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

2

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.

3

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.

4

     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

5

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

6

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

7

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

8

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

9

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.

10

     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

11

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

12

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.

13

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:

14

     Revenues from real estate operations were as follows in 2004 and 2003 (see Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Real Estate Operations” for additional details on 2004, 2003 and 2002 results):

Palmas del Mar

     Palmas del Mar, a master-planned residential community and resort located on the southeastern coast of Puerto Rico near Humacao (“Palmas”), was acquired by a subsidiary of the Company in 1984. Originally over 2,700 acres, Palmas now has approximately 1,130 acres of undeveloped land remaining. The Company conducts its operations at Palmas through Palmas del Mar Properties, Inc. (“PDMPI”) and PDMPI’s subsidiaries. PDMPI is planning the development and/or sale of certain of the remaining acreage at Palmas. PDMPI is also considering various alternatives to accelerate sales of its remaining acreage as well as disposition of other assets. In connection with this, PDMPI has retained and is in the process of working with an agent to assist in its efforts to solicit developer and investor interest in acquiring such acreage and other assets. No assurance can be given that these efforts will be successful. Resort operations at Palmas include a country club with two golf courses and tennis and beach club facilities. 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 over 21,000. Development of Fountain Hills is substantially complete. Future sales are expected to consist of fully developed lots in two developments known as Eagles Nest and Adero Canyon. Eagles Nest, a 506-acre custom lot development planned to include 245 lots, commenced sales in 2004. Lots are expected to be

15

released in phases, including 20 lots in the first phase that were sold in 2004. Development plans have been formulated for Adero Canyon, a 431-acre custom lot development planned to include 171 lots. Financing of the Adero Canyon development will be accomplished either through new or existing credit facilities or joint venture arrangements.

     In 1998, a subsidiary of the Company entered into and holds a 50% interest in a joint venture named FireRock LLC (“FireRock LLC”) 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 consisting of three phases of custom lots, three multifamily parcels and a private country club. The club’s championship-level private 18-hole golf course opened in 2000. The multifamily parcels were sold in 2001 and 2002. Construction of the custom lot portion of the project is complete and lot sales concluded in 2004. The venture continues to own and operate the country club.

Mirada

     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 in the Santa Rosa Mountains, 650 feet above the Coachella Valley floor. Three 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 Rancho Mirage, formerly the Ritz-Carlton Rancho Mirage Hotel, which is owned and operated by a third party, was developed on the second parcel. The third parcel is a recently completed custom lot subdivision comprised of 63 estate lots. In 2004, a subsidiary of the Company sold a one-half interest in a 27-acre parcel in Mirada to a real estate developer. This subsidiary subsequently contributed the remaining one-half interest to, and entered into and holds a 50% interest in, a joint venture formed by the developer and the subsidiary. The joint venture, named RMCAL, LLC (“RMCAL”) will construct and sell 47 villas to be built on the parcel. The two remaining parcels encompass approximately 39 acres. Under a development agreement with the City of Rancho Mirage which extends until 2011, this acreage may be developed with a variety of residential and commercial uses. The Company has also obtained final regulatory and environmental approvals for development of these two parcels and is formulating plans for development and/or marketing of these parcels.

Commercial Lease Properties

     In June 2001, subsidiaries of the Company acquired Lake Pointe Plaza, an office complex located in Sugar Land, Texas, for a purchase price of $131.3 million. The transaction was financed by the subsidiaries through the issuance of $122.5 million of non-recourse notes and the balance from available cash. The office complex is fully leased to affiliates of the seller through May 2021.

     In November 2002, a subsidiary of the Company acquired the Cooper Cameron building, an office building located in Houston, Texas, for a purchase price of $32.7 million. The transaction was financed by the subsidiary through a cash payment of $3.0 million and the issuance of $29.7 million in non-recourse notes. At the time of the acquisition, the subsidiary simultaneously leased the property back to the seller for a period of 22 years.

     In December 2002, a subsidiary of the Company, acquired two business trusts which own a portfolio of sixteen motel properties located in ten different states. The purchase price consisted of a cash payment of $3.5 million and the assumption of certain non-recourse notes with an outstanding principal balance of $49.4 million secured by the properties. The properties were acquired subject to an existing lease agreement under which the properties are fully leased through April 2019, and under which all obligations are guaranteed by the parent company of the current tenant.

     See Note 14 for further information regarding these commercial 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, generally to builders and developers, and fully developed lots to individuals and builders. All sales are made directly to purchasers through the Company’s wholly owned brokerage operations and its marketing personnel, as well as through independent contractors such as real estate brokers who are compensated by means 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 the FireRock Country Club and RMCAL projects.

16

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/or disposable income and, therefore, are affected by changes in general economic conditions and other factors. The real estate development and commercial real estate businesses 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 business of Palmas competes with similar businesses in the Caribbean, Florida and other vacation/holiday destinations. The golfing operation at the FireRock Country Club development competes 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, 2005, the Company’s real estate operations had approximately 65 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 and Valley Race Park, a greyhound racing facility located in Harlingen, Texas. In January 2004, a subsidiary of the Company applied to the Texas Racing Commission (the “Racing Commission”) for an additional license to construct and operate a Class 2 horse racing facility in Laredo, Texas. The review process is only in the preliminary stages, and there can be no assurance that the Company will obtain this additional license as, among other things, there is a competing applicant.

Racing Operations and Facilities

     Sam Houston Race Park and Valley Race Park offer pari-mutuel wagering on live thoroughbred, quarter horse and greyhound racing during meets approved by the Racing Commission on a yearly basis and on simulcast horse and greyhound racing throughout the year. Under the Texas Racing Act and related regulations (collectively, the “Racing Act”), commission revenues for both facilities are a designated portion of the pari-mutuel handle. Revenues are also earned on live and simulcast racing as both a guest and host track (i.e. both facilities receive broadcasts of live racing conducted from other racetracks under various guest simulcast agreements and broadcast live racing conducted at Sam Houston Race Park and Valley Race Park to other race tracks and off track wagering sites under various host simulcast agreements). Sam Houston Race Park and Valley Race Park also derive revenues from food and beverages sales, admission and parking fees, group sales, and advertising sales.

Regulation of Racing Operations

     The ownership and operation of horse and greyhound racetracks in Texas are subject to significant regulation by the Racing Commission under 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 racing 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

17

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 25-mile radius, which includes most of the greater Houston metropolitan area, and that a secondary market of occasional patrons exists outside the 25-mile radius but within a 50-mile radius of the facility. 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. Recent changes to strategies include increased newspaper ad sizes, an expanded outdoor advertising campaign, radio advertising, increased marketing of items offered outside of the racing product, a VIP program with exclusive promotional offers, and greater focus on casual customers. Valley Race Park employs similar strategies to attract patrons. Both race parks also rent out facilities and grounds for group events, which are often unrelated to racing but which increase revenues and expose the facility to potential customers. Sam Houston Race Park had 167 days of live racing in 2004, a significantly greater number than usual as Sam Houston Race Park accommodated requests from the racing industry to alleviate 2004 scheduling issues at the two other Texas Class 1 horse tracks. Sam Houston Race Park currently has 122 days of live racing scheduled for 2005. Valley Race Park had 126 live racing performances (over 110 days) during 2004, and currently has 119 live racing performances (over 99 days) scheduled for 2005.

     Sam Houston Race Park competes with other forms of wagering and entertainment, including a Louisiana “racino” (horse or dog tracks with slot machines or other forms of gaming) located approximately 120 miles from Houston, increasing use of the Internet for horse wagering and general gaming, casinos located approximately 140 miles from Houston, a greyhound racetrack located 55 miles away, a wide range of sporting events and other entertainment activities in the Houston area, the Texas State Lottery, and charitable bingo. Live racing also faces increasing competitive pressure from simulcast signals broadcast by racinos, which are able to offer larger purses and competitive fields. 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 challenges for Sam Houston Race Park are to maintain its customer base in spite of the above competitive pressures and to develop and educate new racing fans in a market where pari-mutuel wagering had been absent from the 1930’s to 1994. Other competitive factors faced by Sam Houston Race Park include the allocation of sufficient live racing days by the Racing Commission and attraction of a sufficient number and quality of race horses to run at Sam Houston Race Park, particularly in view of the larger purses able to be offered by racinos. Competitive factors faced by Valley Race Park include the Texas State Lottery, charitable bingo and Internet-based gaming, as well as the attraction of sufficient greyhounds to run live racing, along with the ability of Valley Race Park to market its simulcast signal due to its brief live racing season.

     The Texas legislature convenes its regular session every other year. It is expected that this body will, during its January to June 2005 regular session, consider measures to enhance state revenues through additional forms of gaming such as video lottery terminals at existing horse and dog racing tracks, gaming on Indian reservations, and full casinos. The Company will vigorously pursue any such legislation that is favorable to it. As any legislation expanding gaming in Texas would likely require the approval of two-thirds of each legislative house and a majority of the state’s voters, no assurance can be given that any such legislation will be enacted or become effective. Moreover, it is not possible to determine what the provisions of any such legislation will be or its effect on the Company.

Employees

     As of March 1, 2005, the Company’s racing operations had approximately 600 year-round employees and approximately 250 seasonal employees.

Kaiser Aluminum

     The Company owns approximately 63% of Kaiser, which operated in several principal aspects of the aluminum industry prior to the bankruptcy filings described below. Kaiser, its principal operating subsidiary, Kaiser Aluminum & Chemical Corporation (“KACC”), and a number of KACC’s subsidiaries (collectively, the “Debtors”) have filed for reorganization under Chapter 11 of the Bankruptcy Code (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

18

supervision of the Bankruptcy Court (the “Bankruptcy Court”). See Note 11 for additional information regarding the status of the Debtors’ reorganization proceedings. The Company and its subsidiary, MAXXAM Group Holdings Inc. (“MGHI”), collectively own 50,000,000 shares of the common stock of Kaiser (the “Kaiser Shares”). See Note 11 for the description of an agreement which the Company and MGHI have with Kaiser regarding disposition of the Kaiser Shares. The Debtors have indicated that they believe that the equity of Kaiser’s stockholders, including the Company, will likely be cancelled without consideration. For further information concerning Kaiser, see Item 3. “Legal Proceedings-Kaiser Litigation,” Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations—Consolidated Operations—Deconsolidation of Kaiser,” and Note 11.

Segment Information

     See Item 7. “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” and Note 3 for additional information regarding revenues, income or loss, and total assets of the Company’s three segments, as well as revenues from the principal products offered by each.

Employees

     At March 1, 2005, MAXXAM and its subsidiaries had approximately 1,775 year-round and seasonal employees (excluding those employed by Kaiser), none of whom are covered by a collective bargaining agreement.

ITEM 2. PROPERTIES

     For information concerning the principal properties of the Company, see Item 1. “Business.”

ITEM 3. LEGAL PROCEEDINGS

General

     Several sections in this Item contain statements which constitute “forward-looking statements” within the meaning of the PSLRA. See this Item and Item 1. “Business—General” for cautionary information with respect to such forward-looking statements.

     The following describes certain legal proceedings in which the Company or its subsidiaries are involved. The Company and certain of its subsidiaries are also involved in various claims, lawsuits and other proceedings not discussed herein which relate to a wide variety of matters. Uncertainties are inherent in the final outcome of those and the below-described matters, and it is presently impossible to determine the resolution of these matters or the actual costs that ultimately may be incurred.

