, the milling of logs into lumber and the manufacture of
lumber into a variety of finished products. Housing, construction and
remodeling are the principal markets for the Company's lumber products.

- - Real estate investment and development, managed through its wholly owned
subsidiary, MAXXAM Property Company. The Company, principally through its
wholly owned subsidiaries, is engaged in the business of residential and
commercial real estate investment and development, primarily in Puerto
Rico, Arizona, California and Texas.

- - Racing operations, through Sam Houston Race Park, Ltd. ("SHRP, LTD."), a
Texas limited partnership, in which the Company currently owns a 100%
interest. SHRP, Ltd. owns and operates a Class 1 pari-mutuel horse racing
facility in the greater Houston metropolitan area, and a pari-mutuel
greyhound racing facility in Harlingen, Texas.

Results and activities for MAXXAM Inc. and for MAXXAM Group Holdings Inc.
("MGHI"), exclusive of their subsidiaries, are not included in the above
segments. MGHI owns 100% of MGI and is a wholly owned subsidiary of the Company.

This Annual Report on Form 10-K contains statements which
constitute"forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. These statements appear in a number of
places in this section (see Item 1. "Business--Aluminum
Operations--General--Reorganization Proceedings," "--Business
Operations--Bauxite and Alumina Business Unit," "--Primary Aluminum Business
Unit," "--Commodities Marketing Business Unit," "--Competition," "--Forest
Products Operations--Harvesting Practices," "--Production Facilities" and
"--Regulatory and Environmental Factors;" most sections under Item 3. "Legal
Proceedings;" several sections under Item 7. "Management's Discussion and
Analysis of Financial Condition and Results of Operations;" and Item 7A.
"Quantitative and Qualitative Disclosures About Market Risk"). Such statements
can be identified by the use of forward-looking terminology such as "believes,"
"expects," "may," "estimates," "will," "should," "plans" or "anticipates" or the
negative thereof or other variations thereon or comparable terminology, or by
discussions of strategy. Readers are cautioned that any such forward-looking
statements are not guarantees of future performance and involve significant
risks and uncertainties, and that actual results may vary materially from the
forward-looking statements as a result of various factors. These factors include
the effectiveness of management's strategies and decisions, general economic and
business conditions, developments in technology, new or modified statutory or
regulatory requirements and changing prices and market conditions. This Report
identifies other factors that could cause such differences between such
forward-looking statements and actual results. No assurance can be given that
these are all of the factors that could cause actual results to vary materially
from the forward-looking statements.

ALUMINUM OPERATIONS

GENERAL

This section contains statements which constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. See Item 1. "Business--General" and below for cautionary information
with respect to such forward-looking statements.

Kaiser operates in several principal aspects of the aluminum industry--the
mining of bauxite, the refining of bauxite into alumina, the production of
primary aluminum from alumina, and the manufacture of fabricated (including
semi-fabricated) aluminum products. In addition to the production utilized by
Kaiser in its operations, Kaiser sells significant amounts of alumina and
primary aluminum in domestic and international markets. References in this
Report to tons refer to metric tons of 2,204.6 pounds.

REORGANIZATION PROCEEDINGS

The Debtors filed the Cases in the Court for reorganization under Chapter
11 of the Code. None of KACC's non-U.S. affiliates were included in the Cases.
The Cases are being jointly administered with the Debtors managing their
businesses in the ordinary course as debtors-in-possession subject to the
control and supervision of the Court.

The Cases were filed as a result of liquidity and cash flow problems of
Kaiser arising in late 2001 and early 2002. Kaiser was facing significant
near-term debt maturities at a time of unusually weak aluminum industry business
conditions, depressed aluminum prices and a broad economic slowdown that was
further exacerbated by the events of September 11, 2001. In addition, Kaiser had
become increasingly burdened by the asbestos litigation and growing legacy
obligations for retiree medical and pension costs. The confluence of these
factors created the prospect of continuing operating losses and negative cash
flow, resulting in lower credit ratings and an inability to access the capital
markets.

The outstanding principal of, and accrued interest on, all long-term debt
of the Debtors became immediately due and payable as a result of the
commencement of the Cases. However, the vast majority of the claims in existence
at the Filing Date (including claims for principal and accrued interest and
substantially all legal proceedings) are stayed (deferred) while Kaiser
continues to manage the businesses. The Court, however, upon motion by the
Debtors, has permitted the Debtors to pay or otherwise honor certain unsecured
pre-Filing Date claims, including employee wages and benefits and customer
claims in the ordinary course of business, subject to certain limitations, and
to fund, on an interim basis pending a final determination on the issue by the
Court, its joint ventures in the ordinary course of business. The Debtors also
have the right to assume or reject executory contracts, subject to Court
approval and certain other limitations. In this context, "assumption" means that
the Debtors agree to perform their obligations and cure certain existing
defaults under the executory contract and "rejection" means that the Debtors are
relieved from their obligations to perform further under the executory contract
and are subject only to a claim for damages for the breach thereof. Any claim
for damages resulting from the rejection of an executory contract is treated as
a general unsecured claim in the Cases.

Generally, pre-Filing Date claims against the Debtors will fall into two
categories: secured and unsecured, including certain contingent or unliquidated
claims. Under the Code, a creditor's claim is treated as secured only to the
extent of the value of the collateral securing such claim, with the balance of
such claim being treated as unsecured. Unsecured and partially secured claims do
not accrue interest after the Filing Date. A fully secured claim, however, may
accrue interest after the Filing Date until the amount due and owing to the
secured creditor, including interest accrued after the Filing Date, is equal to
the value of the collateral securing such claim. The amount and validity of
pre-Filing Date contingent or unliquidated claims, although presently unknown,
ultimately may be established by the Court or by agreement of the parties. As a
result of the Cases, additional pre-Filing Date claims and liabilities may be
asserted, some of which may be significant. No provision has been included in
the accompanying financial statements for such potential claims and additional
liabilities that may be filed on or before a date to be fixed by the Court as
the last day to file proofs of claim.

The following table sets forth certain 2001 financial information for the
Debtors and Kaiser.

Consolidation/
Elimination Kaiser
Debtors non-Debtors Entries Consolidated
------------- --------------- ------------- --------------
(In millions)
Net sales........................................... $ 1,252.8 $ 592.7 $ (112.8) $ 1,732.7
Operating income.................................... 66.0 11.3 (12.4) 64.9
Net income (loss)................................... (445.9) 11.7 (25.2) (459.4)

Current assets...................................... $ 607.6 $ 151.6 $ - $ 759.2
Current liabilities................................. 702.0 101.4 - 803.4
Total assets........................................ 2,449.8 1,654.7 (1,360.8) 2,743.7
Total liabilities and minority interests............ 2,890.9 274.2 19.7 3,184.8
Total equity (deficit).............................. (441.1) 1,380.5 (1,380.5) (441.1)

On February 12, 2002, in order to fund cash requirements during the
pendency of the Cases, Kaiser entered into a post-petition credit agreement with
a group of lenders for debtor-in-possession financing (the "DIP FACILITY") which
provides for a secured, revolving line of credit through the earlier of February
12, 2004, the effective date of a plan of reorganization or voluntary
termination by Kaiser. The DIP Facility replaced Kaiser's Credit Agreement.
Kaiser is able to borrow under the DIP Facility by means of revolving credit
advances and letters of credit (up to $125.0 million) in an aggregate amount
equal to the lesser of $300.0 million or a borrowing base relating to eligible
accounts receivable, eligible inventory and eligible fixed assets reduced by
certain reserves, as defined in the DIP Facility agreement. The DIP Facility is
guaranteed by Kaiser and certain of its significant subsidiaries. Interest on
any outstanding balances will bear a spread over either a base rate or LIBOR, at
Kaiser's option. On March 19, 2002, the Court signed a final order approving the
DIP Facility.

Kaiser's objective is to achieve the highest possible recoveries for all
creditors and stockholders, consistent with the Debtors' abilities to pay and
the continuation of their businesses. However, there can be no assurance that
the Debtors will be able to attain these objectives or achieve a successful
reorganization. Further, there can be no assurance that the liabilities of the
Debtors will not be found in the Cases to exceed the fair value of their assets.
This could result in claims being paid at less than 100% of their face value and
the equity of Kaiser's stockholders being diluted or cancelled. At this time, it
is not possible to predict the outcome of the Cases, in general, or the effect
of the Cases on the businesses of the Debtors or on the interests of creditors
and stockholders.

Two creditors' committees, one representing the unsecured creditors and
the other representing the asbestos claimants, have been appointed as official
committees in the Cases and, in accordance with the provisions of the Code, will
have the right to be heard on all matters that come before the Court. The
Debtors expect that the appointed committees, together with a legal
representative of potential future asbestos claimants to be appointed by the
Court, will play important roles in the Cases and the negotiation of the terms
of any plan or plans of reorganization. The Debtors are required to bear certain
of the committees' costs and expenses, including those of their counsel and
other advisors.

The Debtors anticipate that substantially all liabilities of the Debtors
as of the Filing Date will be resolved under one or more plans of reorganization
to be proposed and voted on in the Cases in accordance with the provisions of
the Code. Although the Debtors intend to file and seek confirmation of such a
plan or plans, there can be no assurance as to when the Debtors will file such a
plan or plans, or that such plan or plans will be confirmed by the Court and
consummated.

As provided by the Code, the Debtors initially have the exclusive right to
propose a plan of reorganization for 120 days following the Filing Date. If the
Debtors fail to file a plan of reorganization during such period or any
extension thereof, or if such plan is not accepted by the requisite classes and
numbers of creditors and equity holders entitled to vote on the plan, other
parties in interest in the Cases may be permitted to propose their own plan(s)
of reorganization for the Debtors.

On April 12, 2002, Kaiser filed with the Court a motion seeking an order
of the Court prohibiting the Company (or MGHI), without first seeking Court
relief, from making any disposition of its stock of Kaiser, including any sale,
transfer, or exchange of such stock or treating any of its Kaiser stock as
worthless for federal income tax purposes. Kaiser indicated in its Court filing
that it was concerned that such a transaction could have the effect of depriving
Kaiser of the ability to utilize the full value of its net operating losses,
foreign tax credits and minimum tax credits. The Company is in the process of
analyzing the motion and other materials which were filed with the Court.

