** **

**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

**FORM 10-Q**

**(Mark One)**

| **x**      |       | **Quarterly Report pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934**                                 |
|------------|------------|------------------------------------------------------------------------------------------------------------------------------|
| ** ** |       | ** **                                                                                                                   |
| ** ** | ** ** | **For the quarterly period ended September 30,  2006**                                                                  |
|       |       |                                                                                                                         |
| ** ** | ** ** | **or**                                                                                                                       |
|       |       |                                                                                                                         |
| **o**      |       | **Transition report pursuant to Section 13 or  15(d) of the Securities Exchange Act of 1934**                                |
| ** ** |       | ** **                                                                                                                   |
| ** ** | ** ** | **For the transition period from         to         ** |

 

**Commission File Number 0-8176**

| **** | **Southwest  Water Company**(Exact name of registrant as specified in its charter) | ** ** |
|------|------------------------------------------------------------------------------------|------------|

 

| **Delaware**                     |   | **95-1840947**          |
|----------------------------------|--------|-------------------------|
| (State or other  jurisdiction of |   | (I.R.S. Employer        |
| incorporation or  organization)  |   | Identification  Number) |

 

**One Wilshire Building****624 South Grand Avenue, Suite 2900****Los Angeles, California 90017-3782**(Address of principal executive offices,including zip code)

**(213)929-1800**(Registrant’s telephone, including areacode)

**None**(Former name, former address and formerfiscal year, if changed since last report)

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes **x**   No **o**

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated filer,or a non-accelerated filer.  (Check one):

Large accelerated filer  **o                                        **Acceleratedfiler  **x**                                          Non-Acceleratedfiler  **o**

Indicate by checkmark whether the registrant is a shell company (as defined in Rule 12b-2 of theAct).  Yes **o**   No **x**

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.

| Class                                   | ** ** | **Outstanding as of November 3, 2006** | ** ** |
|-----------------------------------------|------------|-----------------------------------------------------------------|------------|
| Common Stock,  $.01 par value per share |       | 23,592,695  shares                                              |       |

 

 

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**TABLE OF CONTENTs**
|                | ** ** | ** **                                                                                                                  | ** ** | ** ** |
|----------------|------------|-----------------------------------------------------------------------------------------------------------------------------|------------|------------|
| **Part I**     | ** ** | **Financial Information**                                                                                                   | ** ** | ** ** |
| Item 1.        |       | Financial Statements  (Unaudited)                                                                                           |       |       |
|           |       | Report of Independent Registered Public Accounting  Firm                                                                    |       |       |
|           |       | Condensed Consolidated Balance Sheets as of  September 30, 2006 and December 31, 2005                                  |       |       |
|           |       | Condensed Consolidated Statements of Income for the  three months and nine months ended September 30, 2006 and 2005    |       |       |
|           |       | Condensed Consolidated Statement of Changes in  Stockholders’ Equity for the nine months ended September 30, 2006 |       |       |
|           |       | Condensed Consolidated Statements of Cash Flows for  the nine months ended September 30, 2006 and 2005                 |       |       |
|           |       | Condensed Notes to Consolidated Financial Statements                                                                        |       |       |
| Item 2.        |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                 |       |       |
| Item 3.        |       | Quantitative  and Qualitative Disclosures About Market Risk                                                                 |       |       |
| Item 4.        |       | Controls and  Procedures                                                                                                    |       |       |
| **Part II**    | ** ** | **Other Information**                                                                                                       | ** ** | ** ** |
| Item 1.        |       | Legal Proceedings                                                                                                           |       |       |
| Item 6.        |       | Exhibits                                                                                                                    |       |       |
| **Signatures** | ** ** | ** **                                                                                                                  |

 

i

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**PART I — FINANCIALINFORMATION**

**ITEM 1.**                 FINANCIALSTATEMENTS

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

The Board of Directorsand StockholdersSouthwest Water Company:

We have reviewedthe accompanying condensed consolidated balance sheet of Southwest WaterCompany and subsidiaries (“the Company”) as of September 30, 2006, therelated condensed consolidated statements of income for the three-month andnine month periods ended September 30, 2006 and 2005, the relatedcondensed consolidated statement of changes in stockholders’ equity for thenine-month period ended September 30, 2006, and the related condensedconsolidated statements of cash flows for the nine-month periods endedSeptember 30, 2006 and 2005.  Thesecondensed consolidated financial statements are the responsibility of theCompany’s management.

We conducted ourreviews in accordance with the standards of the Public Company AccountingOversight Board (United States).  Areview of interim financial information consists principally of applyinganalytical procedures and making inquiries of persons responsible for financialand accounting matters.  It issubstantially less in scope than an audit conducted in accordance with thestandards of the Public Company Accounting Oversight Board (United States), theobjective of which is the expression of an opinion regarding the financialstatements taken as a whole. Accordingly, we do not express such an opinion.

Based on ourreviews, we are not aware of any material modifications that should be made tothe condensed consolidated financial statements referred to above for them tobe in conformity with U.S. generally accepted accounting principles.

We have previouslyaudited, in accordance with standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheet of the Companyas of December 31, 2005, and the related consolidated statements of income,changes in stockholders’ equity, and cash flows for the year then ended (notpresented herein); and in our report dated March 13, 2006, we expressed anunqualified opinion on those consolidated financial statements.  In our opinion, the information set forth inthe accompanying condensed consolidated balance sheet as of December 31, 2005,is fairly stated, in all material respects, in relation to the consolidatedbalance sheet from which it has been derived.

/s/  KPMG LLP

Los Angeles, CaliforniaNovember 9, 2006

1

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**SOUTHWEST WATERCOMPANY AND SUBSIDIARIESCondensed Consolidated Balance Sheets(Unaudited)**
| ** **                                     | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(In thousands)**                        | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| **ASSETS**                                     |       |                   |       |                  |       |
| Current Assets:                                |       |                   |       |                  |       |
| Cash and cash equivalents                      |       | $                      | 3,226      |                  | $          | 2,764 |   |
| Restricted cash                                |       | 238                    |       | 241                   |       |
| Accounts receivable, net                       |       | 30,649                 |       | 26,517                |       |
| Other current assets                           |       | 12,502                 |       | 18,224                |       |
| Total current assets                           |       | 46,615                 |       | 47,746                |       |
| Property, Plant  and Equipment, Net:           |       |                   |       |                  |       |
| Regulated utilities                            |       | 360,083                |       | 333,027               |       |
| Non-regulated operations                       |       | 11,674                 |       | 11,794                |       |
| Total property, plant and equipment, net       |       | 371,757                |       | 344,821               |       |
| Other Assets:                                  |       |                   |       |                  |       |
| Goodwill                                       |       | 33,262                 |       | 32,977                |       |
| Intangible assets                              |       | 2,978                  |       | 2,965                 |       |
| Other assets                                   |       | 17,534                 |       | 16,216                |       |
|                                           |       | $                      | 472,146    |                  | $          | 444,725 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY** |       |                   |       |                  |       |
| Current  Liabilities:                          |       |                   |       |                  |       |
| Current portion of long-term debt              |       | $                      | 1,318      |                  | $          | 9,492 |   |
| Accounts payable                               |       | 8,768                  |       | 10,018                |       |
| Other current liabilities                      |       | 24,363                 |       | 21,069                |       |
| Total current liabilities                      |       | 34,449                 |       | 40,579                |       |
| Other  Liabilities and Deferred Credits:       |       |                   |       |                  |       |
| Long-term debt                                 |       | 127,546                |       | 117,603               |       |
| Deferred income taxes                          |       | 22,023                 |       | 22,609                |       |
| Advances for construction                      |       | 8,024                  |       | 8,478                 |       |
| Contributions in aid of construction           |       | 103,552                |       | 94,660                |       |
| Other liabilities and deferred credits         |       | 16,682                 |       | 15,543                |       |
| Commitments and Contingencies                  |       |                   |       |                  |       |
| Stockholders’ Equity:                     |       |                   |       |                  |       |
| Preferred stock                                |       | 461                    |       | 461                   |       |
| Common stock                                   |       | 234                    |       | 222                   |       |
| Additional paid-in capital                     |       | 134,335                |       | 122,368               |       |
| Retained earnings                              |       | 24,840                 |       | 22,202                |       |
| Total stockholders’ equity                |       | 159,870                |       | 145,253               |       |
|                                           |       | $                      | 472,146    |                  | $          | 444,725 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

2

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**SOUTHWEST WATERCOMPANY AND SUBSIDIARIESCondensed Consolidated Statements of Income(Unaudited)**

 
| ** **                                                       | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|------------------------------------------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------------------|------------|
| **(In thousands, except share data)**        | ** ** | **2006**                                             | ** ** | **2005**                                            | ** ** | **2006** | ** ** | **2005** | ** ** |
| Revenues:                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Utility Group                                                    |       | $                                                    | 25,839     |                                                | $          | 23,300 |   | $ | 64,602 |   | $ | 59,054 |   |
| Services Group                                                   |       | 34,302                                               |       | 31,368                                              |       | 101,701 |   | 92,127 |   |
| Total revenues                                                   |       | 60,141                                               |       | 54,668                                              |       | 166,303 |   | 151,181 |   |
| Expenses:                                                        |       |                                                 |       |                                                |       |   |   |   |   |
| Utility Group operating expenses                                 |       | 14,539                                               |       | 12,835                                              |       | 35,442 |   | 33,492 |   |
| Services Group operating expense                                 |       | 29,801                                               |       | 28,038                                              |       | 88,822 |   | 80,611 |   |
| Selling, general and administrative                              |       | 7,783                                                |       | 7,665                                               |       | 25,376 |   | 22,974 |   |
| Impairment of goodwill                                           |       | 261                                                  |       | —                                              |       | 929 |   | — |   |
| Total expenses                                                   |       | 52,384                                               |       | 48,538                                              |       | 150,569 |   | 137,077 |   |
| Operating income                                                 |       | 7,757                                                |       | 6,130                                               |       | 15,734 |   | 14,104 |   |
| Other income (expense):                                          |       |                                                 |       |                                                |       |   |   |   |   |
| Interest expense                                                 |       | (2,081                                               | )          | (1,651                                              | )          | (6,333 | ) | (5,251 | ) |
| Interest income                                                  |       | 108                                                  |       | 119                                                 |       | 363 |   | 332 |   |
| Other, net                                                       |       | 11                                                   |       | 27                                                  |       | — |   | 19 |   |
| Income from  continuing operations before income taxes           |       | 5,795                                                |       | 4,625                                               |       | 9,764 |   | 9,204 |   |
| Provision for  income taxes                                      |       | (2,123                                               | )          | (1,619                                              | )          | (3,575 | ) | (3,280 | ) |
| Income from  continuing operations                               |       | 3,672                                                |       | 3,006                                               |       | 6,189 |   | 5,924 |   |
| Cumulative  effect of change in accounting principle, net of tax |       | —                                               |       | —                                              |       | 71 |   | — |   |
| Loss from  discontinued operations, net of tax                   |       | —                                               |       | —                                              |       | — |   | (4,902 | ) |
| Net income                                                       |       | 3,672                                                |       | 3,006                                               |       | 6,260 |   | 1,022 |   |
| Preferred stock  dividends                                       |       | (6                                                   | )          | (6                                                  | )          | (18 | ) | (18 | ) |
| Net income  applicable to common stockholders                    |       | $                                                    | 3,666      |                                                | $          | 3,000 |   | $ | 6,242 |   | $ | 1,004 |   |
| Earnings per common share:                                       |       |                                                 |       |                                                |       |   |   |   |   |
| Basic:                                                           |       |                                                 |       |                                                |       |   |   |   |   |
| Income from continuing operations                                |       | $                                                    | 0.16       |                                                | $          | 0.14 |   | $ | 0.27 |   | $ | 0.29 |   |
| Cumulative effect of change in accounting principle              |       | —                                               |       | —                                              |       | 0.01 |   | — |   |
| Loss from discontinued operations                                |       | —                                               |       | —                                              |       | — |   | (0.24 | ) |
| Net income applicable to common stockholders                     |       | $                                                    | 0.16       |                                                | $          | 0.14 |   | $ | 0.28 |   | $ | 0.05 |   |
| Diluted:                                                         |       |                                                 |       |                                                |       |   |   |   |   |
| Income from continuing operations                                |       | $                                                    | 0.16       |                                                | $          | 0.14 |   | $ | 0.27 |   | $ | 0.28 |   |
| Cumulative effect of change in accounting principle              |       | —                                               |       | —                                              |       | — |   | — |   |
| Loss from discontinued operations                                |       | —                                               |       | —                                              |       | — |   | (0.23 | ) |
| Net income applicable to common stockholders                     |       | $                                                    | 0.16       |                                                | $          | 0.14 |   | $ | 0.27 |   | $ | 0.05 |   |
| Weighted average common shares outstanding:                      |       |                                                 |       |                                                |       |   |   |   |   |
| Basic                                                            |       | 23,069                                               |       | 20,874                                              |       | 22,691 |   | 20,582 |   |
| Diluted                                                          |       | 23,422                                               |       | 21,714                                              |       | 23,184 |   | 21,282 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

3

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**SOUTHWEST WATERCOMPANY AND SUBSIDIARIESCondensed Consolidated Statement of Changes in Stockholders’ Equity(Unaudited)**
| ** **                                          | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | **Total**   | ** ** |
|-----------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|-------------|------------|
| ** **                                          | ** ** | **Number of**       | ** ** | ** **            | ** ** | **Number of** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Stockholders’** | ** ** |
| **(In thousands)**                             | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**         | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Equity** | ** ** |
| Balance at December 31, 2005                        |       | 9                        |       | $                     | 461        |               | 22,185     |       | $          | 222         |       | $ | 122,368 |   | $ | 22,202 |   | $ | 145,253 |   |
| Dividend reinvestment and stock purchase plans      |       | —                   |       | —                |       | 254                |       | 2          |       | 3,268       |       | — |   | 3,270 |   |
| Proceeds from stock options exercised               |       | —                   |       | —                |       | 706                |       | 7          |       | 3,806       |       | — |   | 3,813 |   |
| Excess tax benefit from stock options exercised     |       | —                   |       | —                |       | —             |       | —     |       | 1,289       |       | — |   | 1,289 |   |
| Stock-based compensation                            |       | —                   |       | —                |       | —             |       | —     |       | 834         |       | — |   | 834 |   |
| Cumulative effect of change in accounting principle |       | —                   |       | —                |       | —             |       | —     |       | (110        | )          | — |   | (110 | ) |
| Debenture conversions                               |       | —                   |       | —                |       | 275                |       | 3          |       | 2,880       |       | — |   | 2,883 |   |
| Net income                                          |       | —                   |       | —                |       | —             |       | —     |       | —      |       | 6,260 |   | 6,260 |   |
| Cash dividends declared                             |       | —                   |       | —                |       | —             |       | —     |       | —      |       | (3,622 | ) | (3,622 | ) |
| Balance  at September 30, 2006                 |       | 9                        |       | $                     | 461        |               | 23,420     |       | $          | 234         |       | $ | 134,335 |   | $ | 24,840 |   | $ | 159,870 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

