UNITED STATES

FORM 10-K

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

MAXXAM INC.

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

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

Securities registered pursuant to Section 12(g) of the Act: None.

     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 þ No o

     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. þ

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

Yes þ No o

     The aggregate market value of the voting and non-voting common equity held by non-affiliates computed by reference to the price at which the common equity was last sold, as of the last business day of the registrant’s most recently completed second fiscal quarter: $82.4 million.

Number of shares of common stock outstanding at March 1, 2005: 5,976,487

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.

TABLE OF CONTENTS

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PART I

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. Some terms used herein are defined in the Glossary of Defined Terms. The Company conducts the substantial portion of its operations through its subsidiaries, which operate in three principal industries. Any reference herein to a company includes the subsidiaries of that company unless otherwise noted or the context indicates otherwise.

•	Forest products, through MAXXAM Group Inc. (“MGI”) and MGI’s wholly owned subsidiary, The Pacific Lumber Company (“Palco”), and Palco’s wholly owned subsidiaries, Scotia Pacific Company LLC (“Scotia LLC”) and Britt Lumber Co., Inc. (“Britt”). MGI operates in several principal aspects of the forest products 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, through MAXXAM Property Company (“MPC”) and other wholly owned subsidiaries of the Company, as well as joint ventures. These subsidiaries are engaged in the business of residential and commercial real estate investment and development, primarily in Arizona, California, Puerto Rico and Texas, including associated golf course or resort operations in certain locations, and also own several commercial real estate properties that are subject to long-term lease arrangements.
•	Racing operations, through Sam Houston Race Park, Ltd. (“SHRP, Ltd.”), a Texas limited partnership, wholly owned by the Company. 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.

     In addition to the above, the Company owns approximately 63% of Kaiser Aluminum Corporation (“Kaiser”). Kaiser and a number of its subsidiaries have filed for reorganization under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”). See “—Kaiser Aluminum” and Notes 1 and 11 to the Consolidated Financial Statements contained herein. Except as otherwise indicated, all references herein to “Notes” represent the Notes to the Consolidated Financial Statements contained herein.

     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 (“PSLRA”). These statements appear in a number of places (see Item 1.“Business—Forest Products Operations—Timber and Timberlands” and “—Regulatory and Environmental Factors;” most sections under Item 3. “Legal Proceedings;” and several sections under Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations”). 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, litigation developments, and changing prices and market conditions. This Report identifies other factors which could cause 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.

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Forest Products Operations

   General

     The Company engages in forest products operations through MGI, Palco, Britt and Scotia LLC. Palco, which has been in continuous operation for over 130 years, engages in several principal aspects of the forest products 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. Palco has over the past three years implemented a number of changes to allow it to operate on a more efficient and cost effective basis. These changes include undertaking a mill improvement project that will include a new state-of-the-art mill, installing a new planer facility, closing two of its sawmills, eliminating certain of its operations such as its company-staffed logging operations, and utilizing more efficient harvesting methods. See “—Production Facilities.”

     The Company’s forest products operations have been adversely affected by the failure of the California North Coast Regional Water Quality Control Board to release for harvest a number of Palco’s timber harvesting plans even though the plans have already been approved by the other government agencies which review Palco’s timber harvesting plans and are in compliance with Palco’s comprehensive multi-species habitat conservation plan. See “—Regulatory and Environmental Factors—Water Quality” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition and Investing and Financing Activities—Forest Products Operations.”

   Timber and Timberlands

     This section contains statements which constitute “forward-looking statements” within the meaning of the PSLRA. See this section and “Business—General” above for cautionary information with respect to such forward-looking statements.