SUMMARY OF BUSINESS OPERATIONS

Kaiser's operations are conducted through KACC's business units. The
following table sets forth production and third party purchases of bauxite,
alumina and primary aluminum and third party shipments and intersegment
transfers of bauxite, alumina, primary aluminum and fabricated products for the
years ended December 31, 2001, 2000 and 1999:

Sources(1) Uses(1)
---------------------------- ---------------------------
Third Party Third Party Intersegment
Production Purchases Shipments Transfers
----------- ------------ ------------ ------------
(In thousands of tons)
Bauxite
2001.................................. 5,628.3 1,916.3 1,512.2 4,355.4
2000.................................. 4,305.0 2,290.0 2,007.0 2,342.0
1999.................................. 5,261.0 2,251.6 1,497.0 3,515.0
Alumina
2001.................................. 2,813.9 (2) 115.0 2,582.7 422.8
2000.................................. 2,042.9 322.0 1,927.1 751.9
1999.................................. 2,524.0 395.0 2,093.9 757.3
Primary Aluminum
2001.................................. 214.3 214.4 437.2 (3)
2000.................................. 411.4 206.5 672.4 (3) -
1999.................................. 426.4 260.1 684.6 (3) -
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(1) Sources and uses will not equal due to the impact of inventory changes and
alumina and metal swaps.
(2) During September 2001, Kaiser sold an 8.3% interest in Queensland Alumina
Limited ("QAL"). See "--Business Operations--Bauxite and Alumina Business
Unit" below for a discussion of the effects of the sale on alumina
production.
(3) Includes both primary aluminum shipments and pounds of aluminum contained
in fabricated aluminum product shipments. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Results of Operations-Aluminum Operations-Summary" for an
allocation of shipments between the primary aluminum and pounds of
aluminum in fabricated aluminum products.

BUSINESS OPERATIONS

Kaiser conducts its operations through its five main business units
(bauxite and alumina, primary aluminum, commodities marketing, flat-rolled
products and engineered products), each of which is discussed below.

Bauxite and Alumina Business Unit
The following table lists Kaiser's bauxite mining and alumina refining
facilities as of December 31, 2001:

ANNUAL
PRODUCTION TOTAL
CAPACITY ANNUAL
KAISER AVAILABLE TO PRODUCTION
ACTIVITY FACILITY LOCATION OWNERSHIP KAISER CAPACITY
- ------------------------------------------- ------------- ----------- ------------ ------------ ------------
(IN THOUSANDS OF TONS)

Bauxite Mining KJBC(1) Jamaica 49.0% 4,500.0 4,500.0
Alpart(2) Jamaica 65.0% 2,275.0 3,500.0
------------ ------------
6,775.0 8,000.0
============ ============

Alumina Refining Gramercy Louisiana 100.0% 1,250.0 1,250.0
Alpart Jamaica 65.0% 942.5 1,450.0
QAL(3) Australia 20.0% 730 3,650.0
------------ ------------
2,922.5 6,350.0
============ ============

- ------------------

(1) Kaiser Jamaica Bauxite Company ("KJBC").
(2) Alumina Partners of Jamaica ("ALPART") bauxite is refined into alumina at
the Alpart refinery.
(3) During September 2001, Kaiser sold an 8.3% interest in QAL.

Kaiser is a major producer of alumina and sells significant amounts of its
alumina production in domestic and international markets. Kaiser's strategy is
to sell a substantial portion of the alumina available to it in excess of its
internal smelting requirements under multi-year sales contracts with prices
linked to the price of primary aluminum. During 2001, Kaiser sold alumina to
approximately 12 customers, the largest and top five of which accounted for
approximately 21% and 64%, respectively, of the business unit's third-party net
sales. All of Kaiser's third-party sales of bauxite in 2001 were made to one
customer, which sales represent approximately 6% of the business unit's
third-party net sales. Kaiser's principal customers for bauxite and alumina
consist of other aluminum producers, trading intermediaries who resell raw
materials to end-users, and users of chemical grade alumina. See "--Commodities
Marketing Business Unit" and "--Competition."

The Government of Jamaica has granted Kaiser a mining lease for the mining
of bauxite which will, at a minimum, satisfy the bauxite requirements of
Kaiser's Gramercy, Louisiana, alumina refinery so that it will be able to
produce at its current rated capacity until 2020. KJBC mines bauxite from the
land which is subject to the mining lease as an agent for Kaiser. Although
Kaiser owns 49% of KJBC, it is entitled to, and generally takes, all of its
bauxite output. A substantial majority of the bauxite mined by KJBC is refined
into alumina at the Gramercy facility, and the remainder is sold to two third
party customers. The Government of Jamaica, which owns 51% of the KJBC, has
agreed to grant Kaiser an additional bauxite mining lease. The new mining lease
will be effective upon the expiration of the current lease in 2020 and will
enable the Gramercy facility to produce at its rated capacity for an additional
ten year period. The Debtors have received the authority from the Court to
continue to fund KJBC's cash requirements in the ordinary course of business.
See Note 3 to the Consolidated Financial Statements for more detailed
information regarding the Gramercy incident.

Alumina produced by the Gramercy plant is primarily sold to third parties.
The Gramercy refinery produces two products: smelter grade alumina and chemical
grade alumina (e.g. hydrate). Smelter grade alumina is sold under long-term
contracts typically linked to London Metal Exchange prices ("LME PRICES") for
primary aluminum. Chemical grade alumina is sold at a premium price over smelter
grade alumina. Production at the Gramercy refinery was completely curtailed in
July 1999 when it was extensively damaged by an explosion in the digestion area
of the plant. A number of employees were injured in the incident, some of them
severely. Production at the plant remained curtailed until the middle of
December 2000 at which time partial production commenced. Construction at the
facility was substantially completed during the third quarter of 2001. During
2001, the Gramercy facility incurred abnormal related start-up costs of
approximately $64.9 million. These abnormal costs resulted from operating the
plant in an interim and less efficient mode pending the completion of
construction and reaching the plant's intended production rates and efficiency.
During the first nine months of 2001, the plant operated at approximately 68% of
its newly rated estimated annual capacity of 1,250,000 tons. During the fourth
quarter of 2001, the plant operated at approximately 90% of its newly-rated
capacity. By the end of February 2002, the plant was operating at just below
100% of its newly-rated capacity. The facility is now focusing its efforts on
achieving its full operating efficiency. While production was curtailed, Kaiser
purchased alumina from third parties, in excess of the amounts of alumina
available from other Kaiser-owned facilities, to supply major customers' needs
as well as to meet intersegment requirements. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition and Investing and Financing Activities--Aluminum
Operations--Financing Activities and Liquidity" and Note 3 to the Consolidated
Financial Statements for further information regarding the Gramercy incident.

Kaiser holds its interests in Alpart through two wholly owned subsidiaries
which did not file petitions for reorganization under the Code. The Debtors have
received the authority from the Court to continue to fund Alpart's cash
requirements in the ordinary course of business. Alpart holds bauxite reserves
and owns a 1.45 million ton per year alumina plant located in Jamaica. Kaiser
owns a 65% interest in Alpart, and Hydro Aluminium a.s ("HYDRO") owns the
remaining 35% interest. Kaiser has management responsibility for the facility on
a fee basis. Kaiser and Hydro have agreed to be responsible for their
proportionate shares of Alpart's costs and expenses. The Government of Jamaica
has granted Alpart a mining lease and has entered into other agreements with
Alpart designed to assure that sufficient reserves of bauxite will be available
to Alpart to operate its refinery, as it may be expanded up to a capacity of 2.0
million tons per year, through the year 2024.

In the first half of 2000, Alpart and JAMALCO, a joint venture between
affiliates of Alcoa Inc. and the Government of Jamaica, began operating a
bauxite mining operation joint venture that consolidates their bauxite mining
operations in Jamaica, the objective of which is to optimize mining operating
and capital costs. The joint venture agreement also grants Alpart certain rights
to acquire bauxite mined from JAMALCO's reserves.

Kaiser owns a 20% interest in QAL after selling an approximate 8.3%
interest in September 2001. Kaiser holds its interest in QAL through a wholly
owned subsidiary which was one of Kaiser's subsidiaries that filed a petition
for reorganization under the Code. The Debtors currently have the authority from
the Court to fund QAL's cash requirements in the ordinary course of business.
QAL, which is located in Queensland, Australia, owns one of the largest and most
competitive alumina refineries in the world. QAL refines bauxite into alumina,
essentially on a cost basis, for the account of its shareholders under long-term
tolling contracts. The shareholders, including Kaiser, purchase bauxite from
another QAL shareholder under long-term supply contracts. Kaiser has contracted
with QAL to take approximately 614,000 tons per year of alumina or pay standby
charges. Kaiser is unconditionally obligated to pay amounts calculated to
service its share ($79.4 million at December 31, 2001) of certain debt of QAL,
as well as other QAL costs and expenses, including bauxite shipping costs. Had
the sale of the QAL interest been effective as of the beginning of 2001,
Kaiser's share of QAL's production for 2001 would have been reduced by
approximately 196,000 tons. Historically, Kaiser has sold about half of its
share of QAL's production to third parties and has used the remainder to supply
its Northwest smelters, which are temporarily curtailed. The reduction in
Kaiser's alumina supply associated with its sale of the QAL interest is expected
to be substantially offset by the return of its Gramercy alumina refinery to
full operations at a higher capacity and by a planned increase in capacity at
its Alpart alumina refinery in Jamaica. Accordingly, the QAL transaction is not
expected to have an adverse impact on Kaiser's ability to satisfy existing
third-party customer contracts.

In 2001, Kaiser sold alumina to approximately 12 customers, the largest
and top five of which accounted for approximately 21% and 64% of the business
unit's third party net sales, respectively. All of Kaiser's third-party sales of
bauxite in 2001 were made to one customer, which sales represent approximately
6% of the business unit's third party net sales. Kaiser's principal customers
for bauxite and alumina consist of other aluminum producers, trading
intermediaries who resell raw materials to end-users, and users of chemical
grade alumina.

Primary Aluminum Business Unit
This section contains statements which constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. See Item 1. "Business--General" and below for cautionary information
with respect to such forward-looking statements.

The following table lists Kaiser's primary aluminum smelting facilities as
of December 31, 2001:

ANNUAL
RATED TOTAL
CAPACITY ANNUAL 2001
KAISER AVAILABLE TO RATED OPERATING
LOCATION FACILITY OWNERSHIP KAISER CAPACITY RATE
- ------------------------------ --------------- ------------ -------------- ------------ -----------
(IN THOUSANDS OF TONS)
Domestic:
Washington Mead 100% 200.0 200.0 -(1)
Washington Tacoma 100% 73.0 73.0 -(1)
-------------- ------------
Subtotal 273.0 273.0
-------------- ------------

International:
Ghana Valco 90% 180.0 200.0 81%
Wales, United Kingdom Anglesey 49% 66.2 135.0 102%
-------------- ------------
Subtotal 246.2 335.0
-------------- ------------

Total 519.2 608.0
============== ============

- ------------------

(1) Production was completely curtailed during 2001.

Kaiser uses proprietary retrofit and control technology in all of its
smelters. This technology, which includes the redesign of the cathodes, anodes
and bus that conduct electricity through reduction cells, improved feed systems
that add alumina to the cells, computerized process control and energy
management systems, and furnace technology for baking of anode carbon, has
significantly contributed to increased and more efficient production of primary
aluminum and enhanced Kaiser's ability to compete more effectively with the
industry's newer smelters.