4

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**SOUTHWEST WATERCOMPANY AND SUBSIDIARIESCondensed Consolidated Statements of Cash Flows(Unaudited)**
| ** **                                                                         | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                         | ** ** | **September 30,**          | ** ** |
| **(In thousands)**                                                            | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| ** **                                                                         | ** ** | ** **                      | ** ** | **(Revised —  See Note 1**) | ** ** |
| **Cash  flows from operating activities of continuing operations:**                |       |                            |       |   |   |
| Net  income                                                                        |       | $                               | 6,260      |   | $ | 1,022 |   |
| Adjustments  to reconcile net income to net cash provided by operating activities: |       |                            |       |   |   |
| Cumulative  effect of change in accounting principle, net of tax                   |       | (71                             | )          | — |   |
| Loss  from discontinued operations, net of tax                                     |       | —                          |       | 4,902 |   |
| Depreciation  and amortization                                                     |       | 8,115                           |       | 7,548 |   |
| Deferred  income taxes                                                             |       | 1,020                           |       | 1,778 |   |
| Stock-based  compensation expense                                                  |       | 834                             |       | 702 |   |
| Impairment  of goodwill                                                            |       | 929                             |       | — |   |
| Gain  on sales of land                                                             |       | (407                            | )          | — |   |
| Changes  in assets and liabilities, net of effects of acquisitions:                |       |                            |       |   |   |
| Restricted  cash                                                                   |       | 3                               |       | 193 |   |
| Accounts  receivable                                                               |       | (4,114                          | )          | (4,667 | ) |
| Other  current assets                                                              |       | 5,333                           |       | 4,731 |   |
| Other  assets                                                                      |       | (1,701                          | )          | (265 | ) |
| Accounts  payable                                                                  |       | (1,286                          | )          | (2,242 | ) |
| Other  current liabilities                                                         |       | 2,086                           |       | 4,053 |   |
| Other  liabilities                                                                 |       | 826                             |       | 441 |   |
| Other,  net                                                                        |       | 34                              |       | 1,143 |   |
| Net  cash provided by operating activities                                         |       | 17,861                          |       | 19,339 |   |
| **Cash flows from investing activities of continuing operations:**                 |       |                            |       |   |   |
| Additions  to property, plant and equipment                                        |       | (29,699                         | )          | (26,055 | ) |
| Acquisitions  of businesses, net of cash acquired                                  |       | (1,809                          | )          | (10,659 | ) |
| Purchase  of minority interest                                                     |       | (1,013                          | )          | — |   |
| Proceeds  from sale of discontinued operations                                     |       | —                          |       | 9,852 |   |
| Proceeds  from sales of land                                                       |       | 427                             |       | — |   |
| Net  cash used in investing activities                                             |       | (32,094                         | )          | (26,862 | ) |
| **Cash flows from financing activities of continuing operations:**                 |       |                            |       |   |   |
| Proceeds  from issuance of long-term debt                                          |       | —                          |       | 20,000 |   |
| Proceeds  from stock option and stock purchase plans                               |       | 7,083                           |       | 7,579 |   |
| Borrowings  under lines of credit                                                  |       | 6,000                           |       | 3,965 |   |
| Contributions  in aid of construction                                              |       | 2,969                           |       | 2,842 |   |
| Capital  improvement reimbursements                                                |       | 2,630                           |       | 144 |   |
| Excess  tax benefit from stock options exercised                                   |       | 1,289                           |       | — |   |
| Dividends  paid                                                                    |       | (3,622                          | )          | (2,982 | ) |
| Payments  on long-term debt                                                        |       | (1,101                          | )          | (16,395 | ) |
| Repayment  of advances for construction                                            |       | (507                            | )          | (654 | ) |
| Deferred  financing costs                                                          |       | (46                             | )          | (220 | ) |
| Net  cash provided by financing activities                                         |       | 14,695                          |       | 14,279 |   |
| **Cash flows from discontinued operations:**                                       |       |                            |       |   |   |
| Operating  activities                                                              |       | —                          |       | (788 | ) |
| Investing  activities                                                              |       | —                          |       | (73 | ) |
| Financing  activities                                                              |       | —                          |       | (532 | ) |
| Net  cash used in discontinued operations                                          |       | —                          |       | (1,393 | ) |
| Net  increase in cash and cash equivalents                                         |       | 462                             |       | 5,363 |   |
| Cash  and cash equivalents at beginning of year                                    |       | 2,764                           |       | 1,388 |   |
| Cash and cash equivalents  at end of year                                          |       | $                               | 3,226      |   | $ | 6,751 |   |

 

The accompanyingnotes are an integral part of the consolidated financial statements.

5

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**SOUTHWEST WATERCOMPANY AND SUBSIDIARIESCondensed Notes to Consolidated Financial Statements(Unaudited)**

**Note 1. Summary ofSignificant Accounting Policies**

**Basis ofPresentation**

These consolidatedinterim financial statements are unaudited. The Company believes the interim financial statements are presented on abasis consistent with the audited financial statements and include alladjustments necessary for a fair presentation of the financial condition,results of operations and cash flows for such interim periods.  All of these adjustments are normal recurringadjustments.

Preparation of theseconsolidated financial statements in conformity with U.S. generally acceptedaccounting principles (“GAAP”) requires the Company to make estimates andjudgments that affect the reported amounts of assets, liabilities anddisclosure of contingent assets and liabilities at the date of the consolidatedfinancial statements and the reported amounts of revenues and expenses duringthe reporting periods.  Actual results coulddiffer from those estimates.

Certain information anddisclosures normally included in financial statements prepared in accordancewith GAAP have been omitted in accordance with Securities and ExchangeCommission’s rules and regulations for interim financial reporting.  These interim consolidated financialstatements should be read in conjunction with Management’s Discussion andAnalysis of Financial Condition and Results of Operations and the auditedfinancial statements and related notes included in the Company’s 2005 AnnualReport on Form 10-K.  The Company’sbusinesses are seasonal because they are affected by weather.  As a result, operating results for interimperiods do not necessarily predict the operating results for any other interimperiod or for the full year.

**Revised 2005Statement of Cash Flows Presentation**

In 2006, the Company hasseparately disclosed the operating, investing and financing portions of thecash flows attributable to discontinued operations, which in 2005 were reportedwithin the operating cash flow category.

**Balancing Accounts**

In April 2006, theCalifornia Public Utilities Commission (the “CPUC”) issued a decision whicheliminates a required earnings test that had prevented some utilities fromrecovering balancing account under-collections, or receivables, fromcustomers.  Because of the uncertaintiesassociated with under-collections this earnings test had created, the Company’sCalifornia utility had established a practice of not recording balancingaccount under-collections (receivables) but instead recording these costs asexpenses until such time the CPUC actually authorized their recovery.  This decision removes that uncertainty.  In the second quarter of 2006, the Companyrecorded $1.4 million of receivables related to balancing accountunder-collections ($0.7 million attributable to 2005 and $0.7 millionattributable to the first six months of 2006) that are now reasonably assuredof recovery from customers.  During thethird quarter of 2006, an additional $0.6 million of receivables related tobalancing account under-collections were recorded.

**Gain on Sale ofLand**

During the first quarterof 2006, the Company recorded a $0.4 million gain on the sale of land that wasno longer used or useful to its California utility’s operations.  The gain is reflected as a reduction ofUtility Group operating expenses in the consolidated financial statements.

6

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** **

**Change inAccounting Principle**

Effective January 1,2006, the Company adopted the provisions of Statement of Financial AccountingStandards (“SFAS”) No. 123(R), *Share-Based Payment*(“SFAS 123(R)”), using the modified prospective method.  Generally, SFAS 123(R) is similar in approachto SFAS 123, which the Company adopted in 2002, and requires that compensationcost relating to share-based payments be recognized in the financial statementsbased on the fair value of the equity or liability instruments issued.  The adoption of SFAS 123(R) required theCompany to change from recognizing the effect of forfeitures as they occur toestimating the number of outstanding instruments for which the requisiteservice is not expected to be rendered. As a result, the Company recorded a benefit of $0.1 million ($0.07million, net of tax) on January 1, 2006, which is reported as a cumulativeeffect of a change in accounting principle. See Note 9 for additional information.

**Recent AccountingPronouncements**

***FINNo. 48***

In July 2006, theFinancial Accounting Standards Board (“FASB”) issued FASB Interpretation No.48, *Accounting for Uncertainty in Income Taxes, aninterpretation of FASB Statement No. 109* (“FIN 48”).  This interpretation clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes*.  FIN 48 prescribes arecognition threshold and measurement model for tax positions taken or expectedto be taken in tax returns.  FIN 48requires a company to recognize in its financial statements the impact of a taxposition if it is “more-likely-than-not” (more than 50%) the position will besustained upon examination, based on the technical merits of the position.  The interpretation also provides guidance onderecognition, classification, interest and penalties, accounting in interimperiods, disclosure, and transition.  Theprovisions of FIN 48 are effective as of the beginning of the Company’s 2007fiscal year, with the cumulative effect of the change in accounting principle,if any, recorded as an adjustment to opening retained earnings.  The Company does not expect the adoption ofFIN 48 will have a material effect on its consolidated financial statements.

***SFAS No. 157***

In September 2006, theFASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS157”).  This statement establishes asingle authoritative definition of fair value, sets out framework forestablishing fair value, and requires additional disclosures about fair valuemeasurements.  This statement appliesonly to fair value measurements that are already required or permitted by otheraccounting standards and is expected to increase the consistency of thosemeasurements.  Adoption of SFAS 157 isrequired for the Company’s fiscal year beginning January 1, 2008 and is appliedprospectively; the Company does not meet the criteria for earlieradoption.  While the Company is stillevaluating the impact this statement will have on it consolidated financialstatements, it does not currently believe the impact will be material.

***SFAS No. 158***

In September 2006, theFASB also issued SFAS No. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans* (“SFAS 158”).  The new statement amends SFAS No. 87, 88,106, 132(R) and other related accounting literature, but retains most of theirmeasurement and disclosure requirements and will not change the amount of netperiodic benefit cost recognized in the income statement.  SFAS 158 will require employers to recognizeas an asset or liability on their balance sheets the over-funded orunder-funded status of a defined benefit postretirement plan.  SFAS 158 will also require employers tomeasure defined benefit plan assets and obligations as of the dates of theemployers’ fiscal year-end balance sheet. The provisions of SFAS 158 require the Company to: i) initiallyrecognize the funded status of the defined benefit postretirement plan as ofthe end of its fiscal year on December 31, 2006; and ii) measure definedbenefit plan assets and obligations as of the dates of its year-end balancesheets starting December 31, 2008.  TheCompany does not expect the adoption of SFAS 158 will have a material effect onits consolidated financial statements.

7

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** **

***SAB No. 108***

In September 2006, theSecurities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”)No. 108 (Topic 1N), *Considering the Effects ofPrior Year Misstatements when Quantifying Misstatements in Current YearFinancial Statements* (“SAB 108”). SAB 108 addresses how the effects of prior year uncorrectedmisstatements should be considered when quantifying misstatements in thecurrent year financial statements. SAB 108 requires companies to quantify misstatements using both thebalance sheet and income statement approaches and to evaluate whether eitherapproach results in quantifying an error that is material in light of relevantquantitative and qualitative factors. This SAB does not change the SEC staff’s previous guidance in SAB No. 99(Topic 1M), *Materiality*, on evaluating themateriality of misstatements.  Whenapplying the new guidance for the first time, if companies identify materialerrors that were in existence at the beginning of their current fiscal year,they may correct those errors through a one-time cumulative-effect adjustmentto beginning-of-year retained earnings. The Company’s fiscal year ending December 31, 2006 will be the initialyear of applying the new guidance.  TheCompany is still evaluating the effect this new guidance will have on itsconsolidated financial statements.

**Note 2.       Acquisitions and Dispositions**

**Acquisitions**

During 2006, the Companyhas acquired two small water utilities and the rights to provide water andwastewater utility service in developing areas located near Austin, Texas.  The aggregate purchase price for theseacquisitions was $1.5 million in cash; liabilities assumed in connection withthe acquisitions were negligible.  Theassets acquired and liabilities assumed have been recorded at their estimatedfair values based upon preliminary valuations, including $0.3 million ofgoodwill.  The consolidated financialstatements include the operations of the acquired utilities subsequent to theirrespective acquisition dates.  Theacquisitions are not material, either individually or in the aggregate, to theCompany’s consolidated results of operations. During 2006, the Company also recorded $0.3 million of contingentconsideration earned by the sellers of businesses acquired in prior years asadditional goodwill.

On March 21, 2006, the10% minority interest stockholder in Operations Technology, Inc. (“OpTech”), aGeorgia-based non-regulated business in the Company’s Services Group, exercisedits right to require the Company to purchase the remaining 10% of OpTech stockthat it did not already own for $1.0 million in cash (Note 6).  In connection with this acquisition, theCompany has allocated $0.5 million of the purchase price to finite-livedintangible assets and the remaining $0.5 million to goodwill.  The intangible assets, principally customerrelationships and tradenames, are being amortized on a straight-line basis overa weighted-average amortization period of 8.1 years.

The acquisitions werefunded with borrowings under the Company’s revolving line of credit.  The Company expects to finalize the purchaseprice allocations during 2006.

**Dispositionof Master Tek**

During the second quarterof 2005, the Company sold Master Tek International, Inc., a subsidiary in itsServices Group that provided utility submetering and billing and collectionservices for multi-family residential properties.  The Company sold Master Tek for $12.2 millionand received $11.1 million in cash at closing with the remaining $1.1 milliondeposited into an escrow account which was to be released to the Company inApril 2006 at the end of a specified indemnification (under representations andwarranties) period.

8

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** **

On March 29, 2006, theCompany received a $1.65 million claim from the buyer for indemnification byreason of alleged breach of certain specified representations andwarranties.  The Company reached asettlement with the buyer by agreeing to release $0.6 million from the escrowaccount to the buyer with the remaining escrow balance being released to theCompany.  The $0.6 million released fromescrow to the buyer was applied against a liability established at closing forcertain retained liabilities and estimated post-closing obligations that wereexpected to be paid by the Company pursuant to the purchase and saleagreement.  The settlement agreement wasfinalized during the third quarter of 2006 and the remaining $0.5 millionescrow account balance was released to the Company.

As a result of the sale,Master Tek is presented as a discontinued operation in the accompanyingconsolidated financial statements and the results of operations and cash flowsfor 2005 have been reclassified to segregate Master Tek’s results for thatperiod.

The followingtables summarize the results of operations of Master Tek included in theconsolidated financial statements.
| ** **                             | ** ** | **Nine Months**   | ** ** |
|----------------------------------------|------------|------------------------|------------|
| ** **                             | ** ** | **Ended**              | ** ** |
| ** **                             | ** ** | **September 30,** | ** ** |
| **(In thousands)**                | ** ** | **2005**               | ** ** |
| Services Group  revenues               |       | $                      | 3,679      |   |
|                                   |       |                   |       |
| Expenses:                              |       |                   |       |
| Services Group operating expense       |       | 3,947                  |       |
| Selling, general and administrative    |       | 1,330                  |       |
| Total expenses                         |       | 5,277                  |       |
|                                   |       |                   |       |
| Operating loss                         |       | (1,598                 | )          |
|                                   |       |                   |       |
| Interest expense                       |       | (369                   | )          |
| Interest income                        |       | 1                      |       |
|                                   |       |                   |       |
| Loss before  income taxes              |       | (1,966                 | )          |
| Income tax  benefit                    |       | 688                    |       |
|                                   |       |                   |       |
| Loss from  operations                  |       | (1,278                 | )          |
| Loss on sale,  net of $345 tax benefit |       | (3,624                 | )          |
|                                   |       |                   |       |
| Loss from discontinued  operations     |       | $                      | (4,902     | ) |

 

**Note 3.       Accounts Receivable**

The Company’s ServicesGroup provides contract operations and maintenance services to clients inMississippi and Texas, among other states. Hurricanes Katrina and Rita caused significant damage in the Gulf Coastregion of the United States during the third quarter of 2005.  The water and wastewater infrastructures forfive clients in Mississippi were disabled by Hurricane Katrina.  The contracts with these clients provide thatthe Company can incur and bill additional expenses during an emergencysituation to restore water supply and wastewater treatment services tocustomers.  In addition, the clientsrequested our assistance with the removal of debris to enable access foremergency vehicles and residents.