     Palco owns and manages, directly or through subsidiaries, approximately 217,000 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, which are located in close proximity to Palco’s sawmills and have an extensive network of roads, contain predominantly conifer timber. Palco’s conifers consist (by volume) of approximately 66% redwood, 30% Douglas-fir, and 4% other conifer timber. Approximately 204,000 acres of Palco’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 timberlands owned by Palco and its subsidiary, Salmon Creek LLC (“Salmon Creek”). The timber in respect of the Scotia LLC Timberlands and the Scotia LLC Timber Rights is collectively referred to as the “Scotia LLC Timber.” The Scotia LLC Timberlands and the timberlands of Palco are collectively referred to as the “Palco Timberlands.” Substantially all of Scotia LLC’s assets are pledged as security for 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.” Under a master purchase agreement, Palco harvests and purchases from Scotia LLC virtually all of the logs harvested from the Scotia LLC Timber. See “—Relationships among the Palco Companies” below for a description of this and other relationships among the Palco Companies.

     In March 1999, Palco, Scotia LLC, and 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 (the “Headwaters Timberlands”) were transferred to the United States government in exchange for (i) an aggregate of $300.0 million, (ii) approximately 7,700 acres of timberlands, and (iii) approval by the federal and state governments of habitat conservation and sustained yield plans (the “Environmental Plans”) in respect of substantially all of the Palco Timberlands. California also agreed to offer to purchase other timberlands owned by Palco and Scotia LLC (which purchases were subsequently consummated).

     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.

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     Scotia LLC’s foresters, wildlife and fisheries biologists, geologists, botanists and other personnel provide 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 implementing and monitoring environmental and regulatory compliance. Scotia LLC’s personnel also prepare timber harvesting plans (“THPs”) and maintain and update the information contained in the GIS. See “—Harvesting Practices” below for a description of the GIS updating process and the THP preparation process. Palco and Scotia LLC engage in extensive efforts to supplement the natural regeneration of timber and increase the amount of timber on its timberlands. Scotia LLC and Palco are 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 among the Palco Companies”), Palco conducts regeneration activities on the Scotia LLC Timberlands on behalf of Scotia LLC. Reforestation of redwood timber generally is accomplished through redwood sprouts from harvested trees and the planting of redwood seedlings at levels designed to optimize growth. Douglas-fir timber is regenerated almost entirely by planting seedlings. During 2004, Palco planted an estimated 1,350,000 redwood and Douglas-fir seedlings.

     California law requires large timberland owners, including Palco, to demonstrate that their timber operations will not decrease the sustainable productivity of their timberlands. The applicable regulations require timber companies to project timber growth and harvest on their timberlands over a 100-year planning period and to demonstrate sustained yield, i.e. that their projected average annual harvest for any decade within the 100-year planning period will not exceed the average annual growth level at the end of the 100-year planning period. 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. Timber companies which do not have a sustained yield plan are allowed to follow alternative procedures (see below).

     Palco 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 the Palco Timberlands. These laws generally prohibit certain adverse impacts on such species (referred to as a “take”), except for incidental take which does not jeopardize the continued existence of the affected species and is 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, the federal and state governments approved the Environmental Plans, which consisted of a sustained yield plan (the “SYP”) and a multi-species habitat conservation plan (the “HCP”) in respect of substantially all of the Palco Timberlands. However, in connection with two lawsuits filed against Palco, a California court invalidated the SYP and the incidental take permits issued by California in connection with the Environmental Plans (the “California Permits”), a decision which Palco has appealed. See Item 3, “Legal Proceedings—Forest Products Litigation.”

     As a result of these cases, Palco has since October 2002 been obtaining review and approval of its THPs under the alternative procedure in the California forest practice rules known as “Option C.” Option C is available to landowners who have submitted an “Option A” plan to the CDF for review (as was done by Palco), and may be used during the review and approval period for the Option A plan. An approved Option A plan is an alternative to obtaining approval of a sustained yield plan. In December 2004, Palco revised and resubmitted its Option A plan, which document (the “Option A Plan”) is currently under review by the CDF.

     In May 2002, Palco completed its first timber cruise since 1986. The results of the timber cruise provided Palco with an estimate of the volume of merchantable timber on the Palco Timberlands. The 2002 cruise data reflected a 0.1 million MBF decrease in estimated overall timber volume as compared to the estimated volumes reported as of December 31, 2001 using the 1986 cruise data (adjusted for harvest and estimated growth). The 2002 cruise data indicated that the Palco Timberlands have significantly less old growth timber than estimated as of December 31, 2001, using the 1986 cruise data. There was also an estimated increase in young growth timber volume almost equal to the estimated decrease in old growth timber volume.