     Certain present and former directors and officers of the Company are defendants in certain of the actions described below. The Company’s bylaws provide for indemnification of its officers and directors to the fullest extent permitted by Delaware law. The Company is obligated to advance defense costs to its officers and directors, subject to the individual’s obligation to repay such amount if it is ultimately determined that the individual was not entitled to indemnification. In addition, the Company’s indemnity obligation can under certain circumstances include amounts other than defense costs, including judgments and settlements.

MAXXAM Inc. Litigation

     This section describes certain legal proceedings in which MAXXAM Inc. (and in some instances, certain of its subsidiaries) is involved. The term “Company,” as used in this section, refers to MAXXAM Inc., except where reference is made to the Company’s consolidated financial position, results of operations or liquidity.

USAT Matters

     On December 26, 1995, the United States Department of Treasury’s Office of Thrift Supervision (“OTS”) initiated a formal administrative proceeding (the “OTS action”) against the Company and others alleging, among other things, misconduct by the Company and certain of its affiliated persons (collectively, the “Respondents”) and others with

19

respect to the failure of United Savings Association of Texas (“USAT”). The OTS sought damages ranging from $326.6 million to $821.3 million under various theories. Following 110 days of proceedings before an administrative law judge during 1997-1999, and over two years of post-trial briefing, on September 12, 2001, the administrative law judge issued a recommended decision in favor of the Respondents on each claim made by the OTS. On October 17, 2002, the OTS action was settled for $0.2 million with no admission of wrongdoing on the part of the Respondents.

     As a result of the dismissal of the OTS action, a related civil action, alleging damages in excess of $250 million, was subsequently dismissed. This action, entitled Federal Deposit Insurance Corporation, as manager of the FSLIC Resolution Fund v. Charles E. Hurwitz (the “FDIC action”), was originally filed by the Federal Deposit Insurance Corporation (“FDIC”) in August 1995 against Mr. Charles E. Hurwitz (Chairman and Chief Executive Officer of the Company).

     On May 31, 2000, the Respondents filed a counterclaim to the FDIC action in the U.S. District Court in Houston, Texas (No. H95-3956). On November 8, 2002, the Respondents filed an amended counterclaim and an amended motion for sanctions (collectively, the “Sanctions Motion”). The Sanctions Motion states that the FDIC illegally paid the OTS to bring the OTS action against the Respondents and that the FDIC illegally sued for an improper purpose (i.e. in order to acquire timberlands held by a subsidiary of the Company). The Respondents are seeking as a sanction to be made whole for the attorneys’ fees they have paid (plus interest) in connection with the OTS and FDIC actions. As of December 31, 2004, such fees were in excess of $40.4 million. The Respondents are pursuing this claim vigorously.

     On January 16, 2001, an action was filed against the Company, Federated Development Company (the predecessor of a principal shareholder of the Company; “Federated”) and certain of the Company’s directors in the Court of Delaware Chancery Court entitled Alan Russell Kahn v. Federated Development Co., MAXXAM Inc., et al., Civil Action 18623NC (the “Kahn lawsuit”). The plaintiff purports to bring this action as a stockholder of the Company derivatively on behalf of the Company. The lawsuit concerns the OTS and FDIC actions, and the Company’s advancement of fees and expenses on behalf of Federated and certain of the Company’s directors in connection with these actions. It alleges that the defendants have breached their fiduciary duties to the Company, and have wasted corporate assets, by allowing the Company to bear all of the costs and expenses of Federated and certain of the Company’s directors related to the OTS and FDIC actions. The plaintiff seeks to require Federated and certain of the Company’s directors to reimburse the Company for all costs and expenses incurred by the Company in connection with the OTS and FDIC actions, and to enjoin the Company from advancing to Federated or certain of the Company’s directors any further funds for costs or expenses associated with these actions. The parties to the Kahn lawsuit have agreed to an indefinite extension of the defendants’ obligations to respond to the plaintiffs’ claims. Although it is impossible to assess the ultimate outcome of the Kahn lawsuit, the Company believes that the resolution of this matter should not result in a material adverse effect on its consolidated financial condition, results of operations or liquidity.

Forest Products Litigation

     A California state court has invalidated the SYP in connection with two lawsuits filed against the Palco Companies, as described below, which decision has been appealed. Other pending judicial and administrative proceedings could affect Palco’s ability to implement the HCP, implement certain approved THPs, or carry out other operations, as discussed below. One such lawsuit was resolved during 2004 (see below). Certain of the remaining pending cases are described below. The Services Agreement requires Palco to prepare and file on behalf of Scotia LLC (at Palco’s cost) all pleadings and motions, and otherwise diligently pursue, 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.

     In March 1999, an action entitled Environmental Protection Information Association, Sierra Club v. California Department of Forestry and Fire Protection, California Department of Fish and Game, The Pacific Lumber Company, Scotia Pacific Company LLC, Salmon Creek Corporation, et al. (the “EPIC-SYP/Permits lawsuit”) was filed in Superior Court in Humboldt County, California (No. CV-990445). This action alleged, among other things, various violations of the CESA and the CEQA, and challenged, among other things, the validity and legality of the SYP and the California Permits. The plaintiffs sought, among other things, to set aside California’s approval of the SYP and the California Permits and injunctive relief to prevent implementation of THPs approved in reliance upon these documents. In March 1999, a similar action, entitled United Steelworkers of America, AFL-CIO, CLC, and Donald Kegley v. California Department of Forestry and Fire Protection, The Pacific Lumber Company, Scotia Pacific Company LLC and Salmon Creek Corporation (the “USWA lawsuit”), was filed in Humboldt County Superior Court (No. CV-990452) challenging the validity and legality of the SYP. The EPIC-SYP/Permits and USWA lawsuits were consolidated for trial.

20

     Following trial, the Court on October 31, 2003 entered a judgment invalidating the SYP and the California Permits due to several deficiencies in agency procedures and the failure of Palco to submit a complete and comprehensible SYP. The Court’s decision, however, allowed for harvesting on THPs which rely on the SYP and were approved prior to July 23, 2003. The short-term effect of the ruling was to preclude approval, under the SYP, of a small number of THPs which were under review but had not been approved, and a minor reduction in 2003 harvesting that had been expected from these specific THPs. As a result of this case, Palco has since October 2002, when the Court issued a stay order preventing future reliance upon the SYP, been obtaining review and approval of new THPs under a procedure provided for in the forest practice rules that does not depend upon the SYP and the California Permits. Palco expects to follow this procedure until the Option A Plan is approved. See Item 1. “Business—Forest Products Operations—Timber and Timberlands.” Palco and the State of California have appealed the October 31, 2003, decision. In September 2004, the Court granted the plaintiffs’ request for reimbursement of an aggregate of $5.8 million in attorneys fees and other expenses incurred in connection with these matters. Palco and the State of California have also appealed this decision.

     In July 2001, an action entitled Environmental Protection Information Center v. The Pacific Lumber Company, Scotia Pacific Company LLC (the “Bear Creek lawsuit”) was filed in the U.S. District Court for the Northern District of California (No. C01-2821), and later amended to add the EPA as a defendant. The lawsuit alleges that Palco’s harvesting and other forestry activities under certain approved THPs will result in discharges of pollutants in violation of the CWA. The plaintiff asserts that the CWA requires the defendants to obtain a permit from the North Coast Water Board before beginning timber harvesting and road construction activities and is seeking to enjoin these activities until such permit has been obtained. The plaintiff also seeks civil penalties of up to $27,500 per day for the defendant’s alleged continued violation of the CWA. On October 14, 2003, in connection with certain motions that had been filed, the Court upheld the validity of an EPA regulation which exempts harvesting and other forestry activities from certain discharge requirements.

     Both state and federal agencies, along with Palco and other timber companies, have relied upon this regulation for more than 25 years. However, the Court interpreted the regulation in such a way as to narrow the forestry operations which are exempted, thereby limiting the regulation’s applicability and subjecting culverts and ditches to permit requirements. This ruling has widespread implications for the timber industry in the United States. The case is not yet final as the trial has not yet been held, and there are many unresolved issues involving interpretation of the Court’s decision and its application to actual operations. Should the decision ultimately become final and held to apply to all Palco’s timber operations, it may have some or all of the following effects: imposing additional permitting requirements, delaying approvals of THPs, increasing harvesting costs, and adding water protection measures beyond those contained in the HCP. Nonetheless, it is not likely that civil penalties will be awarded for operations that occurred prior to the Court’s decision due to the historical reliance by timber companies on the regulation and the Company’s belief that the requirements under the HCP are adequate to ensure that sediment and pollutants from harvesting activities on the Palco Timberlands will not reach levels harmful to the environment. While the impact of a conclusion to this case that upholds the October 14, 2003, ruling may be adverse, the Company does not believe that such an outcome would have a material adverse impact on the Company’s consolidated financial condition, results of operations or liquidity. Nevertheless, due to the numerous ways in which the Court’s interpretation of the regulation could be applied to actual operations, there can be no assurance that this will be the case.

     On November 20, 2002, two similar actions entitled Alan Cook, et al. v. Gary Clark, et al. (the “Cook action”) and Steve Cave, et al. v. Gary Clark, et al. (the “Cave action”) were filed in Humboldt County Superior Court (No.’s DR020718 and DR020719, respectively), which also name Palco and certain affiliates as defendants. On April 4, 2003, the plaintiffs in these actions filed amended complaints and served the defendants with notice of the actions. The Cook action alleges, among other things, that defendants’ logging practices have contributed to an increase in flooding along Freshwater Creek (which runs through the Palco Timberlands), resulting in personal injury and damage to the plaintiffs’ properties. Plaintiffs further allege that in order to have THPs approved in the affected areas, the defendants engaged in certain unfair business practices. The plaintiffs seek, among other things, compensatory and exemplary damages, injunctive relief, and appointment of a receiver to ensure that the watershed is restored. The Cave action contains similar allegations and requests similar relief with respect to the Elk River watershed (a portion of which is contained on the Palco Timberlands). The Company does not believe the resolution of these actions should result in a material adverse effect on its consolidated financial condition, results of operations or liquidity.

     On February 25, 2003, the District Attorney of Humboldt County filed a civil suit entitled The People of the State of California v. The Pacific Lumber Company, Scotia Pacific Holding Company and Salmon Creek Corporation in the Humboldt County Superior Court (No. DR030070) (the “Humboldt DA action”). The suit was filed under California’s

21

unfair competition law and alleges that Palco used certain unfair business practices in connection with completion of the Headwaters Agreement, and that this resulted in Palco being able to harvest significantly more trees under the Environmental Plans than would have otherwise been the case. The suit sought a variety of remedies including a civil penalty of $2,500 for each additional tree that has been or will be harvested due to this alleged increase in harvest, as well as restitution and an injunction in respect of the additional timber harvesting allegedly being conducted. In response to motions filed by Palco for sanctions and dismissal of this suit, on April 30, 2004, the Court issued a ruling requiring the District Attorney to amend his suit to prove that “extrinsic” fraud occurred. In addition, the Court eliminated the remedies being sought, other than for civil penalties, and suggested that it would be inappropriate to base civil penalties on the additional trees harvested. The Court also ruled that it declined “at this juncture” to impose sanctions on the District Attorney. The District Attorney subsequently amended his suit, and Palco later filed new motions to dismiss and for sanctions. After delays resulting from the District Attorney’s efforts to disqualify the trial judge, and that judge’s later self-disqualification, a hearing on these motions was held on February 18, 2005. The Court rejected the sanctions motion, but has not yet ruled on the motion for dismissal. The Company believes that this suit is without merit and that the April 30, 2004, ruling diminished significantly its exposure with respect to this matter; however, there can be no assurance that Palco will ultimately prevail, or that an adverse outcome would not be material to the Company’s consolidated financial condition, results of operations or liquidity.