9

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** **

The Company incurred $0.8million of overtime labor costs and emergency out-of-pocket operating expensesin 2005 and $0.1 million in 2006, related to these recovery efforts for theseclients, which are reflected as operating expenses during those periods.  The Company has billed its clients $0.9million for these emergency services and is assisting its clients in requestingreimbursement from the Federal Emergency Management Agency (“FEMA”) pursuant toguidelines established in FEMA’s Applicant Handbook with respect to thesecosts.  The Company recognized revenuesof $0.8 million during 2005 and $0.1 million during the first quarter of 2006based on the revenue recognition criteria set forth in Staff AccountingBulletin No. 104, *Revenue Recognition*.  Through September 30, 2006, the Companyhas collected $0.6 million of the $0.9 million billed to date and the remaining$0.3 million is reflected in accounts receivable as of September 30,2006.  The Company expects to collect theremaining receivables during the fourth quarter of 2006.

**Note 4.       Goodwill**

The table belowsummarizes the changes in the carrying amount of goodwill, by business segment(Note 12), during the nine months ended September 30, 2006.
| ** **                          | ** ** | **Utility** | *** *** | **Services** | *** *** | *** *** | *** *** |
|-------------------------------------|------------|-------------|--------------|--------------|--------------|--------------|--------------|
| **(In thousands)**             | ** ** | **Group**   | ** **   | **Group**    | ** **   | **Total**    | ** **   |
| Balance,  December 31, 2005         |       | $           | 15,609       |         | $            | 17,368       |         | $ | 32,977 |   |
| Businesses acquired during the year |       | 343         |         | —       |         | 343          |         |
| Acquisition of  minority interest   |       | —      |         | 523          |         | 523          |         |
| Contingent  consideration earned    |       | —      |         | 348          |         | 348          |         |
| Impairment of  goodwill             |       | —      |         | (929         | )            | (929         | )            |
| Balance, September 30,  2006        |       | $           | 15,952       |         | $            | 17,310       |         | $ | 33,262 |   |

The Company has acquiredseveral businesses during 2006, all of which were accounted for as purchases(Note 2).  As a result, the assetsacquired and liabilities assumed have been recorded at their estimated fairvalues based on preliminary valuations with the difference between theaggregate purchase price and the fair value of the identifiable net assetsacquired recorded as goodwill.  During2006, the Company also recorded contingent consideration earned by the sellersof businesses acquired as additional goodwill.

The Company testsgoodwill annually for impairment at the reporting unit level, as of October 31st of each year, or when events or circumstancesindicate the carrying values may not be recoverable.  The Company evaluates goodwill for impairmentusing discounted cash flow methodologies, transaction values for comparablecompanies, and other valuation techniques for reporting units with goodwillbalances.  The realizability of theCompany’s long-lived assets, including goodwill, is dependent on expectedfuture cash flows from the underlying operations.

During the second quarterof 2006, management reviewed the business strategy for its water and wastewatertesting laboratory reporting unit.  Thisreview resulted in management’s decision to realign the operations by reducingthe size and scope of its business activities and focusing on its coreoperations and customers.  The carryingvalue of the entity was tested for impairment using the revised cash flowprojections and it was determined that carrying values were not fullyrecoverable.  As a result, $0.5 millionof goodwill associated with the laboratory reporting unit was deemed to beimpaired and was charged to expense in the second quarter of 2006.

During the third quarterof 2006, a significant contract at the testing laboratory was not renewed.  The carrying value of the entity was testedagain for impairment using revised cash flow projections and it was determinedthat carrying values were not recoverable. As a result, the remaining $0.3 million of goodwill associated with thelaboratory reporting unit was deemed to be impaired and was charged to expensein the third quarter of 2006.

Also during the secondquarter of 2006, management determined that the renewal of a primary contractfor another reporting unit was not likely to occur, significantly reducing thefuture estimated cash flows of the reporting unit.  As a result, $0.1 million of goodwillassociated with this reporting unit was deemed to be impaired and was chargedto expense during the period.

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**Note 5.   Long-TermDebt**

Long-term debt consistsof the following as of September 30, 2006 and December 31, 2005:
| ** **                                           | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| **(In thousands)**                              | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| $100 million  revolving credit facility              |       | $                      | 36,000     |                  | $          | 30,000 |   |
| 6.85% convertible subordinated debentures due 2021   |       | 13,081                 |       | 16,108                |       |
| Term Loans:                                          |       |                   |       |                  |       |
| Monarch Utilities, Inc.:                             |       |                   |       |                  |       |
| 7.37% fixed rate term loan due 2022                  |       | 11,999                 |       | 12,577                |       |
| 5.77% fixed rate term loan due 2022                  |       | 824                    |       | 864                   |       |
| 6.10% fixed rate term loan due 2031                  |       | 20,000                 |       | 20,000                |       |
| First Mortgage Bonds:                                |       |                   |       |                  |       |
| Suburban Water Systems:                              |       |                   |       |                  |       |
| 9.09% series B first mortgage bond due 2022          |       | 8,000                  |       | 8,000                 |       |
| 7.61% series C first mortgage bond due 2006          |       | 8,000                  |       | 8,000                 |       |
| 5.64% series D first mortgage bond due 2024          |       | 15,000                 |       | 15,000                |       |
| New Mexico Utilities, Inc.:                          |       |                   |       |                  |       |
| 6.10% series C first mortgage bond due 2024          |       | 12,000                 |       | 12,000                |       |
| Economic Development Revenue Bonds:                  |       |                   |       |                  |       |
| ECO Resources, Inc.:                                 |       |                   |       |                  |       |
| 6.0% series 1998A due 2018                           |       | 1,810                  |       | 1,810                 |       |
| 5.5% series 1998A due 2008                           |       | 320                    |       | 320                   |       |
| Acquisition-related indebtedness                     |       | 912                    |       | 1,395                 |       |
| Total long-term debt payment obligations             |       | 127,946                |       | 126,074               |       |
| Unamortized Monarch term loan fair value adjustments |       | 918                    |       | 1,021                 |       |
| Total long-term debt                                 |       | 128,864                |       | 127,095               |       |
| Less current portion of long-term debt               |       | (1,318                 | )          | (9,492                | )          |
| Long-term debt,  less current portion                |       | $                      | 127,546    |                  | $          | 117,603 |   |

The $100 millionrevolving line of credit commitment ends on April 1, 2010, at which time allborrowings must be repaid.  Borrowingsunder the credit facility bear interest, at the Company’s option, based on amargin either: a) over the LIBOR rate; or b) under the prime rate.  The margins vary depending upon the Company’sconsolidated debt to equity ratio. Currently, the applicable margins are 0.875% over the LIBOR rate or0.25% under the prime rate.  Theweighted-average interest rates on all credit facility borrowings outstandingwere 6.24% as of September 30, 2006 and 5.37% as of December 31, 2005.

The Company hadirrevocable standby letters of credit in the amount of $4.1 million issued andoutstanding under its revolving credit facility as of September 30, 2006,reducing available borrowings under the credit facility to $59.9 million as ofthat date.

On October 20, 2006,Suburban sold $10.0 million of Series E first mortgage bonds and used $8.0million of the proceeds to repay its maturing Series C first mortgage bonds andthe remainder of the proceeds for working capital purposes, including thefunding of capital expenditure programs. The Series E bonds bear interest at a fixed 6.295% annual rate, payablesemiannually, and are due in 2026.  The$8.0 million of Series C first mortgage bonds were classified as currentobligations as of December 31, 2005.  Asa result of the successful refinancing of these obligations on a long-termbasis, the obligations have been reclassified to long-term as of September 30,2006.

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**Note 6.   Commitmentsand Contingencies**

**LegalProceedings**

Southwest Water and asubsidiary were named as defendants in several lawsuits alleging variousinjuries as a result of water contamination in the San Gabriel Valley MainBasin.  The California Supreme Courtruled in February 2002 that the plaintiffs could not challenge the adequacy ofthe water quality standards established by California Department of HealthServices.  In August 2004, the caseagainst Southwest Water and its subsidiary was dismissed; however, theplaintiffs appealed the dismissal to the Court of Appeals for the State ofCalifornia, First Appellate District.  Acourt date has not been set and, to date, liability insurance carriers haveabsorbed the costs of defense of the lawsuits. Based upon information available at this time, the Company does notexpect that this action will have a material adverse effect on its consolidatedfinancial position, results of operations or cash flows.

In August 2006, theCompany elected not to renew the employment contract of one of its operatingcompany presidents.  Subsequently, theindividual resigned and filed a complaint seeking, among other things, adeclaration that the individual not be bound by a two-year post-employmentnon-compete agreement.  The Company hasfiled an answer and counterclaim to the complaint.  Subsequent to the individual’s resignation,some key employees from the operating company resigned and began competing withthe Company.  The Company has filedlitigation against the former operating company president and certain of thekey employees.  Based upon informationavailable at this time, the Company does not expect that these legal actionswill have a material adverse effect on its consolidated financial position,results of operations or cash flows.

The Company and its subsidiariesare also involved in other routine legal and administrative proceedingsincident to the normal conduct of business. The Company believes the ultimate disposition of such matters will nothave a material adverse effect on its business, consolidated financialposition, results of operations or cash flows.

**EPAInvestigations**

On May 5, 2005, one ofthe Company’s operating subsidiaries received a subpoena to provide records toa grand jury.  The requested recordsrelate to the operations of the San Simeon wastewater treatment plant inCalifornia for the period January 2002 to present.  The subsidiary has operated this facilitysince September 2004.  The facility wasalso served with search warrants executed by the EPA.  The Company is cooperating fully with theinvestigation.  The Company has providedthe records requested and there have been no further developments since thatdate.

On May 18, 2005, the EPAexecuted a search warrant at the Company’s Texas-based testing laboratory andon July 20, 2006 the laboratory received a subpoena to provide additionalrecords and information to a grand jury. The Company is cooperating fully with the investigation and there havebeen no further developments since that date.

**EminentDomain Proceedings**

The AlbuquerqueBernalillo County Water Authority (the “Water Authority”) and the City of RioRancho, New Mexico gave notice on October 19, 2006 that they intend to condemnNew Mexico Utilities Inc. (“NMUI”), one of the Company’s  wholly-owned regulated utilities, in accordancewith the provisions of the New Mexico Eminent Domain Code.  The Company is exposed to the risk of losingits NMUI water and wastewater system if the eminent domain proceedings succeed.  However, under prevailing law, condemningagencies must pay fair market value for property they take through eminentdomain.  While it is too early to predictthe outcome of this matter, the Company believes that the fair market value ofits NMUI system exceeds its recorded net book value as of September 30, 2006.

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** **

**CommitmentsUnder Long-Term Service Contracts**

In 2002, the Company wasretained to facilitate the engineering and construction of a $23.0 millionreverse osmosis water treatment plant in the city of San Juan Capistrano,California for the Capistrano Valley Water District (“CVWD”).  In 2003, the Company obtained a $3.4 millionstandby letter of credit as collateral to insure its performance during thedesign and construction of the water treatment plant.  Construction was completed during 2005.  Upon final acceptance of the completedproject by the CVWD, the standby letter of credit will be terminated and thefinal $2.3 million of the total contract price, which is included in accountsreceivable as of September 30, 2006, will be released to the Company from theconstruction financing escrow account.

The Company now operatesthe completed plant under a twenty-year operating agreement.  The CVWD service contract contains certainguarantees related to the performance of the Company and a subsidiary,including certain liquidated damages, in the event of failure on the part ofthe Company to perform other than by reason of uncontrollable circumstances asdefined in the service contract.  Also,the Company has made other guarantees to CVWD, including guarantees withrespect to the quality and quantity of the finished water and the productionefficiency of the facility.

As part of the financingfor this project, the CVWD sold insured municipal bonds.  The Company entered into an agreement withthe bond insurer to guarantee the Company’s performance under the servicecontract, subject to certain liability caps to the bond insurer in the event ofa default.  During the twenty-yearoperation of the facility, such liability caps will not exceed an amount equalto $4.0 million plus an amount no greater than the replacement cost of theactual reverse osmosis filtration unit within the facility, estimated to beapproximately $1.5 million.

**MinorityInterest Put and Call Rights**

Prior to March 20, 2006,the Company owned 90% of the outstanding common stock of OperationsTechnologies, Inc. (“OpTech”).  Theminority stockholder had the right to require the Company to purchase theremaining 10% of OpTech for the greater of $1.0 million or a formula-determinedamount based on the profitability of OpTech. The Company had the right to purchase the remaining 10% of OpTechbeginning in August 2006 at the same terms. On March 20, 2006, the minority stockholder elected to exercise its rightand the Company acquired the shares based on the formula determined amountwhich was slightly more than the $1.0 million minimum amount (Note 2).

Prior to December 2005,the Company had an 80% interest in Windermere Utility Company.  The stockholders rights agreement providedthat the Company had the right to acquire the remaining 20% of Windermere atany time for $6.0 million payable in common stock of the Company providedcertain market value thresholds were attained. The minority stockholder of Windermere had the right to require theCompany to purchase the shares beginning in October 2005 on essentially thesame terms, depending on the prevailing market value of the common stock.  In December 2005, the minority stockholderelected to exercise its right and the Company issued 450,644 shares of itscommon stock in exchange for the remaining Windermere shares.