The process of converting alumina into aluminum requires significant
amounts of electric power. Electric power represents an important production
input for Kaiser at its aluminum smelters, and its cost can significantly affect
Kaiser's profitability. Kaiser has historically purchased a significant portion
of its electric power for the Mead and Tacoma, Washington, smelters from the
Bonneville Power Administration ("BPA"). Over recent years, the BPA has supplied
approximately half of the electric power for the two plants, with the balance
coming from other suppliers.

In response to the unprecedented high market prices for power in the
Pacific Northwest, Kaiser temporarily curtailed primary aluminum production at
the Mead and Tacoma, Washington, smelters during the second half of 2000 and all
of 2001. During this same period, Kaiser sold the available power that it had
under contract through September 30, 2001. As a result of the curtailments,
Kaiser avoided the need to purchase power on a variable market price basis and
received cash proceeds sufficient to more than offset the cash impact of the
potline curtailments over the period for which the power was sold. As of
December 31, 2001, both the Mead and Tacoma, Washington, smelters were
completely curtailed and are expected to remain curtailed at least through early
2003. However, Kaiser continues to operate the Tacoma rod-mill.

The Mead facility uses pre-bake technology. The Tacoma facility uses
Soderberg technology and produces primary aluminum and high-grade,
continuous-cast, redraw rod, which currently commands a premium price in excess
of the price of primary aluminum. The business unit maintains specialized
laboratories and a miniature carbon plant in the state of Washington which
concentrate on the development of cost-effective technical innovations such as
equipment and process improvements.

During October 2000, Kaiser signed a new power contract with the BPA under
which the BPA, starting October 1, 2001, provides Kaiser's operations in the
State of Washington with up to approximately 290 megawatts of power through
September 2006. The contract provides Kaiser with sufficient power to fully
operate the Flat-Rolled Products Business Unit's Trentwood facility (which
requires up to an approximate 40 megawatts) as well as approximately 40% of the
combined capacity of Kaiser's Mead and Tacoma smelting operations. The BPA has
announced that it currently intends to set rates under the contract in six month
increments. The rate for the initial period (from October 1, 2001 through March
31, 2002) was approximately 46% higher than power costs under the prior
contract. Power prices for the April 2002 through September 2002 period are
essentially unchanged from the prior six-month rate. Kaiser cannot predict what
rates will be charged in future periods. Such rates will be dependent on such
factors as the availability of and demand for electrical power, which are
largely dependent on weather, the price for alternative fuels, particularly
natural gas, as well as general and regional economic and ecological factors.
The contract also includes a take-or-pay requirement and clauses under which
Kaiser's power allocation could be curtailed, or its costs increased, in certain
instances. Under the contract, Kaiser can only remarket its power allocation to
reduce or eliminate take-or-pay requirements. Kaiser is not entitled to receive
any profits from any such remarketing efforts. During October 2001, Kaiser and
the BPA reached an agreement whereby: (a) Kaiser would not be obligated to pay
for potential take-or-pay obligations in the first year of the contract and (b)
Kaiser retained its rights to restart its smelter operations at any time. In
return for the foregoing, Kaiser granted the BPA certain limited power
interruption rights in the first year of the contract if Kaiser is operating its
Northwest smelters. The Department of Energy acknowledged that capital spending
in respect of the Gramercy refinery was consistent with the contractual
provisions of the prior contract with respect to the use of power sale proceeds.
Beginning October 2002, unless there is a further amendment of Kaiser's
obligations, Kaiser could be liable for take-or-pay costs under the BPA
contract, and such amounts could be significant. Kaiser is reviewing its rights
and obligations in respect of the BPA contract in light of the filing of the
Cases. See Note 4 of Notes to Consolidated Financial Statements for additional
information regarding the BPA contract.

Subject to the limited interruption rights granted to the BPA (described
above), Kaiser has sufficient power under contract, and retains the ability, to
restart up to 40% (4.75 potlines) of its Northwest smelting capacity. Were
Kaiser to restart additional capacity (in excess of 4.75 potlines), it would
have to purchase additional power from the BPA or other suppliers. For Kaiser to
make such a decision, it would have to be able to purchase such power at a
reasonable price in relation to current and expected market conditions for a
sufficient term to justify its restart costs, which could be significant
depending on the number of lines restarted and the length of time between the
shutdown and restart. Given recent primary aluminum prices and the forward price
of power in the Northwest, it is unlikely that Kaiser would operate more than a
portion of its Northwest smelting capacity in the near future. Were Kaiser to
restart all or a portion of its Northwest smelting capacity, it would take
between three to six months to reach the full operating rate for such
operations, depending upon the number of lines restarted. Even after achieving
the full operating rate, operating only a portion of the Northwest capacity
would result in production/cost inefficiencies such that operating results
would, at best be breakeven to modestly negative at long-term primary aluminum
prices. However, operating at such a reduced rate could, depending on prevailing
economics, result in improved cash flows as opposed to remaining curtailed and
incurring the Company's fixed and continuing labor and other costs. This is
because Kaiser is contractually liable for certain severance, supplemental
unemployment benefits and early retirement benefits for laid-off workers under
Kaiser's contract with the United Steelworkers of America ("USWA") during
periods of curtailment. As of December 31, 2001, all such contractual
compensation costs have been accrued for all USWA workers in excess of those
expected to be required to run the Northwest smelters at a rate up to the above
stated 40% smelter operating rate. These costs are expected to be incurred
periodically through September 2002. Costs associated with the USWA workers that
Kaiser estimates would be required to operate the smelters at an operating rate
of up to 40% have been accrued through early 2003, as Kaiser does not currently
expect to restart the Northwest smelters prior to that date. If such workers are
not recalled prior to the end of the first quarter of 2003, Kaiser could become
liable for additional early retirement costs. Such costs could be significant
and could adversely impact Kaiser's operating results and liquidity. The present
value of such costs could be in the $50.0 million to $60.0 million range.
However, such costs would likely be paid out over an extended period.

Kaiser manages, and owns a 90% interest in, the Volta Aluminium Company
Limited ("VALCO") aluminum smelter in Ghana. The Valco smelter uses pre-bake
technology and processes alumina supplied by Kaiser and the other participant
into primary aluminum under tolling contracts which provide for proportionate
payments by the participants. Kaiser's share of the primary aluminum is sold to
third parties. Valco's operating level has been subject to fluctuations
resulting from the amount of power it is allocated by the Volta River Authority
("VRA"). The operating level over the last five years has ranged from one to
four out of a total of five potlines. During 2001 and 2000, Valco operated an
average of four potlines. During late 2000, Valco, the Government of Ghana and
the VRA reached an agreement, subject to Parliamentary approval, that would
provide sufficient power for Valco to operate at least three and one-half of its
five potlines through 2017. However, Parliamentary approval has not been
received and, effective March 3, 2002, the Government of Ghana reduced Valco's
power allocation forcing Valco to curtail one of its four operating potlines.
Valco has objected to the power curtailment and expects to seek remedies from
the Government of Ghana. Valco has met with the Government of Ghana and the VRA
and anticipates such discussions will continue in respect of the current and
future power situation. Valco currently expects to operate approximately three
potlines during the remainder of 2002. However, no assurances can be provided
that Valco will continue to receive sufficient power to operate three potlines
for the balance of 2002 or thereafter.

Kaiser owns a 49% interest in the Anglesey Aluminium Limited ("ANGLESEY")
aluminum smelter at Holyhead, Wales. The Anglesey smelter uses pre-bake
technology. Kaiser supplies 49% of Anglesey's alumina requirements and purchases
49% of Anglesey's aluminum output. Kaiser sells its share of Anglesey's output
to third parties. During early 2000, Anglesey entered into a new power agreement
that provides sufficient power to sustain its operations at full capacity
through September 2009.

Kaiser does not expect Valco's or Anglesey's operations to be adversely
affected as a result of the Cases as the Debtors have received the authority
from the Court to fund Valco's and Anglesey's cash requirements in the ordinary
course of business.

Kaiser's principal primary aluminum customers consist of large trading
intermediaries and metal brokers. In 2001, Kaiser sold its primary aluminum
production not utilized for internal purposes to approximately 96 customers, the
largest and top five of which accounted for approximately 72% and 92% of the
business unit's third-party net sales, respectively. See "--Competition."
Marketing and sales efforts are conducted by personnel located in Houston,
Texas, and Tacoma and Spokane, Washington.

Commodities Marketing Business Unit
Kaiser's operating results are sensitive to changes in the prices of
alumina, primary aluminum, and fabricated aluminum products, and also depend to
a significant degree upon the volume and mix of all products sold. Primary
aluminum prices have historically been subject to significant cyclical
fluctuations. Alumina prices, as well as fabricated aluminum product prices
(which vary considerably among products), are significantly influenced by
changes in the price of primary aluminum and generally lag behind primary
aluminum prices by up to three months. From time to time in the ordinary course
of business, Kaiser enters into hedging transactions to provide risk management
in respect of its net exposure of earnings and cash flow related to primary
aluminum price changes. Given the significance of primary aluminum hedging
activities, Kaiser has begun (starting with the year ended December 31, 2000)
reporting its primary aluminum-related hedging activities as a separate segment.
Primary aluminum-related hedging activities are managed centrally on behalf of
all of Kaiser's business segments to minimize transaction costs, monitor
consolidated net exposures and to allow for increased responsiveness to changes
in market factors. Because the agreements underlying Kaiser's hedging positions
provided that the counterparties to the hedging contracts could liquidate
Kaiser's hedging positions if Kaiser filed for reorganization, Kaiser chose to
liquidate these positions in advance of the Filing Date. Gains or losses
associated with these liquidated positions have been deferred and are being
recognized over the original hedging periods as the underlying purchases/sales
are still expected to occur. Kaiser anticipates that, subject to the approval of
the Court and prevailing economic conditions, it may reinstitute an active
hedging program. However, no assurance can be given as to when or if the
appropriate Court approval will be obtained or when or if such hedging
activities will restart. See Item 7A. "Quantitative and Qualitative Disclosures
about Market Risk" and Notes 1 and 17 to the Consolidated Financial Statements.

Hedging activities conducted in respect of Kaiser's cost exposure to
energy prices and foreign exchange rates are not considered a part of the
commodities marketing segment. Rather, such activities are included in the
results of the business unit to which they relate.

Flat-Rolled Products Business Unit
The flat-rolled products business unit operates the Trentwood, Washington,
rolling mill. During recent years, the business unit has sold to the aerospace,
transportation and industrial markets (producing heat treat sheet and plate
products and automotive brazing sheet) and the beverage container market
(producing lid and tab stock), both directly and through distributors.