     On December 17, 2003, an action entitled Humboldt Watershed Council, et al. v. North Coast Regional Water Quality Board, et al. (the “HWC 2003 lawsuit”), naming Palco as a real party in interest, was filed in the Humboldt County Superior Court (No. CV030961). The plaintiffs allege that the North Coast Water Board should have required waste discharge reports in respect of all timber harvesting activities in the Freshwater and Elk River watersheds, including those of Palco. This action has been dismissed by the plaintiffs.

     On November 4, 2004, an action entitled Environmental Protection Information Center, et al. v. California Department of Forestry and Fire Protection, et al. was filed in Humboldt County Superior Court (No. CV04-0809). This action sought an order staying or setting aside CDF’s approval of six THPs along the Van Duzen river, and an order requiring CDF to conduct further review and analysis of the six THPs and to refrain from reliance on information not made available for public review and comment. Following denial by the trial judge of the plaintiffs’ request for injunctive relief and various appellate proceedings which resulted in harvesting operations being allowed to continue, the case was dismissed by the plaintiffs.

     On November 2, 2004, an action entitled Environmental Protection Information Center v. U.S. Fish & Wildlife Service, NOAA Fisheries, et al. (No. C04-4647) was filed in the U.S. District Court for the Northern District of California (the “EPIC-USFWS/NOAA lawsuit”). This lawsuit alleges that two federal agencies have violated certain federal laws and related regulations in connection with their oversight of the HCP and related incidental take permits issued by the federal government (the “Federal Permits”). The plaintiff also alleges that the Federal Permit for the northern spotted owl was unlawfully issued and that Palco violated California’s unfair competition law by using false advertising and making misleading environmental claims. The plaintiff seeks a variety of remedies, including requiring additional actions by the federal agencies and precluding them from authorizing take of the northern spotted owl, an injunction requiring Palco to cease certain alleged unlawful activities, as well as restitution and remediation by Palco. Motions have been filed by the federal government and Palco seeking dismissal of substantial portions of this case, but a hearing date on this motion has not yet been set. The Company does not believe the resolution of this action should result in a material adverse effect on its consolidated financial condition, results of operations or liquidity.

     On November 16, 2001, Palco filed a case entitled The Pacific Lumber Company, et al. v. California State Water Resources Control Board (No. DR010860) in Humboldt County Superior Court (the “THP No. 520 lawsuit”) alleging that the State Water Board had no legal authority to impose mitigation measures that were requested by the staff of the North Coast Water Board during the THP review process and rejected by the CDF prior to approving the THP. When the staff of the North Coast Water Board attempted to impose these mitigation measures in spite of the CDF’s decision, Palco appealed to the State Water Board, which imposed certain of the requested mitigation measures and rejected others. Palco filed the THP No. 520 lawsuit challenging the State Water Board’s decision, and in January 2003, the Superior Court granted Palco’s request for an order invalidating the imposition of these additional measures. The State Water Board appealed this decision, and on March 18, 2004 the appellate court reversed the decision of the Superior Court. The appellate court’s decision could result in increased demands by the regional and state water boards and their staffs to impose controls and limitations upon Palco’s timber harvesting beyond those provided for by the Environmental Plans or could provide additional regulatory powers to the regional and state water boards and their staffs beyond those provided in Senate Bill 810. Palco filed a petition for review of the appellate court’s decision by the California Supreme Court, which in June 2004 agreed to review the decision.

22

Kaiser Litigation

     See Note 11 for a discussion of Kaiser’s reorganization proceedings. Kaiser is a defendant in a number of lawsuits, some of which involve claims of multiple persons, in which the plaintiffs allege that certain of their injuries were caused by, among other things, exposure to asbestos during, and as a result of, their employment or association with Kaiser or exposure to products containing asbestos produced or sold by Kaiser. A variety of other lawsuits and claims are pending against Kaiser. Generally, claims against Kaiser arising from actions or omissions prior to the dates on which the Debtors filed their Cases will be settled in connection with Kaiser’s plan of reorganization.

Other Matters

     On September 2, 2004, the Company was advised that one of its former subsidiaries (which was dissolved in 1999) is a successor to a company which manufactured munitions for the U.S. Navy during World War II. The current owner of the underlying property, which is located in Cranbury, New Jersey, is seeking participation by MGI, the parent of the former subsidiary, in efforts to address contamination of the site which resulted from such operations. The current owner estimates that the costs to determine what remedial actions are needed, and to perform any remedial actions determined necessary, could range from $3.0 million to $8.0 million. Costs for the investigation and remediation could exceed $8.0 million as the result of information learned during the investigation. The Company is currently in the process of determining the extent of its liability, which could require payment of a substantial portion of the costs, as well as the availability of funding from the U.S. Navy and insurance coverage for these activities. Such investigation is anticipated to take several months to complete.

     On December 29, 2004, the New Jersey Department of Environmental Protection (“NJDEP”) issued a Directive against the current owner of the property, MGI, and the U.S. Navy requiring these parties to conduct a remedial investigation and remedial action (“RI/RA”) in respect of the property. As further required by the Directive, MGI and the current owner on January 28, 2005, entered into an Administrative Consent Order (“ACO”) providing, among other things, that MGI and the current owner begin implementing the RI/RA within 120 days of execution of the ACO. MGI and the current owner of the property have also entered into a Participation Agreement providing, among other things, for them to jointly fund the RI/RA and for a mediation process to assist in equitably allocating the costs of the RI/RA.

     On January 21, 2004, the owner of the Candelero Hotel located at Palmas filed a lawsuit against PDMPI claiming an easement on certain property owned by PDMPI, as well as damages. On September 30, 2004, this matter was settled by an agreement in which the hotel owner dismissed all of its claims and agreed to purchase for $9.0 million a parcel of land that included the area covered by the alleged easement. This transaction closed in November 2004.

     The Company is involved in other claims, lawsuits and proceedings. While uncertainties are inherent in the final outcome of such matters and it is presently impossible to determine the actual costs that ultimately may be incurred or their effect on the Company, management believes that the resolution of such uncertainties and the incurrence of such costs should not result in a material adverse effect on the Company’s consolidated financial position, results of operations or liquidity.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

     Not applicable.

23

PART II

ITEM 5.	MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

     The Company’s common stock, $.50 par value (“Common Stock”), is traded on the American Stock Exchange. The stock symbol is MXM. The following table sets forth, for the calendar periods indicated, the high and low sales prices per share of the Company’s Common Stock as reported on the American Stock Exchange Consolidated Composite Tape.

     The following table sets forth the number of record holders of each class of publicly owned securities of the Company at March 1, 2005:

     The Company has not declared any cash dividends on its capital stock and has no present intention to do so.

     The Company may from time to time purchase shares of its Common Stock on national exchanges or in privately negotiated transactions. No such purchases occurred during the twelve months ended December 31, 2004, or through the date of this Report.

24

ITEM 6. SELECTED FINANCIAL DATA

     The following summary of consolidated financial information for each of the five years ended December 31, 2004 is not reported upon herein by independent public accountants and should be read in conjunction with the Consolidated Financial Statements and the Notes thereto which are contained in Item 8 herein.

	•	2004 includes a $1.4 million charge for employee severance and benefit costs at Palco (see Note 3). 2004 also includes a $1.9 million charge in connection with an environmental matter associated with a former subsidiary of the Company (see Note 3).
	•	2003 includes a gain on the sale of acreage in the Grizzly Creek grove of $16.8 million (see Note 14), $8.0 million of insurance recoveries related to the OTS and FDIC actions (see Note 3), as well as a $1.4 million charge to write-down the Company’s casino-related assets to estimated fair value (see Note 3).
	•	2002 includes other items of $0.5 million attributable to Kaiser for the period from January 1, 2002, through February 11, 2002 (see Note 3).
	•	2001 includes the following related to Kaiser: additional valuation allowances related to Kaiser’s deferred tax assets of $505.4 million (see Note 9), business interruption insurance recoveries of $36.6 million, a gain of $163.6 million on the sale of an approximate 8.3% interest in Queensland Alumina Limited (“QAL”), a charge of $57.2 million for asbestos-related claims, and net gains on power sales and several other non-recurring items totaling $163.6 million. 2001 results include the following related to Palco: a gain of $16.7 million on the sale of acreage in the Grizzly Creek grove.
	•	2000 includes the following related to Kaiser: estimated business interruption insurance recoveries of $110.0 million and several other non-recurring items totaling $48.9 million. 2000 results include the following related to Palco: a gain on the sale of the Owl Creek grove of $60.0 million.

(3)	During 2004, Kaiser completed the sale of its interests in Alumina Partners of Jamaica (“Alpart”), the alumina refinery located in Gramercy, Louisiana (“Gramercy”), Kaiser Jamaica Bauxite Company (“KJBC”), Volta Aluminium Company Limited (“Valco”), and Kaiser’s Mead facility and certain related property (the “Mead Facility”). In addition, Kaiser has received confirmation from the Bankruptcy Court to proceed with the sale of its interest in QAL. Alpart, Gramercy, KJBC, Valco, the Mead Facility, QAL and Kaiser’s hedging operations are collectively referred to as “Kaiser’s Discontinued Operations”. The assets and long-term debt, less current maturities reported as discontinued operations are included in the Consolidated Balance Sheet amounts presented above as of December 31, 2001 and 2000. However, the results of operations of Kaiser’s Discontinued Operations are reported separately as discontinued operations in the Consolidated Statements of Operations for the period from January 1, 2002, to February 11, 2002, and for the years ended December 31, 2001 and 2000. The assets and long-term debt of Kaiser’s Discontinued Operations as of December 31, 2002, are not included in the table above due to the deconsolidation of Kaiser on February 12, 2002.
(4)	MAXXAM Inc. did not declare or pay any cash dividends during the five year period ended December 31, 2004.

25

ITEM 7.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     The following should be read in conjunction with the Company’s Consolidated Financial Statements and the Notes thereto appearing in Item 8.

Results of Operations

     This section contains statements which constitute “forward-looking statements” within the meaning of the PSLRA. See Item 1. “Business—General” and below for cautionary information with respect to such forward-looking statements.

     The Company operates in three industries: forest products, through MGI and its wholly owned subsidiaries, principally Palco, Scotia LLC and Britt; real estate investment and development, through various subsidiaries and joint ventures; and racing operations through SHRP, Ltd. MGHI owns 100% of MGI and is a wholly owned subsidiary of the Company. In addition, the Company owns 62% of Kaiser, a producer of fabricated aluminum products. Any reference herein to a company includes the subsidiaries of that company unless otherwise noted or the context indicates otherwise.