  Harvesting Practices

     The ability of Palco to harvest timber depends in large part upon the ability to obtain regulatory approval of THPs prepared by Scotia LLC’s foresters. Prior to harvesting timber in California, companies are obligated to obtain the

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CDF’s approval of a detailed THP for the area to be harvested. A THP must be submitted by a Registered Professional Forester and is required to 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. The number of Scotia LLC’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 (as set forth in the Timber Notes Indenture) 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—Financial Condition and Investing and Financing Activities—Forest Products Operations” regarding delays by the North Coast Water Board in releasing already-approved THPs for harvest. Also see “—Regulatory and Environmental Factors,” Item 3. “Legal Proceedings—Forest Products Litigation,” and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations” for various legal, regulatory, environmental and other challenges being faced by Palco in connection with timber harvesting and other operations on its timberlands.

     Scotia LLC maintains a detailed geographical information system covering the Palco Timberlands (the “GIS”). The GIS covers numerous aspects of these timber properties, including timber type, site productivity class, wildlife and botanical data, geological information, roads, rivers and streams. Pursuant to the Services Agreement (defined below), Palco, to the extent necessary, assists 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, Scotia LLC’s foresters are better able to develop detailed THPs addressing the various regulatory requirements. Scotia LLC also utilizes a Global Positioning System (“GPS”) which can provide precise location of geographic features through satellite positioning. Use of the GPS greatly enhances the quality and efficiency of the GIS data.

     Scotia LLC employs a variety of well-accepted methods of selecting trees for harvest designed to achieve optimal growth and 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 nearly all trees in an area (with the exception of sub-merchantable trees and trees retained for wildlife protection and future stand enhancement) and replacement with a new forest stand. In between are a number of varying levels of partial harvests which can be employed.

   Production Facilities

     Palco operates three highly mechanized sawmills and related facilities located in Scotia, Fortuna and Arcata, California. Palco’s sawmills historically have been supplied almost entirely from timber harvested from Palco’s timberlands, but are supplemented from time to time by logs purchased from third parties. Palco has over the years implemented numerous technological advances that have increased the operating efficiency of its production facilities and the recovery of finished products from its timber.

     In April 2004, Palco commenced a mill improvement project, including a new state-of-the-art sawmill located in Scotia. The new sawmill allows more efficient processing of smaller second growth logs (up to 24” in diameter) and reduces operating and other costs. The first phase of the project, the processing of smaller diameter logs, has been completed and production commenced in the third quarter of 2004. Since commencing production, Palco has made substantial progress in refining the production process. As part of the mill improvement project, equipment from Palco’s Carlotta mill is in the process of being moved to the new mill in Scotia to be used to process larger diameter logs. Completion of this phase of the project is, however, subject to successful resolution of the liquidity problems being experienced by Palco. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition and Investing and Financing Activities—Forest Products Operations.” The Carlotta mill was permanently closed at the end of 2004, and management is considering alternative uses for the property. In addition, Palco in January 2004 completed a new $5

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million planer project in Scotia. The new high speed state-of-the-art system processes rough sawn boards into finished lumber up to four times faster than the older planers replaced by the new system.

     Britt’s mill in Arcata, California, primarily processes small diameter redwood logs into fencing products for sale to retail and wholesale customers. Britt purchases, primarily from Palco 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 produced approximately 86, 76 and 74 million board feet of lumber in 2004, 2003 and 2002, respectively. Palco’s remaining mill, located in Fortuna, produces primarily common grade lumber.

     Subject to market conditions and lumber supply, Palco dries a substantial portion of its lumber before it is processed or sold. Air or kiln-dried lumber generally commands higher prices than “green” lumber, which is lumber sold before it has been dried. Drying also allows Palco to compete in additional markets (due to lower shipping costs resulting from the moisture and weight reduction which occurs in the drying process). Palco owns and can operate up to 35 kilns having an annual capacity of approximately 95 million board feet.