During 2000, KACC shifted the product mix of its Trentwood rolling mill
toward higher value-added product lines, and exited beverage can body stock and
wheel and common alloy products in an effort to enhance its profitability.
Kaiser continues to reassess the product mix of its Trentwood rolling mill, and
has concluded that the business unit's profitability can be enhanced by further
focusing resources on its core, heat-treat business and by exiting lid and tab
stock product lines used in the beverage container market and brazing sheet for
the automotive market. As a result of this decision, Kaiser plans to sell or
idle several pieces of equipment resulting in an impairment charge of
approximately $17.7 million at December 31, 2001. Additional charges are likely
as Kaiser works through all of the operational impacts of this decision to exit
lid and tab stock and brazing sheet.

In 2001, the business unit sold to approximately 101 customers, most of
which represented heat treat product shipments to distributors who sell to a
variety of industrial end-users. The largest and top five customers in the ATI
markets for flat-rolled heat-treat products accounted for approximately 17% and
35%, respectively, of the business unit's third party net sales. The business
unit also sold lid and tab stock to beverage container manufacturing locations
in the United States. The largest and top five of such customers accounted for
approximately 9% and 16%, respectively, of the business unit's third-party net
sales. See "--Competition" below. Sales are made directly to end-use customers
and distributors by Kaiser sales representatives located in the United States
and Europe, and by independent sales agents in Asia.

Engineered Products Business Unit
The engineered products business unit operates soft-alloy and hard-alloy
extrusion facilities and engineered component (forgings) facilities in the
United States and Canada. Major markets for extruded products are in the ground
transportation industry, to which the business unit sells extruded shapes for
automobiles, light-duty vehicles, heavy-duty trucks and trailers, and shipping
containers, and in the distribution, durable goods, defense, building and
construction, ordnance and electrical markets.

Soft-alloy extrusion facilities are located in Los Angeles, California;
Sherman, Texas; Tulsa, Oklahoma; Richmond, Virginia; and London, Ontario,
Canada. Products manufactured at these facilities include rod, bar, tube, shapes
and billet. Hard-alloy extrusion facilities are located in Newark, Ohio, and
Jackson, Tennessee, and produce rod, bar, screw machine stock, redraw rod,
forging stock and billet. The business unit also extrudes seamless tubing in
both hard and soft alloys at a facility in Richland, Washington, and produces
drawn tube in both hard and soft alloys at a facility in Chandler, Arizona, that
it purchased in May 2000. Soft-alloy extruded seamless and drawn tubing is also
produced at the Richmond, Virginia facility.

The business unit sells forged parts to customers in the automotive,
heavy-duty truck, general aviation, rail, machinery and equipment, and ordnance
markets. The high strength-to-weight properties of forged aluminum make it
particularly well-suited for automotive applications. Forging facilities are
located in Oxnard, California, and Greenwood, South Carolina. Through its sales
and engineering office in Southfield, Michigan, the business unit staff works
with automobile makers and other customers and plant personnel to create new
automotive component designs and to improve existing products.

Kaiser's London, Ontario facility (the "LONDON FACILITY") is owned by one
of its wholly owned subsidiaries that did not file a petition for reorganization
under the Code. The Debtors have received the authority to continue to fund the
London Facility's cash requirements in the ordinary course of business.
Accordingly, Kaiser does not believe the London Facility's operations will be
adversely affected by the Cases.

In 2001, the engineered products business unit had approximately 400
customers, the largest and top five of which accounted for approximately 10% and
24%, respectively, of the business unit's third party net sales. See
"--Competition" below. Sales are made directly to end-use customers and
distributors by Kaiser sales representatives located across the United States.

COMPETITION

Kaiser competes globally with producers of bauxite, alumina, primary
aluminum, and fabricated aluminum products. Many of Kaiser's competitors have
greater financial resources than Kaiser. Primary aluminum and, to some degree,
alumina are commodities with generally standard qualities, and competition in
the sale of these commodities is based primarily upon price, quality and
availability. Aluminum competes in many markets with steel, copper, glass,
plastic, and other materials. Kaiser competes with numerous domestic and
international fabricators in the sale of fabricated aluminum products and
markets its fabricated aluminum products in the United States and abroad. Sales
are made directly and through distributors to a large number of customers.
Competition in the sale of fabricated products is based upon quality,
availability, price and service, including delivery performance. Kaiser
concentrates its fabricating operations on selected products in which it
believes it has production expertise, high-quality capability, and geographic
and other competitive advantages. Kaiser believes that, assuming the current
relationship between worldwide supply and demand for alumina and primary
aluminum does not change materially, the loss of any one of Kaiser's customers,
including intermediaries, would not have a material adverse effect on its
financial condition or results of operations. Also see the description of each
of the business units above.

LABOR MATTERS

As a result of the September 1998 strike by the USWA and the subsequent
"lock-out" by Kaiser in January 1999, and prior to the settlement of the dispute
in September 2000, Kaiser was operating five of its U.S. facilities with
salaried employees and other employees. Under the terms of the settlement, USWA
members generally returned to the affected plants during October 2000. The new
labor contract, which expires in September 2005, provides for a 2.6% average
annual increase in the overall wage and benefit packages, and results in the
reduction of at least 540 hourly jobs at the five facilities (from approximately
2,800 in September 1998). It also provides that Kaiser is liable for certain
severance and supplemental unemployment benefits for laid-off workers. See Note
4 to the Consolidated Financial Statements for a discussion of the labor dispute
and settlement.

Although the USWA dispute has been settled and the workers have returned
to the facilities, two allegations of unfair labor practices ("ULPS") remain in
connection with the USWA strike and subsequent lock-out. Kaiser believes that
these charges are without merit. See Item 3. "Legal Proceedings--Kaiser
Litigation--Labor Matters" and Note 16 to the Consolidated Financial Statements,
"--Labor Matters" for a discussion of the ULPs. The Company believes that the
remaining charges made against Kaiser by the USWA are without merit.

RESEARCH AND DEVELOPMENT

Net expenditures for Kaiser-sponsored research and development activities
were $4.0 million in 2001, $5.6 million in 2000 and $11.0 million in 1999.
Kaiser estimates that research and development net expenditures will be in the
range of $3.0 million to $5.0 million in 2002.

EMPLOYEES

During 2001, Kaiser employed an average of approximately 6,500 persons,
compared with an average of approximately 7,800 persons in 2000 and
approximately 8,600 persons in 1999. At December 31, 2000, Kaiser employed
approximately 5,800 persons (excluding approximately 1,100 on a layoff status),
of which approximately 3,100 were employed by the Debtors, and 2,700 were
employed by the non-Debtors. The foregoing employee figures for 2000 and 1999
include the USWA workers who were subject to the lockout imposed by Kaiser as a
result of the labor dispute that was settled in September 2000. During the labor
dispute, Kaiser operated the five affected facilities with temporary workers who
were not included in the employee counts for 2000 and 1999.

The labor agreements with hourly employees at the Los Angeles, California,
and Richmond, Virginia, Engineered products facilities were renewed in 2001. The
labor agreement with the employees at the Valco smelter in Ghana was renewed
during the first quarter of 2002 and the labor agreement with the employees at
the Alpart refinery in Jamaica is expected to be renewed during the second
quarter of 2002.

ENVIRONMENTAL MATTERS

Kaiser is subject to a wide variety of international, federal, state and
local environmental laws and regulations (the "ENVIRONMENTAL LAWS"). The
Environmental Laws regulate, among other things, air and water emissions and
discharges; the generation, storage, treatment, transportation and disposal of
solid and hazardous waste; and the release of hazardous or toxic substances,
pollutants and contaminants into the environment. During the pendency of the
Cases, substantially all pending litigation, except certain environmental claims
and litigation, against the Debtors is stayed.

Kaiser's current and former operations can subject it to fines or
penalties for alleged breaches of the Environmental Laws and to other actions
seeking clean-up or other remedies under these Environmental Laws. Kaiser also
may be subject to damages related to alleged injuries to health or to the
environment, including claims with respect to certain waste disposal sites and
the clean-up of sites currently or formerly used by Kaiser.

Currently, Kaiser is subject to certain lawsuits under the Comprehensive
Environmental Response, Compensation and Liability Act of 1980, as amended by
the Superfund Amendments and Reauthorization Act of 1986 ("CERCLA"). Kaiser,
along with certain other companies, has been named as a Potentially Responsible
Party for clean-up costs at certain third-party sites listed on the National
Priorities List under CERCLA. As a result, Kaiser may be exposed not only to its
assessed share of clean-up but also the costs of others if they are unable to
pay. Additionally, Kaiser's Mead, Washington, facility has been listed on the
National Priorities List under CERCLA. Kaiser and the regulatory authorities
agreed to a plan of remediation in January 2000.

In response to environmental concerns, Kaiser has established
environmental accruals representing its estimate of the costs it may reasonably
expect to incur in connection with these matters. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of
Operations--Financial Condition and Investing and Financing Activities--Aluminum
Operations--Environmental, Labor and Other Contingencies" and Note 16 to the
Consolidated Financial Statements under the heading "Aluminum
Operations--Environmental Contingencies."

PROPERTIES

The locations and general character of the principal plants, mines, and
other materially important physical properties relating to Kaiser's operations
are described above. Kaiser owns in fee or leases all of the real estate and
facilities used in connection with its business. Plants and equipment and other
facilities are generally in good condition and suitable for their intended uses,
subject to changing environmental requirements. Although Kaiser's domestic
aluminum smelters were initially designed early in Kaiser's history, they have
been modified frequently over the years to incorporate technological advances in
order to improve efficiency, increase capacity, and achieve energy savings.
Kaiser believes that its plants are cost competitive on an international basis.
However, the long-term viability of Kaiser's Pacific Northwest smelters may be
adversely impacted if an adequate supply of power at reasonable prices is not
ultimately available.

Kaiser's obligations under the DIP Facility, are secured by, among other
things, mortgages on its major domestic plants. For a description of the DIP
Facility, see Item 7. "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Financial Condition and Investing and
Financing Activities--Aluminum Operations" and Note 11 to the Consolidated
Financial Statements.

FOREST PRODUCTS OPERATIONS

GENERAL

The Company engages in forest products operations through MGI and its
wholly owned subsidiaries, Pacific Lumber and Britt, and Pacific Lumber's wholly
owned subsidiary, Scotia Pacific Company LLC ("SCOTIA LLC"). Pacific Lumber,
which has been in continuous operation for over 130 years, engages in several
principal aspects of the lumber industry--the growing and harvesting of redwood
and Douglas-fir timber, the milling of logs into lumber products and the
manufacturing of lumber into a variety of value-added finished products. Britt
manufactures redwood fencing and decking products from small diameter logs, a
substantial portion of which Britt acquires from Pacific Lumber (as Pacific
Lumber cannot efficiently process them in its own mills).