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**Note 7.       Earnings Per Share**

The following table is areconciliation of the numerators (income) and denominators (shares) used inboth the basic and diluted earnings per share calculations.
| ** **                                                            | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                                                            | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(In thousands, except share data)**             | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Numerators—Net income  applicable to common stockholders:        |       |                             |       |                            |       |   |   |   |   |
| Income from  continuing operations                                    |       | $                                | 3,672      |                            | $          | 3,006 |   | $ | 6,189 |   | $ | 5,924 |   |
| Less preferred  stock dividends                                       |       | (6                               | )          | (6                              | )          | (18 | ) | (18 | ) |
| Income from  continuing operations applicable to common stockholders  |       | 3,666                            |       | 3,000                           |       | 6,171 |   | 5,906 |   |
| Cumulative  effect of change in accounting principle                  |       | —                           |       | —                          |       | 71 |   | — |   |
| Loss from  discontinued operations                                    |       | —                           |       | —                          |       | — |   | (4,902 | ) |
| Net income  applicable to common stockholders                         |       | $                                | 3,666      |                            | $          | 3,000 |   | $ | 6,242 |   | $ | 1,004 |   |
| Denominators—Weighted  average common shares outstanding:        |       |                             |       |                            |       |   |   |   |   |
| Basic weighted  average common shares outstanding                     |       | 23,069                           |       | 20,874                          |       | 22,691 |   | 20,582 |   |
| Plus shares  issued on assumed exercise of stock options and warrants |       | 353                              |       | 840                             |       | 493 |   | 700 |   |
| Diluted weighted  average common shares outstanding                   |       | 23,422                           |       | 21,714                          |       | 23,184 |   | 21,282 |   |
| Earnings per  share applicable to common stockholders:                |       |                             |       |                            |       |   |   |   |   |
| Basic:                                                                |       |                             |       |                            |       |   |   |   |   |
| Continuing  operations                                                |       | $                                | 0.16       |                            | $          | 0.14 |   | $ | 0.27 |   | $ | 0.29 |   |
| Cumulative  effect of change in accounting principle                  |       | —                           |       | —                          |       | 0.01 |   | — |   |
| Discontinued  operations                                              |       | —                           |       | —                          |       | — |   | (0.24 | ) |
| Net income  applicable to common stockholders                         |       | $                                | 0.16       |                            | $          | 0.14 | ) | $ | 0.28 |   | $ | 0.05 |   |
| Diluted:                                                              |       |                             |       |                            |       |   |   |   |   |
| Continuing  operations                                                |       | $                                | 0.16       |                            | $          | 0.14 |   | $ | 0.27 |   | $ | 0.28 |   |
| Cumulative  effect of change in accounting principle                  |       | —                           |       | —                          |       | — |   | — |   |
| Discontinued  operations                                              |       | —                           |       | —                          |       | — |   | (0.23 | ) |
| Net income applicable  to common stockholders                         |       | $                                | 0.16       |                            | $          | 0.14 |   | $ | 0.27 |   | $ | 0.05 |   |

The difference betweenbasic and diluted earnings per share is the effect of stock options that, underthe treasury share method, give rise to potentially dilutive commonshares.  As described in Note 5, theCompany has $13.1 million of 6.85% fixed-rate convertible subordinatedebentures outstanding as of September 30, 2006.  The debentures are convertible into commonstock at any time prior to maturity, unless previously redeemed, at aconversion price of $11.018 per share which totals 1.2 million shares as ofSeptember 30, 2006.  At such time asthe assumed conversion of the debentures has a dilutive effect on earnings pershare, the debentures will be included in the calculation of diluted earningsper share after adjusting net income for the after-tax effect of the debentureinterest expense.

Both basic and dilutedearnings per common share and the related weighted average common sharesoutstanding for the three months and nine months ended September 30, 2005have been retroactively adjusted to reflect a 5% stock distribution declared onJanuary 2, 2006.

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**Note 8.   ConsolidatedStatements of Cash Flows**

The following informationsupplements the Company’s consolidated statements of cash flows.
| ** **                                                                                                     | ** ** | **Nine Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                     | ** ** | **September 30,**          | ** ** |
| **(In thousands)**                                                                                        | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Cash paid during  the year for:                                                                                |       |                            |       |   |   |
| Interest                                                                                                       |       | $                               | 6,420      |   | $ | 5,193 |   |
| Income taxes paid (refunded), net                                                                              |       | (1,948                          | )          | (1,345 | ) |
| Components of cash paid for acquisitions:                                                                      |       |                            |       |   |   |
| Fair value of assets acquired                                                                                  |       | $                               | 1,859      |   | $ | 12,336 |   |
| Liabilities assumed                                                                                            |       | (50                             | )          | (1,677 | ) |
| Cash paid for acquisitions                                                                                     |       | $                               | 1,809      |   | $ | 10,659 |   |
| Components of proceeds from sale of discontinued  operations:                                                  |       |                            |       |   |   |
| Fair value of assets sold                                                                                      |       | $                               | —     |   | $ | 12,748 |   |
| Liabilities assumed by buyer                                                                                   |       | —                          |       | (598 | ) |
| Selling price                                                                                                  |       | —                          |       | 12,150 |   |
| Transaction expenses                                                                                           |       | —                          |       | (1,228 | ) |
| Held in escrow and included in other receivables                                                               |       | —                          |       | (1,070 | ) |
| Net cash proceeds from sale of discontinued  operations                                                        |       | $                               | —     |   | $ | 9,852 |   |
| Non-cash investing and financing activities:                                                                   |       |                            |       |   |   |
| Non-cash contributions in aid of construction and  advances for construction conveyed to Company by developers |       | $                               | 5,823      |   | $ | 2,248 |   |
| Debentures  converted into common stock                                                                        |       | 3,027                           |       | 408 |   |

 

**Note 9.       Stock Based Incentive Compensation Plans**

Prior to May 2006, theCompany had three stock-based incentive compensation plans: a Stock OptionPlan, a Director Stock Option Plan, and an Employee Stock Purchase Plan.  At the May 2006 annual meeting ofstockholders, the stockholders approved a new Equity Incentive Plan whichreplaced the previously existing Stock Option Plan and Director Stock Option Plan.  The table below summarizes the number ofshares authorized and available for issuance under the two stock-based plans asof September 30, 2006.
| ** **                    | ** ** | **Number of Shares** | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| **(In thousands)**       | ** ** | **Authorized**                 | ** ** | **Available** | ** ** |
| Equity Incentive  Plan        |       | 5,434                          |       | 1,201 |   |
| Employee Stock  Purchase Plan |       | 1,256                          |       | 898 |   |
| Total                         |       | 6,690                          |       | 2,099 |   |

 

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** **

Effective January 1,2006, the Company adopted the provisions of SFAS No. 123(R), “*Share-Based Payment*” (“SFAS 123(R)”), using the modifiedprospective method.  Generally,SFAS 123(R) is similar in approach to SFAS 123, which the Company adoptedin 2002, and requires that compensation cost relating to share-based paymentsbe recognized in the financial statements based on the fair value of the equityor liability instruments issued.  Becausethe Company has been recognizing compensation cost related to share-basedpayments since its 2002 adoption of SFAS 123, the adoption of SFAS 123(R) didnot have a material effect on the consolidated financial statements.

The adoption of SFAS123(R) required the Company to change from recognizing the effect offorfeitures as they occur to estimating the number of options for which therequisite service is not expected to be rendered and reducing the periodiccompensation cost recorded accordingly. As a result, the Company recorded a benefit of $0.1 million ($0.07million, net of tax) on January 1, 2006, which is reported as the cumulativeeffect of a change in accounting principle, to reflect the amount ofcompensation cost previously recognized related to outstanding options as ofDecember 31, 2005 that are not expected to vest based on an estimate offorfeitures derived from historical data.

The following tableillustrates the pro forma effect if the Company had applied the provisions ofSFAS 123(R) as of January 1, 2005:
| ** **                                              | ** ** | **Period Ended**            | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                              | ** ** | **September 30, 2005** | ** ** |
| ** **                                              | ** ** | **Three**                        | ** ** | **Nine** | ** ** |
| **(In thousands)**                                 | ** ** | **Months**                       | ** ** | **Months** | ** ** |
| Compensation  cost:                                     |       |                             |       |   |   |
| Recorded in 2005 recognizing forfeitures as they  occur |       | $                                | 236        |   | $ | 702 |   |
| Net change                                              |       | 10                               |       | 43 |   |
| Pro forma for  2005 estimating expected forfeitures     |       | $                                | 246        |   | $ | 745 |   |

 
| ** **                                                | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended**  | ** ** |
|-----------------------------------------------------------|------------|----------------------------------|------------|----------------------------------|------------|
| ** **                                                | ** ** | **September 30, 2005** | ** ** | **September 30, 2005** | ** ** |
| **(In thousands, except share data)** | ** ** | **As Reported**             | ** ** | **Pro Forma**               | ** ** | **As Reported** | ** ** | **Pro Forma** | ** ** |
| Income from  continuing operations                        |       | $                                | 3,006      |                             | $          | 2,996 |   | $ | 5,924 |   | $ | 5,881 |   |
| Net income                                                |       | 3,006                            |       | 2,996                            |       | 1,022 |   | 979 |   |
| Net income  applicable to common stockholders             |       | 3,000                            |       | 2,990                            |       | 1,004 |   | 961 |   |
| Basic income per common share: (1)                        |       |                             |       |                             |       |   |   |   |   |
| Income from continuing operations                         |       | 0.14                             |       | 0.14                             |       | 0.29 |   | 0.28 |   |
| Net income applicable to common                           |       | 0.14                             |       | 0.14                             |       | 0.05 |   | 0.05 |   |
| Diluted income per common share: (2)                      |       |                             |       |                             |       |   |   |   |   |
| Income from continuing operations                         |       | 0.14                             |       | 0.14                             |       | 0.28 |   | 0.28 |   |
| Net income  (loss) applicable to common                   |       | 0.14                             |       | 0.14                             |       | 0.05 |   | 0.05 |   |
|                                                           |            |                                  |            |                                  |            |  |  |  |  |  |  |  |  |

----

(1)             Basedon approximately 20.9 million and 20.6 million weighted average common shares outstandingduring the three months and nine months ended September 30, 2005,respectively (Note 7).

(2)             Basedon approximately 21.7 million and 21.3 million weighted average common sharesoutstanding during the three months and nine months ended September 30,2005, respectively (Note 7).

16

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** **

**StockOption Plans**

The fair value of eachoption grant is estimated on the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions used for grantsin 2006 and 2005:
| ** **               | ** ** | **Nine Months Ended** | ** ** |
|--------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **September 30,**          | ** ** |
| ** **               | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Dividend yield           |       | 1.4                             | %          | 1.7 | % |
| Expected  volatility     |       | 33.5                            | %          | 24.3 | % |
| Risk-free  interest rate |       | 4.8                             | %          | 4.1 | % |
| Expected life in years   |       | 4.6                             |       | 5.7 |   |

The weighted averagegrant date fair value of options granted during the three months endedSeptember 30, 2005 was $3.41 (none granted during the same period in2006), and $4.99 and $3.01 per share for the nine months endedSeptember 30, 2006 and 2005, respectively. Compensation expense arising from stock option grants was $0.2 millionand $0.2 million during the three months ended September 30, 2006 and2005, respectively, and $0.8 million and $0.7 million during the nine monthsended September 30, 2006 and 2005, respectively.  As of September 30, 2006, aggregateunrecognized compensation costs, before estimated forfeitures, totals $1.8million and is expected to be recognized over the next five years (2.2 years ona weighted average basis).

The following tablesummarizes all stock option plan activity during the nine months endedSeptember 30, 2006:
| ** **                                                     | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|---------------|------------|
| ** **                                                     | ** ** | **Number** | ** ** | **Average**   | ** ** |
| ** **                                                     | ** ** | **of**     | ** ** | **Exercise**  | ** ** |
| **(In thousands, except exercise prices)** | ** ** | **Shares** | ** ** | **Price**     | ** ** |
| Outstanding at  December 31, 2005                              |       | 2,641      |       | $             | 8.30       |   |
| Granted                                                        |       | 436        |       | 16.24         |       |
| Exercised                                                      |       | (816       | )          | 6.66          |       |
| Forfeited                                                      |       | (281       | )          | 10.86         |       |
| Expired                                                        |       | (5         | )          | 2.38          |       |
| Outstanding at  September 30, 2006                        |       | 1,975      |       | 10.19         |       |
|                                                                |            |            |            |               |            |  |

The total intrinsic valueof options exercised during the three months ended September 30, 2006 and2005 was $3.2 million and $2.6 million, respectively, and $6.0 million and $2.9million for the nine months ended September 30, 2006 and 2005,respectively.

The following tablessummarize information about stock options outstanding and exercisable as ofSeptember 30, 2006.
| ** **                                                              | *** *** | *** ***    | *** *** | **Expected**     | *** *** | *** ***    | *** *** |
|-------------------------------------------------------------------------|--------------|-----------------|--------------|------------------|--------------|-----------------|--------------|
| **(In thousands, except as indicated)**             | ** **   | **Outstanding** | ** **   | **to Vest** | ** **   | **Exercisable** | ** **   |
| Number of shares                                                        |         | 1,975           |         | 1,847            |         | 1,101           |         |
| Weighted average  remaining contractual life in years                   |         | 4.07            |         | 3.97             |         | 2.57            |         |
| Weighted average  exercise price per share                              |         | $               | 10.19        |             | $            | 9.97            |         | $ | 7.67 |   |
| Aggregate intrinsic  value (at closing stock price of $12.23 per share) |         | $               | 5,725        |             | $            | 5,621           |         | $ | 5,034 |   |

 

17

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** **
| ** **                                                         | ** ** | **Outstanding**        | ** ** | **Exercisable** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|-----------------|------------|
| ** **                                                         | ** ** | **Number**             | ** ** | **Weighted-**   | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Outstanding**        | ** ** | **Average**     | ** ** | **Weighted-** | ** ** | **Exercisable** | ** ** | **Weighted-** | ** ** |
| ** **                                                         | ** ** | **as of**         | ** ** | **Remaining**   | ** ** | **Average** | ** ** | **as of** | ** ** | **Average** | ** ** |
| ** **                                                         | ** ** | **September 30,** | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **September 30,** | ** ** | **Exercise** | ** ** |
| **(In thousands, except per share data)** | ** ** | **2006**               | ** ** | **Life**        | ** ** | **Price** | ** ** | **2006** | ** ** | **Price** | ** ** |
| Range of per share  exercise prices:                               |       |                   |       |            |       |   |   |   |   |   |   |
| $  1.69 to $  3.99                             |       | 17                     |       | 0.81 years      |       | $ | 3.34 |   | 16 |   | $ | 3.34 |   |
| $  4.00 to $  7.99                             |       | 603                    |       | 2.65 years      |       | 6.25 |   | 603 |   | 6.25 |   |
| $  8.00 to  $11.99                                       |       | 771                    |       | 3.84 years      |       | 9.68 |   | 458 |   | 9.44 |   |
| $12.00 to $17.75                                                   |       | 584                    |       | 5.92 years      |       | 15.13 |   | 24 |   | 12.79 |   |
| $  1.69 to $17.75                                        |       | 1,975                  |       | 4.07 years      |       | 10.19 |   | 1,101 |   | 7.67 |   |
|                                                                    |            |                        |            |                 |            |  |  |  |  |  |  |  |  |

**EmployeeStock Purchase Plan (“ESPP”)**

The Company has astockholder-approved employee stock purchase plan (“ESPP”) that allows eligibleemployees to purchase 1.3 million shares of common stock through payrolldeductions of up to 10% of their salary, not to exceed $25,000 per year.  The purchase price of the stock is 90% of thelower of the three-day average share price calculated at the beginning and endof each three-month offering period. Under the ESPP, the Company issued 5,895 and 15,048 shares to employeesduring the three months and nine months ended September 30, 2006, respectively.  Compensation expense recognized by theCompany resulting from employee stock purchases pursuant to this plan wasnominal for the three months and nine months ended September 30, 2006 and2005.  As of September 30, 2006, 0.9million shares remain available for future purchases.

**Note 10.     Stock Purchase Plan**

**DividendReinvestment and Direct Stock Purchase Plan (“DRIP / DSPP”)**

The Company has adividend reinvestment and stock purchase plan that gives common stockholdersthe option of receiving their dividends in cash or in common stock at adiscount from prevailing market prices (“DRIP”).  The plan also permits existing stockholdersto purchase additional common stock, up to a maximum of $10,000 per month, at adiscount (“DSPP”); new investors may participate in the plan, subject to a $250minimum initial investment.  The Companymay, at its sole discretion, permit purchases above the $10,000 statedmaximum.  The discounts may range from 0%to 5%, as determined from time to time by the Company.  The DRIP and DSPP discounts offered by theCompany are 3% for the DRIP and 3% for the DSPP as of September 30,2006.  During 2006, the Companyregistered an additional 1,200,000 shares of common stock that were authorizedto be issued under the plan.  As of September 30,2006, there are 3.7 million shares authorized for issuance under the plan ofwhich 1.3 million shares remain available for issuance.