     Consolidated Operations

     Selected Operational Data

     The following table presents selected financial information for the years ended December 31, 2004, 2003 and 2002 for the Company’s consolidated operations.

     Deconsolidation of Kaiser

     Under generally accepted accounting principles for entities consolidated through voting interests, consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. Under these rules, legal reorganization or bankruptcy represent conditions which can preclude consolidation in instances where control rests with the bankruptcy court, rather than the majority owner. As a result of Kaiser’s filing for bankruptcy (as discussed in Note 1), Kaiser’s financial results were deconsolidated beginning February 12, 2002, and the Company began reporting its investment in Kaiser using the cost method, under which the investment is reflected as a single amount on the Company’s balance sheet of $(516.2) million, and the recording of earnings or losses from Kaiser was discontinued after February 11, 2002. Since Kaiser’s results are no longer consolidated and the Company believes that it is not probable that it will be obligated to fund losses related to its investment in Kaiser, any adjustments reflected in Kaiser’s financial statements subsequent to February 12, 2002 (relating to the recoverability and classification of recorded asset amounts and the classification of liabilities or the effects

26

on existing stockholders’ deficit as well as adjustments made to Kaiser’s financial information for loss contingencies and other matters), are not expected to affect the Company’s financial results.

     The following condensed pro forma financial data reflects the results of operations of the Company, excluding Kaiser, for the year ended December 31, 2002, the year in which Kaiser was deconsolidated (in millions, except share data).

     See Notes 1 and 11 for further discussion of Kaiser’s reorganization proceedings and other information regarding the Company’s investment in Kaiser.

     Kaiser Discontinued Operations

     As part of Kaiser’s plan to divest certain of its commodity-based assets, Kaiser during 2004, with the approval of the Bankruptcy Court, completed or finalized plans for the sale of its interests in Kaiser’s Discontinued Operations. In accordance with Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment and Disposal of Long-Lived Assets” (“SFAS No. 144”), the operating results of Kaiser’s interests in the divested assets have been reported as discontinued operations in the accompanying Consolidated Statement of Operations for the period from January 1, 2002, to February 11, 2002, the date that Kaiser was deconsolidated (see discussion of the deconsolidation of Kaiser above). Combined income statement information in respect of Kaiser’s Discontinued Operations for the period from January 1, 2002, to February 11, 2002, included in income (loss) from discontinued operations is as follows (in millions):

     Overview of Consolidated Results of Operations

     Net Sales

     Net sales for 2004 totaled $347.5 million, compared to $336.6 million in 2003. Net sales for the real estate segment increased $16.5 million due to higher sales of real estate acreage at the Company’s Palmas del Mar and Mirada developments. Net sales for the racing segment increased $0.8 million due to more live race days being held. Net sales for the Company’s forest products segment decreased $6.4 million primarily due to lower lumber revenues. Lumber sales for 2004 were impacted by lower shipments resulting from lower harvest levels.

     Net sales for 2003 totaled $336.6 million, compared to $366.7 million in 2002. The decline is primarily attributable to the deconsolidation of Kaiser’s financial results beginning February 12, 2002, the date Kaiser filed for Chapter 11 reorganization. Net sales for 2002 included $65.7 million attributable to Kaiser (excluding discontinued operations) for the period from January 1, 2002 to February 11, 2002, whereas 2003 included none of Kaiser’s financial results. Net sales for the Company’s forest products segment increased $9.1 million for 2003 versus 2002, reflecting favorable trends in lumber prices, while net sales for the real estate segment increased $29.4 million for 2003 as compared to 2002, primarily due to increased sales of real estate acreage and commercial lots. Due to a decline in attendance, 2003 net sales for the Company’s racing segment declined by $2.9 million from 2002.

27

     Operating Income (Loss)

     The Company recorded operating income of $14.3 million in 2004 compared to operating income of $41.4 million for the prior year period. Operating results for the forest products segment decreased by $29.1 million, primarily as a result of the decrease in net sales noted above and an increase in cost of sales due primarily to declines in harvest, which led to higher third party log purchases. The real estate segment recorded operating income of $29.7 million versus operating income of $17.1 million in 2003, primarily due to the increases in net sales noted above. The racing segment’s operating loss increased by $1.2 million despite the increase in live race days noted above due primarily to an increase in marketing and development costs. The corporate segment’s operating loss increased by $9.4 million due primarily to an increase in stock-based compensation expense which is adjusted as the market value of the Company’s Common Stock changes, in addition to a $1.9 million charge for an environmental matter discussed under “Other Matters” in Note 12.

     The Company recorded operating income of $41.4 million in 2003 compared to an operating loss of $15.9 million in 2002. Operating income for the Company’s forest products segment increased $15.7 million for 2003, primarily due to $17.5 million in gains on sales of timberlands and other assets, while the real estate segment’s operating results improved from a loss of $0.2 million in 2002 to income of $17.1 million in 2003 as a result of the increase in net sales discussed above. Results for the racing segment declined from operating income of $0.4 million in 2002 to an operating loss of $1.9 million in 2003 as a result of an increase in selling, general and administrative expenses. Kaiser contributed $24.4 million (excluding discontinued operations) to the consolidated operating loss for 2002.

     Loss Before Income Taxes, Minority Interests and Discontinued Operations

     The Company’s consolidated loss before income taxes, minority interests and discontinued operations increased by $36.3 in 2004 compared to the prior year, primarily as a result of the decrease in operating income discussed above. Investment, interest and other income decreased by $12.2 million, primarily because results for 2003 included income related to an $8.0 million reimbursement from an insurer for certain costs incurred in connection with the OTS and FDIC actions.

     The Company’s consolidated loss before income taxes, minority interests and discontinued operations decreased by $85.4 million in 2003 compared to the prior year, principally due to the deconsolidation of Kaiser and the improved operating results discussed above. In addition, the Company’s investment, interest and other income for 2003 includes income related to the $8.0 million reimbursement from an insurer discussed above. Interest expense decreased $8.1 million in 2003 from the preceding year as a result of early extinguishment of MGHI’s Senior Secured Notes (the “MGHI Notes”).

     Forest Products Operations

     Industry Overview and Selected Operational Data

     This section contains statements which constitute “forward-looking statements” within the meaning of the PSLRA. See this section and Item 1. “Business—General” for cautionary information with respect to such forward-looking statements.

     The Company’s forest products operations are conducted through MGI and its wholly owned subsidiaries, principally Palco, Scotia LLC and Britt. The segment’s business is somewhat seasonal, and its net sales have been historically higher in the months of April through November than in the months of December through March. Management expects that the segment’s revenues and cash flows will continue to be somewhat seasonal. Accordingly, the segment’s results for any one quarter are not necessarily indicative of results to be expected for the full year.

     Regulatory and environmental matters as well as certain pending legal matters play a significant role in the Company’s forest products operations. See Item 1. “Business—Forest Products Operations—Regulatory and Environmental Matters” and Note 12 for further discussion of these matters. Regulatory compliance and related litigation have caused and may continue to cause delays in approval of THPs and delays in harvesting on THPs once they are approved. This has resulted and may continue to result in a decline in harvest, an increase in the cost of logging operations, and increased costs related to timber harvest litigation.

     The cash flows of Palco and Scopac have both been adversely impacted by the failure of the North Coast Water Board to release for harvest a number of already-approved THPs. Scotia LLC expects that without the release of

28

additional THPs, its cash flows from operations, together with funds available under its line of credit, will be inadequate to pay the entire amount of interest due on the July 20, 2005, payment date for its Timber Notes. Palco is in default under the Palco Credit Agreement and estimates that, without the prompt release of a substantial portion of these THPs and necessary amendments to the Palco Credit Agreement, its cash flow from operations, together with funds available under the Palco Credit Agreement, will not provide sufficient liquidity to fund its current level of operations. For further information, see “—Financial Condition and Investing and Financing Activities—Forest Products Operations.”

     Furthermore, there can be no assurance that certain other pending legal, regulatory and environmental matters or future governmental regulations, legislation or judicial or administrative decisions, adverse weather conditions, or low lumber or log prices, will not have a material adverse effect on the Company’s financial condition, results of operations or liquidity. See Item 1. “Business—Forest Products Operations—Regulatory and Environmental Factors,” Item 3. “Legal Proceedings” and Note 12 for further information regarding regulatory and legislative matters and legal proceedings relating to the Company’s forest products operations.

     During 2001, comprehensive external and internal reviews were conducted of Palco’s business operations. These reviews were conducted in an effort to identify ways in which Palco could operate on a more efficient and cost effective basis. Based upon these reviews, Palco implemented a number of changes during the last quarter of 2001 and the first quarter of 2002, including closing two of its four sawmills, eliminating certain of its operations, including its company-staffed logging operations (now relying exclusively on contract loggers) and its soil amendment and concrete block activities, utilizing more efficient harvesting methods and adopting other cost saving measures. Palco has continued to examine ways in which to achieve additional cost savings. During 2004, Palco opened a new planer facility in Scotia and began construction on a new sawmill in Scotia, California. The project is expected to cost $27.3 million ($20.5 million of which was expended in 2004) with the last phase scheduled for completion in the third quarter of 2005 (subject to available cash). Funds for this project are being provided from existing cash resources and borrowings under the Palco Credit Agreement. As part of the project, the Carlotta mill was permanently closed, and the equipment from the Carlotta mill is in the process of being moved to the new mill in Scotia. Management is considering alternative uses for the property. Further actions may be taken during 2005 as a result of Palco’s continuing evaluation process or in response to the financial difficulties discussed above, and writedowns of certain assets may be required.

29

     The following table presents selected operational and financial information for the years ended December 31, 2004, 2003 and 2002 for the Company’s forest products operations.

30

     Net Sales

     Net sales for the forest products segment in 2004 were $6.4 million below the prior year’s net sales. While total lumber shipments were only slightly lower than the prior year and prices in most categories of lumber improved, the mix of products sold continued to shift from higher-priced redwood and upper grade Douglas-fir lumber to lower-priced common grade Douglas fir, which produced an overall decline of $4.8 million in net sales of lumber. Sales of logs, power and other products, which accounted for 11.3% of the segment’s sales product mix in 2004, were down a combined $1.6 million compared to the prior year.

     The forest products segment’s net sales for 2003 increased compared to the preceding year. Lumber sales increased by $13.6 million primarily as a result of higher average sales prices for redwood common grade lumber. Although lumber shipments were higher, this improvement was unfavorably impacted by a shift in the mix of product from higher-priced redwood and upper grade Douglas-fir lumber to lower-priced common grade Douglas-fir lumber. Net sales of logs to third parties decreased $7.9 million or 55% in 2003. Sales of surplus power from Palco’s cogeneration power plant increased over the prior year due to increases in both volume and prices.

     Operating Income (Loss)

     Operating income for the forest products segment was $5.4 million in 2004, which was significantly below the prior year’s operating income of $34.5 million. The decline was primarily attributable to three factors: the decline in net sales discussed above, an increase in the per unit production cost of lumber and the 2003 gain of $16.8 million on the sale of timberlands in the Grizzly Creek grove. Per unit lumber production costs were adversely affected by the declines in harvest, which led to increased third party log purchases approximating 35.3 mmbf in 2004, as compared to 21.4 mmbf in 2003.