TIMBER AND TIMBERLANDS

Pacific Lumber owns and manages approximately 218,000 acres of virtually
contiguous commercial timberlands located in Humboldt County along the northern
California coast, an area which has very favorable soil and climate conditions
for growing timber. These timberlands contain approximately 71% redwood, 23%
Douglas-fir and 6% other timber, are located in close proximity to Pacific
Lumber's and Britt's sawmills, and contain an extensive network of roads.
Approximately 205,000 acres of Pacific Lumber's timberlands are owned by Scotia
LLC (the "SCOTIA LLC TIMBERLANDS"), and Scotia LLC has the exclusive right to
harvest (the "SCOTIA LLC TIMBER RIGHTS") approximately 12,200 acres of Pacific
Lumber's timberlands. The timber in respect of the Scotia LLC Timberlands and
the Scotia LLC Timber Rights is collectively referred to as the "SCOTIA LLC
TIMBER." Substantially all of Scotia LLC's assets are pledged as security for
Scotia LLC's $867.2 million original aggregate principal amount of its 6.55%
Series B Class A-1 Timber Collateralized Notes, 7.11% Series B Class A-2 Timber
Collateralized Notes and 7.71% Series B Class A-3 Timber Collateralized Notes
(collectively, the "TIMBER NOTES"). The Indenture governing the Timber Notes is
referred to herein as the "TIMBER NOTES INDENTURE." Pacific Lumber harvests and
purchases from Scotia LLC virtually all of the logs harvested from the Scotia
LLC Timber. See "--Relationships with Scotia LLC and Britt" below for a
description of this and other relationships among Pacific Lumber, Scotia LLC and
Britt.

On March 1, 1999, Pacific Lumber and its wholly owned subsidiaries, Scotia
LLC and Salmon Creek LLC ("SALMON CREEK")(collectively, the "PALCO COMPANIES")
consummated the Headwaters Agreement (the "HEADWATERS AGREEMENT") with the
United States and California. Pursuant to the agreement, approximately 5,600
acres of timberlands owned by the Palco Companies known as the Headwaters Forest
and the Elk Head Springs Forest (the "HEADWATERS TIMBERLANDS") were transferred
to the United States. In exchange, Salmon Creek was paid $299.9 million, Scotia
LLC was paid $150,000 and approximately 7,700 acres of timberlands known as the
Elk River Timberlands (the "ELK RIVER TIMBERLANDS") were transferred to Pacific
Lumber and subsequently transferred to Scotia LLC. In addition, habitat
conservation and sustained yield plans (the "ENVIRONMENTAL PLANS") were approved
covering the Scotia LLC Timberlands and California agreed to purchase a portion
of Pacific Lumber's Grizzly Creek grove, as well as Scotia LLC's Owl Creek
grove. In December 2000, California purchased the Owl Creek grove for $67.0
million in cash, and on November 15, 2001, purchased a portion of the Grizzly
Creek grove for $19.8 million in cash. Salmon Creek placed $169.0 million of the
proceeds from the sale of the Headwaters Timberlands into a Scheduled
Amortization Reserve Account ("SAR ACCOUNT") in order to support principal
payments on Scotia LLC's Timber Notes. See "Regulatory and Environmental
Factors" below and Note 16 to the Consolidated Financial Statements.

Timber generally is categorized by species and the age of a tree when it
is harvested. "OLD GROWTH" trees are often defined as trees which have been
growing for approximately 200 years or longer and "YOUNG GROWTH" trees are those
which have been growing for less than 200 years. The forest products industry
grades lumber into various classifications according to quality. The two broad
categories into which all grades fall based on the absence or presence of knots
are called "upper" and "common" grades, respectively. Old growth trees have a
higher percentage of upper grade lumber than young growth trees.

Pacific Lumber engages in extensive efforts to supplement the natural
regeneration of timber and increase the amount of timber on its timberlands.
Pacific Lumber is required to comply with California forestry regulations
regarding reforestation, which generally require that an area be reforested to
specified standards within an established period of time. Pursuant to the
Services Agreement described below (see "--Relationships with Scotia LLC and
Britt"), Pacific Lumber conducts regeneration activities on the Scotia LLC
Timberlands for Scotia LLC. Regeneration of redwood timber generally is
accomplished through the natural growth of new redwood sprouts from the stump
remaining after a redwood tree is harvested. Such new redwood sprouts grow
quickly, thriving on existing mature root systems. In addition, Pacific Lumber
supplements natural redwood regeneration by planting redwood seedlings.
Douglas-fir timber is regenerated almost entirely by planting seedlings. During
2001, Pacific Lumber planted an estimated 1,006,000 redwood and Douglas-fir
seedlings.

California law requires timber owners such as Pacific Lumber to
demonstrate that their operations will not decrease the sustainable productivity
of their timberlands. A timber company may comply with this requirement by
submitting a sustained yield plan to the California Department of Forestry and
Fire Protection ("CDF") for review and approval. A sustained yield plan contains
a timber growth and yield assessment, which evaluates and calculates the amount
of timber and long-term production outlook for a company's timberlands, a fish
and wildlife assessment, which addresses the condition and management of
fisheries and wildlife in the area, and a watershed assessment, which addresses
the protection of aquatic resources. The relevant regulations require
determination of a long-term sustained yield ("LTSY") harvest level, which is
the average annual harvest level that the management area is capable of
sustaining in the last decade of a 100-year planning horizon. The LTSY is
determined based upon timber inventory, projected growth and harvesting
methodologies, as well as soil, water, air, wildlife and other relevant
considerations. A sustained yield plan must demonstrate that the average annual
harvest over any rolling ten-year period within the planning horizon does not
exceed the LTSY.

Pacific Lumber is also subject to federal and state laws providing for the
protection and conservation of wildlife species which have been designated as
endangered or threatened, certain of which are found on Pacific Lumber's
timberlands. These laws generally prohibit certain adverse impacts on such
species (referred to as a "TAKE"), except for incidental takes which do not
jeopardize the continued existence of the affected species and which are made in
accordance with an approved habitat conservation plan and related incidental
take permit. A habitat conservation plan analyzes the impact of the incidental
take and specifies measures to monitor, minimize and mitigate such impact. As
part of the Headwaters Agreement, Scotia LLC and Pacific Lumber reached
agreement with various federal and state regulatory agencies with respect to a
sustained yield plan (the "SYP") and a multi-species habitat conservation plan
(the "HCP"). See "--Regulatory and Environmental Factors" below.

During 2001, comprehensive external and internal reviews were conducted by
Pacific Lumber with respect to its business operations. These reviews were an
effort to identify ways in which Pacific Lumber could operate on a more
efficient and cost effective basis. Based upon the results of these reviews,
Pacific Lumber, among other things, indefinitely idled two of its four sawmills,
eliminated certain of its operations, including its soil amendment and concrete
block activities, has began utilizing more efficient harvesting methods and
adopted certain other cost saving measures. Most of these changes were
implemented by Pacific Lumber in the last quarter of 2001, or the first quarter
of 2002. Pacific Lumber also ended its internal logging operations as of April
1, 2002, and intends to rely exclusively on third party contract loggers to
conduct these activities in the future. See "--Production Facilities" and
"--Regulatory and Environmental Factors - Timber Operations."

HARVESTING PRACTICES

This section contains statements which constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. See Item 1. "Business--General" in this section for cautionary
information with respect to such forward-looking statements.

The ability of Pacific Lumber to harvest timber largely depends upon its
ability to obtain regulatory approval of timber harvesting plans ("THPS"). Prior
to harvesting timber in California, companies are required to obtain the CDF's
approval of a detailed THP for the area to be harvested. A THP must be submitted
by a registered professional forester and must include information regarding the
method of proposed timber operations for a specified area, whether the
operations will have any adverse impact on the environment and, if so, the
mitigation measures to be used to reduce any such impact. The CDF's evaluation
of THPs incorporates review and analysis of such THPs by several California and
federal agencies and public comments received with respect to such THPs. An
approved THP is applicable to specific acreage and specifies the harvesting
method and other conditions relating to the harvesting of the timber covered by
such THP. The number of Pacific Lumber's approved THPs and the amount of timber
covered by such THPs varies significantly from time to time, depending upon the
timing of agency review and other factors. Timber covered by an approved THP is
typically harvested within a one year period from the date that harvesting first
begins. The Timber Notes Indenture requires Scotia LLC to use its best efforts
(consistent with prudent business practices) to maintain a number of pending
THPs which, together with THPs previously approved, would cover rights to
harvest a quantity of Scotia LLC Timber adequate to pay interest and principal
amortization based on the Minimum Principal Amortization Schedule for the Timber
Notes for the next succeeding twelve month period. See Item 7. "Management's
Discussion and Analysis of Financial Condition and Results of Operations--Forest
Products Operation--Industry Overview" for information regarding developments in
the rate of THP approvals.

Pacific Lumber maintains a detailed geographical information system
covering its timberlands (the "GIS"). The GIS covers numerous aspects of Pacific
Lumber's properties, including timber type, tree class, wildlife data, roads,
rivers and streams. Pursuant to the Services Agreement (as defined below),
Pacific Lumber, to the extent necessary, provides Scotia LLC with personnel and
technical assistance to assist Scotia LLC in updating, upgrading and improving
the GIS and the other computer systems owned by Scotia LLC. By carefully
monitoring and updating this data base and conducting field studies, Pacific
Lumber's foresters are better able to develop detailed THPs addressing the
various regulatory requirements. Pacific Lumber also utilizes a Global
Positioning System ("GPS") which allows precise location of geographic features
through satellite positioning. Use of the GPS greatly enhances the quality and
efficiency of the GIS data.

Pacific Lumber employs a variety of well-accepted methods of selecting
trees for harvest designed to achieve optimal regeneration. These methods,
referred to as "silvicultural systems" in the forestry profession, range from
very light thinnings aimed at enhancing the growth rate of retained trees to
clear cutting which results in the harvest of all trees in an area and
replacement with a new forest stand. In between are a number of varying levels
of partial harvests which can be employed.

PRODUCTION FACILITIES

This section contains statements which constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. See Item 1. "Business--General" in this section for cautionary
information with respect to such forward-looking statements.

Pacific Lumber owns four highly mechanized sawmills and related facilities
located in Scotia, Fortuna and Carlotta, California. The sawmills historically
have been supplied almost entirely from timber harvested from Pacific Lumber's
timberlands, but are supplemented from time to time by logs purchased from third
parties. Since 1986, Pacific Lumber has implemented numerous technological
advances that have increased the operating efficiency of its production
facilities and the recovery of finished products from its timber. Pacific Lumber
produced approximately 160, 205 and 155 million board feet of lumber in 2001,
2000 and 1999, respectively. The Fortuna sawmill produces primarily common grade
lumber and during 2001 produced approximately 98 million board feet of lumber.
The Carlotta sawmill produces both common and upper grade redwood lumber and
during 2001 produced approximately 37 million board feet of lumber. Although
partially curtailed during July through November of 2001, Carlotta restarted in
December 2001. As part of Pacific Lumber's strategic review of its operations,
Sawmills "A" and "B" were indefinitely idled in 2001. Sawmill "A" processed
Douglas-fir logs and Sawmill "B" processed primarily large diameter redwood
logs. During 2001, Sawmills "A" and "B" processed approximately 17 million and 6
million board feet of lumber, respectively. Sawmills "A" and "B" are both
located in Scotia. See Item 7. "Management's Discussion and Analysis of
Financial Condition and Results of Operations--Results of Operations-Forest
Products Operations-Industry Overview."