18

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**Note 11. EmployeeRetirement Plan**

The Company has anon-qualified supplemental executive retirement plan (“SERP”) for certain keyexecutive officers for the purpose of providing supplemental income benefits toplan participants or their survivors upon retirement or death.  The following table details the components ofthe net periodic benefit costs:
| ** **                 | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|----------------------------|------------|----------------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **September 30,**           | ** ** | **September 30,**          | ** ** |
| **(In thousands)**    | ** ** | **2006**                         | ** ** | **2005**                        | ** ** | **2006** | ** ** | **2005** | ** ** |
| Service cost               |       | $                                | 16         |                            | $          | 16 |   | $ | 49 |   | $ | 48 |   |
| Interest cost              |       | 19                               |       | 20                              |       | 57 |   | 60 |   |
| Recognized  actuarial loss |       | 13                               |       | 22                              |       | 39 |   | 66 |   |
| Total                      |       | $                                | 48         |                            | $          | 58 |   | $ | 145 |   | $ | 174 |   |

 

**Note 12.     Segment Information**

The Company’s businessesare segmented into two operating groups: the Utility Group and the ServicesGroup.  Each segment is a strategicbusiness unit that offers different services. They are managed separately since each business requires differentoperating and growth strategies.  Theaccounting policies of the segments are described in the summary of significantaccounting policies in Note 1 to the audited financial statements included inthe Company’s 2005 Form 10-K.

The Utility Group ownsand operates public water and wastewater utilities in Alabama, California, NewMexico, Oklahoma and Texas.  State andfederal agencies issue regulations regarding standards of water quality,safety, environmental and other matters which affect these operations.  In the regulated utility subsidiaries, therates that they charge for water and wastewater services are established bystate or local regulatory authorities. The service areas in which the Utility Group operates constitutemonopolies with allowable rates determined by state or local regulatoryagencies.

The Services Groupoperates and manages water and wastewater treatment facilities owned by cities,public agencies, municipal utility districts, private entities andinvestor-owned utilities, including some of the companies in the UtilityGroup.  The Services Group also providesconstruction and construction management services, certified water andwastewater laboratory testing services, and public works services.  The Services Group, while subject to certainenvironmental standards, is not regulated in its pricing, marketing or rates ofreturn.

The following tablepresents information about the operations of each segment for the three monthsand nine months ended September 30, 2006 and 2005.

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** **
| ** **                                                    | ** ** | ** **  | ** ** | ** **         | ** ** | **Total**     | ** ** | **Corporate**      | ** ** | ** **       | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|--------------------|------------|---------------|------------|--------------------|------------|------------------|------------|
| ** **                                                    | ** ** | **Utility** | ** ** | **Services**       | ** ** | **Operating** | ** ** | **and**            | ** ** | **Consolidated** | ** ** |
| **(In thousands)**                                       | ** ** | **Group**   | ** ** | **Group (1)** | ** ** | **Segments**  | ** ** | **Other (2)** | ** ** | **Total**        | ** ** |
| Three months  ended September 30, 2006:                  |       |        |       |               |       |          |       |               |       |             |       |
| Revenues (1)                                                  |       | $           | 25,839     |               | $          | 34,302        |       | $                  | 60,141     |             | $          | — |   | $ | 60,141 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Operating income (loss)                                       |       | $           | 9,513      |               | $          | 922           |       | $                  | 10,435     |             | $          | (2,678 | ) | $ | 7,757 |   |
| Interest expense                                              |       | (1,564      | )          | (464               | )          | (2,028        | )          | (53                | )          | (2,081           | )          |
| Interest income                                               |       | 8           |       | 83                 |       | 91            |       | 17                 |       | 108              |       |
| Other income (expense)                                        |       | (12         | )          | —             |       | (12           | )          | 23                 |       | 11               |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 7,945      |               | $          | 541           |       | $                  | 8,486      |             | $          | (2,691 | ) | $ | 5,795 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Three months  ended September 30, 2005:                  |       |        |       |               |       |          |       |               |       |             |       |
| Revenues (1)                                                  |       | $           | 23,300     |               | $          | 31,368        |       | $                  | 54,668     |             | $          | — |   | $ | 54,668 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Operating income (loss)                                       |       | $           | 8,564      |               | $          | 434           |       | $                  | 8,998      |             | $          | (2,868 | ) | $ | 6,130 |   |
| Interest expense                                              |       | (1,020      | )          | (398               | )          | (1,418        | )          | (233               | )          | (1,651           | )          |
| Interest income                                               |       | 10          |       | 71                 |       | 81            |       | 38                 |       | 119              |       |
| Other income (expense)                                        |       | (30         | )          | 35                 |       | 5             |       | 22                 |       | 27               |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 7,524      |               | $          | 142           |       | $                  | 7,666      |             | $          | (3,041 | ) | $ | 4,625 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Nine months  ended September 30, 2006:                   |       |        |       |               |       |          |       |               |       |             |       |
| Revenues (1)                                                  |       | $           | 64,602     |               | $          | 101,701       |       | $                  | 166,303    |             | $          | — |   | $ | 166,303 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Operating income (loss)                                       |       | $           | 23,290     |               | $          | 2,590         |       | $                  | 25,880     |             | $          | (10,146 | ) | $ | 15,734 |   |
| Interest expense                                              |       | (4,637      | )          | (1,442             | )          | (6,079        | )          | (254               | )          | (6,333           | )          |
| Interest income                                               |       | 37          |       | 247                |       | 284           |       | 79                 |       | 363              |       |
| Other income (expense)                                        |       | (37         | )          | —             |       | (37           | )          | 37                 |       | —           |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 18,653     |               | $          | 1,395         |       | $                  | 20,048     |             | $          | (10,284 | ) | $ | 9,764 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Nine months  ended September 30, 2005:                   |       |        |       |               |       |          |       |               |       |             |       |
| Revenues (1)                                                  |       | $           | 59,054     |               | $          | 92,127        |       | $                  | 151,181    |             | $          | — |   | $ | 151,181 |   |
|                                                          |       |        |       |               |       |          |       |               |       |             |       |
| Operating income (loss)                                       |       | $           | 20,237     |               | $          | 3,311         |       | $                  | 23,548     |             | $          | (9,444 | ) | $ | 14,104 |   |
| Interest expense                                              |       | (3,357      | )          | (1,394             | )          | (4,751        | )          | (500               | )          | (5,251           | )          |
| Interest income                                               |       | 32          |       | 260                |       | 292           |       | 40                 |       | 332              |       |
| Other income (expense)                                        |       | (84         | )          | 93                 |       | 9             |       | 10                 |       | 19               |       |
| Income (loss)  from continuing operations before income taxes |       | $           | 16,828     |               | $          | 2,270         |       | $                  | 19,098     |             | $          | (9,894 | ) | $ | 9,204 |   |

----

(1)             Inaddition to services provided to external customers, some companies in theServices Group provide construction, operations and maintenance services tocompanies in the Utility Group.  Inaccordance with SFAS No. 71, *Accounting for the Effectsof Certain Types of Regulation*, the Company does not eliminate theintersegment profit on sales to affiliated utilities when the sales price isreasonable and it is probable that, through the rate making process, futurerevenue approximately equal to the sales price will result from the regulated affiliate’suse of the services.  Intersegmentrevenues were $9.2 million and $7.9 million for three months endedSeptember 30, 2006 and 2005, respectively, and $26.2 million and $22.4million for nine months ended September 30, 2006 and 2005, respectively.  Intersegment profit was $2.6 million and $2.4million for three months ended September 30, 2006 and 2005, respectively,and $7.9 million and $6.7 million for nine months ended September 30, 2006and 2005, respectively.

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** **

(2)             Consistsof costs that include headquarters expenses and any corporate functionaldepartments whose costs are not allocated to the reportable segments.

The following tablepresents information about identifiable assets by segment as ofSeptember 30, 2006 and December 31, 2005.
| ** **               | ** ** | **September 30,** | ** ** | **December 31,** | ** ** |
|--------------------------|------------|------------------------|------------|-----------------------|------------|
| **(In thousands)**  | ** ** | **2006**               | ** ** | **2005**              | ** ** |
| Utility Group            |       | $                      | 403,210    |                  | $          | 371,714 |   |
| Services Group           |       | 74,641                 |       | 68,546                |       |
| Corporate and  other     |       | 6,079                  |       | 13,321                |       |
| Inter-group  elimination |       | (11,784                | )          | (8,856                | )          |
| Total assets             |       | $                      | 472,146    |                  | $          | 444,725 |   |

Corporate and otherassets reflect corporate headquarters assets, excluding investments in andreceivables from subsidiaries.  Theinter-group elimination reflects the elimination of inter-group receivables asof the period end date.

**Note13.     Subsequent Event**

On October 20, 2006, theCompany’s California utility sold $10.0 million of first mortgage bonds andused $8.0 million of the proceeds to repay maturing first mortgage bonds andthe remainder of the proceeds for working capital purposes, including thefunding of capital expenditure programs (Note 5).

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**ITEM 2.    MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

### **SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS**

Certain statements inManagement’s Discussion and Analysis of Financial Condition and Results ofOperations (the “MD&A”), other than purely historical information,including estimates, projections, statements relating to our business plans,objectives, and expected operating results, and the assumptions upon whichthose statements are based, are “forward-looking statements” within the meaningof the Private Securities Litigation Reform Act of 1995, Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934.  These forward-looking statementsgenerally are identified by the words “believes,” “project,” “expects,” “anticipates,”“estimates,” “intends,” “strategy,” “plan,” “may,” “will,” “would,” “will be,” “willcontinue,” “will likely result,” and similar expressions.  Forward-looking statements are based oncurrent expectations and assumptions that are subject to risks anduncertainties which may cause actual results to differ materially from theforward-looking statements.  We undertakeno obligation to update or revise publicly any forward-looking statements,whether as a result of new information, future events or otherwise.

The following discussionsshould be read in conjunction with the consolidated financial statements andaccompanying notes included in this quarterly report and in our 2005 annualreport on Form 10-K.

### **OVERVIEW**

Southwest Water Companyprovides a broad range of services including water production, treatment anddistribution; wastewater collection and treatment; utility billing andcollection; utility infrastructure construction management; and public worksservices.  We own regulated publicutilities and also serve cities, utility districts and private companies undercontract.  Our subsidiaries are segmentedinto two operating groups: our Utility Group and our Services Group.

We grow our Utility Groupby:

·                  increasing thenumber of customers we serve;

·                  increasing therate customers pay for our services through rate case filings with stateregulatory commissions;

·                  creating newutilities by partnering with the development community in high growth markets;and

·                  acquiringutilities from cities, municipalities and private owners in high growthmarkets.

Our most recentsignificant Utility Group acquisition, which affects the comparability of thehistorical financial condition and results of operations described in theMD&A, is an Alabama-based wastewater collection and treatment system, whichwe operate as Southwest Water Alabama, which we acquired in September2005.  During 2006, we also acquired twosmall water utilities and the rights to provide water and wastewater utilityservice in developing areas located near Austin, Texas.  While these acquisitions are insignificant toour financial results, both individually and in the aggregate, they arestrategically important as they expand our utility ownership in an area that iscurrently experiencing significant population growth.

We grow our ServicesGroup by:

·                  increasing thenumber of clients we have contracts with;

·                  increasingthe customer base for our existing contracts;

·                  providingadditional services to clients to enhance the value of our contracts; and

·                  acquiringstrategically located, well-established service contract businesses in highgrowth markets.

Our most recentsignificant Services Group acquisition, which affects the comparability of thehistorical financial condition and results of operations described in theMD&A, is Novus Utilities; an Alabama based contract operations company,which we acquired in March 2005.

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**Disposition**

In June 2005 we soldMaster Tek International, Inc., our submetering business that providedmulti-family residential utility metering, billing and collection services forresidential properties.  We elected tosell Master Tek because of changes in the submetering market which would have requiredsignificant capital investments in future years.  We believe growth opportunities involving ourcore competencies of operating and managing water and wastewater facilitiesexceed those of the submetering business. The sale of this business, which was part of our Services Group, is notexpected to affect the operations of our remaining businesses in the ServicesGroup or our Utility Group.  As a resultof the sale, the business we sold is reflected as a discontinued operation inour consolidated financial statements and the discussion below is focused oncontinuing operations for all periods.

### **RESULTS OF OPERATIONS**

**ThreeMonths Ended September 30, 2006 Compared to 2005**

**Revenues.**  Revenues increased $5.5 million, or 10.0%, to$60.1 million for the three months ended September 30, 2006 from $54.7million for the same period during the prior year.  By segment, revenues increased as follows:
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|-----------------------------------|------------|------------|------------|
| ** **                                                     | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentage data)** | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)**                    | ** ** | **2006**   | ** ** | **2005** | ** ** |
| Utility Group                                                  |       | $                                | 25,839     |         | $          | 23,300                            |       | $          | 2,539      |   | 43.0 | % | 42.6 | % |
| Services Group                                                 |       | 34,302                           |       | 31,368       |       | 2,934                             |       | 57.0       |       | 57.4 |   |
| Total                                                          |       | $                                | 60,141     |         | $          | 54,668                            |       | $          | 5,473      |   | 100.0 | % | 100.0 | % |

***UtilityGroup.***  Revenuesincreased $2.5 million, or 10.9%, to $25.8 million for the three months endedSeptember 30, 2006, from $23.3 million for the same period during theprior year.  The increase was primarilydue to the following:

·                  a $1.1 millionincrease at our California utility due to higher consumption as a result ofwarmer temperatures in Southern California during the summer months versus theprior year and an increase in rates that went into effect on July 1, 2006;

·                  a $0.8 millionincrease at our New Mexico and Texas utilities primarily resulting from anincrease in the number of connections, a fourth quarter 2005 rate increase atour Texas utilities and, to a lesser extent, increased consumption; and

·                  a $0.6 millionincrease related to our acquisition of a wastewater treatment facility inAlabama at the end of the third quarter of 2005.

***ServicesGroup.***  Revenuesincreased $2.9 million, or 9.4%, to $34.3 million for the three months endedSeptember 30, 2006 from $31.4 million for the same period during the prioryear.  The increase in revenues wasprimarily due to the following:

·                  a $1.7 millionincrease in contract operations, maintenance, public works and construction dueto new contracts and increased demand for services; and

·                  a$1.2 million increase related to growth in the customer base under existingcontracts as a result of increased housing starts.

23

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**Expenses.**  Expenses increased $3.8 million, or 7.9%, to$52.4 million for the three months ended September 30, 2006 from $48.5million for the same period during the prior year as follows:
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                         | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|------------------------------------|------------|------------|------------|
| ** **                                                     | ** ** | **September 30,**           | ** ** | **Increase** | ** ** | **Percent of Revenues*** | ** ** |
| **(In thousands, except percentage data)** | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)**                     | ** ** | **2006**   | ** ** | **2005** | ** ** |
| Utility Group  operating expenses                              |       | $                                | 14,539     |         | $          | 12,835                             |       | $          | 1,704      |   | 56.3 | % | 55.1 | % |
| Services Group  operating expenses                             |       | 29,801                           |       | 28,038       |       | 1,763                              |       | 86.9       |       | 89.4 |   |
| Selling, general  and administrative expenses                  |       | 7,783                            |       | 7,665        |       | 118                                |       | 12.9       |       | 14.0 |   |
| Impairment of  goodwill                                        |       | 261                              |       | —       |       | 261                                |       | 0.4        |       | — |   |
| Total                                                          |       | $                                | 52,384     |         | $          | 48,538                             |       | $          | 3,846      |   | 87.1 |   | 88.8 |   |

----

*                 Utility Group and Services Group operatingexpenses are computed as a percent of their respective revenues.  Selling general and administrative expenses,impairment of goodwill and total expenses are computed as a percent of totalrevenues.

***UtilityGroup Operating Expenses.*** Operating expenses increased $1.7 million, or 13.3%, to $14.5 millionfor the three months ended September 30, 2006, from $12.8 million for thesame period during the prior year.  Theincrease in operating expenses was primarily due to the following:

·                  a $1.0 millionincrease in expenses at our New Mexico and Texas utilities related to higherproduction costs as a result of higher revenues and increased costs forchemicals, lab fees and sludge hauling;

·                  a $0.4 millionincrease related to our acquisition of a wastewater treatment facility inAlabama at the end of the third quarter of 2005; and

·                  a $0.9 millionincrease at our California utility resulting from an increase in otheroperating expenses, including property taxes and depreciation; offset by

·                  a $0.6 milliondecrease resulting from our California utility recording a balancing accountreceivable pursuant to a CPUC decision which eliminated a required earningstest.

Operating expenses were56.3% and 55.1% of related revenues for the three months endedSeptember 30, 2006 and 2005, respectively. This increase was primarily due to higher operating costs at our Texasutilities.

***ServicesGroup Operating Expenses.*** Operating expenses increased $1.8 million, or 6.3%, to $29.8 million forthe three months ended September 30, 2006 from $28.0 million for the sameperiod during the prior year.  Theincrease in operating expenses was due to the following:

·                  a $2.1 millionincrease related to the cost of serving new contracts and growth in existingcontracts, including the impact of rising fuel and fleet related expenses; offsetby

·                  a $0.3 milliondecrease in our testing laboratory’s 2006 operating expenses as a result ofincreased focus on bottom line performance.

Operating expenses as apercentage of the related revenues decreased to 86.9% for the three monthsended September 30, 2006 compared to 89.4% for the same period during theprior year.

***Selling,General and Administrative Expenses.***  Selling, general and administrative expensesincreased $0.1 million, or 1.5%, to $7.8 million for the three months ended September 30,2006 and are comparable to $7.7 million for the same period during the prioryear.

Selling, general andadministrative expenses, as a percent of total revenues, were 12.9% and 14.0%for the three months ended September 30, 2006 and 2005, respectively.

***Impairmentof Goodwill.*** During the three months ended September 30, 2006, a $0.3 million chargewas recorded to reflect the impairment of goodwill in accordance with theimpairment testing provision of SFAS No. 142, *Goodwill andOther Intangible Assets*(“SFAS 142”).  As required by SFAS 142, we test goodwillannually for impairment at the reporting unit level, as of October 31st of each year, or when events or circumstancesindicate the carrying values may not be recoverable.  We evaluate goodwill for impairment usingdiscounted cash flow 

24

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methodologies, transaction values for comparablecompanies, and other valuation techniques for reporting units with goodwillbalances.  The realizability of theCompany’s long-lived assets, including goodwill, is dependent on expectedfuture cash flows from the underlying operations.

During the third quarterof 2006, a significant contract at our water and wastewater testing laboratorywas not renewed.  The carrying value ofthe entity was tested for impairment using the revised cash flow projectionsand it was determined that carrying values were not recoverable.  As a result, $0.3 million of goodwillassociated with the laboratory reporting unit was deemed to be impaired and wascharged to expense in the third quarter of 2006.  See the discussion of goodwill impairmentcharges for the nine months ended September 30, 2006 for additionalinformation.

**Other Income (Expense).**  Other expense increased $0.5 million, or30.4%, to $2.0 million for the three months ended September 30, 2006 from$1.5 million for the same period during the prior year as follows:
| ** **              | *** *** | **Three Months Ended** | *** *** | *** *** | *** *** |
|-------------------------|--------------|----------------------------------|--------------|--------------|--------------|
| ** **              | ** **   | **September 30,**           | ** **   | ** **   | ** **   |
| **(In thousands)** | ** **   | **2006**                         | ** **   | **2005**     | ** **   | **Change** | ** ** |
| Interest expense        |         | $                                | (2,081       | )            | $            | (1,651 | ) | $ | (430 | ) |
| Interest income         |         | 108                              |         | 119          |         | (11 | ) |
| Other                   |         | 11                               |         | 27           |         | (16 | ) |
| Total                   |         | $                                | (1,962       | )            | $            | (1,505 | ) | $ | (457 | ) |

***InterestExpense.***  Interestexpense increased $0.4 million, or 26.0%, for the three months endedSeptember 30, 2006 compared to the same period during the prior year.  The major components of interest expense wereas follows:
| ** **                          | *** *** | **Three Months Ended** | *** *** | *** *** | *** *** |
|-------------------------------------|--------------|----------------------------------|--------------|--------------|--------------|
| ** **                          | ** **   | **September 30,**           | ** **   | **Increase** | ** **   |
| **(In thousands)**             | *** *** | **2006**                         | *** *** | **2005**     | *** *** | **(Decrease)** | *** *** |
| Interest  expense:                  |         |                             |         |         |         |   |   |
| Revolving lines of credit           |         | $                                | 647          |         | $            | 496 |   | $ | 151 |   |
| Mortgage bonds and bank term loans  |         | 1,215                            |         | 906          |         | 309 |   |
| Convertible subordinated debentures |         | 221                              |         | 289          |         | (68 | ) |
| Other indebtedness                  |         | 202                              |         | 387          |         | (185 | ) |
| Total interest incurred             |         | 2,285                            |         | 2,078        |         | 207 |   |
| Less capitalized interest           |         | (204                             | )            | (427         | )            | 223 |   |
| Total interest  expense             |         | $                                | 2,081        |         | $            | 1,651 |   | $ | 430 |   |

 

The increase in total interestincurred is primarily due to an increase in borrowings levels on our mortgagebonds and bank term loans and an increase in interest rates related to ourrevolving line of credit, which was partially offset by lower borrowing levelson the revolving line of credit.  Averageborrowings on the line of credit decreased to $37.9 million for the threemonths ended September 30, 2006 from $40.0 million for the same periodduring the prior year.  The weightedaverage interest rate on those borrowings increased to 6.8% for the threemonths ended September 30, 2006 from 5.0% for the same period during theprior year.  Interest related to ourmortgage bonds and bank term loans increased as a result of a net increase inaverage borrowings between the periods; average borrowings increased to $94.6million for the three months ended September 30, 2006 from $92.6 millionfor the same period during the prior year.

Our average balances ofinterest bearing debt outstanding were approximately $130.4 million and $127.1 millionfor the three months ended September 30, 2006 and 2005, respectively.  Our effective weighted average interest rateincreased to 6.4% for the three months ended September 30, 2006 from 5.2%for the same period during the prior year.

**Provision for Income Taxes.**  Our effective consolidated income tax ratewas 36.6% for the three months ended September 30, 2006 and is comparableto 35.0% for the same period during the prior year.

25

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**Nine Months Ended September 30,2006 Compared to 2005**

**Revenues.**  Revenues increased $15.1 million, or 10.0%,to $166.3 million for the nine months ended September 30, 2006 from $151.2million for the same period during the prior year.  By segment, revenues increased as follows:
| ** **                                                     | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------|------------|--------------|------------|-----------------------------------|------------|------------|------------|
| ** **                                                     | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentage data)** | ** ** | **2006**                        | ** ** | **2005**     | ** ** | **(Decrease)**                    | ** ** | **2006**   | ** ** | **2005** | ** ** |
| Utility Group                                                  |       | $                               | 64,602     |         | $          | 59,054                            |       | $          | 5,548      |   | 38.8 | % | 39.1 | % |
| Services Group                                                 |       | 101,701                         |       | 92,127       |       | 9,574                             |       | 61.2       |       | 60.9 |   |
| Total                                                          |       | $                               | 166,303    |         | $          | 151,181                           |       | $          | 15,122     |   | 100.0 | % | 100.0 | % |

***UtilityGroup.***  Revenuesincreased $5.5 million, or 9.4%, to $64.6 million for the nine months endedSeptember 30, 2006, from $59.1 million for the same period during theprior year.  The increase was primarilydue to the following:

·                  a $2.3 millionincrease at our New Mexico and Texas utilities primarily resulting from anincrease in the number of connections, a fourth quarter 2005 rate increase atour Texas utilities and, to a lesser extent, increased consumption;

·                  a $1.9 millionincrease related to our acquisition of a wastewater treatment facility inAlabama at the end of the third quarter of 2005; and

·                  a $1.3 millionincrease at our California utility related to increased consumption and anincrease in rates that went into effect on July 1st ofthis year.

***ServicesGroup.***  Revenuesincreased $9.6 million, or 10.4%, to $101.7 million for the nine months endedSeptember 30, 2006 from $92.1 million for the same period during the prioryear.  The increase in revenues wasprimarily due to the following:

·                  a $4.7 millionincrease in contract operations, maintenance, public works and construction dueto new contracts;

·                  a $4.2 millionincrease related to growth in the customer base under existing contracts as aresult of increased housing starts; and

·                  a $1.4 millionincrease resulting from the acquisition of an Alabama-based contract operationscompany in March 2005; offset by

·                  a $0.7 milliondecrease in revenues at our testing laboratory operation.

**Expenses.**  Expenses increased $13.5 million, or 9.8%, to$150.6 million for the nine months ended September 30, 2006 from $137.1million for the same period during the prior year as follows:
| ** **                                                     | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** | ** **                               | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|---------------------------------|------------|--------------|------------|------------------------------------------|------------|------------|------------|
| ** **                                                     | ** ** | **September 30,**          | ** ** | **Increase** | ** ** | **Percent of Revenues *** | ** ** |
| **(In thousands, except percentage data)** | ** ** | **2006**                        | ** ** | **2005**     | ** ** | **(Decrease)**                           | ** ** | **2006**   | ** ** | **2005** | ** ** |
| Utility Group  operating expenses                              |       | $                               | 35,442     |         | $          | 33,492                                   |       | $          | 1,950      |   | 54.9 | % | 56.7 | % |
| Services Group  operating expenses                             |       | 88,822                          |       | 80,611       |       | 8,211                                    |       | 87.3       |       | 87.5 |   |
| Selling, general  and administrative expenses                  |       | 25,376                          |       | 22,974       |       | 2,402                                    |       | 15.3       |       | 15.2 |   |
| Impairment of  goodwill                                        |       | 929                             |       | —       |       | 929                                      |       | 0.6        |       | — |   |
| Total                                                          |       | $                               | 150,569    |         | $          | 137,077                                  |       | $          | 13,492     |   | 90.5 |   | 90.7 |   |

----

*                 Utility Group and Services Group operatingexpenses are computed as a percent of their respective revenues.  Selling general and administrative expenses,impairment of goodwill and total expenses are computed as a percent of totalrevenues.

***UtilityGroup Operating Expenses.*** Operating expenses increased $1.9 million, or 5.8%, to $35.4 million forthe nine months ended September 30, 2006, from $33.5 million for the sameperiod during the prior year.  Theincrease in operating expenses was primarily due to the following:

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·                  a $1.6 millionincrease in expenses at our New Mexico and Texas utilities resulting from anincrease in the number of connections we serve which caused higher costsrelated to water productions, chemicals, lab fees and sludge hauling;

·                  a $1.7 millionincrease in operating expenses at our California utility resulting from higherwater production costs; and

·                  a $1.0 millionincrease related to our acquisition of a wastewater treatment facility inAlabama at the end of the third quarter of 2005; offset by

·                  a $2.0 milliondecrease resulting from our California utility recording a balancing accountreceivable pursuant to a CPUC decision which eliminated a required earningstest; and

·                  a $0.4 millionreduction in expenses at our California utility resulting from a gain on thesale of land that was no longer used or useful to its operations.

Operating expenses were54.9% and 56.7% of related revenues for the nine months endedSeptember 30, 2006 and 2005, respectively. Operating expenses as a percent of related revenues for 2006 were 58.6%excluding the effect of the gain on the sale of land and the favorable CPUCdecision.  The adjusted increase isprimarily due to higher operating costs in our California and Texas utilities.

***ServicesGroup Operating Expenses.*** Operating expenses increased $8.2 million, or 10.2%, to $88.8 millionfor the nine months ended September 30, 2006 from $80.6 million for thesame period during the prior year.  Theincrease in operating expenses was due to the following:

·                  a $7.5 millionincrease related to the cost of serving new contracts and the growth inexisting contracts, including the impact of rising fuel and fleet relatedexpenses; and

·                  a $1.1 millionincrease from our acquisition of an Alabama-based contract operations companyin March 2005; offset by

·                  a $0.4 milliondecrease in our testing laboratory’s 2006 operating expenses as a result ofincreased focus on bottom line performance.

Operating expenses as apercentage of the related revenues of 87.3% for the nine months endedSeptember 30, 2006 is comparable to 87.5% for the same period during theprior year.

***Selling,General and Administrative Expenses.***  Selling, general and administrative expensesincreased $2.4 million, or 10.5%, to $25.4 million for the nine months endedSeptember 30, 2006 compared to $23.0 million for the same period duringthe prior year.  The increase in selling,general and administrative expenses was primarily due to the following:

·                  a $1.1 millionincrease in salaries, wages and related benefits resulting from workforceincreases to support our business growth;

·                  a $0.8 millionincrease related to one-time charges for relocation assistance extended to ournew CEO;

·                  a $0.5 millionincrease attributable to acquisitions which occurred in 2005; and

·                  a $0.2 millionincrease in legal fees, most of which is attributable to routine legal andadministrative proceedings incident to the normal conduct of business; offsetby

·                  a $0.2 milliondecrease in Sarbanes-Oxley compliance-related costs.

Selling, general andadministrative expenses, as a percent of total revenues, were 15.3% and 15.2%for the nine months ended September 30, 2006 and 2005, respectively.  Selling, general and administrative expensesas a percent of revenue excluding the one-time CEO relocation assistance costswere 14.5% for the nine months ended September 30, 2006.

***Impairmentof Goodwill.*** During the nine months ended September 30, 2006, charges totaling $0.9million have been recorded to reflect the impairment of goodwill in accordancewith the impairment testing provision of 

27

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SFAS No. 142. As required by SFAS 142, we test goodwill annually for impairment at thereporting unit level, as of October 31st ofeach year, or when events or circumstances indicate the carrying values may notbe recoverable.  We evaluate goodwill forimpairment using discounted cash flow methodologies, transaction values forcomparable companies, and other valuation techniques for reporting units withgoodwill balances.  The realizability ofthe Company’s long-lived assets, including goodwill, is dependent on expectedfuture cash flows from the underlying operations.

During the second quarterof 2006, we reviewed the business strategy for our water and wastewater testinglaboratory reporting unit.  This reviewresulted in our decision to realign the operations by reducing the size andscope of its business activities and focusing on its core operations andcustomers.  This realignment is intendedto create a strong foundation for providing high-quality laboratory testing andreporting services to municipal utility districts and targeted commercialcustomers, enhancing future growth and performance.  The carrying value of the entity was testedfor impairment using the revised cash flow projections and it was determinedthat carrying values were not fully recoverable.  As a result, $0.5 million of goodwillassociated with the laboratory reporting unit was deemed to be impaired and wascharged to expense in the second quarter of 2006.

Additionally, in thesecond quarter we determined that the renewal of a primary contract for anotherreporting unit was not likely to occur, significantly reducing future estimatedcash flows of the reporting unit.  As aresult, $0.1 million of goodwill associated with this reporting unit was deemedto be impaired and was charged to expense during that period.

During the third quarterof 2006, a significant contract at the testing laboratory was not renewed.  The carrying value of the entity was testedagain for impairment using the revised cash flow projections and it wasdetermined that carrying values were not recoverable.  As a result, the remaining $0.3 million ofgoodwill associated with the laboratory reporting unit was deemed to beimpaired and was charged to expense in the third quarter of 2006.

**Other Income (Expense).**  Other expense increased $1.1 million, or21.7%, to $6.0 million for the nine months ended September 30, 2006 from$4.9 million for the same period during the prior year as follows:
| ** **              | *** *** | **Nine Months Ended** | *** *** | *** *** | *** *** |
|-------------------------|--------------|---------------------------------|--------------|--------------|--------------|
| ** **              | ** **   | **September 30,**          | ** **   | ** **   | ** **   |
| **(In thousands)** | ** **   | **2006**                        | ** **   | **2005**     | ** **   | **Change** | ** ** |
| Interest expense        |         | $                               | (6,333       | )            | $            | (5,251 | ) | $ | (1,082 | ) |
| Interest income         |         | 363                             |         | 332          |         | 31 |   |
| Other                   |         | —                          |         | 13           |         | (13 | ) |
| Total                   |         | $                               | (5,970       | )            | $            | (4,906 | ) | $ | (1,064 | ) |

 

***InterestExpense.***  Interestexpense increased $1.1 million, or 20.6%, for the nine months endedSeptember 30, 2006 compared to the same period during the prior year.  The major components of interest expense wereas follows:
| ** **                          | ** ** | **Nine Months Ended** | ** ** | ** **   | ** ** |
|-------------------------------------|------------|---------------------------------|------------|--------------|------------|
| ** **                          | ** ** | **September 30,**          | ** ** | **Increase** | ** ** |
| **(In thousands)**             | ** ** | **2006**                        | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| Interest  expense:                  |       |                            |       |         |       |   |   |
| Revolving lines of credit           |       | $                               | 1,776      |         | $          | 1,372 |   | $ | 404 |   |
| Mortgage bonds and bank term loans  |       | 3,648                           |       | 2,985        |       | 663 |   |
| Convertible subordinated debentures |       | 727                             |       | 880          |       | (153 | ) |
| Other indebtedness                  |       | 609                             |       | 523          |       | 86 |   |
| Total interest incurred             |       | 6,760                           |       | 5,760        |       | 1,000 |   |
| Less capitalized interest           |       | (427                            | )          | (509         | )          | 82 |   |
| Total interest  expense             |       | $                               | 6,333      |         | $          | 5,251 |   | $ | 1,082 |   |

The increase in totalinterest incurred is primarily due to an increase in borrowings levels on ourmortgage bonds and bank term loans and an increase in interest rates related toour revolving line of credit.  Averageborrowings on the line of credit decreased to $36.6 million for the nine monthsended September 30, 2006 from 

28

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$38.8 million for the same period during the prioryear.  The weighted average interest rateon those borrowings increased to 6.5% for the nine months endedSeptember 30, 2006 from 4.7% for the same period during the prioryear.  Interest related to our mortgagebonds and bank term loans increased as a result of a net increase in averageborrowings between the periods; average borrowings increased to $93.1 millionfor the nine months ended September 30, 2006 from $89.6 million for thesame period during the prior year.

Our average balances ofinterest bearing debt outstanding were approximately $130.0 million and $125.7million for the nine months ended September 30, 2006 and 2005,respectively.  Our effective weightedaverage interest rate increased to 6.5% for the nine months endedSeptember 30, 2006 from 5.6% for the same period during the prior year.

**Provision for Income Taxes.**  Our effective consolidated income tax ratewas 36.6% for the nine months ended September 30, 2006 and is comparableto 35.8% for the same period during the prior year (based on combined pre-taxincome and related income taxes for both continuing and discontinuedoperations).

**Cumulative Effect of Change inAccounting Principle.** Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R),*Share-Based Payment* (“SFAS 123(R)”).  The adoption of SFAS 123(R) required usto change from recognizing the effect of forfeitures as they occur toestimating the number of outstanding instruments for which the requisiteservice is not expected to be rendered. As required by SFAS 123(R) we recorded a $0.07 million (net of tax)benefit on January 1, 2006 to reflect the reduction in compensation expensethat would have resulted had we been estimating the effect of forfeitures inprior periods.

**Loss from DiscontinuedOperations.**  Loss fromdiscontinued operations, which pertains to our submetering business we soldduring the second quarter of 2005, was $4.9 million for the nine months endedSeptember 30, 2005.  The loss iscomprised of a $1.3 million operating loss and a $3.6 million loss on the saleof the business.

### **RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS**

**FIN No. 48.**  In July 2006, the Financial AccountingStandards Board (“FASB”) issued FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes, an interpretation of FASBStatement No. 109* (“FIN 48”). This interpretation clarifies the accounting for uncertainty in incometaxes recognized in a company’s financial statements in accordance with SFASNo. 109, *Accounting for Income Taxes*.  FIN 48 prescribes a recognition threshold andmeasurement model for tax positions taken or expected to be taken in taxreturns.  FIN 48 requires a company torecognize in its financial statements the impact of a tax position if it is “more-likely-than-not”(more than 50%) the position will be sustained upon examination, based on thetechnical merits of the position.  Theinterpretation also provides guidance on derecognition, classification,interest and penalties, accounting in interim periods, disclosure, andtransition.  The provisions of FIN 48 areeffective as of the beginning of our 2007 fiscal year, with the cumulativeeffect of the change in accounting principle, if any, recorded as an adjustmentto opening retained earnings.  We do notexpect the adoption of FIN 48 will have a material effect on our consolidatedfinancial statements.

**SFAS No. 157.**  In September 2006, the FASB issued SFAS No.157, *Fair Value Measurements*(“SFAS 157”).  This statement establishes a singleauthoritative definition of fair value, sets out framework for establishingfair value, and requires additional disclosures about fair valuemeasurements.  This statement appliesonly to fair value measurements that are already required or permitted by otheraccounting standards and is expected to increase the consistency of thosemeasurements.  Adoption of SFAS 157 isrequired for our fiscal year beginning January 1, 2008 and is appliedprospectively; we not meet the criteria for earlier adoption.  While we still are evaluating the impact thisstatement will have on our consolidated financial statements, we do notcurrently believe the impact will be material.

**SFAS No. 158.**  In September 2006, the FASB also issued SFASNo. 158, *Employers’ Accounting for Defined Benefit Pensionand Other Postretirement Plans* (“SFAS 158”).  The new statement amends SFAS No. 87, 88,106, 132(R) and other related accounting literature, but retains most of theirmeasurement and disclosure requirements and will not change the amount of netperiodic benefit cost recognized in the income statement.  SFAS 158 will require employers to recognizeas an asset or liability on their balance sheets the over-funded orunder-funded status of a defined benefit postretirement plan.  SFAS 158 will also require employers tomeasure defined benefit plan assets and obligations as of the dates of theemployers’ fiscal year-end balance sheet. The provisions of 

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SFAS 158 require the Company to: i) initiallyrecognize the funded status of the defined benefit postretirement plan as ofthe end of its fiscal year on December 31, 2006; and ii) measure definedbenefit plan assets and obligations as of the dates of its year-end balancesheets starting December 31, 2008.  We donot expect the adoption of SFAS 158 will have a material effect on ourconsolidated financial statements.

**SAB No. 108.**  In September 2006, the Securities andExchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108(Topic 1N), *Considering the Effects of Prior Year Misstatementswhen Quantifying Misstatements in Current Year Financial Statements*(“SAB 108”).  SAB 108 addresses how theeffects of prior year uncorrected misstatements should be considered whenquantifying misstatements in the current year financial statements.  SAB 108 requires companies to quantifymisstatements using both the balance sheet and income statement approaches andto evaluate whether either approach results in quantifying an error that ismaterial in light of relevant quantitative and qualitative factors.  This SAB does not change the SEC staff’sprevious guidance in SAB No. 99 (Topic 1M), *Materiality*, onevaluating the materiality of misstatements. When applying the new guidance for the first time, if companies identifymaterial errors that were in existence at the beginning of their current fiscalyear, they may correct those errors through a one-time cumulative-effectadjustment to beginning-of-year retained earnings.  Our fiscal year ending December 31, 2006 willbe the initial year of applying the new guidance.  We are still evaluating the effect this newguidance will have on our consolidated financial statements.

### **LIQUIDITY AND CAPITAL RESOURCES**

Our overall objectiveswith respect to liquidity and capital resources are to:

·                  generatesufficient operating cash flows to service our debt and tax obligations, fundcapital improvements and organic growth, and pay dividends to our stockholders;

·                  utilize ourcredit facility for major capital improvements and to manage seasonal cashneeds;

·                  obtain externalfinancing for major acquisitions; and

·                  maintainapproximately equal levels of debt and equity consistent with theinvestor-owned water utility industry.

Our statements of cashflows are summarized as follows:
| ** **                             | ** ** | **Nine Months Ended** | *** *** | ** **   | *** *** |
|----------------------------------------|------------|---------------------------------|--------------|--------------|--------------|
| ** **                             | ** ** | **September 30,**          | *** *** | **Increase** | *** *** |
| **(In thousands)**                | ** ** | **2006**                        | ** **   | **2005**     | ** **   | **(Decrease)** | ** ** |
| Net cash  provided by (used in):       |       |                            |         |         |         |   |   |
| Continuing operations:                 |       |                            |         |         |         |   |   |
| Operating activities                   |       | $                               | 17,861       |         | $            | 19,339 |   | $ | (1,478 | ) |
| Investing activities                   |       | (32,094                         | )            | (26,862      | )            | (5,232 | ) |
| Financing activities                   |       | 14,695                          |         | 14,279       |         | 416 |   |
| Total continuing operations            |       | 462                             |         | 6,756        |         | (6,294 | ) |
| Discontinued operations:               |       |                            |         |         |         |   |   |
| Operating activities                   |       | —                          |         | (788         | )            | 788 |   |
| Investing activities                   |       | —                          |         | (73          | )            | 73 |   |
| Financing activities                   |       | —                          |         | (532         | )            | 532 |   |
| Total discontinued operations          |       | —                          |         | (1,393       | )            | 1,393 |   |
| Increase in cash  and cash equivalents |       | $                               | 462          |         | $            | 5,363 |   | $ | (4,901 | ) |

**Cash Flows From OperatingActivities. **Net cashprovided by operating activities decreased by $1.5 million during the ninemonths ended September 30, 2006 compared to the same period during theprior year.  In 2006, $2.0 million ofbalancing account under-collections (receivables) were recorded as a result ofa favorable California Public Utilities Commission decision regarding recoveryof under-collections.  Operating cashflows in future periods will reflect the collection of the balance account.  Excluding the effect of recording thebalancing account in 2006, cash flows from operations are comparable with theprior year period.

30

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**Cash Flows From InvestingActivities.**  Cash usedin investing activities totaled $32.1 million for the nine months endedSeptember 30, 2006 compared to $26.9 million for the same period during2005 as follows:
| ** **                                              | *** *** | **Nine Months Ended** | *** *** | *** *** | *** *** |
|---------------------------------------------------------|--------------|---------------------------------|--------------|--------------|--------------|
| ** **                                              | ** **   | **September 30,**          | *** *** | **Increase** | *** *** |
| **(In thousands)**                                 | ** **   | **2006**                        | ** **   | **2005**     | ** **   | **(Decrease)** | ** ** |
| Cash flows used in  (provided by) investing activities: |         |                            |         |         |         |   |   |
| Additions to  property, plant and equipment             |         | $                               | 29,699       |         | $            | 26,055 |   | $ | 3,644 |   |
| Acquisition of  businesses, net of cash acquired        |         | 1,809                           |         | 10,659       |         | (8,850 | ) |
| Purchase of  minority interest                          |         | 1,013                           |         | —       |         | 1,013 |   |
| Proceeds from  sale of discontinued operations          |         | —                          |         | (9,852       | )            | 9,852 |   |
| Proceeds from  sales of land                            |         | (427                            | )            | —       |         | (427 | ) |
| Net cash used for  investing activities                 |         | $                               | 32,094       |         | $            | 26,862 |   | $ | 5,232 |   |

The followingtable summarizes additions to property, plant and equipment additions for 2006and 2005.
| ** **                                             | ** ** | **Nine Months Ended** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **September 30,**          | ** ** |
| ** (In thousands)**                          | ** ** | **2006**                        | ** ** | **2005** | ** ** |
| Company-financed  additions                            |       | $                               | 24,100     |   | $ | 23,069 |   |
| Capital improvement  reimbursements                    |       | 2,630                           |       | 144 |   |
| Cash contributions  received in aid of construction    |       | 2,969                           |       | 2,842 |   |
| Total cash  additions to property, plant and equipment |       | 29,699                          |       | 26,055 |   |
| Non-cash  contributions in aid of construction         |       | 5,823                           |       | 2,248 |   |
| Total additions to  property, plant and equipment      |       | $                               | 35,522     |   | $ | 28,303 |   |

Capital projectsprimarily relate to the expansion, replacement and renovation of our water andwastewater systems, particularly at our Texas and New Mexico utilities.  Contributions in Aid of Construction (“CIAC”)represent contributions in the form of cash, services or property received fromdevelopers, governmental agencies, municipalities or individuals for thepurpose of constructing utility plant and is not refundable.  In 2006, we expect to spend approximately$30.0 million on company-financed additions, principally within our UtilityGroup, and expect to receive $11.0 million of CIAC resulting in total expectedadditions to property, plant and equipment of about $41.0 million.

In March 2006, weacquired the remaining 10% interest in Operations Technology, Inc. (“OpTech”)that we did not already own for $1.0 million in cash.  We also made substantial investments inacquisitions during 2006 and 2005 and expect we will continue to do so in thefuture.

**Cash Flows From FinancingActivities.**  Duringfirst nine months of 2006, we financed our growth through a broad range ofcapital initiatives:

·                  received $7.1million of proceeds from our direct stock purchase plan, our employee stockpurchase and option plans and our director option plan;

·                  borrowed $6.0million under our revolving line of credit; and

·                  received $5.6million of capital improvement reimbursements and contributions in aid ofconstruction.

Aggregate borrowingsunder our revolving line of credit increased by a net $6.0 million during thenine months ended September 30, 2006 and were primarily used to fund ourinvesting activities.  Additionalborrowing availability under our revolving credit facility was $59.9 million asof September 30, 2006.

During the nine monthsended September 30, 2006, we have paid dividends totaling $3.6 million and ourquarterly dividend rate is currently $0.0524 per common share.

**Cash Flows From DiscontinuedOperations.**  Net cashused in discontinued operations was $1.4 million and reflects the cash flows ofthe discontinued operation prior to June 30, 2005, the date it was sold.

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**Fourth Quarter 2006 Debt Refinancing.**  On October 20, 2006, our California utilitysold $10.0 million of Series E first mortgage bonds and used $8.0 million ofthe proceeds to repay its maturing Series C first mortgage bonds and theremainder of the proceeds for working capital purposes, including the fundingof capital expenditure programs.  TheSeries E bonds bear interest at a fixed 6.295% annual rate, payablesemiannually, and are due in 2026.  The$8.0 million of Series C first mortgage bonds were classified as currentobligations as of December 31, 2005.  Asa result of the successful refinancing of these obligations on a long-termbasis, the obligations have been classified as long-term (due in 2026) as ofSeptember 30, 2006.

### **CONTRACTUAL OBLIGATIONS**

The following tablesummarizes our known contractual obligations to make future cash payments as ofSeptember 30, 2006, as well as an estimate of the periods during whichthese payments are expected to be made.
| ** **                                       | ** ** | ** ** | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|------------|------------|---------------------------------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | **Remainder**                               | ** ** | **2007** | ** ** | **2009** | ** ** | **2011** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | **of**                                      | ** ** | **and** | ** ** | **and** | ** ** | **and** | ** ** |
| **(In thousands)**                          | ** ** | **Total**  | ** ** | **2006**                                    | ** ** | **2008** | ** ** | **2010** | ** ** | **Beyond** | ** ** |
| Long-term debt  (1):                             |       |       |       |                                        |       |   |   |   |   |   |   |
| Bank line of credit (2)                          |       | $          | 36,000     |                                        | $          | — |   | $ | — |   | $ | 36,000 |   | $ | — |   |
| Mortgage bonds (3)                               |       | 43,000     |       | —                                      |       | — |   | — |   | 43,000 |   |
| Bank term loans (4)                              |       | 32,823     |       | 205                                         |       | 1,645 |   | 1,646 |   | 29,327 |   |
| Convertible subordinated debentures (5)          |       | 13,081     |       | —                                      |       | — |   | — |   | 13,081 |   |
| Economic development revenue bonds (6)           |       | 2,130      |       | 100                                         |       | 220 |   | 245 |   | 1,565 |   |
| Notes payable (7)                                |       | 912        |       | 86                                          |       | 826 |   | — |   | — |   |
| Total long-term debt                             |       | 127,946    |       | 391                                         |       | 2,691 |   | 37,891 |   | 86,973 |   |
| Repayment of advances for construction (8)       |       | 9,076      |       | 550                                         |       | 1,196 |   | 720 |   | 6,610 |   |
| Lease assignment  obligations (9)                |       | 2,531      |       | 73                                          |       | 2,458 |   | — |   | — |   |
| Operating lease  obligations                     |       | 31,532     |       | 1,681                                       |       | 10,569 |   | 5,729 |   | 13,553 |   |
| Total  obligations as of September 30, 2006 |       | $          | 171,085    |                                        | $          | 2,695 |   | $ | 16,914 |   | $ | 44,340 |   | $ | 107,136 |   |

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(1)                      Excludesinterest payment obligations, which are described in the following notes.  The terms of the long-term debt are morefully described in the notes to the consolidated financial statements includedin this report and our 2005 Annual Report on Form 10-K.

(2)                      The banklines of credit bear interest at variable rates and therefore the amount offuture interest payments are uncertain. Borrowings bear interest, at our option, based on a margin either: a)over the LIBOR rate; or b) under the prime rate.  The margins vary based on our consolidateddebt to equity ratio.  Theweighted-average interest rate on our bank line of credit borrowings was 6.24%as of September 30, 2006.

(3)                      Interest onthe mortgage bonds is fixed at a weighted-average annual interest rate of 6.53%and is payable semiannually.

(4)                      Interest onthe bank term loans is fixed at a weighted-average annual interest rate of6.56% and is payable semiannually.

(5)                      Interest onthe convertible debentures is fixed at a 6.85% annual rate and is payablequarterly.  The debentures areconvertible, at the option of the holder, into shares of our common stock atany time prior to their maturity.

(6)                      Interest onthe economic development bonds is fixed at a weighted-average annual interestrate of 5.92% and is payable semiannually.

(7)                      Interest ispayable either monthly or quarterly at rates ranging from 5.0% to 7.5% peryear.

(8)                      Advances forconstruction are non-interest bearing.

(9)                      Interest onthe lease assignment obligations is fixed at a weighted-average interest rateof 8.39% and is payable monthly.

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### **FINANCIAL CONDITION AND LIQUIDITY**

As of September 30, 2006,we had working capital of approximately $12.2 million and $59.9 million ofadditional borrowings available under our line of credit facility which expireson April 1, 2010.  In addition to ourline of credit, our California and New Mexico mortgage bond indentures permitthe issuance of an additional $80.8 million of first mortgage bonds as ofSeptember 30, 2006.  However, theterms of our credit facility do not permit additional first mortgage bondindebtedness without prior consent from the credit facility lenders.  The mortgage bond indentures also limit theamount of cash and property dividends our California and New Mexico utilitiesmay pay to the parent company to fund its payment obligations.  Dividends have averaged $3.0 to $4.0 millionper year and are less than the aggregate cumulative dividend restrictionthreshold by $44.2 million as of September 30, 2006.

We also have on file aregistration statement with the Securities and Exchange Commission, which iseffective for the issuance of up to $50.0 million aggregate principal amount ofcommon stock, debt securities and warrants. To date we have issued approximately $43.6 million of common stock underthe shelf registration, and about $6.4 million remains available for issuanceas of September 30, 2006.  We mayoffer any of these securities for sale at any time and from time to time.

As of September 30,2006, we have contractual obligations totaling $171.1 million (excludinginterest), $2.7 million of which is due during the remainder of 2006.  We were in compliance with all loan agreementcovenants during the nine months ended September 30, 2006.

We believe that ourexpected operating cash flows, together with borrowings under our revolvingcredit facility ($59.9 million of which was available as of September 30,2006 and expires on April 1, 2010) will be sufficient to meet our operatingexpenses, working capital and capital expenditure requirements as well as ourdebt service obligations for the next twelve months.  However, our ability to comply with debtfinancial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well ascompetitive, legislative, regulatory, business and other factors beyond ourcontrol.

### **CERTAIN CONTRACTUAL COMMITMENTS ANDINDEMNITIES**

In 2002, we were retainedto facilitate the engineering and construction of a $23.0 million reverseosmosis water treatment plant in the city of San Juan Capistrano, Californiafor the Capistrano Valley Water District (“CVWD”).  In 2003, we obtained a $3.4 million standbyletter of credit as collateral to insure our performance during the design andconstruction of the water treatment plant. Construction was completed during 2005 and upon final acceptance of thecompleted project by the CVWD, which is expected in 2006, the standby letter ofcredit will be terminated.

We now operate thecompleted plant under a twenty-year operating agreement.  The CVWD service contract contains certainguarantees related to our performance, including certain liquidated damages, inthe event of failure on our part to perform other than by reason ofuncontrollable circumstances as defined in the service contract.  Also, we have made other guarantees to CVWD,including guarantees with respect to the quality and quantity of the finishedwater and the production efficiency of the facility.

As part of the financingfor this project, the CVWD sold insured municipal bonds.  We entered into an agreement with the bondinsurer to guarantee our performance under the service contract, subject tocertain liability caps to the bond insurer in the event of a default.  During the twenty-year operation of thefacility, such liability caps will not exceed an amount equal to $4.0 millionplus an amount no greater than the replacement cost of the actual reverseosmosis filtration unit within the facility, estimated to be approximately $1.5million.

We had irrevocablestandby letters of credit in the amount of $4.1 million issued and outstandingunder our credit facility, including the CVWD letter of credit described above,as of September 30, 2006.

During our normal courseof business, we have entered into agreements containing indemnities pursuant towhich we may be required to make payments in the future.  These indemnities are in connection withfacility leases and liabilities and operations and maintenance and constructioncontracts entered into by our Services Group. The duration of these indemnities, commitments and guarantees varies,and in certain cases, is indefinite. Substantially 

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all of these indemnities provide no limitation on themaximum potential future payments we could be obligated to make and is notquantifiable.  We have not recorded anyliability for these indemnities.

In connection with thesale of Master Tek, we indemnified the buyer with respect to representationsand warranties.  Our indemnities withrespect to these matters are limited in terms of duration to periods rangingfrom one year to the expiration of the applicable statue of limitations.

### **OFF-BALANCE SHEET ARRANGEMENTS**

Through the date of thisreport, we did not have any relationships with unconsolidated entities orfinancial partnerships, such as entities often referred to as structuredfinance or special purpose entities, which would have been established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes.  In addition,we do not engage in trading activities involving non-exchange tradedcontracts.  We are not materially exposedto any financing, liquidity, market or credit risk that could arise if we hadengaged in these relationships.  We do nothave relationships or transactions with persons or entities that derivebenefits from their non-independent relationship with us or our subsidiaries.

We lease some of ourequipment and office facilities under operating leases which are deemed to beoff-balance sheet arrangements.  Ourfuture operating lease payment obligations are more fully described under thecaption “—Contractual Obligations” above.

**ITEM 3.**                    QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

As of September 30,2006, we had $128.9 million of long-term variable and fixed-rate debt.  We are exposed to market risk based onchanges in prevailing interest rates.

Market risk related toour variable-rate debt is estimated as the potential decrease in pre-taxearnings resulting from an increase in interest rates.  We have $36.0 million of long-term debt thatbears interest at variable rates based on either the prime rate or LIBOR.  Our variable-rate debt had a weighted averageinterest rate of 6.24% as of September 30, 2006.  A hypothetical one percent (100 basis points)increase in the average interest rates charged on our variable-rate debt wouldreduce our pre-tax earnings by approximately $0.4 million per year.

Our fixed-rate debt,which had a carrying value of $92.9 million as of September 30, 2006, hada fair value of $89.2 million as of that date. Market risk related to our fixed-rate debt is deemed to be the potentialincrease in fair value resulting from a decrease in prevailing interestrates.  Our fixed-rate debt had aweighted average interest rate of 6.7% as of September 30, 2006.  A hypothetical ten percent decrease ininterest rates, from 6.7% to 6.0%, would increase the fair value of ourfixed-rate debt by approximately $5.6 million.

We do not use derivativefinancial instruments to manage or reduce these risks although we may elect doso in the future.  We do not enter intoderivatives or other financial instruments for trading or speculative purposes.

**ITEM 4.**                    CONTROLS ANDPROCEDURES

Under the supervision andwith the participation of our management, including the Chief Executive Officerand Chief Financial Officer, we have evaluated the effectiveness of ourdisclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) asof the end of the period covered by this report.  Based on that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer have concluded that these disclosurecontrols and procedures are effective. There were no changes in our internal control over financial reportingduring the quarter ended September 30, 2006 that have materially affected,or are reasonably likely to materially affect, our internal control overfinancial reporting.

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**PART II — OTHERINFORMATION**

**ITEM 1.**                 LEGAL PROCEEDINGS

Information required bythis Item 1 is contained in Note 6 to the consolidated financial statements,Part I, Item 1 of this report, under the captions “Legal Proceedings,” “EPAInvestigations” and “Eminent Domain Proceedings.”  The text under those captions is incorporatedby reference into this Item 1.

**ITEMS 1A, 2, 3, 4AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.**

**ITEM 6.**                    EXHIBITS
| Exhibit   Number | ** ** | ** ** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                |
|------------------|------------|------------|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.2              |       |       |       | Amendment No. 3 to Amended and Restated Bylaws of  Southwest Water Company effective May 16, 2006 (incorporated by  reference to Exhibit 3.2 to the Company’s Form 8-K filed with the  Commission on May 19, 2006)                                                                           |
| 4.1.6            |       | *          |       | Fifth Amendment and  Supplement to Indenture of Mortgage and Deed of Trust between Suburban Water  Systems and U.S. Bank National Association, dated October 20, 2006                                                                                                                                  |
| 4.13.1           |       |       |       | Southwest Water Company  2006 Equity Incentive Plan (incorporated by reference as Exhibit 4.13.1 to  the Company’s Registration Statement on Form S-8, File No. 33-134575,  filed with the Commission on May 31, 2006)                                                                            |
| 4.13.2           |       |       |       | Southwest Water Company  2006 Equity Incentive Plan Notice of Restricted Stock Award and Restricted  Stock Agreement (incorporated by reference as Exhibit 4.13.2 to the Company’s  Registration Statement on Form S-8, File No. 33-134575, filed with the  Commission on May 31, 2006)           |
| 4.13.3           |       |       |       | Southwest Water Company  2006 Equity Incentive Plan Notice of Restricted Stock Unit Award and  Restricted Stock Unit Agreement (incorporated by reference as Exhibit 4.13.3  to the Company’s Registration Statement on Form S-8, File No. 33-134575,  filed with the Commission on May 31, 2006) |
| 4.13.4           |       |       |       | Southwest Water Company  2006 Equity Incentive Plan Stock Option Agreement (incorporated by reference  as Exhibit 4.13.4 to the Company’s Registration Statement on Form S-8, File  No. 33-134575, filed with the Commission on May 31, 2006)                                                     |
| 4.13.5           |       |       |       | Southwest Water Company  2006 Equity Incentive Plan SAR Agreement (incorporated by reference as  Exhibit 4.13.5 to the Company’s Registration Statement on Form S-8, File No.  33-134575, filed with the Commission on May 31, 2006)                                                              |
| 10.1             |       |       |       | Executive Employment  Agreement dated April 28, 2006, between Cheryl L. Clary and Southwest Water  Company (incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K  filed with the Commission on May 3, 2006)                                                              |
| 10.2             |       |       |       | Executive Employment  Agreement dated April 28, 2006, between Michael O. Quinn and Southwest Water  Company (incorporated by reference to Exhibit 10.2 to the Company’s Form 8-K  filed with the Commission on May 3, 2006)                                                             |
| 10.3             |       |       |       | Change of Control  Agreement dated April 28, 2006, between Cheryl L. Clary and Southwest Water  Company (incorporated by reference to Exhibit 10.3 to the Company’s Form 8-K  filed with the Commission on May 3, 2006)                                                                 |
| 10.4             |       |       |       | Change of Control  Agreement dated April 28, 2006, between Michael O. Quinn and Southwest Water  Company (incorporated by reference to Exhibit 10.4 to the Company’s Form 8-K  filed with the Commission on May 3, 2006)                                                                |

 

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| Exhibit  Number | ** ** | ** ** | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                                               |
|-----------------|------------|------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 10.5            |       |       |       | Change of Control  Agreement dated as of May 15, 2006, between Southwest Water Company, a  Delaware corporation, and Mark A. Swatek, the Company’s Chairman of the Board  and Chief Executive Officer (incorporated by reference to Exhibit 10.1 to the  Company’s Form 8-K filed with the Commission on May 19, 2006) |
| 10.17.1.1       |       | *          |       | First Amendment to  Amended and Restated Master Loan Agreement (MLA No. RX 0936) dated November  6, 2006 between Monarch Utilities I L.P. and CoBank, ACB                                                                                                                                                                             |
| 15              |       | *          |       | Letter regarding  unaudited interim financial information from Independent Registered Public  Accounting Firm                                                                                                                                                                                                                         |
| 21.1            |       | *          |       | Subsidiaries of the  Registrant                                                                                                                                                                                                                                                                                                       |
| 31.1            |       | *          |       | Certification of  Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                         |
| 31.2            |       | *          |       | Certification of  Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                                                                                                                                                         |
| 32.1            |       | *          |       | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                  |
| 32.2            |       | *          |       | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of  2002                                                                                                                                                                                                                                  |

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*                             Filedherewith

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**SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereto dulyauthorized.
|                         |   | **SOUTHWEST WATER COMPANY (REGISTRANT)** |
|-------------------------|--------|------------------------------------------|
| Date: November  9, 2006 |   | By:                                      |   | /s/ CHERYL L. CLARY |
|                    |   |                                     |   | Cheryl L. Clary |
|                    |   |                                     |   | Chief Financial  Officer |

 

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