     Palco also 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. 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 Palco’s state-of-the-art end and edge glue plant. The result is a standard sized upper grade product which can be sold at a significant premium over common grade products.

     Palco owns and operates a cogeneration power plant which is fueled by the wood residue from logging and lumber production operations. The operations of Palco and Britt supplied 58% of the fuel in 2004. The power plant is capable of producing up to 35 megawatts per hour and generates substantially all of the energy requirements of Scotia, California, the town adjacent to the Palco Timberlands. Several of Palco’s facilities are located in Scotia and a number of its employees live there. Palco sells surplus power to Pacific Gas and Electric Company. In 2004, the sale of surplus power accounted for approximately 5% of MGI’s total revenues.

  Products

     MGI produced 298.1, 289.3 and 267.8 million board feet of lumber in 2004, 2003 and 2002, respectively. The following table sets forth the distribution of MGI’s lumber production (on a net board foot basis) and revenues by product line:

     In 2004, MGI sold 296.9 million board feet of lumber. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Forest Products Operations” for additional

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information. 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 available 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 larger diameter logs and is characterized by an absence of knots and other defects, little to no sapwood, and a tighter grain, is used primarily in distinctive interior and exterior applications. 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 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 larger diameter 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 somewhat interchangeable with common grades of other whitewood species, although the strength of Douglas-fir makes it more desirable in certain applications.

     MGI does not have any significant contractual relationships with third parties relating to the purchase of logs. During 2004, MGI purchased approximately 35.3 million board feet of logs from third parties. Palco 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. Subject principally to economic feasibility, Palco also produces and sells to third parties wood chips from hardwood trees.

  Backlog and Seasonality

     MGI’s backlog of sales orders at December 31, 2004 was $50.8 million, of which it is estimated that $18.7 million will be shipped in the first quarter of 2005. The sales backlog at December 31, 2003, was $35.2 million, of which $12.7 million was shipped in the first quarter of 2004. 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 also “—Regulatory and Environmental Factors” below and Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition and Investing and Financing Activities—Forest Products Operations.”

  Marketing

     The housing, construction and remodeling markets are the primary markets for MGI’s lumber products. MGI’s goal is to maintain a wide distribution of its products geographically. MGI’s accounts are primarily wholesale, followed by industrial end users, manufacturers, retailers and exporters. MGI’s redwood and Douglas-fir lumber is 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 81% of common redwood sales in 2004. Common grades of Douglas-fir lumber are sold primarily in California. In 2004, MGI’s largest three customers accounted for approximately 13%, 7% and 5%, respectively, of MGI’s total net lumber sales. Exports of lumber accounted for approximately 3% of MGI’s total net lumber sales in 2004. 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, strong brand recognition, competitive prices and long history, MGI believes it has a strong degree of customer loyalty. However, this customer

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loyalty would be severely tested if product shortages result from the failure of the North Coast Water Board to release for harvest already-approved THPs. See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition and Investing and Financing Activities—Forest Products Operations.”

  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 Simpson, Redwood Empire, Sierra Pacific, Canadian cedar lumber producers, as well as other imports and non-wood alternatives.

  Employees

     As of March 1, 2005, MGI had approximately 835 employees.

  Relationships among the Palco Companies

     The Palco Companies are parties to several agreements among themselves, including a master purchase agreement, a services agreement, an additional services agreement, a reciprocal rights agreement, and an environmental indemnification agreement.