Britt owns a 46,000 square foot mill in Arcata, California. Britt's
primary business is the processing of small diameter redwood logs into fencing
products for sale to retail and wholesale customers. Britt purchases, primarily
from Pacific Lumber but also from other timberland owners, small diameter (6 to
15 inch) redwood logs of varying lengths. Britt processes these logs at its mill
into a variety of fencing products, including "dog-eared" 1" by 6" fence stock
in six foot lengths, 4" by 4" fence posts in 6 through 12 foot lengths, and
other lumber products in 6 through 12 foot lengths. Britt's purchases of logs
from third parties are generally consummated pursuant to short-term contracts of
12 months or less. Britt's manufacturing operations are conducted on 12 acres of
land, ten acres of which are leased on a long-term fixed price basis from an
unrelated third party. An 18 acre log sorting and storage yard is located
one-quarter of a mile away. Britt's (single shift) mill capacity, assuming 40
production hours per week, is estimated at 37.4 million board feet for fencing
products per year. Britt recently constructed a 25,000 square foot
remanufacturing facility for fencing products which became operational in the
third quarter of 2001.

Pacific Lumber operates a finishing and remanufacturing plant in Scotia
which processes rough lumber into a variety of finished products such as trim,
fascia, siding and paneling. These finished products include a variety of
customized trim and fascia patterns. Remanufacturing enhances the value of some
grades of lumber by assembling knot-free pieces of narrower and shorter lumber
into wider or longer pieces in Pacific Lumber's state-of-the-art end and edge
glue plants. The result is a standard sized upper grade product which can be
sold at a significant premium over common grade products. Pacific Lumber has
also installed a lumber remanufacturing facility at its mill in Fortuna which
processes low grade redwood common lumber into value-added, higher grade redwood
fence and related products.

Pacific Lumber dries the majority of its upper grade lumber before it is
sold. Upper grades of redwood lumber are generally air-dried for three to twelve
months and then kiln-dried for seven to twenty-four days to produce a
dimensionally stable and high quality product which generally commands higher
prices than "green" lumber (which is lumber sold before it has been dried).
Upper grade Douglas-fir lumber is generally kiln-dried immediately after it is
cut. Pacific Lumber owns and can operate up to 34 kilns, having an annual
capacity of approximately 95 million board feet, to dry its upper grades of
lumber efficiently in order to produce a quality, premium product. Pacific
Lumber also maintains several large enclosed storage sheds which can hold
approximately 27 million board feet of lumber.

Pacific Lumber owns and operates a modern 25-megawatt cogeneration power
plant which is fueled almost entirely by the wood residue from Pacific Lumber's
milling and finishing operations. This power plant generates substantially all
of the energy requirements of Scotia, California, the town adjacent to Pacific
Lumber's timberlands where several of its manufacturing facilities are located.
Pacific Lumber sells surplus power to Pacific Gas and Electric Company. In 2001,
the sale of surplus power accounted for approximately 6% of Pacific Lumber's
total revenues.

PRODUCTS

The following table sets forth the distribution of MGI's lumber production
(on a net board foot basis) and revenues by product line:

YEAR ENDED DECEMBER 31, 2001 YEAR ENDED DECEMBER 31, 2000
------------------------------------------ ---------------------------------------
% OF TOTAL % OF TOTAL
LUMBER % OF TOTAL LUMBER % OF TOTAL
PRODUCTION LUMBER % OF TOTAL PRODUCTION LUMBER % OF TOTAL
PRODUCT VOLUME REVENUES REVENUES VOLUME REVENUES REVENUES
- ----------------------------------- ------------- ------------ ------------ ----------- ----------- -----------
Upper grade redwood lumber......... 7% 19% 15% 7% 16% 14%
Common grade redwood lumber........ 68% 62% 51% 59% 58% 51%
------------- ------------ ------------ ----------- ----------- -----------
Total redwood lumber............ 75% 81% 66% 66% 74% 65%
------------- ------------ ------------ ----------- ----------- -----------
Upper grade Douglas-fir lumber..... 4% 7% 6% 4% 9% 8%
Common grade Douglas-fir lumber.... 20% 11% 9% 28% 16% 14%
------------- ------------ ------------ ----------- ----------- -----------
Total Douglas-fir lumber........ 24% 18% 15% 32% 25% 22%
------------- ------------ ------------ ----------- ----------- -----------
Other grades of lumber............. 1% 1% 1% 2% 1% 1%
------------- ------------ ------------ ----------- ----------- -----------
Total lumber................. 100% 100% 82% 100% 100% 88%
============= ============ ============ =========== =========== ===========

Logs............................... 6% 2%
============ ===========

Hardwood chips..................... 2% 2%
Softwood chips..................... 2% 4%
------------ -----------

Total wood chips................ 4% 6%
============ ===========

In 2001, MGI sold 244 million board feet of lumber, which accounted for
82% of its total revenues. Lumber products vary greatly by the species and
quality of the timber from which they are produced. Lumber is sold not only by
grade (such as "upper" grade versus "common" grade), but also by board size and
the drying process associated with the lumber.

Redwood lumber has historically been MGI's largest product category.
Redwood is commercially grown only along the northern coast of California and
possesses certain unique characteristics that permit it to be sold at a premium
to many other wood products. Such characteristics include its natural beauty,
superior ability to retain paint and other finishes, dimensional stability and
innate resistance to decay, insects and chemicals. Typical applications include
exterior siding, trim and fascia for both residential and commercial
construction, outdoor furniture, decks, planters, retaining walls and other
specialty applications. Redwood also has a variety of industrial applications
because of its chemical resistance and because it does not impart any taste or
odor to liquids or solids.

Upper grade redwood lumber, which is derived primarily from large diameter
logs and is characterized by an absence of knots and other defects, is used
primarily in distinctive interior and exterior applications. The overall supply
of upper grade lumber has been diminishing due to increasing environmental and
regulatory restrictions and other factors. See Item 7. "Management's Discussion
and Analysis of Financial Condition and Results of Operations--Results of
Operations--Forest Products Operations--Industry Overview." Common grade redwood
lumber, historically MGI's largest volume product, has many of the same
aesthetic and structural qualities of redwood uppers, but has some knots,
sapwood and a coarser grain. Such lumber is commonly used for construction
purposes, including outdoor structures such as decks, hot tubs and fencing.

Douglas-fir lumber is used primarily for new construction and some
decorative purposes and is widely recognized for its strength, hard surface and
attractive appearance. Douglas-fir is grown commercially along the west coast of
North America and in Chile and New Zealand. Upper grade Douglas-fir lumber is
derived primarily from old growth Douglas-fir timber and is used principally in
finished carpentry applications. Common grade Douglas-fir lumber is used for a
variety of general construction purposes and is largely interchangeable with
common grades of other whitewood lumber.

MGI does not have any significant contractual relationships with third
parties relating to the purchase of logs. During 2001, MGI purchased
approximately 25 million board feet of logs from third parties. Pacific Lumber
uses a whole-log chipper to produce wood chips from hardwood trees which would
otherwise be left as waste. These chips are sold to third parties primarily for
the production of facsimile and other specialty papers. Pacific Lumber also
produces softwood chips from the wood residue from its milling operations. These
chips are sold to third parties for the production of wood pulp and paper
products.

BACKLOG AND SEASONALITY

MGI's backlog of sales orders at each of December 31, 2001 and 2000 was
approximately $15.7 million, the substantial portion of which was delivered in
the first quarter of the next fiscal year. See Item 7. "Management's Discussion
and Analysis of Financial Condition and Results of Operations--Results of
Operations--Forest Products Operations--Net Sales." MGI has historically
experienced lower first quarter sales due largely to the general decline in
construction-related activity during the winter months. As a consequence, MGI's
results in any one quarter are not necessarily indicative of results to be
expected for the full year. See "--Regulatory and Environmental Factors" below
and Item 7. "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Results of Operations--Forest Products
Operations--Industry Overview."

MARKETING

The housing, construction and remodeling markets are the primary markets
for MGI's lumber products. MGI's policy is to maintain a wide distribution of
its products both geographically and in terms of the number of customers. MGI
sells its lumber products throughout the country to a variety of accounts, the
large majority of which are wholesalers, followed by retailers, industrial
users, exporters and manufacturers. Upper grades of redwood and Douglas-fir
lumber are sold throughout the entire United States, as well as to export
markets. Common grades of redwood lumber are sold principally west of the
Mississippi River, with California accounting for approximately 75% of these
sales in 2001. Common grades of Douglas-fir lumber are sold primarily in
California. In 2001, Pacific Lumber had three customers which accounted for
approximately 15%, 3% and 3%, respectively, of MGI's total net lumber sales.
Exports of lumber accounted for approximately 4% of MGI's total revenues in
2001. MGI markets its products through its own sales staff which focuses
primarily on domestic sales.

MGI actively follows trends in the housing, construction and remodeling
markets in order to maintain an appropriate level of inventory and assortment of
products. Due to its high quality products, competitive prices and long history,
MGI believes it has a strong degree of customer loyalty.

COMPETITION

MGI's lumber is sold in highly competitive markets. Competition is
generally based upon a combination of price, service, product availability and
product quality. MGI's products compete not only with other wood products but
with metals, masonry, plastic and other construction materials made from
non-renewable resources. The level of demand for MGI's products is dependent on
such broad factors as overall economic conditions, interest rates and
demographic trends. In addition, competitive considerations, such as total
industry production and competitors' pricing, as well as the price of other
construction products, affect the sales prices for MGI's lumber products.
Competition in the common grade redwood and Douglas-fir lumber market is
intense, with MGI competing with numerous large and small lumber producers. MGI
primarily competes with the northern California mills of Georgia Pacific,
Simpson and Redwood Empire.

EMPLOYEES

As of March 1, 2002, MGI had approximately 1,100 employees, none of whom
are covered by a collective bargaining agreement.

RELATIONSHIPS WITH SCOTIA LLC AND BRITT

Scotia LLC's foresters, wildlife and fisheries biologists, geologists and
other personnel are responsible for providing a number of forest stewardship
techniques, including protecting the timber located on the Scotia LLC
Timberlands from forest fires, erosion, insects and other damage, overseeing
reforestation activities and monitoring environmental and regulatory compliance.
Scotia LLC's personnel are also responsible for preparing THPs and updating the
information contained in the GIS. See "--Harvesting Practices" above for a
description of the GIS updating process and the THP preparation process.