     The forest products segment’s operating income of $34.5 million reflected an increase of $15.7 million over 2002. Results for 2003 include the $16.8 million gain on the sale of timberlands in the Grizzly Creek grove. Although gross margins on sales of lumber increased, higher harvesting costs per unit limited the improvement to $2.4 million. Gross margins from cogeneration power increased $1.7 million, which was more than offset by a decline of $3.2 million on log sales. Selling, general and administrative expenses increased $3.9 million, primarily due to increases in salaries and benefits, severance costs, expenses associated with a public relations campaign by Palco, and costs related to various legal matters.

     Loss Before Income Taxes

     The loss before income taxes increased $31.2 million in 2004 compared to 2003, primarily due to the decreases in operating results discussed above. In addition, earnings on cash, cash equivalents and other investments declined due to lower investment balances and lower returns during 2004 versus 2003. The declines on returns on investment funds was partially offset by a decrease in interest expense.

     The loss before income taxes decreased $15.4 million in 2003 compared to 2002. The decrease was principally attributable to the increase in operating income discussed above. Investment, interest and other income (expense) and interest expense for 2003 were comparable to 2002.

31

Real Estate Operations

     Industry Overview and Selected Operational Data

     The Company, principally through its wholly owned subsidiaries and joint ventures, invests in and develops residential and commercial real estate, primarily in Arizona, California, Puerto Rico, and Texas. The following table presents selected operational and financial information for the years ended December 31, 2004, 2003 and 2002, respectively, for the Company’s real estate operations.

32

     Net Sales

     Net sales for the real estate segment include: revenues from sales of developed lots, bulk acreage and other real property associated with the Company’s real estate developments; revenues from resort and other commercial operations conducted at these real estate developments; and lease revenues from a number of commercial properties.

     Net sales for the real estate segment increased $16.5 million in 2004 from the year ago period, largely driven by acreage sales at Palmas del Mar and Mirada, an increase in lot sales at Fountain Hills and Mirada, and increases in net sales from commercial operations at Palmas del Mar and Fountain Hills. Acreage sales at Fountain Hills declined between periods, and Other net sales in 2003 included $8.8 million from the sale of a parcel of real estate in Lake Havasu, Arizona.

     Net sales for the real estate segment increased $29.4 million in 2003 from the prior year. Real estate sales at Fountain Hills increased $10.6 million over 2002 to $19.3 million for 2003 due to an increase in acreage and commercial lot sales, while revenues from lot sales at Mirada increased $5.1 million over the prior year to $5.3 million for 2003. The $8.8 million sale of the Lake Havasu parcel during 2003 also contributed to the improvement in net sales. In addition, the Company’s commercial lease properties (several of which were acquired in the fourth quarter of 2002) had sales of $15.9 million, an increase of $6.6 million over the prior year. Real estate sales at Palmas increased slightly in 2003; however, this was more than offset by a decline in resort and commercial operations at Palmas, which was due in large part to closure of the Company’s casino facility at Palmas in March 2003 (see Note 3).

     Operating Income (Loss)

     Operating results increased by $12.6 million for 2004 versus 2003 primarily due to increased sales as discussed above. In addition, operating results for 2003 include a $1.4 million charge to recognize the impairment of Palmas’

casino assets related to the foreclosure of a hotel which was owned and operated by a third party from whom the casino leased space.

     The increase in the real estate segment’s operating results from 2002 to 2003 was due largely to the increase in sales discussed above.

     Income (Loss) Before Income Taxes

     The segment’s income before income taxes increased by $15.4 million for 2004 versus 2003, due to the higher operating results discussed above, as well as an increase in equity earnings from FireRock, LLC.

     Income (loss) before income taxes increased $11.3 million in 2003 compared to 2002 due to the impact of the improved operating results discussed above. Interest expense increased $5.7 million in 2003 compared to 2002, primarily due to increased borrowings used to fund the acquisition of several commercial lease properties in late 2002.

Racing Operations

     Industry Overview and Selected Operational Data

     The Company indirectly owns SHRP, Ltd., a Texas limited partnership that owns and operates Sam Houston Race Park, a Class 1 horse racing facility in Houston, Texas, and Valley Race Park, a greyhound racing facility located in Harlingen, Texas. Results of operations between quarterly periods are generally not comparable for this segment due to the timing, varying lengths and types of racing meets held. Historically, Sam Houston Race Park and Valley Race Park have derived a significant amount of their annual pari-mutuel commissions from live racing and simulcasting. Pari-mutuel commissions have typically been highest during the first and fourth quarters of the year, the time during which Sam Houston Race Park and Valley Race Park have historically conducted live thoroughbred and greyhound racing, respectively. However, for 2004 only, Sam Houston Race Park was granted 40 additional live race days.

33

     The following table presents selected operational and financial information for the years ended December 31, 2004, 2003 and 2002, respectively, for the Company’s racing operations.

34

     Net Sales

     Net sales for the racing segment for 2004 increased by $0.8 million compared to the prior year due primarily to 40 more live racing days at Sam Houston Race Park. Net sales for Valley Race Park for 2004 were comparable to the prior year. Average daily attendance declined at both race parks.

     Net sales for the Company’s racing segment totaled $49.8 million for 2003, a decrease of $2.9 million from the previous year. While the number of live and simulcast racing days for 2003 was comparable to 2002, the segment’s overall average daily attendance at both Sam Houston Race Park and Valley Race Park declined for 2003. This negatively impacted pari-mutuel commissions.

     Operating Income (Loss)

     Despite an increase in net sales for 2004, the operating loss for the segment increased versus the prior year primarily due to higher costs of sales and operations. The increase in costs of sales and operations was due to the increase in live racing days during the year, which led to higher utility, payroll and other operating expenses.

     Operating results decreased by $2.3 million in 2003. The major reasons for the decrease were the lower net sales discussed above, in addition to the impact of a $1.1 million increase in operating expenses. The increase in operating expenses was largely driven by an increase in selling, general and administrative expenses including costs associated with legislative efforts.

     Income Before Income Taxes

     The decrease in income before income taxes for this segment for 2004 as compared to 2003, as well as the decrease in income before income taxes for 2003 versus 2002, are both attributable to the operating losses discussed above.

Other Items Not Directly Related to Industry Segments

     Operating Loss

     The operating losses represent corporate general and administrative expenses that are not attributable to the Company’s industry segments. For 2004, such losses include $1.9 million related to an accrual for an environmental matter discussed under “Other Matters” in Note 12. In addition to this accrual, results for 2004 include $6.1 million related to an increase in stock-based compensation expense, which is adjusted as the market value of the Company’s Common Stock changes and as awards vest. The decrease in the operating loss in 2003 versus 2002 was primarily due to certain general and administrative expenses incurred in 2002 as a result of Kaiser’s Chapter 11 filing (see Note 1). The operating loss for 2002 also included severance and moving expenses incurred as a result of reduction in Corporate staff and office space.

     Income (Loss) Before Income Taxes

     Income (loss) before income taxes includes operating losses, investment, interest and other income (expense) and interest expense, that are not attributable to the Company’s industry segments. Results for 2003 include income related to an $8.0 million reimbursement from an insurer for certain costs incurred in connection with the OTS and FDIC actions (see Note 12). The loss before income taxes for 2002 includes interest expense of $8.1 million attributable to the MGHI Notes which were extinguished in December of 2002.

35

Provision for Income Taxes

     The Company generated a loss before income taxes of $46.9 million for 2004; however, the Company has recorded no tax benefit associated with the loss for the period. The benefit for income taxes of $0.3 million reflected in the Consolidated Statement of Operations consists principally of state taxes. Each period, the Company evaluates the appropriate factors in determining the realizability of the deferred tax assets attributable to losses and credits generated in the current period and those being carried forward. These factors are discussed further in Note 9. Based on this evaluation, the Company provided full valuation allowances with respect to the deferred tax assets attributable to losses and credits generated during 2004. These valuation allowances were in addition to the valuation allowances which were provided in prior years.

Financial Condition and Investing and Financing Activities

     This section contains statements which constitute “forward-looking statements” within the meaning of the PSLRA. See this section and Item 1. “Business—General” for cautionary information with respect to such forward-looking statements.

Overview

     The Company conducts its operations primarily through its subsidiaries. Creditors of subsidiaries of the Company have priority with respect to the assets and earnings of such subsidiaries over the claims of the creditors of the Company. Certain of the Company’s subsidiaries, principally Palco and Scotia LLC, are restricted by their various debt instruments as to the amount of funds that can be paid in the form of dividends or loaned to affiliates. Scotia LLC is highly leveraged and has significant debt service requirements (see Note 1). “MAXXAM Parent” is used in this section to refer to the Company on a stand-alone basis without its subsidiaries.

Cash Flow

     Operating Activities

     Net cash provided by operating activities of $29.0 million for the year ended December 31, 2004, principally reflects net loss (after adding back depreciation, depletion, amortization and other reconciling items, totaling $2.9 million), in addition to a $4.4 million decrease in inventories, a $5.6 million decrease in long-term assets (primarily real estate), and a $12.1 million increase in long-term liabilities (primarily attributable to increases in deferred sales revenue at Fountain Hills of $6.6 million, increases in membership deposits at Palmas of $2.2 million, and increases in pension liabilities of $2.3 million related to the Company’s defined benefit pension plans).

     Net cash provided by operating activities of $15.3 million for the year ended December 31, 2003, principally reflects net loss (after adding back depreciation, depletion, amortization and other reconciling items, totaling $6.9 million), a $4.4 million decrease in inventories, a $1.8 million decrease in long-term assets and an $8.0 million increase in long-term liabilities, offset by net changes to other working capital accounts totaling $5.1 million.

     Investing Activities

     Net cash used for investing activities of $26.2 million for the year ended December 31, 2004, principally reflects capital expenditures of $32.7 million, $20.5 million of which were related to Palco’s new sawmill project, offset by proceeds from the sale of marketable securities and other short-term investments of $5.8 million.

     Net cash used for investing activities of $0.8 million for the year ended December 31, 2003, principally reflects capital expenditures of $23.8 million, partly offset by proceeds from the sale of timberlands and other assets of $22.5 million.

     Financing Activities

     Net cash provided by financing activities of $4.8 million for the year ended December 31, 2004, principally reflects net borrowings on the Scotia LLC and Palco lines of credit of $18.2 million and $13.1 million, respectively, as well as borrowings on real estate credit facilities of $5.3 million, offset by repayments on real estate credit facilities of $25.7 million (principally related to the Mirada development) and principal payments on and repurchases of Timber Notes, net of restricted cash withdrawals, of $5.3 million.

     Net cash used for financing activities of $22.5 million for the year ended December 31, 2003, principally reflects repayments on real estate credit facilities of $11.1 million, treasury stock purchases of $9.0 million, principal payments on and repurchases of Timber Notes, net of restricted cash withdrawals, of $5.1 million, offset by proceeds from borrowings on credit facilities (primarily real estate) of $2.9 million.

36

MAXXAM Parent

     MAXXAM Parent and MGHI own the 50,000,000 Kaiser Shares, representing an approximate 63% interest in Kaiser. As a result of the Cases, the value of Kaiser common stock has declined substantially, and the market value of the Kaiser Shares based on the price per share quoted at the close of business on March 1, 2005, was $4.5 million. There can be no assurance that such value would be realized should the Kaiser Shares be sold, and it is likely that the Company’s ownership interest in Kaiser will be cancelled without consideration. Disposition of the Kaiser Shares is restricted under an agreement among Kaiser, MAXXAM Parent and MGHI. See also Notes 1 and 11.

     MAXXAM Parent expects that its general and administrative costs, net of cost reimbursements from subsidiaries will range from $7.0 million to $9.0 million for the next year. There can be no assurance, however, that MAXXAM Parent’s cash requirements for its corporate, general and administrative expenses will not increase.

     Although there are no restrictions on the Company’s ability to pay dividends on its capital stock, the Company has not paid any dividends for a number of years and has no present intention to do so.

     MAXXAM Parent believes that its existing resources will be sufficient to fund its working capital requirements for the next year. With respect to long-term liquidity, MAXXAM Parent believes that its existing cash and cash resources, together with distributions from the real estate segment, should be sufficient to meet its working capital requirements. However, there can be no assurance that this will be the case. See “—Forest Products Operations” below regarding potential adverse impacts upon MAXXAM Parent as a result of the liquidity issues being experienced by Palco and Scotia LLC.

Forest Products Operations

     Substantially all of MGI’s consolidated assets are owned by Palco, and a significant portion of Palco’s consolidated assets are owned by Scotia LLC. The holders of the Timber Notes have priority over the claims of creditors of Palco with respect to the assets and cash flows of Scotia LLC. The Palco Credit Agreement (described below) contains certain restrictive covenants which effectively preclude the distribution of funds from Palco to MGI.

     Regulatory and environmental matters as well as certain pending legal matters play a significant role in the Company’s forest products operations. See Item 1. “Business—Forest Products Operations—Regulatory and Environmental Factors” and Note 12 for discussion of these matters. Regulatory compliance and related litigation have caused and may continue to cause delays in approval of Scotia LLC’s THPs and delays in harvesting on its THPs once they are approved. This has resulted and may continue to result in a decline in harvest, an increase in the cost of logging operations, and increased costs related to timber harvest litigation.

     As discussed in Item 1. “Business—Forest Products Operations—Regulatory and Environmental Factors—Water Quality,” the North Coast Water Board is requiring Palco and Scotia LLC to apply various waste discharge reporting, mitigation and erosion control requirements in respect of timber harvesting activities in several watersheds, and may impose additional measures in the future. The North Coast Water Board in December 2003 directed its staff to formulate WWDRs for the Freshwater and Elk River watersheds. These requirements have not yet been formulated, and the North Coast Water Board has failed to release for harvest a number of THPs already approved by the other government agencies which review Scotia LLC’s THPs.

     The failure of the North Coast Water Board to release these THPs for harvest has adversely impacted the cash flows of both Palco and Scotia LLC. Scotia LLC estimates that, without the prompt release of a substantial portion of these THPs, its cash flows from operations, together with funds available under the Scotia LLC Line of Credit described below, will be inadequate to pay the entire amount of interest due on the July 20, 2005 Timber Notes payment date, which would constitute an event of default under the Timber Notes Indenture. Palco is in default under the Palco Credit Agreement described below and estimates that, without the prompt release of a substantial portion of these THPs and necessary amendments to the Palco Credit Agreement, its cash flow from operations, together with funds available under the Palco Credit Agreement, will not provide sufficient liquidity to fund its current level of operations. Palco and Scotia LLC are continuing efforts to obtain the clearance of the North Coast Water Board of sufficient THPs. Palco has received a limited waiver of the default through March 18, 2005, from the lender under the Palco Credit Agreement and is seeking a more permanent solution to the default. There can be no assurance that these efforts with the North Coast Water Board and the lender under the Palco Credit Agreement will be successful.

37

     In the event of a failure to pay interest on the Timber Notes in full when due, the Trustee or the holders of at least 25% of the aggregate outstanding principal amount of the Timber Notes may cause all principal, interest and other amounts related to the Timber Notes to become immediately due and payable. Also, in the event of a failure by Palco or Scotia LLC to perform its respective covenants or agreements under the Master Purchase Agreement or by Palco to perform its covenants or agreements under the Services Agreement that continues for 30 days after notice from the Trustee or the holders of 25% or more of the outstanding principal amount of the Timber Notes, the holders of a majority of the aggregate outstanding principal amount of the Timber Notes may cause all principal, interest and other amounts related to the Timber Notes to become immediately due and payable. In the event of any such acceleration, the Agent under the Scotia LLC Line of Credit may also accelerate the advances then outstanding thereunder. If such accelerations of Timber Notes and/or advances under the Scotia LLC Line of Credit occur, the Trustee may exercise all rights under the Timber Notes Indenture and related security documents, including applying funds to pay accelerated amounts, and selling the Scotia LLC Timberlands and other assets and using the proceeds thereof to pay accelerated amounts. In the event that Scotia LLC were to seek protection by filing under the Bankruptcy Code, all amounts related to the Timber Notes would become immediately due and payable under the Timber Notes Indenture and all advances under the Scotia LLC Line of Credit agreement could be accelerated. The foregoing rights of the Trustee and holders of Timber Notes are subject to the rights of Scotia LLC under the Bankruptcy Code.

     Without an extension of the limited waiver of Palco’s default under the Palco Credit Agreement and a restructuring or replacement of that facility, Palco’s lender may take any of the following actions: reduce the amount of funds available to Palco for borrowing; refuse to make new loans to or issue new letters of credit for the benefit of Palco; declare any or all loans and other amounts owed under the agreement to be immediately due and payable; require Palco to cash collateralize all outstanding letters of credit; or pursue its other rights and remedies under the Palco Credit Agreement and related security agreements. The existence of the default also requires Palco to pay interest on amounts borrowed under the Palco Credit Agreement at a per annum rate 2% higher than the rate at which interest would be owed if no default existed. If any acceleration under the Palco Credit Agreement occurs, then the agent for the lender may exercise all rights under that agreement and related security documents, including selling Palco’s assets and using the proceeds thereof to pay the accelerated amounts. In the event that Palco were to seek protection by filing under the Bankruptcy Code, all loans and other amounts owed under the Palco Credit Agreement would become immediately due and payable. The foregoing rights of the lender under the Palco Credit Agreement are subject to the rights of Palco under the Bankruptcy Code.

     In the event of a Scotia LLC default or a Palco liquidity shortfall, whether resulting from a failure to extend the limited waiver past March 18, 2005, any action described above taken by Palco’s lender, or otherwise, Palco and Scotia LLC could be forced to take extraordinary actions, which may include: reducing expenditures by laying off employees and shutting down various operations; seeking other sources of liquidity, such as from asset sales; and considering seeking protection by filing under the Bankruptcy Code.

     On December 8, 2004, Standard & Poor’s Ratings Services (“S&P”) lowered Palco’s credit rating from B- to CCC+. As a result, Palco may be required to post a security deposit for workers compensation liabilities in July 2005, in an amount that has not been determined but that could be material to Palco’s liquidity, capital resources, and results of operations. If improvements in Palco’s liquidity, capital resources, and results of operations produce an upward revision in Palco’s credit rating, or if a waiver of this requirement is allowed under applicable law, then posting of such a security deposit may not be necessary. Palco management is in the process of evaluating the potential amount of such a security deposit, if required. There can be no assurance that such a security deposit will not be required or that, if required, the amount will not be material. Palco management is also evaluating whether other potential obligations or unanticipated adverse financial reports may result from the S&P credit action described above.

     The liquidity issues being experienced by Palco and Scotia LLC could result in claims against and could have adverse impacts on MAXXAM Parent, MGHI and/or MGI. For example, under ERISA law, were Palco to terminate its pension plan, MAXXAM Parent and its wholly owned subsidiaries would be jointly and severally liable for any unfunded pension plan obligations. The unfunded obligation attributable to Palco’s pension plan as of December 31, 2004 is estimated to have been in the range of approximately $35 million based upon current annuity placement interest rate assumptions. In addition, it is possible that certain transactions could be entered into in connection with a potential restructuring or reorganization of Palco or Scotia LLC, such as a sale of all or a portion of the equity ownership in Palco and/or Scotia LLC, a sale of a substantial portion of Palco’s and/or Scotia LLC’s assets and/or a cancellation of some or all of Palco’s and/or Scotia LLC’s indebtedness, which could require the utilization of all or a substantial portion of,

38

or the loss of significant portion of, the Company’s net operating losses for federal and state income tax purposes and could require tax payments.

     In addition, there can be no assurance that certain other pending legal, regulatory and environmental matters or future governmental regulations, legislation or judicial or administrative decisions, adverse weather conditions, or low lumber or log prices, will not have a material adverse effect on the Company’s financial condition, results of operations or liquidity. See Item 1. “Business—Forest Products Operations—Regulatory and Environmental Factors,” Item 3. “Legal Proceedings” and Note 12 for further information regarding regulatory and legislative matters and legal proceedings relating to the Company’s forest products operations.

     The Scotia LLC Line of Credit allows Scotia LLC to borrow up to one year’s interest on the Timber Notes (the “Scotia LLC Line of Credit”). On June 20, 2003, the Scotia LLC Line of Credit was extended to July 7, 2006. At or near the completion of such extension, Scotia LLC intends to request that the Scotia LLC Line of Credit be extended for an additional period of not less than 364 days. If not extended, Scotia LLC may draw upon the full amount available. The amount drawn would be repayable in 12 semiannual installments on each note payment date (after the payment of certain other items, including the Aggregate Minimum Principal Amortization Amount, as defined, then due), commencing approximately two and one-half years following the date of the draw. At December 31, 2004, Scotia LLC could have borrowed a maximum of $57.1 million under the Scotia LLC Line of Credit, and there were $18.2 million in borrowings outstanding under the facility. At January 31, 2005, the maximum availability under the Scotia LLC Line of Credit was $55.9 million, and there were $45.9 million in borrowings outstanding under this facility.

     On the note payment date in January 2004, Scotia LLC had $4.1 million set aside in the note payment account to pay the $27.2 million of interest due (net of $2.0 million of additional interest due in respect of Timber Notes held by Scotia LLC). The funds available under the Scotia LLC Line of Credit were used to pay the remaining $23.1 million of interest due. Scotia LLC repaid $12.7 million of principal on the Timber Notes (an amount equal to Scheduled Amortization, as set forth in the Timber Notes Indenture (“Scheduled Amortization”)) using funds held in the Scheduled Amortization Reserve Account, a reserve account used to support principal payments on the Timber Notes (“SAR Account”).

     On the note payment date in July 2004, Scotia LLC used $26.6 million (net of $2.1 million of additional interest due in respect of Timber Notes held by Scotia LLC) of the funds available under the Scotia LLC Line of Credit to pay the entire $26.6 million of interest due. Scotia LLC repaid $4.5 million of principal on the Timber Notes (an amount equal to Scheduled Amortization) using funds held in the SAR Account.

     On the note payment date in January 2005, Scotia LLC used $26.3 million (net of $2.2 million of additional interest due in respect of Timber Notes held by Scotia LLC) of the funds available under the Scotia LLC Line of Credit to pay the entire $26.3 million of interest due. Scotia LLC repaid $10.6 million of principal on the Timber Notes (an amount equal to Scheduled Amortization) using funds held in the SAR Account.

     With respect to the note payment date in July 2005, as a result of the matters discussed above, Scotia LLC may not have adequate funds available under the Scotia LLC Line of Credit to pay the entire $25.9 million of interest which will be due (net of $2.0 million of additional interest which would be due in respect of Timber Notes held by Scotia LLC). Should this occur, Scotia LLC would be in default under the Timber Notes Indenture. Should a default not occur, Scotia LLC anticipates paying the $5.0 million of principal due on the Timber Notes (an amount equal to Scheduled Amortization) by using funds held in the SAR Account.

     During 2004, $10.9 million of funds from the SAR Account were used to repurchase $11.0 million principal amount of Timber Notes, as permitted under the Timber Notes Indenture, resulting in a loss of $0.3 million (net of unamortized deferred financing costs) on the repurchase of debt.

     Due to its highly leveraged condition, Scotia LLC is more sensitive than less leveraged companies to factors affecting its operations, including low log prices, governmental regulation and litigation affecting its timber harvesting practices (see “—Results of Operations—Forest Products Operations” above and Note 12), and general economic conditions. Scotia LLC’s cash flows from operations are significantly impacted by harvest volumes and log prices. The Master Purchase Agreement between Scotia LLC and Palco (see Item 1. “Business—Forest Products Operations—Relationships among the Palco Companies”) 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

39

Agreement provides that if the purchase price equals or exceeds the “SBE Price” 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.

     In December 2004, the State Board of Equalization adopted the new Harvest Value Schedule for the first half of 2005. The prices published in that schedule reflected a 14.3% increase in the SBE Price for small redwood logs and a 12.5% increase for small Douglas-fir logs from the prices published for the second half of 2004.

     On January 27, 2005, S&P announced that it was placing its ratings on all classes of Timber Notes on CreditWatch with negative implications. S&P indicated that the CreditWatch placements reflected Palco’s difficulties in obtaining approval from the North Coast Water Board to move forward with harvesting related to certain THPs. S&P also indicated that any additional delays in the ability to harvest on the Scotia LLC Timberlands (and the inability to generate adequate revenue) could put into question whether Scotia LLC will have sufficient funds to make payment of full and timely interest on the July 2005 Timber Notes note payment date. In addition, on February 7, 2005, Moody’s Investors Services lowered the ratings on all classes of the Timber Notes, reflecting concerns over continued weak cash flow from timber operations due to difficulties in obtaining approval of THPs. The rating on the Class A-1 Timber Notes was lowered from A1 to Baa2; the rating on the Class A-2 Timber Notes was lowered from A3 to Baa3; and the rating on the Class A-3 Timber Notes was lowered from Baa2 to Ba1. All three ratings will remain on review for possible downgrade, as Moody’s noted that there is some risk that there will be insufficient cash to make full payment of interest on the July 2005 note payment date.

     On January 23, 2004, Palco entered into an asset-based credit agreement with a bank (the “Palco Credit Agreement”). This agreement provides for a three-year revolving facility after which Palco may request a one-year extension. Borrowings under the agreement bear interest at rates based upon (and at variable margins above) LIBOR or the prime rate, and are secured by the substantial portion of Palco’s assets. Effective February 22, 2005, the Palco Credit Agreement was amended by, among other things: reducing the maximum amount of potential borrowings from $35.0 million to $30.0 million; decreasing the borrowing base reserve by $2.0 million (and thereby increasing the amount able to be borrowed by the same amount); and requiring more frequent submissions of borrowing base certificates. At December 31, 2004, $13.1 million in borrowings and $0.3 million in letters of credit were outstanding under the Palco Credit Agreement. In accordance with the agreement, Palco is required to maintain a certain base level of borrowings through February 12, 2005, based on certain collateral balances. Palco is required to meet certain quarterly earnings thresholds under a covenant of the Palco Credit Agreement. As of December 31, 2004, Palco was not in compliance with this covenant.

     Capital expenditures have been made during the past three years to improve production efficiency and reduce operating costs. In April 2004, Palco commenced a mill improvement project, including construction of a new sawmill in Scotia, California. The project is expected to cost $27.3 million ($20.5 million of which was expended in 2004) with the last phase scheduled for completion in the third quarter of 2005. Funds for this project are being provided from existing cash resources and borrowings under the Palco Credit Agreement. Palco believes that the new mill will improve annual results from operations by at least $20.0 million, assuming an adequate supply of logs. As part of the project, equipment from Palco’s Carlotta mill is in the process of being moved to the new mill in Scotia, and the Carlotta mill was permanently closed. The Carlotta mill and other equipment would be used to process large diameter logs. Completion of this project is, however, subject to successful resolution of the liquidity problems being experienced by Palco. Management is considering alternative uses for the Carlotta property. Capital expenditures, excluding expenditures for the new sawmill and for timberlands, are estimated to be between $5.0 million and $7.0 million for 2005. Subject to available resources, Palco and Scotia LLC may purchase additional timberlands from time to time as appropriate opportunities arise.

     The Company estimates that funding requirements for pension benefits for 2005 will range from $2.2 million to $2.4 million. Palco’s share of these amounts ranges from $1.6 million to $1.8 million.

     Palco will require funds available under the Palco Credit Agreement in order to meet its working capital and capital expenditure requirements for the next year. Palco’s ability to meet such requirements could be adversely affected should Palco be unsuccessful in its efforts to obtain a more permanent solution to the default discussed above. Furthermore, Palco’s cash flows from operations may be adversely affected by diminished availability of logs from Scotia LLC, lower

40

lumber prices, adverse weather conditions, pending legal, regulatory and environmental matters or increased funding requirements for its pension plan. See “—Results of Operations—Forest Products Operations” above, as well as Note 12, for discussion of the regulatory, environmental and legal matters affecting harvest levels and operating costs.

     With respect to long-term liquidity, until such time as Palco has adequate cash flows from operations and/or dividends from Scotia LLC, there can be no assurance that Palco will be able to meet its working capital, capital expenditures and debt service obligations. Liquidity, capital resources and results of operations in the long-term may continue to be adversely affected by the same factors affecting short-term cash flows from operations, as discussed above.

Real Estate Operations

     Capital expenditures and real estate improvements and development costs are expected to be approximately $32.0 million to $33.0 million in 2005. The Company expects that these expenditures will be funded by existing cash and available credit facilities.

     The Company believes that the existing cash and credit facilities of its real estate subsidiaries are sufficient to fund the working capital and capital expenditure requirements of such subsidiaries for 2005. With respect to the long-term liquidity of such subsidiaries, the Company believes that their ability to generate cash from the sale of their existing real estate, together with their ability to obtain financing and joint venture partners, should provide sufficient funds to meet their working capital and capital expenditure requirements. PDMPI and its subsidiaries, however, have required advances from MAXXAM Parent in prior years to fund their operations, and PDMPI may require such advances in the future.

Racing Operations

     Capital expenditures and investments in new ventures are expected to be between $2.0 million and $2.5 million in 2005.

     Subsequent to December 31, 2004, SHRP, Ltd. borrowed $4.5 million from MAXXAM Parent to fund its 2005 capital expenditures and improve its working capital position. SHRP, Ltd.’s management expects that SHRP, Ltd. will require additional advances from MAXXAM Parent to fund its operations and capital expenditures in the future. SHRP, Ltd. is experiencing strong competition from internet wagering and “racinos” in surrounding states. These factors will also play a role in SHRP, Ltd.’s long-term liquidity.

Kaiser’s Operations

     As a result of the filing of the Cases, claims against the Debtors for principal and accrued interest on secured and unsecured indebtedness existing on the Filing Date are stayed while the Debtors continue business operations as debtors-in-possession, subject to the control and supervision of the Court. At this time, it is not possible to predict the effect of the Cases on the businesses of the Debtors. With respect to the Company’s interest in Kaiser, the Debtors have indicated that the equity of Kaiser’s stockholders will likely be cancelled without consideration. See Note 11 for further information.

Off-Balance Sheet Arrangements

     The Company does not have any off-balance sheet financing, other than operating leases entered into in the normal course of business and disclosed below, or unconsolidated special purpose entities. The Company does not use derivatives for any of its treasury or risk management activities.

41

Contractual Obligations

     The following table presents information with respect to the Company’s contractual obligations as of December 31, 2004 (in millions).

Trends

     Real Estate Operations

     PDMPI is considering various alternatives to accelerate sales of its remaining 1,130 acres of undeveloped land as well as disposition of other assets. In connection with this, PDMPI has retained and is in the process of working with an agent to assist in its efforts to solicit developer and investor interest in acquiring such acreage and other assets. No assurance can be given that these efforts will be successful.

     Racing Operations

     The Texas legislature convenes its regular session every other year. It is expected that this body will, during its January to June 2005 regular session, consider measures to enhance state revenues through additional forms of gaming such as video lottery terminals at existing horse and dog racing tracks, gaming on Indian reservations, and full casinos. The Company will vigorously pursue any such legislation that is favorable to it. As any legislation expanding gaming in Texas would likely require the approval of two-thirds of each legislative house and a majority of the state’s voters, no assurance can be given that any such legislation will be enacted or become effective. Moreover, it is not possible to determine what the provisions of any such legislation will be or its effect on the Company.

     Critical Accounting Policies and Estimates

     This section contains statements which constitute “forward-looking statements” within the meaning of the PSLRA. See Item 1. “Business—General” and below for cautionary information with respect to such forward-looking statements.

     The discussion and analysis of the Company’s financial condition and results of operations is based upon the Company’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these consolidated financial statements requires

42

the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures of contingent assets and liabilities. Estimates are based on historical experience and on various other assumptions that are believed to be reasonable under the circumstances. The result of this process forms the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. The Company re-evaluates its estimates and judgments on a regular, ongoing basis. Actual results may differ from these estimates due to changed circumstances and conditions.

     The following accounting policies and estimates are considered critical in light of the potentially material impact that the estimates, judgments and uncertainties affecting the application of these policies might have on the Company’s reported financial information.

     Principles of Consolidation–Deconsolidation of Kaiser

     Under generally accepted accounting principles for entities consolidated through voting interests, consolidation is generally required for investments of more than 50% of the outstanding voting stock of an investee, except when control is not held by the majority owner. Under these principles, legal reorganization or bankruptcy represent conditions which can preclude consolidation in instances where control rests with the bankruptcy court, rather than the majority owner. As discussed under “—Results of Operations—Consolidated Operations—Deconsolidation of Kaiser,” on February 12, 2002, Kaiser and certain of its subsidiaries filed for reorganization under Chapter 11 of the Bankruptcy Code. As a result, the Company deconsolidated Kaiser’s financial results beginning February 12, 2002, and began reporting its investment in Kaiser using the cost method.

     Through February 11, 2002, under generally accepted principles of consolidation, the Company had recognized losses in excess of its investment in Kaiser of $516.2 million. Since Kaiser’s results are no longer consolidated and the Company believes that it is not probable that it will be obligated to fund losses related to its investment in Kaiser, any adjustments reflected in Kaiser’s financial statements subsequent to February 12, 2002 (relating to the recoverability and classification of recorded asset amounts and classification of liabilities or the effects on existing stockholders’ deficit, as well as adjustments made to Kaiser’s financial information for loss contingencies and other matters), are not expected to affect the Company’s financial results.

     The Company expects to consider reversal of these losses when either: (1) Kaiser’s bankruptcy is resolved and the amount of the Company’s remaining investment in Kaiser is determined or (2) the Company disposes of the Kaiser Shares. Accordingly, these consolidated financial statements do not reflect any adjustments related to the deconsolidation of Kaiser other than presenting the Company’s investment in Kaiser using the cost method, which reflects the investment as a single amount on its balance sheet, and discontinuing the recording of earnings or losses from Kaiser after February 11, 2002. When either of the events described above occurs, the Company will re-evaluate the appropriate accounting treatment of its investment in Kaiser based upon the facts and circumstances at such time. The Debtors have indicated that the equity of Kaiser’s stockholders, including the Company, will likely be cancelled without consideration as a result of Kaiser’s plan of reorganization.

     Loss Contingencies

     The Company is involved in various claims, lawsuits, environmental matters and other proceedings discussed in Note 12. Such matters involve uncertainty as to possible losses the Company may ultimately realize when one or more future events occur or fail to occur. The Company accrues and charges to income estimated losses from contingencies when it is probable (at the balance sheet date) that an asset has been impaired or liability incurred and the amount of loss can be reasonably estimated. Differences between estimates recorded and actual amounts determined in subsequent periods are treated as changes in accounting estimates (i.e., they are reflected in the financial statements in the period in which they are determined to be losses, with no retroactive restatement).

     The Company estimates the probability of losses on legal contingencies based on the advice of internal and external counsel, the outcomes from similar litigation, the status of the lawsuits (including settlement initiatives), legislative and regulatory developments, and other factors. For larger environmental matters, the Company estimates the losses using estimates prepared by third party experts and the advice of internal and external counsel. Risks and uncertainties are inherent with respect to the ultimate outcome of litigation and environmental contingencies. See Notes 3 and 12 for further discussion of the Company’s material legal and environmental contingencies.

43

     Income Taxes

     The Company accrues and charges to income estimated taxes when it is probable (at the balance sheet date) that a liability has been incurred and the amount of the liability can be reasonably estimated, including situations in which the Company has and has not received tax assessments from the relevant taxing authority. Taxes are provided in those instances where the Company considers it probable that additional tax may be due in excess of amounts reflected in our tax returns as filed. The Company believes amounts currently provided for any such potential assessments will not be settled within the next twelve months and settlement of such amounts would not have a significant impact on the Company’s consolidated financial position, results of operations and/or liquidity. See Note 9 for further discussion of the Company’s income taxes.

     Deferred Tax Asset Valuation Allowances

     As of December 31, 2004, the Company had $76.8 million of deferred tax assets (net of $78.3 million in valuation allowances) and $70.8 million of deferred tax liabilities. The deferred tax assets and liabilities reported in the Company’s balance sheet reflect the amount of taxes that the Company has prepaid or for which it will receive a tax benefit (an asset) or will have to pay in the future (a liability) because of temporary differences that result from differences in timing of revenue recognition or expense deductibility between generally accepted accounting principles and the Internal Revenue Code. Accounting rules require that a deferred tax asset be reduced by a valuation allowance if, based on the weight of available evidence, it is more likely than not (a likelihood of more than 50%) that all or some portion of the deferred tax asset will not be realized. The Company considers all available evidence, both positive and negative, to determine whether a valuation allowance is needed. The need for a valuation allowance ultimately depends on the existence of sufficient taxable income to realize the benefit of a future deductible amount.

     Assessing the need for and amount of a valuation allowance for deferred tax assets requires significant judgment. The fact that a benefit may be expected for a portion but not all of a deferred tax asset increases the judgmental complexity of the determination. Projections of future taxable income, by their very nature, require estimates and judgments about future events that, although they might conceivably be predictable, are far less certain than events that have already occurred and can be objectively measured.

     Uncertainties that might exist with respect to the realization of the Company’s deferred tax assets relate to future taxable income. See Note 9 for further discussion of the Company’s valuation allowances on deferred tax assets.

     Pension and Other Postretirement Benefit Plan Obligations and Expenses

     Estimating future benefit payments for purposes of measuring pension benefit obligations requires the Company to make a number of assumptions about future experience. These assumptions are combined with the terms of the Company’s plans to produce an estimate of required future benefit payments, which is discounted to reflect the time value of money. As a result, assumptions about the covered population (demographic assumptions) and about the economic environment (economic assumptions) significantly affect pension and other postretirement benefit obligations. The most significant demographic assumptions are expected retirement age, life expectancy, and turnover, while the key economic assumptions are the discount rate, the salary growth rate, and the expected return on plan assets.

     The projected benefit obligation for the Company’s pension plans and the accumulated postretirement benefit obligation for the Company’s other postretirement benefit plans was determined using a discount rate of 5.875% at December 31, 2004, and 6.25% at December 31, 2003. The assumed weighted average long-term rate of compensation increase is 4.11%. The assumed weighted average long-term rate of return on plan assets is 8.5%. Plan assets consist principally of common stocks and U.S. government and other fixed-income obligations.

     The estimated impact of a 25 basis point decrease in the discount rate (from 5.875% to 5.625%) would increase the Company’s aggregate pension obligation by approximately $5.8 million, while the estimated impact of a 25 basis point increase in the discount rate (from 5.875% to 6.125%) would decrease the Company’s aggregate pension obligation by approximately $5.6 million.

     Generally accepted accounting principles are applied to determine the expense that the Company recognizes related to pension obligations, while pension plan funding is governed by tax and labor laws. The Company expects pension expense to be approximately $4.5 million in 2005, while cash contributions are expected to range from $2.2 million to $2.4 million in 2005. This compared to pension expense of $3.2 million and cash contributions of $1.0 million in 2004.

     At December 31, 2004, the Company had $30.6 million in accrued liabilities related to pension benefits. This amount consists of an accrued liability of $17.4 million reflecting the cumulative excess of the amount the Company has

44

expensed over the amount the Company has funded since inception of its plans, as well as an additional minimum liability of $13.2 million reflecting the excess of the accumulated benefit obligation over the fair value of plan assets.

     See Note 10 for further discussion of the Company’s obligations related to pension and other postretirement benefit plans.

     Impairment of Noncurrent Assets

     The Company reviews noncurrent assets for impairment when circumstances indicate that the carrying amount of such assets may not be recoverable. Impairment is indicated if the total undiscounted future cash flows expected to result from use of the assets, including the possible residual value associated with their eventual disposition, are less than the carrying amount of the assets. Assets are written down to fair value and a loss is recognized upon impairment. Fair value increases on assets previously written down for impairment losses are not recognized.

     Considerable judgment is exercised in the Company’s assessment of the need for an impairment write-down. Indicators of impairment must be present. The estimates of future cash flows, based on reasonable and supportable assumptions and projections, require management’s subjective judgments. In some instances, situations might exist where impairments are the result of changes in economic conditions or other factors that develop over time, which increases the subjectivity of assumptions made. Depending on the assumptions and estimates used, the estimated future cash flows projected in the evaluation of long-lived assets can vary within a wide range of outcomes. A probability-weighted approach is used for situations in which alternative courses of action to recover the carrying amount of long-lived assets are under consideration or a range is estimated for the amount of possible future cash flows.

New Accounting Standards

     See Note 2 for a discussion of new accounting pronouncements and their potential impact on the Company.

ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

     The Company is exposed to changes in interest rates primarily under the Scotia LLC Line of Credit and the Palco Credit Agreement, as well as certain other debt facilities used to finance real estate development activities. These facilities bear interest at either the prime interest rate or LIBOR plus a specified percentage point spread. The Scotia LLC Line of Credit was established in conjunction with the offering of the Timber Notes. The Company’s objective in maintaining its other variable rate borrowings is flexibility in borrowing funds and making repayments without penalties. As of December 31, 2004, there were $32.2 million in borrowings outstanding under all variable rate facilities. Based on the amount of borrowings outstanding under these facilities during 2004, a 1% change in interest rates effective from the beginning of the year would have resulted in an increase or decrease in annual interest expense of $0.4 million.

     All of the Company’s other debt is fixed-rate, and therefore, does not expose the Company to the risk of higher interest payments due to changes in market interest rates. The Company does not utilize interest rate swaps or similar hedging arrangements.

45

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
MAXXAM Inc.
Houston, Texas

We have audited the accompanying consolidated balance sheets of MAXXAM Inc. and subsidiaries (the “Company”) as of December 31, 2004 and 2003, and the related consolidated statements of operations, cash flows, and stockholders’ deficit for each of the three years in the period ended December 31, 2004. Our audits also included the financial statement schedules listed in the Index at Item 15(a)(2). These financial statements and financial statement schedules are the responsibility of the Company’s management. Our responsibility is to express an opinion on the financial statements and financial statement schedules based on our audits. We did not audit the financial statements of Sam Houston Race Park, Ltd. (a subsidiary), which statements reflect total revenue constituting 14.5 percent, 14.8 percent, and 11.2 percent of consolidated total revenues for the years ended December 31, 2004, 2003, and 2002, respectively. Such financial statements were audited by other auditors whose report has been furnished to us, and our opinion, insofar as it relates to the amounts included for Sam Houston Race Park, Ltd., is based solely on the report of such other auditors.

We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the report of other auditors provide a reasonable basis for our opinion.

In our opinion, based on our audits and the report of other auditors, such consolidated financial statements present fairly, in all material respects, the financial position of MAXXAM Inc. and subsidiaries as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, based on our audits and (as to the amounts included for Sam Houston Race Park, Ltd.) the report of other auditors, such financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly in all material respects the information set forth therein.

The accompanying consolidated financial statements have been prepared assuming that MAXXAM Inc., and its subsidiaries will continue as going concerns. As discussed in Note 1 to the consolidated financial statements, at December 31, 2004, the cash flows of MAXXAM Inc.’s wholly owned subsidiary, The Pacific Lumber Company (“Palco”) and Palco’s wholly owned subsidiary, Scotia Pacific Company LLC (“Scotia LLC”) have been adversely affected by delays in obtaining regulatory approvals to harvest timber. Palco was in default under an asset-based credit agreement with a bank. Scotia LLC has estimated that without additional approvals, Scotia LLC will be unable to pay the entire amount of interest due in July, 2005 on its timber notes. Such failure to pay interest would constitute an event of default under the indenture governing the timber notes. The difficulties of these subsidiaries in meeting their loan agreement covenants and paying the interest on the timber notes raise substantial doubts about Palco’s and Scotia LLC’s ability to continue as going concerns. Further, the difficulties of these subsidiaries raise substantial doubt about the ability of MAXXAM Inc. and subsidiaries to realize their timber related assets and discharge their timber related liabilities in the normal course of business and to continue as a going concern. The consolidated financial statements do not include any adjustments that might result from the outcome of these uncertainties.

We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 14, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.

DELOITTE & TOUCHE LLP

Houston, Texas
March 14, 2005

46

MAXXAM INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEET
(In millions of dollars, except share information)

The accompanying notes are an integral part of these financial statements.

47

MAXXAM INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF OPERATIONS
(In millions of dollars, except per share information)