     Palco and Scotia LLC are parties to a master purchase agreement (the “Master Purchase Agreement”) which governs the sale to Palco of logs harvested from the Scotia LLC Timberlands. As Palco purchases logs from Scotia LLC pursuant to the Master Purchase Agreement, Palco is responsible, at its own expense, for harvesting and removing the standing Scotia LLC Timber covered by approved THPs, with the purchase price being based upon “stumpage prices.” Title to, and the obligation to pay for, harvested logs passes to Palco once the logs are measured. The Master Purchase Agreement contemplates that all sales of logs by Scotia LLC to Palco will be at fair market value (based on stumpage prices) for each species and category of timber. The Master Purchase Agreement provides that if the purchase price equals or exceeds the SBE Price (as defined below) and a structuring price set forth in a schedule to the Timber Notes Indenture, the purchase price is deemed to be at fair market value. If the purchase price equals or exceeds the SBE Price, but is less than the structuring price, then Scotia LLC is required to engage an independent forestry consultant to confirm that the purchase price reflects fair market value. “SBE Price” is the stumpage price for each species and category of timber as set forth in the most recent “Harvest Value Schedule” (or any successor publication) published by the California State Board of Equalization (or any successor agency) applicable to the timber sold during the applicable period. Harvest Value Schedules are published twice a year for purposes of computing a yield tax imposed on timber harvested between January 1 through June 30 and July 1 through December 31. SBE Prices are not necessarily representative of actual prices that would be realized from unrelated parties at subsequent dates.

     Scotia LLC relies on Palco, pursuant to a services agreement between the companies (the “Services Agreement”), to provide operational, management and related services not performed by Scotia LLC’s own employees with respect to the Scotia LLC Timberlands. These services include protecting the Scotia LLC Timberlands from fire, disease and insects; maintaining and rehabilitating roads on the Scotia LLC Timberlands; building new roads to permit the harvesting of Scotia LLC Timber; providing certain timber management services, such as replanting and reforestation, designed to supplement the natural regeneration of, and increase the amount of, Scotia LLC Timber; assisting Scotia LLC to comply with all applicable environmental laws; advising and consulting with Scotia LLC regarding legislative matters; preparing and filing on behalf of Scotia LLC (at Palco’s cost) all pleadings and motions, and otherwise diligently pursuing, appeals of any denial and defense of any challenge to approval of any THP or the Environmental Plans or similar plan or permit and related matters; and otherwise furnishing all equipment, personnel and expertise not within the Scotia LLC’s possession and reasonably necessary for the operation and maintenance of the Scotia LLC Timberlands and Scotia LLC Timber.

     Palco is required to provide all services under the Services Agreement in a manner consistent in all material respects with prudent business practices which are consistent with then-current applicable industry standards and are in compliance in all material respects with all applicable timber laws. Scotia LLC pays Palco a services fee which is

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adjusted annually based on a specified government price index relating to wood products and reimburses Palco for the cost of constructing, rehabilitating and maintaining roads, and performing reforestation services, on the Scotia LLC Timberlands. Certain of such reimbursable expenses vary in relation to the amount of timber to be harvested in any given period.

     Scotia LLC provides certain services to Palco pursuant to an additional services agreement between the companies. These services include (i) assisting Palco to operate, maintain and harvest its own timber properties, (ii) updating and providing access to the GIS with respect to information concerning Palco’s own timber properties and (iii) assisting Palco with its statutory and regulatory compliance. This agreement provides that Palco shall pay Scotia LLC a fee for such services equal to Scotia LLC’s actual cost of providing such services, as determined in accordance with generally accepted accounting principles.

     The Palco Companies are also parties to a reciprocal rights agreement whereby, among other things, the parties have granted to each other certain reciprocal rights of egress and ingress through their respective properties in connection with the operation and maintenance of such properties and their respective businesses. In addition, Palco and Scotia LLC are parties to an environmental indemnification agreement, pursuant to which Palco has agreed to indemnify Scotia LLC from and against certain present and future liabilities arising with respect to hazardous materials, hazardous materials contamination or disposal sites, or under environmental laws with respect to the Scotia LLC Timberlands. In particular, Palco is liable with respect to any contamination which occurred on the Scotia LLC Timberlands prior to the date of their transfer to Scotia LLC.

  Regulatory and Environmental Factors

     This section contains statements which constitute “forward-looking statements” within the meaning of the PSLRA. See this section and “Business—General” above for cautionary information with respect to such forward-looking statements.