Scotia LLC and Pacific Lumber are parties to several agreements between
themselves, including a master purchase agreement and a services agreement,
relating to the conduct of their forest products' operations. The master
purchase agreement governs the sale to Pacific Lumber by Scotia LLC of logs
harvested from the Scotia LLC Timberlands. Under the services agreement, Pacific
Lumber provides operational, management and related services to Scotia LLC with
respect to the Scotia LLC Timberlands. Scotia LLC and Pacific Lumber are also
parties to agreements providing for reciprocal rights of ingress and egress
through their respective properties, the indemnification of Scotia LLC by
Pacific Lumber for environmental liabilities incurred in connection with the
Scotia LLC Timberlands, and certain services provided by Scotia LLC to Pacific
Lumber.

Pacific Lumber is also a party to an agreement with Britt (the "BRITT
AGREEMENT") which governs the sale of logs by Pacific Lumber and Britt to each
other, the sale of hog fuel (wood residue) by Britt to Pacific Lumber for use in
Pacific Lumber's cogeneration plant, the sale of lumber by Pacific Lumber and
Britt to each other, and the provision by Pacific Lumber of certain
administrative services to Britt (including accounting, purchasing, data
processing, safety and human resources services).

REGULATORY AND ENVIRONMENTAL FACTORS

This section contains statements which constitute "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995. See Item 1. "Business--General" in this section for cautionary
information with respect to such forward-looking statements.

General
Pacific Lumber's business is subject to the Environmental Plans and a
variety of California and federal laws and regulations dealing with timber
harvesting, threatened and endangered species and habitat for such species, and
air and water quality. Compliance with such laws and regulations also plays a
significant role in Pacific Lumber's business. The California Forest Practice
Act (the "FOREST PRACTICE ACT") and related regulations adopted by the
California Board of Forestry and Fire Protection (the "BOF") set forth detailed
requirements for the conduct of timber harvesting operations in California.
These requirements include the obligation of timber companies to obtain
regulatory approval of detailed THPs containing information with respect to
areas proposed to be harvested (see "--Harvesting Practices" above). California
law also requires large timber companies submitting THPs to demonstrate that
their proposed timber operations will not decrease the sustainable productivity
of their timberlands. See "--Timber and Timberlands" above. The federal
Endangered Species Act (the "ESA") and California Endangered Species Act (the
"CESA") provide in general for the protection and conservation of specifically
listed wildlife and plants which have been declared to be endangered or
threatened. These laws generally prohibit the take of certain species, except
for incidental takes pursuant to otherwise lawful activities which do not
jeopardize the continued existence of the affected species and which are made in
accordance with an approved habitat conservation plan and related incidental
take permits. A habitat conservation plan, among other things, analyzes the
potential impact of the incidental take of species and specifies measures to
monitor, minimize and mitigate such impact. The operations of Pacific Lumber are
also subject to the California Environmental Quality Act (the "CEQA"), which
provides for protection of the state's air and water quality and wildlife, and
the California Water Quality Act and federal Clean Water Act, which require that
Pacific Lumber conduct its operations so as to reasonably protect the water
quality of nearby rivers and streams. Compliance with such laws, regulations and
judicial and administrative interpretations, together with other regulatory and
environmental matters, have resulted in restrictions on the scope and timing of
Pacific Lumber's timber operations, increased operational costs and engendered
litigation and other challenges to its operations.

The Environmental Plans
The Environmental Plans, consisting of the HCP and the SYP, were approved
by the applicable federal and state regulatory agencies upon the consummation of
the Headwaters Agreement. In connection with approval of the Environmental
Plans, incidental take permits ("PERMITS") were issued with respect to certain
threatened, endangered and other species found on the Scotia LLC Timberlands.
The Permits cover the 50-year term of the HCP and allow incidental takes of 17
different species covered by the HCP, including four species which are found on
the Scotia LLC Timberlands and had previously been listed as endangered or
threatened under the ESA and/or the CESA. The agreements which implement the
Environmental Plans also provide for various remedies (including the issuance of
written stop orders and liquidated damages) in the event of a breach by Scotia
LLC of these agreements or the Environmental Plans.

Under the Environmental Plans, harvesting activities are prohibited or
restricted on certain areas of the Scotia LLC Timberlands. For a 50-year period,
harvesting activities are severely restricted in several areas (consisting of
substantial quantities of old growth redwood and Douglas-fir timber) to serve as
habitat conservation areas for the marbled murrelet, a coastal seabird, and
certain other species. Harvesting in certain other areas of the Scotia LLC
Timberlands is currently prohibited while these areas are evaluated for the
potential risk of landslide and the degree to which harvesting activities will
be prohibited or restricted in the future. Further, additional areas alongside
streamsides have been designated as buffers, in which harvesting is prohibited
or restricted, to protect aquatic and riparian habitat. Streamside buffers and
restrictions related to potential landslide prone acres may be adjusted up or
down, subject to certain minimum and maximum buffers, based upon an ongoing
watershed analysis process, which the HCP requires be completed within five
years of its effective data. The first analysis by the Company of a watershed,
Freshwater, was released in June 2001. This analysis was used by the Company to
develop proposed harvesting prescriptions. Because the Company and the
government agencies were unable to reach agreement on the appropriate
prescriptions, the matter is being reviewed by an independent panel of
scientists. Analyses for two additional watersheds are currently undergoing
agency review. Pacific Lumber and the agencies are working to streamline the
watershed analysis process prior to beginning up to three more watershed studies
in 2002.

The HCP also imposes certain restrictions on the use of roads on the
timberlands covered by the HCP during several months of the year and during
periods of wet weather. However, Pacific Lumber anticipates that some harvesting
will be able to be conducted during these other months. The HCP also requires
that 75 miles of roads be stormproofed on an annual basis (within a specified
six month period) and that certain other roads must be built or repaired (within
a specified five month period).

The HCP contains an adaptive management provision, which various
regulatory agencies have clarified will be implemented on a timely and efficient
basis, and in a manner which will be both biologically and economically sound.
This provision allows the Palco Companies to propose changes to any of the HCP
prescriptions based on, among other things, certain economic considerations. The
regulatory agencies have also clarified that in applying this adaptive
management provision, to the extent the changes proposed do not result in the
jeopardy of a particular species, the regulatory agencies will consider the
practicality of the suggested changes, including the cost and economic
feasibility and viability. Pacific Lumber and the agencies are currently
discussing proposed adaptive management changes related to roads, streamside
buffers, wildlife and rare plants.

Water Quality
Under the Federal Clean Water Act, the Environmental Protection Agency
(the "EPA") is required to establish total maximum daily load limits ("TMDLS")
in water courses that have been declared to be "water quality impaired." The EPA
and the North Coast Regional Water Quality Control Board ("NORTH COAST WATER
BOARD") are in the process of establishing TMDLs for 17 northern California
rivers and certain of their tributaries, including certain water courses that
flow within the Scotia LLC Timberlands. The Company expects this process to
continue into 2010. In December 1999, the EPA issued a report dealing with TMDLs
on two of the nine water courses. The agency indicated that the requirements
under the HCP would significantly address the sediment issues that resulted in
TMDL requirements for these water courses. However, a September 2000 report by
the staff of the North Coast Water Board proposed various actions, including
restrictions on harvesting beyond those required under the HCP. Establishment of
the final TMDL requirements applicable to the Company's timberlands will be a
lengthy process, and the final TMDL requirements applicable to the Company's
timberlands may require aquatic protection measures that are different from or
in addition to the prescriptions to be developed pursuant to the watershed
analysis process provided for in the HCP.

Impact of Future Legislation
Laws, regulations and related judicial decisions and administrative
interpretations dealing with Pacific Lumber's business are subject to change and
new laws and regulations are frequently introduced concerning the California
timber industry. From time to time, bills are introduced in the California
legislature and the U.S. Congress which relate to the business of Pacific
Lumber, including the protection and acquisition of old growth and other
timberlands, threatened and endangered species, environmental protection, air
and water quality and the restriction, regulation and administration of timber
harvesting practices. In addition to existing and possible new or modified
statutory enactments, regulatory requirements and administrative and legal
actions, the California timber industry remains subject to potential California
or local ballot initiatives and evolving federal and California case law which
could affect timber harvesting practices. It is not possible to assess the
effect of such future legislative, judicial and administrative events on Pacific
Lumber or its business.

Timber Operations
In order to conduct logging operations, stormproofing and certain other
activities, a company must obtain from the CDF a Timber Operator's License. In
December 2001, Pacific Lumber was granted a Timber Operator's License for 2002.
Pacific Lumber had historically conducted logging operations on the Scotia LLC
Timberlands with its own staff of logging personnel as well as through contract
loggers. However, effective April 1, 2002, Pacific Lumber ended its internal
logging operations and intends to rely exclusively on third party contract
loggers to conduct these activities in the future.

REAL ESTATE OPERATIONS

GENERAL

The Company, principally through its wholly owned subsidiaries, invests in
and develops residential and commercial real estate primarily in Arizona, Puerto
Rico, California and Texas. Real estate properties and receivables for real
estate sales as of December 31, 2001 are as follows:

BOOK VALUE
AS OF DECEMBER
31, 2001
--------------
(IN MILLIONS
OF DOLLARS)

Palmas del Mar (Puerto Rico):
Developed lots................................................... 12 lots $ 2.2
Undeveloped land and parcels held for sale....................... 1,233 acres 30.8
Property, plant and equipment, receivables and other, net........ 12.0
--------------
Total......................................................... 45.0
--------------
Resort operations (owned facilities)(1):
Palmas Country Club(2)........................................ 28.5
Casino........................................................ 0.3
--------------
Total......................................................... 28.8
--------------
Fountain Hills (Arizona):
Residential, commercial and industrial developed lots............ 34 lots 2.4
Residential lots under development............................... 48 lots 4.5
Undeveloped residential land..................................... 1,000 acres 8.8
Property, plant, equipment and receivables, net.................. 1.0
--------------
Total......................................................... 16.7
--------------
Rancho Mirage (California):
Residential developed lots and lots under development............ 69 lots 16.1
Undeveloped land................................................. 57 acres 10.8
--------------
Total......................................................... 26.9
--------------
Other properties (3):
Residential developed lots....................................... 75 lots 0.2
Undeveloped land................................................. 214 acres 1.2
Receivables for sales of real estate, net........................ 5.0
--------------
Total......................................................... 6.4
--------------
LakePointe Plaza (Texas):
Property, plant and equipment.................................... 128.7
--------------
Total real estate properties and receivables..................... $ 252.5
==============
- ---------------

(1) At Palmas del Mar, third parties own other resort facilities, including a
marina and restaurants.
(2) Palmas Country Club operations include two 18-hole golf courses, a 20
court tennis facility, a member clubhouse, and a beach club. Amounts shown
are net of accumulated depreciation.
(3) Includes various properties in Arizona, New Mexico and Texas.

BOOK VALUE
AS OF DECEMBER
31, 2001
-------------
(IN MILLIONS
OF DOLLARS)
Joint Ventures:
FireRock, LLC(1):
Residential developed lots and lots under development............. 166 lots $ 12.0
Undeveloped land.................................................. 120 acres 0.3
Golf course, clubhouse and other club facilities.................. 21.1
Other property, plant and equipment, net.......................... 1.0
-------------
Total........................................................... $ 34.4
=============
Investment in FireRock LLC........................................ $ 6.9
=============

SunRidge Canyon L.L.C.(1):
Residential developed lots........................................ 1 lot $ 0.1
Golf course....................................................... 8.9
-------------
Total........................................................... $ 9.0
=============
Investment in SunRidge Canyon L.L.C............................... $ 1.0
=============
- ------------------

(1) 50% owned.

Revenues from real estate operations are as follows:

YEARS ENDED DECEMBER 31,
-----------------------
2001 2000
---------- -----------
Palmas del Mar:
Real estate sales...................................................................... $ 11.7 $ 4.8
Resort operations and other............................................................ 12.6 12.0
---------- -----------
Total............................................................................... 24.3 16.8
---------- -----------
Fountain Hills:
Real estate sales...................................................................... 33.6 15.0
Resort operations and other............................................................ 3.5 3.6
---------- -----------
Total............................................................................... 37.1 18.6
---------- -----------
Rancho Mirage:
Real estate sales...................................................................... - 0.3
Resort operations and other............................................................ 0.2 0.1
---------- -----------
Total............................................................................... 0.2 0.4
---------- -----------
Other:
Real estate sales...................................................................... 2.9 6.3
Resort operations and other............................................................ 0.2 5.1
---------- -----------
Total............................................................................... 3.1 11.4
---------- -----------

LakePointe Plaza:......................................................................... 4.4 -
---------- -----------
Total............................................................................... $ 69.1 $ 47.2
========== ===========

FireRock LLC(1):
Real estate sales...................................................................... $ 24.9 $ 28.9
Resort operations and other............................................................ 3.2 2.1
---------- -----------
Total............................................................................... $ 28.1 $ 31.0
========== ===========
SunRidge Canyon L.L.C.(1):
Real estate sales...................................................................... $ 0.8 $ 9.3
Resort operations and other............................................................ 4.2 4.4
---------- -----------
Total............................................................................... $ 5.0 $ 13.7
========== ===========
- -----------------

(1) 50% owned.

PALMAS DEL MAR

Palmas del Mar is a master-planned residential community and resort
located on the southeastern coast of Puerto Rico near Humacao ("PALMAS"). The
Company is planning the development and sale of certain of the remaining
acreage. Future sales are expected to consist of undeveloped acreage,
semi-developed parcels and fully-developed lots. Resort operations include golf,
tennis, beach club and casino facilities owned by subsidiaries of the Company.
Certain other amenities, including a hotel, marina, equestrian center and
various restaurants, are owned and operated by third parties.

FOUNTAIN HILLS

In 1968, a subsidiary of the Company purchased and began developing
approximately 12,100 acres of real property at Fountain Hills, Arizona, which is
located near Phoenix and adjacent to Scottsdale, Arizona. The year-round
population of Fountain Hills is approximately 20,000. The Company is planning
the development of certain remaining acreage at Fountain Hills. Future sales are
expected to consist mainly of undeveloped acreage, semi-developed parcels and
fully-developed lots.

In 1994, a subsidiary of the Company entered into a joint venture to
develop a 950 acre area in Fountain Hills known as SunRidge Canyon. The
development is a residential, golf-oriented, upscale master-planned community.
Sales of the individual lots began in November 1995. The project consists of
custom lots, marketed on an individual basis, production lots marketed to home
builders, and a championship level 18-hole daily fee golf course. The
development is owned by SunRidge Canyon L.L.C., an Arizona limited liability
company organized by a subsidiary of the Company and SunCor Development Company.
A subsidiary of the Company holds a 50% equity interest in the joint venture.

In 1998, a subsidiary of the Company entered into a joint venture to
develop an 808 acre area in Fountain Hills known as FireRock Country Club. The
development is a residential, golf-oriented, upscale master-planned community. A
championship level private 18-hole golf course opened in February 2000, and the
clubhouse opened in September 2000. The first phase (120 lots) of the project
has been developed, and construction of the second phase (178 lots) is currently
underway. The development is owned by FireRock, L.L.C., a limited liability
company organized by a subsidiary of the Company (which holds a 50% equity
interest in the joint venture) and an unaffiliated third party.

RANCHO MIRAGE

In 1991, a subsidiary of the Company acquired Mirada, a 220-acre luxury
resort-residential project located in Rancho Mirage, California. Mirada is a
master planned community built into the Santa Rosa Mountains, 650 feet above the
Coachella Valley floor. Two of the six parcels within the project have been
developed, one of which is the first phase of a custom lot subdivision of 46
estate lots. The Lodge at Ranch Mirage, formerly the Ritz-Carlton Rancho Mirage
Hotel, which is owned and operated by a third party, was developed on the second
parcel. The four remaining parcels encompass approximately 130 acres, which,
under a development agreement with the City of Rancho Mirage which extends until
2011, may be developed with a variety of residential and commercial uses. The
Company has nearly completed construction on the second phase of the custom lot
subdivision consisting of 63 estate lots and is currently planning to develop
and/or market the remaining parcels. The Company has obtained final regulatory
and environmental approvals for development of all four of its remaining parcels
within Mirada, including the second phase of the custom lot subdivision.

OTHER PROPERTIES

The Company through its subsidiaries, owns a number of other properties in
Arizona and Texas. Efforts are underway to sell most of these properties.

MARKETING

The Company is engaged in marketing and sales programs of varying
magnitudes at its real estate developments. The Company intends to continue
selling undeveloped acreage and semi-developed parcels to builders and
developers and fully developed lots to individuals and builders. All sales are
made directly to purchasers through the Company's marketing personnel,
independent contractors or through independent real estate brokers who are
compensated through the payment of customary real estate brokerage commissions.
The Company may also continue to enter into joint ventures with third parties
similar to those entered into in connection with its SunRidge Canyon and
FireRock developments.

Competition and Regulation and Other Industry Factors
There is intense competition among companies in the real estate investment
and development business. Sales and payments on real estate sales obligations
depend, in part, on available financing and disposable income and, therefore,
are affected by changes in general economic conditions and other factors. The
real estate development business and commercial real estate business are subject
to other risks such as shifts in population, fluctuations in the real estate
market, and unpredictable changes in the desirability of residential, commercial
and industrial areas. The resort and time-sharing business of Palmas competes
with similar businesses in the Caribbean, Florida and other locations. The
golfing operations in connection with the SunRidge Canyon and FireRock
developments compete with similar businesses in the areas in and surrounding
Phoenix, Arizona.

The Company's real estate operations are subject to comprehensive federal,
state and local regulation. Applicable statutes and regulations may require
disclosure of certain information concerning real estate developments and credit
policies of the Company and its subsidiaries. Periodic approval is required from
various agencies in connection with the design of developments, the nature and
extent of improvements, construction activity, land use, zoning, and numerous
other matters. Failure to obtain such approval, or periodic renewal thereof,
could adversely affect the real estate development and marketing operations of
the Company and its subsidiaries. Various jurisdictions also require inspection
of properties by appropriate authorities, approval of sales literature,
disclosure to purchasers of specific information, bonding for property
improvements, approval of real estate contract forms and delivery to purchasers
of a report describing the property.

EMPLOYEES

As of March 1, 2002, the Company's real estate operations had
approximately 168 employees.

RACING OPERATIONS

GENERAL

SHRP, Ltd. owns and operates Sam Houston Race Park, a Texas Class 1 horse
racing facility located within the greater Houston metropolitan area. In January
2000, a wholly owned subsidiary of SHRP, Ltd. acquired Valley Race Park, a
greyhound racing facility located in Harlingen, Texas, which had been closed
since 1995. Valley Race Park opened for simulcast wagering in mid-March of 2000,
and live greyhound racing began in December 2000.

RACING OPERATIONS AND FACILITIES

Sam Houston Race Park offers pari-mutuel wagering on live thoroughbred or
quarter horse racing or simulcast racing seven days a week throughout the year.
Simulcasting is the process by which live races held at one facility are
broadcast simultaneously to other locations at which additional wagers are
placed on the race being broadcast. Sam Houston Race Park's principal sources of
revenue are its statutory and contractual share of total wagering on live and
simulcast racing. Sam Houston Race Park also derives revenues from admission
fees, food services, group sales, advertising sales and other sources.

REGULATION OF RACING OPERATIONS

The ownership and operation of horse and greyhound racetracks in Texas are
subject to significant regulation by the Texas Racing Commission (the "RACING
COMMISSION") under the Texas Racing Act and related regulations (collectively,
the "RACING ACT"). The Racing Act provides, among other things, for the
allocation of wagering proceeds among betting participants, purses, racetracks,
the state of Texas and for other purposes, and empowers the Racing Commission to
license and regulate substantially all aspects of horse and greyhound racing in
the state. The Racing Commission must approve the number of live race days that
may be offered each year, as well as all simulcast agreements. Class 1 horse
racetracks in Texas are entitled to conduct at least seventeen weeks of live
racing for each breed of horses (thoroughbreds and quarter horses), while
greyhound tracks are entitled to conduct live racing nearly year round.

MARKETING AND COMPETITION

SHRP, Ltd's management believes that the majority of Sam Houston Race
Park's patrons reside within a 20-mile radius, which includes most of the
greater Houston metropolitan area, and that a secondary market of occasional
patrons can be developed outside the 20-mile radius but within a 50-mile radius
of the race park. Sam Houston Race Park uses a number of marketing strategies in
an attempt to reach these people and make them more frequent visitors to Sam
Houston Race Park. Sam Houston Race Park competes with other forms of
entertainment, including casinos located approximately 125 to 150 miles from
Houston, a greyhound racetrack located 60 miles from Sam Houston Race Park, a
wide range of sporting events and other entertainment activities in the Houston
area and certain other forms of wagering which are offered on the Internet. Sam
Houston Race Park could in the future also compete with other forms of gambling
in Texas, including casino gambling on Indian reservations or otherwise. While
Sam Houston Race Park believes that the location of Sam Houston Race Park is a
competitive advantage over the other more distant gaming ventures mentioned
above, the most significant challenge for Sam Houston Race Park is to develop
and educate new racing fans in a market where pari-mutuel wagering has been
absent since the 1930s.