     General

     Palco’s business is subject to a variety of California and federal laws and regulations, as well as the HCP, dealing with timber harvesting practices, 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 Palco’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 timberland owners, including Palco, to demonstrate that their proposed timber operations constitute the maximum sustainable production of their timberlands over time. 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. These laws generally prohibit the take of certain species, except for specifically authorized incidental take 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, specifies measures to minimize and mitigate the potential impact of the incidental take of species and to monitor the effects of the activities covered by the plan. Palco is 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 Porter-Cologne Water Quality Control Act and federal Clean Water Act (the “CWA”), which require that Palco 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 substantial restrictions on the scope and timing of Palco’s timber operations, increased operational costs significantly, and engendered continual litigation and other challenges to its operations. Moreover, the cash flows of Palco and Scotia LLC have recently been adversely affected by the failure of the North Coast Water Board to release for harvest THPs which have already been approved by the other government agencies that approve Scotia LLC’s THPs. See “—Water Quality” below.

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     Environmental Plans

     The Environmental Plans, consisting of the HCP and the SYP, which cover the substantial portion of the timberlands of the Palco Companies, were approved by the federal and state governments upon the consummation of the Headwaters Agreement. In connection with approval of the Environmental Plans, incidental take permits (the “Permits”) were issued with respect to certain threatened, endangered and other species found on the timberlands covered by the Environmental Plans. The Permits were to cover the 50-year term of the HCP and allow incidental take of 17 different species covered by the HCP, including nine species which are found on the Palco Timberlands that have been listed under the ESA and/or the CESA. On October 31, 2003, the Court hearing the EPIC-SYP/Permits lawsuit (as defined below), entered a judgment invalidating the SYP and the California Permits, and that decision is now on appeal. See Item 3. “Legal Proceedings—Forest Products Litigation” for further information regarding this matter. 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 the Palco Companies of these agreements or the Environmental Plans.

     Under the HCP, harvesting activities are prohibited or restricted on certain areas of the Palco Timberlands. Some of these restrictions continue for the entire 50-year term of the HCP. For example, several areas (consisting of substantial quantities of timber, including old growth redwood and Douglas-fir timber) are designated as habitat conservation areas for the marbled murrelet, a coastal seabird, and certain other species. Harvesting in certain other areas of the Palco Timberlands is currently prohibited while these areas are evaluated for the potential risk of landslide. Further, additional areas alongside streams have been designated as buffers, in which harvesting is prohibited or restricted, to protect aquatic and riparian habitat. Restrictions on harvest in streamside buffers and potential landslide prone acres may be adjusted up or down, subject to certain minimum and maximum buffers, based upon the ongoing watershed analysis process described below. The adaptive management process described below may also be used to modify most of these restrictions.

     The first analysis of a watershed, Freshwater, was released in June 2001. This analysis was used by the Palco Companies and the government agencies to develop proposed harvesting prescriptions. Prescriptions for the Van Duzen watershed were approved in January 2004. Prescriptions for a third watershed (Lower Eel — Eel Delta) were approved in March 2004. The Freshwater, Van Duzen and Lower Eel prescriptions each resulted in a reduction in the size of the streamside buffers set forth in the Environmental Plans and also provide for geologic reviews in order to conduct any harvesting activities on potential landslide-prone areas. This effectively reduced both the size and operational restrictions in respect of landslide-prone areas. The analysis for a fourth watershed, Elk River, was submitted in mid-2004 for agency and public review, and prescriptions for Elk River have been developed and are undergoing review by the relevant agencies.

     The HCP required the Palco Companies, together with the government agencies, to establish a schedule resulting in completion of the initial watershed analysis process for all covered lands within five years. However, due largely to the number of agencies involved and the depth and complexity of the analyses, the process has proven to require more time than originally anticipated. Accordingly, the Palco Companies have been working with the government agencies to establish an appropriate timeline and to streamline the process for implementation of watershed analysis on the remaining portions of Palco Timberlands to ensure that such studies are time and cost efficient, and that such studies continue to provide scientific results necessary to evaluate potential changes to the harvesting restrictions on those lands. The Palco Companies have received an extension to March 2007 of the time in which the watershed analysis process must be completed. A proposed streamlined process is undergoing review by the relevant agencies.

     The HCP 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, Palco has conducted, and expects to be able to continue to conduct, some harvesting during these periods. An adaptive management change approved in 2003 for the road restrictions has improved the ability to construct and use roads on the Palco Timberlands in ways that are consistent with the operational needs of the Palco Companies. The HCP also requires that 75 miles of roads be stormproofed (i.e., reconstructed to reduce sediment generation) on an annual basis and that certain other roads must be improved or repaired. The nature of this work requires that it be performed in the dry periods of the year. To date, over 450 miles of roads have been stormproofed.

     The HCP contains an adaptive management provision, which both the state and federal governments 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 many of the HCP prescriptions based on, among other things, economic considerations. The regulatory agencies have also clarified that in applying this adaptive

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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. The Palco Companies and the agencies have implemented various adaptive management changes related to wildlife and rare plants, and other changes relating to roads and streamside buffers. These adaptive management changes have increased Palco’s ability to conduct harvesting operations and/or reduce operating costs while still meeting the obligations of the Environmental Plans.

     Water Quality

     Laws and regulations dealing with water quality are impacting the Palco Companies primarily in four areas: efforts by the federal Environmental Protection Agency (the “EPA”) and the North Coast Water Board to establish total maximum daily load limits (“TMDLs”) in watercourses that have been declared to be water quality impaired; actions by the North Coast Water Board to impose waste discharge reporting requirements in respect of watersheds on the Palco Timberlands and in some cases, clean-up or prevention measures; actions by the North Coast Water Board during the THP approval process which impose certain operational requirements on individual THPs; and a directive of the North Coast Water Board to its staff to develop watershed-wide waste discharge requirements (“WWDRs”) for the Freshwater and Elk River watersheds.

     Under the CWA, the EPA is required to establish TMDLs for relevant contaminants in watercourses that have been declared to be “water quality impaired.” The EPA and the North Coast Water Board are in the process of establishing TMDLs for many northern California rivers and certain of their tributaries, including nine watercourses that flow within the Palco Timberlands. On the Palco Timberlands, the relevant contaminant is simple sediment dust, dirt and gravel that is abundant in watercourses largely as a function of the area’s normally heavy rainfall and soil that erodes easily. 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 watercourses. The agency indicated that the requirements under the HCP would significantly address the sediment issues that resulted in TMDL requirements for these watercourses. The North Coast Water Board has begun the process of establishing the TMDL requirements applicable to two other watercourses on the Palco Timberlands, with a targeted completion of 2006 for these two watercourses. Scotia LLC’s scientists are actively working with North Coast Water Board staff to ensure these TMDLs recognize and incorporate the environmental protection measures of the HCP. The final TMDL requirements applicable to the Palco Timberlands may require aquatic protection measures that are different from or in addition to those in the HCP or that result from the prescriptions to be developed pursuant to the watershed analysis process provided for in the HCP.

     For each of the three winter periods since 2002, the North Coast Water Board has required Palco to submit “Reports of Waste Discharge” in order to conduct winter harvesting operations in the Freshwater and Elk River watersheds. After consideration of these reports, the North Coast Water Board imposed requirements on the Palco Companies to implement additional mitigation and erosion control practices in these watersheds for each of the three winter operating periods. The North Coast Water Board has also extended the requirements for certain mitigation and erosion control practices in three additional watersheds (Bear, Jordan and Stitz Creek). The Palco Companies and the North Coast Water Board are currently in discussions to determine what these measures will be. The requirements imposed to date by the North Coast Water Board have significantly increased operating costs; additional requirements imposed in the future could further increase costs and cause delays in THP approvals.

     The North Coast Water Board has also issued a clean up and abatement order (the “Elk River Order”) for the Elk River watershed, which is aimed at addressing existing sediment production sites through clean up actions. The North Coast Water Board has also initiated the process which could result in similar orders for the Freshwater and Bear Creek watersheds, and is contemplating similar actions for the Jordan and Stitz Creek watersheds. The Elk River Order has resulted in increased costs to Palco that could extend over a number of years. Additional orders in other watersheds (should they be issued), may also result in further cost increases. Palco’s appeal of the Elk River Order to the State Water Resources Control Board (the “State Water Board”) was denied. Palco has appealed the decision of the State Water Board in state court , but is holding such appeal in abeyance until resolution of the THP No. 520 lawsuit described below. See Item 3. “Legal Proceedings—Forest Products Litigation.”

     In addition to the foregoing actions, the North Coast Water Board in December 2003 directed its staff to create WWDRs for the Freshwater and Elk River watersheds. As harvesting activities on the Palco Timberlands cannot readily be moved between watersheds due to, among other things, historic harvest patterns, adjacency restrictions, and the age

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classes of trees, that action and the other matters described above could, in addition to the potential effects noted above, individually or collectively result in reduced harvest. In that regard, the staff of the North Coast Water Board has not yet formulated the required WWDRs for the Freshwater and Elk River watersheds, and has on several occasions postponed its projected date for their completion. As a result, the North Coast Water Board has failed to release for harvest a number of Scotia LLC’s THPs that are located in the Freshwater and Elk River watersheds, even though these THPs have already been approved by the other government agencies which review Scotia LLC’s THPs and are in compliance with the HCP. The delay in receiving the release of these THPs has adversely impacted the cash flows of both Palco and Scotia LLC. Furthermore, it is likely that additional delays in the development of the Freshwater and Elk River WWDRs will occur, and such delays could have adverse impacts beyond those currently being experienced.

     On February 25, 2005, the Executive Officer of the staff of the North Coast Water Boardpublicly announced approval of the release of additional THPs such that Palco would be allowed to harvest up to 50% of the harvest limit established by the CDF for the Freshwater and Elk River watersheds. Since this announcement, Palco and Scotia LLC have continued their efforts with the North Coast Water Board staff to obtain the release of additional THPs and will make a presentation to the North Coast Water Board itself on March 16, 2005, in furtherance of these efforts. No assurance can be given that the efforts of Palco and Scotia LLC will be successful. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Financial Condition and Investing and Financing Activities—Forest Products Operations” for further information regarding this matter, including extraordinary actions which Palco and Scotia LLC could be forced to take if their efforts are not successful.

     California Senate Bill 810, which became effective January 1, 2004, provides regional water quality control boards with additional authority related to the approval of THPs on land within impaired watersheds. Under this law, a THP “may not be approved if the appropriate regional water quality control board finds, based on substantial evidence, that the timber operations proposed in the plan will result in a discharge into a watercourse that has been classified as impaired due to sediment...that causes or contributes, to a violation of the regional water quality control plan.” The Company is uncertain of the operational and financial effects which will ultimately result from Senate Bill 810. While this provision has not yet been invoked in respect of the Palco Timberlands, because substantially all rivers and waterbodies on the Palco Timberlands are classified as sediment-impaired, implementation of this law could result in delays in obtaining approval of THPs, lower harvest levels and increased costs and additional protection measures beyond those contained in the HCP. Also see the description of the THP No. 520 lawsuit under Item 3. “Legal Proceedings—Forests Products Litigation.”

     Impact of Future Legislation

     Laws, regulations and related judicial decisions and administrative interpretations dealing with MGI’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 MGI, 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 federal and California judicial decisions which could affect timber harvesting practices. It is not possible to assess the effect of such future legislative, judicial and administrative developments on MGI or its business.

     Timber Operators License

     In order to conduct logging operations, road building, stormproofing and certain other activities, a company must obtain a Timber Operator’s License from the CDF. In December 2003, Palco was granted a Timber Operator’s License for 2004-2005.

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Real Estate Operations

  General

     The Company, principally through its wholly owned subsidiaries, invests in and develops residential and commercial real estate, primarily in Puerto Rico, Arizona, California, and Texas. Real estate properties and receivables as of December 31, 2004 are as follows: