**UNITEDSTATES**

**SECURITIESAND 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, 2007**                                                                                                                                                                                                                                               |
|           |       |                                                                                                                                                                                                                                                                                                |
| **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**

 

(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 area code)

 

**None**

(Former name, former address and former fiscal year, if changed sincelast report)

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days.  Yes x   No o

 

Indicateby check mark whether the registrant is a large accelerated filer, anaccelerated filer, or a non-accelerated filer. (Check one):

Large accelerated filer  o                                                 Acceleratedfiler  x                                                   Non-Acceleratedfiler  o

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Act).  Yes o   No x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date.

 

| **Class**                              | ** ** | **Outstanding  as of November 2, 2007** |
|----------------------------------------|------------|-----------------------------------------|
| Common Stock, $.01 par value per share |       | 24,232,637 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, 2007 and  December 31, 2006                                  |       |       |
|           |       |                                                                                                                   |       |       |
|           |       | Condensed Consolidated Statements of Income for the three months and  nine months ended September 30, 2007 and 2006    |       |       |
|           |       |                                                                                                                   |       |       |
|           |       | Condensed Consolidated Statement of Changes in Stockholders’ Equity  for the nine months ended September 30, 2007 |       |       |
|           |       |                                                                                                                   |       |       |
|           |       | Condensed Consolidated Statements of Cash Flows for the nine months  ended September 30, 2007 and 2006                 |       |       |
|           |       |                                                                                                                   |       |       |
|           |       | 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** | ** ** |                                                                                                                   |       |       |

 

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# **PARTI — FINANCIAL INFORMATION**

 

## **ITEM 1.**   FINANCIAL STATEMENTS

 

### **REPORTOF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

The Board of Directors and StockholdersSouthwest Water Company:

 

We have reviewed the accompanying condensedconsolidated balance sheet of Southwest Water Company and subsidiaries (“theCompany”) as of September 30, 2007, the related condensed consolidatedstatements of income for the three-month and nine-month periods endedSeptember 30, 2007 and 2006, the related condensed consolidated statementof changes in stockholders’ equity for the nine-month period endedSeptember 30, 2007, and the related condensed consolidated statements ofcash flows for the nine-month periods ended September 30, 2007 and2006.  These condensed consolidated financialstatements are the responsibility of the Company’s management.

 

We conducted our reviews in accordance withthe standards of the Public Company Accounting Oversight Board (UnitedStates).  A review of interim financialinformation consists principally of applying analytical procedures and making inquiriesof persons responsible for financial and accounting matters.  It is substantially less in scope than anaudit conducted in accordance with the standards of the Public CompanyAccounting Oversight Board (United States), the objective of which is theexpression of an opinion regarding the financial statements taken as awhole.  Accordingly, we do not expresssuch an opinion.

 

Based on our reviews, we are not aware of anymaterial modifications that should be made to the condensed consolidatedfinancial statements referred to above for them to be in conformity with U.S.generally accepted accounting principles.

 

We have previously audited, in accordancewith the standards of the Public Company Accounting Oversight Board (UnitedStates), the consolidated balance sheet of the Company as of December 31, 2006,and the related consolidated statements of income, changes in stockholders’equity, and cash flows for the year then ended (not presented herein); and inour report dated March 13, 2007, we expressed an unqualified opinion on thoseconsolidated financial statements.  Inour opinion, the information set forth in the accompanying condensedconsolidated balance sheet as of December 31, 2006, is fairly stated, in allmaterial respects, in relation to the consolidated balance sheet from which ithas been derived.

 

/s/  KPMG LLP

 

Los Angeles, California

November 9, 2007

 

1

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

### **CONDENSEDCONSOLIDATED BALANCE SHEETS (UNAUDITED)**

 
| *** ***                                  | *** *** | ***September 30,*** | *** ***  | ***December 31,*** | ** ** |
|-----------------------------------------------|--------------|---------------------|---------------|--------------------|------------|
| **(In thousands)**                            | ** **   | **2007**            | ** **    | **2006**           | ** ** |
|                                          |         |                |          |               |       |
| **ASSETS**                                    |         |                |          |               |       |
|                                          |         |                |          |               |       |
| Current Assets:                               |         |                |          |               |       |
| Cash and cash equivalents                     |         | $                   | 2,419         |               | $          | 4,294 |   |
| Accounts receivable, net                      |         | 27,377              |          | 27,512             |       |
| Other current assets                          |         | 11,868              |          | 16,451             |       |
| Total current assets                          |         | 41,664              |          | 48,257             |       |
|                                          |         |                |          |               |       |
| Property, Plant and Equipment, Net:           |         |                |          |               |       |
| Regulated utilities                           |         | 404,884             |          | 378,260            |       |
| Non-regulated operations                      |         | 16,966              |          | 11,365             |       |
| Total property, plant and equipment, net      |         | 421,850             |          | 389,625            |       |
|                                          |         |                |          |               |       |
| Other Assets:                                 |         |                |          |               |       |
| Goodwill                                      |         | 34,647              |          | 33,152             |       |
| Intangible assets                             |         | 2,659               |          | 2,844              |       |
| Other assets                                  |         | 18,917              |          | 17,815             |       |
|                                          |         |                |          |               |       |
|                                          |         | $                   |  519,737 |               | $          | 491,693 |   |
|                                          |         |                |          |               |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |         |                |          |               |       |
|                                          |         |                |          |               |       |
| Current Liabilities:                          |         |                |          |               |       |
| Accounts payable                              |         | $                   | 9,687         |               | $          | 12,746 |   |
| Current portion of long-term debt             |         | 1,498               |          | 1,423              |       |
| Other current liabilities                     |         | 22,642              |          | 21,661             |       |
| Total current liabilities                     |         | 33,827              |          | 35,830             |       |
|                                          |         |                |          |               |       |
| Other Liabilities and Deferred Credits:       |         |                |          |               |       |
| Long-term debt                                |         | 143,090             |          | 128,624            |       |
| Deferred income taxes                         |         | 29,365              |          | 26,011             |       |
| Advances for construction                     |         | 7,948               |          | 8,413              |       |
| Contributions in aid of construction          |         | 116,128             |          | 110,024            |       |
| Other liabilities and deferred credits        |         | 17,038              |          | 16,264             |       |
|                                          |         |                |          |               |       |
| Commitments and Contingencies                 |         |                |          |               |       |
|                                          |         |                |          |               |       |
| Stockholders’ Equity:                    |         |                |          |               |       |
| Preferred stock                               |         | 458                 |          | 458                |       |
| Common stock                                  |         | 242                 |          | 238                |       |
| Additional paid-in capital                    |         | 143,806             |          | 138,728            |       |
| Retained earnings                             |         | 27,757              |          | 27,031             |       |
| Accumulated other comprehensive income        |         | 78                  |          | 72                 |       |
| Total stockholders’ equity               |         | 172,341             |          | 166,527            |       |
|                                          |         |                |          |               |       |
|                                          |         | $                   |  519,737 |               | $          | 491,693 |   |

 

See accompanying notes to consolidated financial statements.

 

2

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

### **CONDENSEDCONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)**

 
| ** **                                                       | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                       | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In thousands, except per share  data)**                       | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Revenues:                                                        |       |                   |       |                  |       |   |   |   |   |
| Utility Group                                                    |       | $                      | 26,041     |                  | $          | 25,839 |   | $ | 69,629 |   | $ | 64,602 |   |
| Services Group                                                   |       | 31,317                 |       | 33,105                |       | 90,778 |   | 98,232 |   |
| Total revenues                                                   |       | 57,358                 |       | 58,944                |       | 160,407 |   | 162,834 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Expenses:                                                        |       |                   |       |                  |       |   |   |   |   |
| Utility Group operating expenses                                 |       | 15,030                 |       | 14,539                |       | 39,619 |   | 35,442 |   |
| Services Group operating expenses                                |       | 28,608                 |       | 29,272                |       | 80,733 |   | 86,021 |   |
| Selling, general and administrative  expenses                    |       | 8,437                  |       | 7,115                 |       | 26,282 |   | 24,708 |   |
| Impairment of goodwill                                           |       | —                 |       | 261                   |       | — |   | 929 |   |
| Total expenses                                                   |       | 52,075                 |       | 51,187                |       | 146,634 |   | 147,100 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Operating income                                                 |       | 5,283                  |       | 7,757                 |       | 13,773 |   | 15,734 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Other income (expense):                                          |       |                   |       |                  |       |   |   |   |   |
| Interest expense                                                 |       | (2,182                 | )          | (2,081                | )          | (6,376 | ) | (6,333 | ) |
| Interest income                                                  |       | 291                    |       | 108                   |       | 507 |   | 363 |   |
| Other, net                                                       |       | (41                    | )          | 11                    |       | (102 | ) | — |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Income before income taxes and change in accounting  principle   |       | 3,351                  |       | 5,795                 |       | 7,802 |   | 9,764 |   |
| Provision for income taxes                                       |       | (1,276                 | )          | (2,123                | )          | (2,890 | ) | (3,575 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Income before change in accounting  principle                    |       | 2,075                  |       | 3,672                 |       | 4,912 |   | 6,189 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Cumulative effect of change in accounting  principle, net of tax |       | —                 |       | —                |       | — |   | 71 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Net income                                                       |       | 2,075                  |       | 3,672                 |       | 4,912 |   | 6,260 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Preferred stock dividends                                        |       | (6                     | )          | (6                    | )          | (18 | ) | (18 | ) |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Net income applicable to common stockholders                     |       | $                      | 2,069      |                  | $          | 3,666 |   | $ | 4,894 |   | $ | 6,242 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Earnings per common share:                                       |       |                   |       |                  |       |   |   |   |   |
| Basic:                                                           |       |                   |       |                  |       |   |   |   |   |
| Income before change in accounting  principle                    |       | $                      | 0.09       |                  | $          | 0.16 |   | $ | 0.20 |   | $ | 0.27 |   |
| Cumulative effect of change in accounting  principle             |       | —                 |       | —                |       | — |   | 0.01 |   |
| Net income applicable to common  stockholders                    |       | $                      | 0.09       |                  | $          | 0.16 |   | $ | 0.20 |   | $ | 0.28 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Diluted:                                                         |       |                   |       |                  |       |   |   |   |   |
| Income before change in accounting  principle                    |       | $                      | 0.08       |                  | $          | 0.16 |   | $ | 0.20 |   | $ | 0.27 |   |
| Cumulative effect of change in accounting  principle             |       | —                 |       | —                |       | — |   | — |   |
| Net income applicable to common  stockholders                    |       | $                      | 0.08       |                  | $          | 0.16 |   | $ | 0.20 |   | $ | 0.27 |   |
|                                                             |       |                   |       |                  |       |   |   |   |   |
| Weighted average common shares outstanding:                      |       |                   |       |                  |       |   |   |   |   |
| Basic                                                            |       | 24,178                 |       | 23,069                |       | 24,054 |   | 22,691 |   |
| Diluted                                                          |       | 24,472                 |       | 23,422                |       | 24,357 |   | 23,184 |   |

 

See accompanying notes to consolidated financial statements.

 

3

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

### **CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)**

 
| ** **                                      | ** ** | ** **           | ** ** | ** **        | ** ** | ** **     | ** ** | ** ** | ** ** | ** **  | ** ** | ** **   | ** ** | **Accumulated**   | ** ** | ** **             | ** ** |
|-------------------------------------------------|------------|----------------------|------------|-------------------|------------|----------------|------------|------------|------------|-------------|------------|--------------|------------|-------------------|------------|------------------------|------------|
| ** **                                      | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Additional** | ** ** | ** ** | ** ** | **Other**   | ** ** | **Total**    | ** ** |
| ** **                                      | ** ** | **Number of**        | ** ** | ** **        | ** ** | **Number  of** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Comprehensive** | ** ** | **Stockholders’** | ** ** |
| **(In thousands)**                              | ** ** | **Shares**           | ** ** | **Amount**        | ** ** | **Shares**     | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Income**        | ** ** | **Equity**             | ** ** |
| ** **                                      | ** ** | ** **           | ** ** | ** **        | ** ** | ** **     | ** ** | ** ** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | ** **             | ** ** |
| Balance at  December 31, 2006                   |       | 9                    |       | $                 | 458        |           | 23,802     |       | $          | 238         |       | $            | 138,728    |              | $          | 27,031                 |       | $ | 72 |   | $ | 166,527 |   |
|                                            |       |                 |       |              |       |           |       |       |       |        |       |         |       |              |       |                   |       |
| Comprehensive  income:                          |       |                 |       |              |       |           |       |       |       |        |       |         |       |              |       |                   |       |
| Net income                                      |       | —               |       | —            |       | —         |       | —     |       | —      |       | 4,912        |       | —            |       | 4,912                  |       |
| Other  comprehensive income, net of tax:        |       |                 |       |              |       |           |       |       |       |        |       |         |       |              |       |                   |       |
| Amortization of  actuarial net gain             |       | —               |       | —            |       | —         |       | —     |       | —      |       | —       |       | (37               | )          | (37                    | )          |
| Amortization of  prior service costs            |       | —               |       | —            |       | —         |       | —     |       | —      |       | —       |       | 43                |       | 43                     |       |
| Comprehensive  income                           |       |                 |       |              |       |           |       |       |       |        |       |         |       |              |       | 4,918                  |       |
|                                            |       |                 |       |              |       |           |       |       |       |        |       |         |       |              |       |                   |       |
| Dividend  reinvestment and stock purchase plans |       | —               |       | —            |       | 158            |       | 2          |       | 2,066       |       | —       |       | —            |       | 2,068                  |       |
| Proceeds from  stock options exercised          |       | —               |       | —            |       | 172            |       | 2          |       | 765         |       | —       |       | —            |       | 767                    |       |
| Tax benefit from  stock options exercised       |       | —               |       | —            |       | —         |       | —     |       | 414         |       | —       |       | —            |       | 414                    |       |
| Share-based  compensation expense               |       | —               |       | —            |       | 27             |       | —     |       | 1,311       |       | —       |       | —            |       | 1,311                  |       |
| Debenture  conversions                          |       | —               |       | —            |       | 50             |       | —     |       | 522         |       | —       |       | —            |       | 522                    |       |
| Cash dividends  declared                        |       | —               |       | —            |       | —         |       | —     |       | —      |       | (4,186       | )          | —            |       | (4,186                 | )          |
|                                            |       |                 |       |              |       |           |       |       |       |        |       |         |       |              |       |                   |       |
| Balance at  September 30, 2007                  |       | 9                    |       | $                 | 458        |           | 24,209     |       | $          | 242         |       | $            | 143,806    |              | $          | 27,757                 |       | $ | 78 |   | $ | 172,341 |   |

 

See accompanying notes to consolidated financial statements.

 

4

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

### **CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**

 
| *** ***                                                                       | ** ** | ***Nine Months Ended*** | ** ** |
|------------------------------------------------------------------------------------|------------|-------------------------|------------|
| *** ***                                                                       | ** ** | ***September 30,***     | ** ** |
| **(In thousands)**                                                                 | ** ** | **2007**                | ** ** | **2006** | ** ** |
|                                                                               |       |                    |       |   |   |
| **Cash flows from operating activities:**                                          |       |                    |       |   |   |
| Net income                                                                         |       | $                       | 4,912      |   | $ | 6,260 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |                    |       |   |   |
| Cumulative effect of change in accounting  principle, net of tax                   |       | —                  |       | (71 | ) |
| Depreciation and amortization                                                      |       | 9,187                   |       | 8,115 |   |
| Deferred income taxes                                                              |       | 2,890                   |       | 1,020 |   |
| Share-based compensation expense                                                   |       | 1,311                   |       | 834 |   |
| Impairment of goodwill                                                             |       | —                  |       | 929 |   |
| Gain on sales of land                                                              |       | —                  |       | (407 | ) |
| Changes in assets and liabilities, net of  effects of acquisitions:                |       |                    |       |   |   |
| Accounts receivable                                                                |       | 261                     |       | (4,114 | ) |
| Other current assets                                                               |       | 3,618                   |       | 5,333 |   |
| Other assets                                                                       |       | (1,329                  | )          | (1,701 | ) |
| Accounts payable                                                                   |       | (3,073                  | )          | (1,286 | ) |
| Other current liabilities                                                          |       | 648                     |       | 2,086 |   |
| Other liabilities                                                                  |       | (419                    | )          | 826 |   |
| Other, net                                                                         |       | (11                     | )          | 37 |   |
| Net cash provided by operating activities                                          |       | 17,995                  |       | 17,861 |   |
|                                                                               |       |                    |       |   |   |
| **Cash flows from investing activities:**                                          |       |                    |       |   |   |
| Additions to property, plant and equipment                                         |       | (29,953                 | )          | (29,699 | ) |
| Acquisitions of businesses, net of cash  acquired                                  |       | (6,547                  | )          | (1,809 | ) |
| Purchase of minority interest                                                      |       | —                  |       | (1,013 | ) |
| Proceeds from sales of land                                                        |       | 42                      |       | 427 |   |
| Net cash used in investing activities                                              |       | (36,458                 | )          | (32,094 | ) |
|                                                                               |       |                    |       |   |   |
| **Cash flows from financing activities:**                                          |       |                    |       |   |   |
| Borrowings under lines of credit                                                   |       | 16,000                  |       | 6,000 |   |
| Capital improvement reimbursements                                                 |       | 3,046                   |       | 2,630 |   |
| Proceeds from stock option and stock  purchase plans                               |       | 2,835                   |       | 7,083 |   |
| Excess tax benefit from stock options  exercised                                   |       | 414                     |       | 1,289 |   |
| Contributions in aid of construction                                               |       | 360                     |       | 2,969 |   |
| Dividends paid                                                                     |       | (4,186                  | )          | (3,622 | ) |
| Payments on long-term debt                                                         |       | (1,372                  | )          | (1,101 | ) |
| Repayment of advances for construction                                             |       | (509                    | )          | (507 | ) |
| Deferred financing costs                                                           |       | —                  |       | (46 | ) |
| Net cash provided by financing activities                                          |       | 16,588                  |       | 14,695 |   |
|                                                                               |       |                    |       |   |   |
| Net change in cash and cash equivalents                                            |       | (1,875                  | )          | 462 |   |
| Cash and cash equivalents at beginning of  year                                    |       | 4,294                   |       | 2,764 |   |
| Cash and cash equivalents at end of period                                         |       | $                       | 2,419      |   | $ | 3,226 |   |

 

See accompanying notes to consolidated financial statements.

 

5

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

### **CONDENSEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

###  

**Note 1.       Summaryof Significant Accounting Policies**

** **

**Basis of Presentation**

** **

These consolidated interim financialstatements are unaudited.  The Companybelieves the interim financial statements are presented on a basis consistentwith the audited financial statements and include all adjustments necessary fora fair presentation of the financial condition, results of operations and cashflows for such interim periods.  All ofthese adjustments are normal recurring adjustments.

 

Preparation of these consolidated financialstatements in conformity with U.S. generally accepted accounting principles (“GAAP”)requires the Company to make estimates and judgments that affect the reportedamounts of assets, liabilities and disclosure of contingent assets andliabilities at the date of the consolidated financial statements and the reported amounts of revenues andexpenses during the reporting periods. Actual results could differ from those estimates.

 

Certain information and disclosures normallyincluded in financial statements prepared in accordance with GAAP have beenomitted in accordance with Securities and Exchange Commission’s rules andregulations for interim financial reporting. These interim consolidated financial statements should be read in conjunctionwith Management’s Discussion and Analysis of Financial Condition and Results ofOperations and the audited financial statements and related notes included inthe Company’s 2006 Annual Report on Form 10-K. The Company’s businesses are seasonal because they are affected byweather.  As a result, operating resultsfor interim periods do not necessarily predict the operating results for anyother interim period or for the full year.

 

**Change in Presentation**

** **

Effective January 1, 2007, the Company electedto allocate a portion of its Services Group’s operating expense overheadbetween affiliated and unaffiliated customers for segment reporting purposes(Note 11).  In prior periods, alloperating expense overhead was reflected as operating expenses attributable tounaffiliated customers.  This change inallocation methodology increased the gross profit from sales to unaffiliatedcustomers and decreased the gross profit from sales to affiliated customers bythe same amount.  In accordance with SFASNo. 131, *Disclosures about Segments of an Enterprise andRelated Information*, prior year amounts have been reclassified toconform to the 2007 presentation.

 

In accordance with SFAS No. 71, *Accounting for the Effects of Certain Types of Regulation* (“SFAS71”), the Company does not eliminate the intersegment profit recognized onsales to affiliated customers because the Company believes the sales price isreasonable and it is probable that, through the rate making process, futureUtility Group revenue approximately equal to the sales price will result fromthe regulated utilities’ use of the services. The Company does, however, eliminate the Services Group’s revenues fromaffiliated customers to the extent of its cost. Consequently, this change resulted in a decrease in the Services Group’srevenues and direct operating expenses reported in 2006 by the sameamounts.  Consolidated gross profit,operating income and net income are unchanged.

 

In the third quarter of 2006, the Companycentralized many of its common business functions into a shared servicesdepartmental structure which was classified as selling, general andadministrative expenses.  EffectiveJanuary 1, 2007 the Company concluded that these expenses were more operationalin nature and elected to classify these expenses as direct operatingexpenses.  As a result, prior yearamounts have also been reclassified to conform to the 2007 presentation.

 

6

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**Accounting Guidance and PronouncementsAdopted During 2007**

** **

*SFAS No. 158*

* *

In September 2006, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans – anamendment of FASB Statements No. 87, 88, 106, and 132(R)*(“SFAS 158”).  This statement requires balance sheetrecognition of the funded status of pension and postretirement benefitplans.  Under SFAS 158, actuarial gainsand losses, prior service costs or credits, and any remaining transition assetsor obligations that have not been recognized under previous accountingstandards must be recognized in accumulated other comprehensive income (loss),net of tax effects, until they are amortized as a component of net periodicbenefit cost.  The balance sheetrecognition provisions of SFAS 158 were effective for the Company’s fiscalyear ended December 31, 2006 and, as a result, the Company began recognizingthe unamortized portion of actuarial gains and prior service costs inaccumulated other comprehensive income. The adoption of SFAS 158 did not have a material effect on theconsolidated financial statements.

 

*FIN No. 48*

* *

On January 1, 2007, the Company adopted theprovisions of FASB Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes* (“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*(“SFAS 109”).  FIN 48 requires companies to recognizethe financial statement benefit of a tax position only after determining therelevant tax authority would “more likely than not” sustain the positionfollowing an examination by the taxing authority.  For tax positions meeting themore-likely-than-not threshold, the amount recognized in the financialstatements is the largest benefit that has a greater than 50% likelihood ofbeing realized upon settlement with the relevant taxing authority.

 

As of December 31, 2006 and September 30,2007, the Company’s liabilities for uncertain tax positions were notsignificant.  The Company’s policy is torecognize interest and penalties related to liabilities for uncertain taxbenefits in the income tax expense line-item of the consolidated statements ofincome.  Net interest and penaltiesincurred during the three months and nine months ended September 30, 2007and 2006 were insignificant.

 

The Company is subject to federal and variousstate and local income taxes.  Taxregulations within each jurisdiction are subject to the interpretation ofrelated tax laws and regulations and require significant judgment toapply.  The Company is no longer subjectto federal, state and local income tax return examinations by taxingauthorities for years before 2002.  TheCompany’s federal income tax returns for the 2002 through 2004 tax years wererecently examined by the Internal Revenue Service.  The examination was concluded in February2007 and resulted in no net change for the tax years examined.  State and local income tax returns from 2002to the present and federal income tax returns from 2005 to the present arestill subject to examinations by taxing authorities.

 

7

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**Recent Accounting Pronouncements**

** **

*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 value measurements.  This statement applies only to fair valuemeasurements that are already required or permitted by other accountingstandards 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 will beapplied prospectively under most circumstances. While the Company is still evaluating the impact this statement willhave on its consolidated financial statements, management currently believesthe impact will not be material.

 

*SFAS No. 159*

* *

In February 2007, the FASB issued SFAS No.159, *The Fair Value Option for Financial Assets andFinancial Liabilities – Including an amendment of FASB Statement No. 115*(“SFAS 159”).  This statement permitscompanies to choose to measure many financial instruments and other specifieditems at fair value.  This statement iseffective for the Company’s fiscal year beginning January 1, 2008 and will beapplied prospectively.  While the Companyis still evaluating the impact this statement will have on its consolidatedfinancial statements, management currently believes the impact will not bematerial.

 

**Note 2.       Acquisitions**

** **

During the nine months endedSeptember 30, 2007, the Company acquired:

 

•                  substantially all of the assets of asmall water and wastewater collection utility in a high growth area of northernMississippi, just south of Memphis, Tennessee, in February 2007; and

 

•                  all of the common stock of two waterutilities in a high population growth area northwest of San Antonio, Texas inMay 2007.

 

The aggregate purchase price for theseacquisitions was $6.5 million in cash plus $2.5 million of liabilitiesassumed.  The assets acquired andliabilities assumed have been recorded at their estimated fair values based uponpreliminary valuations.  Utility planttotaling $7.2 million, identifiable finite-lived intangible assets (principallycustomer relationships) totaling $0.2 million and goodwill totaling $1.5million were recorded.  Approximately$6.4 million, including goodwill, is not deductible for income taxpurposes.  As a result, a $1.7 milliondeferred income tax liability was also recorded.

 

The consolidated financial statements includethe operations of the utilities subsequent to their respective acquisitiondates.  The acquisitions are notmaterial, either individually or in the aggregate, to the Company’sconsolidated financial statements.  TheCompany expects to finalize the purchase price allocations during 2007.

 

8

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On March 20, 2006, the 10% minority intereststockholder in Operations Technology, Inc. (“OpTech”), a Georgia-basednon-regulated business in the Company’s Services Group, exercised its right torequire the Company to purchase the remaining 10% of OpTech stock that it didnot already own for $1.0 million in cash. In connection with this acquisition, the Company allocated $0.5 millionof the purchase price to finite-lived intangible assets and the remaining $0.5million to goodwill.  The intangibleassets, principally customer relationships and tradenames, are being amortizedon a straight-line basis over a weighted-average amortization period of 8.1years.

 

The acquisitions were funded with borrowingsunder the Company’s revolving line of credit.

 

**Note 3.       Goodwill**

** **

The table below summarizes the changes in thecarrying amount of goodwill, by business segment (Note 11), during the ninemonths ended September 30, 2007.

 
| ** **                          | ** ** | **Utility** | ** ** | **Services** | *** *** | *** *** | *** *** |
|-------------------------------------|------------|-------------|------------|--------------|--------------|--------------|--------------|
| **(In thousands)**                  | ** ** | **Group**   | ** ** | **Group**    | ** **   | **Total**    | ** **   |
|                                |       |        |       |         |         |         |         |
| Balance, December 31, 2006          |       | $           | 15,899     |         | $            | 17,253       |         | $ | 33,152 |   |
|                                |       |        |       |         |         |         |         |
| Businesses acquired during the year |       | 1,495       |       | —       |         | 1,495        |         |
| Balance, September 30, 2007         |       | $           | 17,394     |         | $            | 17,253       |         | $ | 34,647 |   |

 

The Company has acquired several businessesduring 2007, all of which were accounted for as purchases (Note 2).  As a result, the assets acquired andliabilities assumed have been recorded at their estimated fair values based onpreliminary valuations with the difference between the aggregate purchase priceand the fair value of the identifiable net assets acquired recorded asgoodwill.

 

9

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**Note 4.       Long-TermDebt**

 

Long-term debt consists of the following asof September 30, 2007 and December 31, 2006:

 
| *** ***                                          | *** *** | ***September 30,*** | *** *** | ***December 31,*** | ** ** |
|-------------------------------------------------------|--------------|---------------------|--------------|--------------------|------------|
| **(In thousands)**                                    | ** **   | **2007**            | ** **   | **2006**           | ** ** |
|                                                  |         |                |         |               |       |
| $100 million revolving credit facility                |         | $                   | 52,000       |               | $          | 36,000 |   |
|                                                  |         |                |         |               |       |
| 6.85% convertible subordinated debentures  due 2021   |         | 12,060              |         | 12,610             |       |
|                                                  |         |                |         |               |       |
| Term Loans:                                           |         |                |         |               |       |
| Monarch Utilities, Inc.:                              |         |                |         |               |       |
| 7.37% fixed rate term loan due 2022                   |         | 11,229              |         | 11,807             |       |
| 5.77% fixed rate term loan due 2022                   |         | 772                 |         | 811                |       |
| 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              |       |
| 5.64% series D first mortgage bond due 2024           |         | 15,000              |         | 15,000             |       |
| 6.30% series E first mortgage bond due 2026           |         | 10,000              |         | 10,000             |       |
| New Mexico Utilities, Inc.:                           |         |                |         |               |       |
| 6.10% series C first mortgage bond due 2024           |         | 12,000              |         | 12,000             |       |
|                                                  |         |                |         |               |       |
| Economic Development Revenue Bonds:                   |         |                |         |               |       |
| ECO Resources, Inc.:                                  |         |                |         |               |       |
| 5.5% series 1998A due 2008                            |         | 220                 |         | 220                |       |
| 6.0% series 1998A due 2018                            |         | 1,810               |         | 1,810              |       |
|                                                  |         |                |         |               |       |
| Acquisition-related indebtedness and other            |         | 709                 |         | 904                |       |
| Total long-term debt payment obligations              |         | 143,800             |         | 129,162            |       |
| Unamortized Monarch term loan fair value  adjustments |         | 788                 |         | 885                |       |
| Total long-term debt                                  |         | 144,588             |         | 130,047            |       |
| Less current portion of long-term debt                |         | (1,498              | )            | (1,423             | )          |
| Long-term debt, less current portion                  |         | $                   | 143,090      |               | $          | 128,624 |   |

 

The $100 million revolving line of creditcommitment ends on April 1, 2010 (if not renewed or extended), at which timeall borrowings must be repaid. Borrowings under the credit facility bear interest, at the Company’soption, based on a margin either: a) over the LIBOR rate; or b) under the primerate.  The margins vary depending uponthe Company’s consolidated debt to equity ratio.  Currently, the applicable margins are 0.875%over the LIBOR rate or 0.25% under the prime rate.  The weighted-average interest rates on all creditfacility borrowings outstanding were 6.32% as of September 30, 2007 and 6.23%as of December 31, 2006.

 

The Company had irrevocable standby lettersof credit in the amount of $2.0 million issued and outstanding under itsrevolving credit facility as of September 30, 2007, reducing availableborrowings under the credit facility to $46.0 million as of that date.

 

10

----

 

**Note 5.       Commitmentsand Contingencies**

** **

**Legal Proceedings**

** **

New Mexico Utilities, Inc. (“NMUI”), one ofthe Company’s wholly-owned regulated utilities, has an agreement with theAlbuquerque Bernalillo County Water Utility Authority, a political subdivisionof the State of New Mexico (the “Water Authority”), whereby the Water Authoritytreats the effluent from NMUI’s wastewater collection system for a fee.  The treated effluent is returned to the RioGrande Underground Basin, creating return flow credits.  Return flow credits supplement NMUI’sexisting water rights, enabling it to pump additional water from the basin.

 

In August 2004, the Water Authority increasedthe fee charged to NMUI, using a different formula than had been used tocalculate fee increases in prior years. The Company believes the increase violates the terms of a writtenagreement between the parties. Subsequently, the Water Authority also claimed ownership of the returnflow credits.  The Company filed aComplaint for Declaratory Judgment in the Second Judicial District Court,County of Bernalillo, State of New Mexico, requesting that the Court settlethese disputes.  In a letter ruling datedMay 2, 2007, the Court ruled that the Water Authority could use a new formulato set fees for NMUI.  The Company fileda motion for reconsideration and that motion was denied on October 2, 2007.  The matter has now been set for trial in thefall of 2008.  The Court has not ruled onwhether the new rate was appropriate; has made no determination as to anyamount NMUI may owe to the Water Authority, or ruled on the ownership of thereturn flow credits.  Although theCompany cannot give any assurances as to the ultimate resolution of thismatter, the Company does not believe that it is probable it will be required topay the disputed fees and related late payment penalties, which totaled $4.4million as of September 30, 2007, and has not recognized a reserve for anypotential liabilities in the accompanying consolidated financialstatements.  The Company is unable topredict the impact the resolution of the return flow credits ownership disputewill have on its consolidated financial statements.

 

In September 2007, NMUI received a $0.7million retroactive billing adjustment from the Water Authority covering theperiod from August 2003 through April 2006 for the volume of wastewater itbelieves NMUI discharged into the treatment system versus the amount reportedby NMUI.  The amounts reported by NMUIwere based on a calculation methodology that had been agreed to by both partiesand used for years, including years prior to the billing adjustment period.  NMUI is contesting the billingadjustment.  Although the Company cannotgive any assurances as to the ultimate resolution of this matter, the Companydoes not believe that it is probable it will be required to pay the retroactivebilling and therefore has not recognized a reserve for any potential liabilityfor this amount in the accompanying consolidated financial statements.

 

In addition, on January 19, 2007, the WaterAuthority and the City of Rio Rancho, a home-rule municipal corporation, asPetitioners, filed a Petition for Condemnation against NMUI and others, asDefendants, in the Second Judicial District Court, County of Bernalillo, Stateof New Mexico (the “Petition”).  ThePetition seeks to acquire, by condemnation, all of the assets of NMUI, includingall real property, through the stated power of eminent domain.  The Petition also alleges that thePetitioners need to acquire the NMUI assets for the public purposes ofproviding water and wastewater services to NMUI customers and that the acquisitionof NMUI is necessary, appropriate and in the public interest.  The Company is contesting the Petition andthe matter is scheduled for trial in the fall of 2008.  If the Company does not prevail, thePetitioners must pay fair market value for the utility as determined by thecourt, based on appraisals.  NMUI and thePetitioners do not agree on the value of the assets which the Petitioners seekto condemn.  While it is too early topredict the outcome of this matter, the Company believes that the fair marketvalue of its NMUI utility exceeds its recorded net book value as of September30, 2007.

 

11

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Southwest Water and a subsidiary were namedas defendants in several lawsuits alleging various injuries as a result ofwater contamination in the San Gabriel Valley Main Basin.  The California Supreme Court ruled inFebruary 2002 that the plaintiffs could not challenge the adequacy of the waterquality standards established by California Department of Health Services.  In August 2004, the case against SouthwestWater and its subsidiary was dismissed; however, the plaintiffs appealed thedismissal to the Court of Appeals for the State of California, First AppellateDistrict (1DCA Civil No.  B178283).  Oral arguments for the appeal were presentedon June 20, 2007 and the Company (and the other defendants) prevailed at theappellate level.  The Court ruled thatthe only time a regulated water utility or public water company can be heldliable in tort for water quality issues is when they have violated a numericalstandard set by the Department of Health Services or other similar regulatoryagency.  Liability insurance carriershave absorbed all costs related to the lawsuits and appeals.  The parties have entered into a settlementagreement which provides, in part, that no further appeals will be filed,effectively ending this litigation.

 

The Company and its subsidiaries are alsoinvolved in other routine legal and administrative proceedings arising duringthe ordinary course of business.  TheCompany believes the ultimate disposition of such matters will not have amaterial adverse effect on its business, consolidated financial position,results of operations or cash flows.

 

**EPA Investigations**

** **

On May 5, 2005, one of the Company’soperating subsidiaries received a subpoena to provide records to a grandjury.  The requested records relate tothe operations of the San Simeon wastewater treatment plant in California forthe period January 2002 to the date of the subpoena.  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 and has provided the records requested.  There have been no further significantdevelopments since May 5, 2005.

 

On May 18, 2005, the EPA executed a searchwarrant at the Company’s Texas-based testing laboratory and on July 20,2006 the laboratory received a subpoena to provide additional records andinformation to a grand jury.  The Companyis cooperating fully with the investigation and has provided the recordsrequested.  There have been no furthersignificant developments since July 20, 2006.

 

**Settlement Agreement Liability**

** **

In 2006, the Company negotiated a settlementagreement with a municipality relating to possible fines and penalties forspecified violations occurring during the time the Company operated themunicipality’s wastewater system.  TheCompany’s maximum payment obligation is capped at $0.7 million under theagreement provided that total fines and penalties levied do not exceed aspecified amount.  The water qualitycontrol board has preliminary indicated that fines and penalties exceeding theamount contemplated by the settlement agreement may be levied. The Companybelieves there are convincing arguments for negotiating a reduction in theamounts levied but has elected to accrue the $0.7 million maximum amountcontemplated by the settlement agreement. In the event total fines and penalties exceed the specified amount, themunicipality may, at its option, cancel the settlement agreement.

 

12

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** **

In 2002, the Company was retained tofacilitate the engineering and construction of a $23.0 million reverse osmosiswater treatment plant in the city of San Juan Capistrano, California for theCapistrano Valley Water District (“CVWD”). In 2003, the Company obtained a $3.4 million standby letter of credit ascollateral to insure its performance during the design and construction of thewater treatment plant.  Construction wascompleted during 2005 and the $3.4 million standby letter of credit wasreleased on May 3, 2007.  The Companyobtained final acceptance of the completed project from the CVWD and payment ofthe final $2.3 million of the total contract price in July 2007.

 

The Company now operates the completed plantunder a twenty-year operating agreement. The CVWD service contract contains three guarantees related to theperformance of the Company and its subsidiary during the term of the operatingagreement.  The agreement provides forthe Company to pay liquidated damages in the event it fails to perform forreasons other than those caused by “uncontrollable circumstances,” as such termis defined in the agreement.

 

During the term of the operating agreement,the Company may be liable for liquidated damages relating to any lost paymentsfrom a financial assistance agreement CVWD has with a state water agency, up toa maximum of $1.4 million per contract year. The Company has also made guarantees to CVWD with respect to thequantity of finished water produced by the facility.  In the event the actual number of acre feetof finished water delivered is less than the water delivery guarantee, theCompany is required to pay liquidated damages of approximately $600 per acrefoot of shortfall, up to a maximum of 15.8 acre feet per day.  Finally, the Company has made guarantees withrespect to seven measurable finished water quality standards.  Liquidated damages for failure to meet thesequality standards range from $100 to $400 per day per failed quality standard(up to a maximum of $2,800 per day), depending on the number of violations percontract year.  The CVWD has not assertedany claims for liquidated damages pursuant to these guarantees through the dateof this report.

 

As part of the financing for this project,the CVWD sold insured municipal bonds. The Company entered into an agreement with the bond insurer to guaranteethe Company’s performance under the service contract, subject to certainliability 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.

 

**Water Supply Commitment**

** **

One of the Company’s regulated utilities hasa water supply contract providing for the purchase of water to supplement itsown water supply.  The agreement requiresthe Company to purchase minimum quantities of water annually at a specifiedprice.  The price is subject to annualadjustment for production cost increases incurred by the seller.  The minimum quantity is also subject toadjustment based on average actual water purchases over a moving two-yearperiod, but the minimum will not be reduced below a specified threshold.  As of September 30, 2007, the minimumannual purchase commitment is $0.5 million through 2024.

 

13

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**Note 6.       EarningsPer Share**

 

The following table is a reconciliation ofthe numerators (income) and denominators (shares) used in both the basic anddiluted earnings per share calculations.

 
| ** **                                                                      | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|---------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                      | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In thousands)**                                                              | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                            |       |                   |       |                  |       |   |   |   |   |
| Numerators—Net income applicable to common  stockholders:                  |       |                   |       |                  |       |   |   |   |   |
| Income before change in accounting  principle                                   |       | $                      | 2,075      |                  | $          | 3,672 |   | $ | 4,912 |   | $ | 6,189 |   |
| Less preferred stock dividends                                                  |       | (6                     | )          | (6                    | )          | (18 | ) | (18 | ) |
| Income before change in accounting  principle applicable to common stockholders |       | 2,069                  |       | 3,666                 |       | 4,894 |   | 6,171 |   |
| Cumulative effect of change in accounting  principle                            |       | —                 |       | —                |       | — |   | 71 |   |
| Net income applicable to common  stockholders                                   |       | $                      | 2,069      |                  | $          | 3,666 |   | $ | 4,894 |   | $ | 6,242 |   |
|                                                                            |       |                   |       |                  |       |   |   |   |   |
| Denominators—Weighted average common shares  outstanding:                  |       |                   |       |                  |       |   |   |   |   |
| Basic weighted average common shares  outstanding                               |       | 24,178                 |       | 23,069                |       | 24,054 |   | 22,691 |   |
| Plus shares issued on assumed exercise of  stock options and warrants           |       | 294                    |       | 353                   |       | 303 |   | 493 |   |
| Diluted weighted average common shares  outstanding                             |       | 24,472                 |       | 23,422                |       | 24,357 |   | 23,184 |   |

 

As described in Note 4, the Company has $12.1million of 6.85% fixed-rate convertible subordinate debentures outstanding asof September 30, 2007.  Thedebentures are convertible into common stock at any time prior to maturity,unless previously redeemed, at a conversion price of $11.018 per share whichtotals 1.1 million shares as of September 30, 2007.  At such time as the assumed conversion of thedebentures has a dilutive effect on earnings per share, the debentures will beincluded in the calculation of diluted earnings per share after adjusting netincome for the after-tax effect of the debenture interest expense.

 

14

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**Note 7.       ConsolidatedStatements of Cash Flows**

 

The following information supplements theCompany’s consolidated statements of cash flows.

 
| *** ***                                                                                                   | ** ** | ***Nine Months Ended*** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| *** ***                                                                                                   | ** ** | ***September 30,***     | ** ** |
| ***(In thousands)***                                                                                           | ** ** | **2007**                | ** ** | **2006** | ** ** |
|                                                                                                           |       |                    |       |   |   |
| Cash paid during the period for:                                                                               |       |                    |       |   |   |
| Interest                                                                                                       |       | $                       | 5,853      |   | $ | 6,420 |   |
| Income taxes paid (refunded), net                                                                              |       | (666                    | )          | (1,948 | ) |
|                                                                                                           |       |                    |       |   |   |
| Components of cash paid for acquisitions:                                                                      |       |                    |       |   |   |
| Fair value of assets acquired                                                                                  |       | $                       | 9,057      |   | $ | 1,859 |   |
| Liabilities assumed                                                                                            |       | (2,510                  | )          | (50 | ) |
| Cash paid for acquisitions                                                                                     |       | $                       | 6,547      |   | $ | 1,809 |   |
|                                                                                                           |       |                    |       |   |   |
| Non-cash investing and financing  activities:                                                                  |       |                    |       |   |   |
| Non-cash contributions in aid of  construction and advances for construction conveyed to Company by developers |       | $                       | 5,875      |   | $ | 5,823 |   |
| Debentures converted into common stock                                                                         |       | 550                     |       | 3,057 |   |

 

**Note 8.       Share-BasedCompensation Plans**

** **

The Company has two share-based compensationplans: an Equity Incentive Plan and an Employee Stock Purchase Plan.

 

As more fully described in Note 13 to theCompany’s consolidated financial statements included in its 2006 Annual Reporton Form 10-K, effective January 1, 2006, the Company adopted theprovisions of SFAS No. 123(R), “*Share-Based Payment*”(“SFAS 123(R)”).  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.

 

**Equity Incentive Plan**

** **

The stockholder-approved Equity IncentivePlan (“EIP”) authorizes the Company to award up to 5.4 million shares of itscommon stock.  As of September 30, 2007,1.0 million shares were available for granting future awards under the planwhich may be granted until May 16, 2016. The Company has reserved 2.8 million shares of its authorized commonshares for issuance upon exercise of awards outstanding and future awardsavailable for granting under the plan. Under the EIP, the Company may award, either qualified or non-qualifiedstock options, stock appreciation rights, restricted stock, restricted stockunits and other stock-based awards to officers, employees and non-employeedirectors.

 

15

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The following table summarizes thecompensation expense and related income tax benefit related to share-basedcompensation expense recognized during the periods:

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                    | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In thousands)**                            | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                    | ** ** | ** **             | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options                                 |       | $                      | 396        |                  | $          | 249 |   | $ | 1,197 |   | $ | 834 |   |
| Restricted stock awards                       |       | 52                     |       | —                |       | 114 |   | — |   |
| Share-based compensation expense              |       | 448                    |       | 249                   |       | 1,311 |   | 834 |   |
| Income tax benefit                            |       | (172                   | )          | (91                   | )          | (485 | ) | (305 | ) |
| Share-based compensation expense, net of  tax |       | $                      | 276        |                  | $          | 158 |   | $ | 826 |   | $ | 529 |   |

 

*Stock Options*

* *

The following table summarizes all stockoption activity during the nine months ended September 30, 2007:

 
| ** **                                                   | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|---------------|------------|
| ** **                                                   | ** ** | **Number** | ** ** | **Average**   | ** ** |
| ** **                                                   | ** ** | **of**     | ** ** | **Exercise**  | ** ** |
| **(In thousands, except weighted  average exercise prices)** | ** ** | **Shares** | ** ** | **Price**     | ** ** |
|                                                         |       |       |       |          |       |
| Outstanding at December 31, 2006                             |       | 1,788      |       | $             | 10.29      |   |
| Granted                                                      |       | 342        |       | 12.83         |       |
| Exercised                                                    |       | (228       | )          | 6.93          |       |
| Forfeited                                                    |       | (171       | )          | 13.53         |       |
| Expired                                                      |       | (10        | )          | 6.17          |       |
| Outstanding at September 30, 2007                            |       | 1,721      |       | 10.94         |       |
|                                                         |       |       |       |          |       |
| Exercisable at September 30, 2007                            |       | 976        |       | 9.01          |       |
|                                                              |            |            |            |               |            |  |

 

The fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions used for grants in 2007 and2006:

 
| *** ***            | *** *** | ***Nine Months Ended*** | ** **   |
|-------------------------|--------------|-------------------------|--------------|
| *** ***            | *** *** | ***September 30,***     | *** *** |
| ** **              | ** **   | **2007**                | ** **   | **2006** | ** ** |
|                    |         |                    |         |   |   |
| Dividend yield          |         | 1.8                     | %            | 1.4 | % |
| Expected volatility     |         | 35.5                    | %            | 33.5 | % |
| Risk-free interest rate |         | 4.7                     | %            | 4.8 | % |
| Expected life in years  |         | 4.7                     |         | 4.6 |   |

 

The weighted average grant date fair value ofoptions granted using these assumptions was $4.57 per share for the threemonths ended September 30, 2007 (none granted during the same period in2006), and $3.92 and $4.99 per share for the nine months endedSeptember 30, 2007 and 2006, respectively.

 

16

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*Restricted Stock Awards*

* *

Under the EIP, the Company may award sharesof restricted stock to employees that vest and are released to the employee asthe vesting conditions are met.  TheCommittee has established a straight-line vesting schedule over a three-yearperiod of continuous service to the Company for all awards granted todate.  Restricted stock is forfeited inthe event a participant terminates employment with the Company prior to theaward vesting.  The grant date fair valueof stock awarded is recognized as compensation expense over the vesting term.

 

The following table summarizes all restrictedstock award activity during the nine months ended September 30, 2007:

 
| ** **                                                         | ** ** | ** ** | ** ** | **Weighted-**  | ** ** |
|--------------------------------------------------------------------|------------|------------|------------|----------------|------------|
| ** **                                                         | ** ** | **Number** | ** ** | **Average**    | ** ** |
| ** **                                                         | ** ** | **of**     | ** ** | **Grant Date** | ** ** |
| **(In thousands, except weighted  average grant date fair value)** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
|                                                               |       |       |       |           |       |
| Outstanding at December 31, 2006                                   |       | —     |       | $              | —     |   |
| Awarded                                                            |       | 27         |       | 12.76          |       |
| Vested and released                                                |       | —     |       | —         |       |
| Forfeited                                                          |       | —     |       | —         |       |
| Outstanding at September 30, 2007                             |       | 27         |       | 12.76          |       |
|                                                                    |            |            |            |                |            |  |

 

**Employee Stock Purchase Plan (“ESPP”)**

** **

The Company has a stockholder-approvedemployee stock purchase plan (“ESPP”) that allows eligible employees topurchase 1.005 million shares of common stock through payroll deductions of upto 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, employees purchased 5,274 and 15,785 shares for $62,000and $187,000 during the three months and nine months ended September 30, 2007,respectively, and 5,895 and 15,048 shares for $63,000 and $183,000 during thethree months and nine months ended September 30, 2006, respectively.

 

The fair value of ESPP shares purchased isestimated using a Black-Scholes option pricing model with the followingweighted average assumptions used for 2007 and 2006:

 
| *** ***            | *** *** | ***Nine Months Ended*** | ** **   |
|-------------------------|--------------|-------------------------|--------------|
| *** ***            | *** *** | ***September 30,***     | *** *** |
| ** **              | ** **   | **2007**                | ** **   | **2006** | ** ** |
|                    |         |                    |         |   |   |
| Dividend yield          |         | 1.5                     | %            | 1.4 | % |
| Expected volatility     |         | 35.3                    | %            | 33.6 | % |
| Risk-free interest rate |         | 4.9                     | %            | 4.8 | % |
| Expected life in years  |         | 0.25                    |         | 0.25 |   |

 

 

Compensation expense recognized by theCompany resulting from employee stock purchases pursuant to this plan was$13,000 and $15,000 for the three months ended September 30, 2007 and 2006,respectively, and $36,000 and $37,000 for the nine months ended September 30,2007 and 2006, respectively.  As ofSeptember 30, 2007, 0.6 million shares remain available for future purchases.

 

17

----

 

**Note 9.       DividendReinvestment and Direct Stock Purchase Plan (“DRIP / DSPP”)**

 

The Company has a dividend reinvestment andstock purchase plan that gives common stockholders the option of receiving theirdividends in cash or in common stock at a discount from prevailing marketprices (“DRIP”).  The plan also permitsexisting stockholders to purchase additional common stock, up to a maximum of$10,000 per month, at a discount (“DSPP”); new investors may participate in theplan, subject to a $250 minimum initial investment.  The Company may, at its sole discretion,permit purchases above the $10,000 stated maximum.  The discounts may range from 0% to 5%, asdetermined from time to time by the Company. The DRIP and DSPP discounts offered by the Company are 5% for the DRIPand 0% for the DSPP as of September 30, 2007. As of September 30, 2007, there are 3.7 million shares authorizedfor issuance under the plan of which 1.0 million shares remain available forissuance.

 

**Note 10.     EmployeeRetirement Plan**

 

The Company has a non-qualified supplementalexecutive retirement plan (“SERP”) for certain key executive officers for thepurpose of providing supplemental income benefits to plan participants or theirsurvivors upon retirement or death.  Theplan measurement date is December 31st of each year.  As discussed in Note 1, the Company adoptedthe balance sheet recognition requirements of SFAS 158 on December 31, 2006 andbegan recognizing the unamortized portion of actuarial gains and prior servicecosts in accumulated other comprehensive income.  The following table details the components ofthe net periodic benefit costs:

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                               | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In thousands)**                       | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                     |       |                   |       |                  |       |   |   |   |   |
| Service cost                             |       | $                      | —     |                  | $          | 17 |   | $ | — |   | $ | 49 |   |
| Interest cost                            |       | 16                     |       | 19                    |       | 48 |   | 57 |   |
| Amortization of actuarial (gains) losses |       | (19                    | )          | 3                     |       | (57 | ) | 12 |   |
| Amortization of prior service costs      |       | 22                     |       | 10                    |       | 66 |   | 27 |   |
| Net periodic benefit costs               |       | $                      | 19         |                  | $          | 49 |   | $ | 57 |   | $ | 145 |   |

 

The sole remaining participant in the planhas reached retirement age and the plan provides that no additional benefitsaccrue upon reaching retirement age. Summarized in the table below is information about the changes in theprojected benefit obligation and the liability recognized in the consolidatedbalance sheet as of September 30, 2007.

 
| ** **                                                     | ** ** | **September  30,** | ** ** |
|----------------------------------------------------------------|------------|--------------------|------------|
| **(In thousands)**                                             | ** ** | **2007**           | ** ** |
|                                                           |       |               |       |
| Projected benefit obligation:                                  |       |               |       |
| Balance at December 31, 2006                                   |       | $                  | 1,224      |   |
| Interest cost                                                  |       | 48                 |       |
| Payment of benefit obligation                                  |       | (174               | )          |
| Balance at September 30, 2007                                  |       | $                  | 1,098      |   |
|                                                           |       |               |       |
| Amounts recognized in accumulated other  comprehensive income: |       |               |       |
| Actuarial gains                                                |       | $                  | (142       | ) |
| Prior service cost                                             |       | 22                 |       |
| Related deferred income taxes                                  |       | 42                 |       |
| Total                                                          |       | $                  | (78        | ) |

 

18

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**Note 11.**     Segment Information

 

The Company’s businesses are segmented intotwo operating groups: the Utility Group and the Services Group.  Each segment is a strategic business unitthat offers different services.  They aremanaged separately since each business requires different operating and growthstrategies.  The accounting policies ofthe segments are described in the summary of significant accounting policies inNote 1 to the audited financial statements included in the Company’s 2006 Form10-K.

 

The Utility Group owns and operates publicwater and wastewater utilities in Alabama, California, New Mexico, Mississippi,Oklahoma and Texas.  State and federalagencies 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 Group operates and manages waterand wastewater treatment facilities owned by cities, public agencies, municipalutility districts, private entities and investor-owned utilities, includingsome of the companies in the Utility Group. The Services Group also provides construction and constructionmanagement services, certified water and wastewater laboratory testing services,and public works services.  The ServicesGroup, while subject to certain environmental standards, is not regulated inits pricing, marketing or rates of return.

 

As more fully described in Note 1, effectiveJanuary 1, 2007, the Company elected to allocate a portion of its Services Group’soperating expense overhead between affiliated and unaffiliated customers forsegment reporting purposes.  Prior yearamounts have been reclassified to conform to the 2007 presentation.

 

19

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The following tables present informationabout the operations of each segment for the three months and nine months endedSeptember 30, 2007 and 2006.

 
| ** **                                                            | ** ** | **Utility** | ** ** | **Services** | ** ** | ** **        | ** ** | ** **           | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------|------------|-------------|------------|--------------|------------|-------------------|------------|----------------------|------------|------------------|------------|
| **(In  thousands)**                                                   | ** ** | **Group**   | ** ** | **Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations (3)** | ** ** | **Consolidated** | ** ** |
| ** **                                                            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | ** **           | ** ** | ** **       | ** ** |
| **Three  months ended September 30, 2007:**                           |       |        |       |         |       |              |       |                 |       |             |       |
| Revenues:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Unaffiliated customers                                                |       | $           | 26,041     |         | $          | 30,562            |       | $                    | —     |             | $          | — |   | $ | 56,603 |   |
| Intersegment (1) (3)                                                  |       | 415         |       | 7,161        |       | —            |       | (6,821               | )          | 755              |       |
| Total revenues                                                        |       | 26,456      |       | 37,723       |       | —            |       | (6,821               | )          | 57,358           |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Expenses:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 15,030      |       | 28,608       |       | —            |       | —               |       | 43,638           |       |
| Operating expenses–intersegment (3)                              |       | 415         |       | 6,406        |       | —            |       | (6,821               | )          | —           |       |
| Selling, general and administrative                                   |       | 1,852       |       | 2,964        |       | 3,621             |       | —               |       | 8,437            |       |
| Total expenses                                                        |       | 17,297      |       | 37,978       |       | 3,621             |       | (6,821               | )          | 52,075           |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Operating income (loss)                                               |       | 9,159       |       | (255         | )          | (3,621            | )          | —               |       | 5,283            |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Interest expense                                                      |       | (1,746      | )          | (65          | )          | (371              | )          | —               |       | (2,182           | )          |
| Interest income                                                       |       | 3           |       | 271          |       | 17                |       | —               |       | 291              |       |
| Other income (expense)                                                |       | (41         | )          | —       |       | —            |       | —               |       | (41              | )          |
| Income (loss) before income taxes                                     |       | $           | 7,375      |         | $          | (49               | )          | $                    | (3,975     | )                | $          | — |   | $ | 3,351 |   |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| **Three  months ended September 30, 2006:**                           |       |        |       |         |       |              |       |                 |       |             |       |
| Revenues:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Unaffiliated customers                                                |       | $           | 25,839     |         | $          | 31,711            |       | $                    | —     |             | $          | — |   | $ | 57,550 |   |
| Intersegment (1) (3)                                                  |       | 428         |       | 9,158        |       | —            |       | (8,192               | )          | 1,394            |       |
| Total revenues                                                        |       | 26,267      |       | 40,869       |       | —            |       | (8,192               | )          | 58,944           |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Expenses:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 14,539      |       | 29,272       |       | —            |       | —               |       | 43,811           |       |
| Operating expenses–intersegment (3)                              |       | 428         |       | 7,764        |       | —            |       | (8,192               | )          | —           |       |
| Selling, general and administrative                                   |       | 1,787       |       | 2,650        |       | 2,678             |       | —               |       | 7,115            |       |
| Impairment of goodwill                                                |       | —      |       | 261          |       | —            |       | —               |       | 261              |       |
| Total expenses                                                        |       | 16,754      |       | 39,947       |       | 2,678             |       | (8,192               | )          | 51,187           |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Operating income (loss)                                               |       | 9,513       |       | 922          |       | (2,678            | )          | —               |       | 7,757            |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Interest expense                                                      |       | (1,564      | )          | (464         | )          | (53               | )          | —               |       | (2,081           | )          |
| Interest income                                                       |       | 8           |       | 83           |       | 17                |       | —               |       | 108              |       |
| Other income (expense)                                                |       | (12         | )          | —       |       | 23                |       | —               |       | 11               |       |
| Income (loss) before income taxes and  change in accounting principle |       | $           | 7,945      |         | $          | 541               |       | $                    | (2,691     | )                | $          | — |   | $ | 5,795 |   |

 

*See accompanying notes to the segment information following thesetables.*

 

20

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| ** **                                                            | ** ** | **Utility** | ** ** | **Services** | ** ** | ** **        | ** ** | ** **           | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------|------------|-------------|------------|--------------|------------|-------------------|------------|----------------------|------------|------------------|------------|
| **(In  thousands)**                                                   | ** ** | **Group**   | ** ** | **Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations (3)** | ** ** | **Consolidated** | ** ** |
| ** **                                                            | ** ** | ** **  | ** ** | ** **   | ** ** | ** **        | ** ** | ** **           | ** ** | ** **       | ** ** |
| **Nine  months ended September 30, 2007:**                            |       |        |       |         |       |              |       |                 |       |             |       |
| Revenues:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Unaffiliated customers                                                |       | $           | 69,629     |         | $          | 87,794            |       | $                    | —     |             | $          | — |   | $ | 157,423 |   |
| Intersegment (1) (3)                                                  |       | 1,305       |       | 20,645       |       | —            |       | (18,966              | )          | 2,984            |       |
| Total revenues                                                        |       | 70,934      |       | 108,439      |       | —            |       | (18,966              | )          | 160,407          |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Expenses:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 39,619      |       | 80,733       |       | —            |       | —               |       | 120,352          |       |
| Operating expenses–intersegment (3)                              |       | 1,305       |       | 17,661       |       | —            |       | (18,966              | )          | —           |       |
| Selling, general and administrative                                   |       | 6,241       |       | 9,213        |       | 10,828            |       | —               |       | 26,282           |       |
| Total expenses                                                        |       | 47,165      |       | 107,607      |       | 10,828            |       | (18,966              | )          | 146,634          |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Operating income (loss)                                               |       | 23,769      |       | 832          |       | (10,828           | )          | —               |       | 13,773           |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Interest expense                                                      |       | (4,846      | )          | (669         | )          | (861              | )          | —               |       | (6,376           | )          |
| Interest income                                                       |       | 13          |       | 448          |       | 46                |       | —               |       | 507              |       |
| Other income (expense)                                                |       | (144        | )          | —       |       | 42                |       | —               |       | (102             | )          |
| Income (loss) before income taxes                                     |       | $           | 18,792     |         | $          | 611               |       | $                    | (11,601    | )                | $          | — |   | $ | 7,802 |   |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| **Nine  months ended September 30, 2006:**                            |       |        |       |         |       |              |       |                 |       |             |       |
| Revenues:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Unaffiliated customers                                                |       | $           | 64,602     |         | $          | 93,783            |       | $                    | —     |             | $          | — |   | $ | 158,385 |   |
| Intersegment (1) (3)                                                  |       | 1,178       |       | 26,217       |       | —            |       | (22,946              | )          | 4,449            |       |
| Total revenues                                                        |       | 65,780      |       | 120,000      |       | —            |       | (22,946              | )          | 162,834          |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Expenses:                                                             |       |        |       |         |       |              |       |                 |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 35,442      |       | 86,021       |       | —            |       | —               |       | 121,463          |       |
| Operating expenses–intersegment (3)                              |       | 1,178       |       | 21,768       |       | —            |       | (22,946              | )          | —           |       |
| Selling, general and administrative                                   |       | 5,870       |       | 8,692        |       | 10,146            |       | —               |       | 24,708           |       |
| Impairment of goodwill                                                |       | —      |       | 929          |       | —            |       | —               |       | 929              |       |
| Total expenses                                                        |       | 42,490      |       | 117,410      |       | 10,146            |       | (22,946              | )          | 147,100          |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Operating income (loss)                                               |       | 23,290      |       | 2,590        |       | (10,146           | )          | —               |       | 15,734           |       |
|                                                                  |       |        |       |         |       |              |       |                 |       |             |       |
| Interest expense                                                      |       | (4,637      | )          | (1,442       | )          | (254              | )          | —               |       | (6,333           | )          |
| Interest income                                                       |       | 37          |       | 247          |       | 79                |       | —               |       | 363              |       |
| Other income (expense)                                                |       | (37         | )          | —       |       | 37                |       | —               |       | —           |       |
| Income (loss) before income taxes and  change in accounting principle |       | $           | 18,653     |         | $          | 1,395             |       | $                    | (10,284    | )                | $          | — |   | $ | 9,764 |   |

 

*See accompanying notes to the segment information following thesetables.*

 

21

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----

**Notes**

 

(1)          Some companies in the Services Group provideconstruction, operations and maintenance services to companies in the UtilityGroup and recognize a profit on those services. In accordance with SFAS 71, the Company does not eliminate theintersegment profit recognized on these services because the Company believesthe sales price is reasonable and it is probable that, through the rate makingprocess, future Utility Group revenue approximately equal to the sales pricewill result from the regulated utilities’ use of the services.  The Company does, however, eliminate theServices Group’s revenues from affiliated customers to the extent of itscost.  Consequently, Services Grouprevenues reflected in the consolidated statements of income includeintersegment gross profits as follows:

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | **Nine Months Ended** | ** ** |
|-----------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                  | ** ** | **September 30,**      | ** ** | **September 30,**     | ** ** |
| **(In  thousands)**         | ** ** | **2007**               | ** ** | **2006**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                        |       |                   |       |                  |       |   |   |   |   |
| Services Group revenues:    |       |                   |       |                  |       |   |   |   |   |
| From unaffiliated customers |       | $                      | 30,562     |                  | $          | 31,711 |   | $ | 87,794 |   | $ | 93,783 |   |
| Intersegment profits        |       | 755                    |       | 1,394                 |       | 2,984 |   | 4,449 |   |
| Total revenues              |       | 31,317                 |       | 33,105                |       | 90,778 |   | 98,232 |   |
|                             |            |                        |            |                       |            |  |  |  |  |  |  |  |  |

 

(2)          Consists of costs that include headquartersexpenses and any corporate functional departments whose costs are not allocatedto our reportable segments.  Corporateand other assets reflect corporate headquarters assets, excluding investmentsin and receivables from subsidiaries.

 

(3)          Reflects the elimination of Services Grouprevenues derived from the Utility Group, to the extent of costs as described in(1) above.  In addition, a company in theUtility Group provides services to a company in the Services Group.  Intersegment revenues and expenses, includingall profit, associated with these services are fully eliminated uponconsolidation.

 

22

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## **ITEM 2.**                             MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITIONAND RESULTS OF OPERATIONS

 

### **SPECIALNOTE ABOUT FORWARD-LOOKING STATEMENTS**

###  

Management’s Discussion and Analysis ofFinancial Condition and Results of Operations (“MD&A”) is intended to helpthe reader understand the results of operations and financial condition ofSouthwest Water Company.  This MD&Aalso contains “forward-looking statements” within the meaning of the PrivateSecurities Litigation Reform Act of 1995, Section 27A of the Securities Act of1933, as amended, and Section 21E of the Securities Exchange Act of 1934, asamended.  All statements contained hereinthat are not clearly historical in nature are forward-looking, and the words “anticipate,”“believe,” “belief,” “expect,” “estimate,” “project,” “plan,” “intend,” “continue,”“predict,” “may,” “will,” “should, “strategy,” “will likely result,” “willlikely continue,” and similar expressions are generally intended to identifyforward-looking statements. Forward-looking statements are subject to risks and uncertainties thatcould cause actual results to differ materially from our historical experienceand our present expectations or projections. A detailed discussion of these and other risks and uncertainties thatcould cause actual results and events to differ materially from suchforward-looking statements is included in the section entitled “Item 1A.  Risk Factors” in our 2006 Annual Report onForm 10-K.  Caution should be taken notto place undue reliance on any such forward-looking statements since suchstatements speak only as of the date when made. Other than as required by applicable law, we undertake no obligation topublicly update or revise forward-looking statements whether as a result of newinformation, future events, or otherwise.

 

The MD&A is intended to help the readerunderstand the results of operations, financial condition and cash flows ofSouthwest Water Company and is provided as a supplement to, and should be readin conjunction with, our condensed consolidated financial statements and theaccompanying notes to the financial statements included in this report.

 

### **OVERVIEW**

###  

Southwest Water Company provides a broadrange of services including water production, treatment and distribution;wastewater collection and treatment; utility billing and collection; utilityinfrastructure construction management; and public works services.  We own regulated public utilities and alsoserve cities, utility districts and private companies under contract.  Our subsidiaries are segmented into twooperating groups: our Utility Group and our Services Group.

 

#### **Utility Group**

#### ** **

Our Utility Group owns public water andwastewater utilities in Alabama, California, New Mexico, Oklahoma and Texasand, beginning in February 2007, Mississippi. Except for our California utility, our utilities are operated bycompanies in our Services Group.  Stateand federal agencies issue regulations regarding standards of water quality,safety, environmental and other matters which affect these operations.  The rates that our regulated utilitysubsidiaries charge for water and wastewater usage are established by state orlocal authorities.

 

Utility Group revenues reflect fees earnedfor the production and distribution of water and the collection and treatmentof sewage for residential, business, industrial and public authority use.  The group’s operating expenses reflect thecosts associated with purchasing, producing and distributing water, collectingand treating wastewater, salaries, wages and employee benefits, facilitiescosts, supplies and equipment, repairs and maintenance, professional fees andother costs.

 

We grow our Utility Group by:

 

•                  increasing the number of customers weserve;

 

•                  increasing the rate customers pay forour services through rate case filings with state regulatory commissions;

 

•                  creating new utilities by partneringwith the development community in high growth markets; and

 

•                  acquiring utilities from cities,municipalities and private owners in high growth markets.

 

23

----

 

In our pursuit of long-term Utility Groupgrowth, during 2006 we acquired two small water utilities and the rights toprovide water and wastewater utility service in developing areas located nearAustin, Texas, in February 2007, we acquired a small water and wastewaterutility located in northern Mississippi, just south of Memphis, Tennessee and,in May 2007, acquired two water and wastewater utilities near San Antonio,Texas.  While these acquisitions areinsignificant to our financial results, both individually and in the aggregate,they are strategically important as they expand our utility ownership in areasthat are currently experiencing significant population growth.

 

In 2007, the Albuquerque Bernalillo CountyWater Utility Authority and the City of Rio Rancho, New Mexico, filed aPetition for Condemnation (the “Petition”) against our New Mexico regulatedutility, New Mexico Utilities, Inc. (“NMUI”). The Petition seeks to acquire, by condemnation, all of the assets ofNMUI, including all real property, through the alleged power of eminentdomain.  The Petition also alleges thatthe Petitioners need to acquire the utility assets for the public purposes ofproviding water and wastewater services to customers and that the acquisitionof NMUI is necessary, appropriate and in the public interest.  We believe we have defenses to the Actionwhich we intend to vigorously assert.  Ifwe do not prevail, the Petitioners must pay fair market value as determined bythe court, based on appraisals.  NMUI andthe Petitioners do not agree on the value of the assets which the Petitionersseek to condemn.  While it is too earlyto predict the outcome of this matter, we believe that the fair market value ofthe NMUI utility exceeds its recorded net book value as of September 30, 2007.

 

#### **Services Group**

#### ** **

Our Services Group operates our contractservice businesses in which we operate and maintain water and wastewaterfacilities owned by cities, public agencies, municipal utility districts,private entities and investor-owned utilities, including most of our ownutilities.  Our Services Group operatesprimarily in Alabama, California, Colorado, Georgia, Mississippi, New Mexicoand Texas.  While state and federalagencies issue regulations regarding standards of water quality, safety,environmental and other matters which affect these operations, our ServicesGroup’s pricing is not subject to regulation.

 

Services Group revenues reflect fees earnedfor water and wastewater facility operations and maintenance services,equipment maintenance and repair, sewer pipeline video inspections andcleaning, billing and collection services, public works and state-certifiedwater and wastewater laboratory analysis. Our Services Group also facilitates the design, construction, projectmanagement and operating aspects of various water and wastewater projects.  The group’s operating expenses reflectsalaries, wages and employee benefits, fleet and facilities costs, supplies andequipment, repairs and maintenance, professional fees and other costs.  Most work performed by the Services Group isrequired to be performed by state licensed and certified technicians.

 

Some companies in our Services Group provideconstruction, operations and maintenance services to our Utility Group andrecognize a profit on those services.  Inaccordance with SFAS No. 71, *Accounting for the Effectsof Certain Types of Regulation* (“SFAS 71”), we do not eliminate theServices Group’s profit because management believes the sales price isreasonable and it is probable that, through the rate making process, futureUtility Group revenue approximately equal to the sales price will result fromthe regulated utilities’ use of the services. We do, however, eliminate revenues to the extent of the related costs inthe consolidated financial statements in accordance with the guidance providedin SFAS 71.

 

We grow our Services Group by:

 

•                  increasing the number of clients wehave contracts with;

 

•                  increasing the customer base for ourexisting contracts;

 

•                  providing additional services toclients to enhance the value of our contracts; and

 

•                  acquiring strategically located,well-established service contract businesses in high growth markets.

 

The relationships we build with our servicecontract clients can position us for additional growth when a client decides tosell their utility.  Our 2006acquisitions of small water and wastewater utilities near Austin, Texas areexamples of this growth strategy, as they were operated by our Services Groupprior to the utilities being sold to us.

 

24

----

 

#### **Selling,General and Administrative Expenses**

#### ** **

Selling, general and administrative expensesconsist of costs related to personnel, facilities, insurance, consulting andprofessional services, which support our sales, marketing, human resources,finance and administration functions for the entire company.

 

### **RESULTSOF OPERATIONS**

###  

#### **Three MonthsEnded September 30, 2007 Compared to 2006**

#### ** **

**Revenues.**  Revenues decreased $1.6 million, or 2.7%, to$57.4 million for the three months ended September 30, 2007 from $58.9 millionfor the same period during the prior year. By segment, revenues changed as follows:

 
| ** **                              | ** ** | **Three  Months Ended** | ** ** | ** **   | ** ** | ** **              | ** ** |
|-----------------------------------------|------------|-------------------------|------------|--------------|------------|-------------------------|------------|
| ** **                              | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**                | ** ** | **2006**     | ** ** | **(Decrease)**          | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                    |       |                    |       |         |       |                    |       |   |   |   |   |
| Utility Group                           |       | $                       | 26,041     |         | $          | 25,839                  |       | $ | 202 |   | 45.4 | % | 43.8 | % |
| Services Group                          |       | 31,317                  |       | 33,105       |       | (1,788                  | )          | 54.6 | % | 56.2 | % |
| Total                                   |       | $                       | 57,358     |         | $          | 58,944                  |       | $ | (1,586 | ) | 100.0 | % | 100.0 | % |

 

***UtilityGroup.*** Revenues increased $0.2 million, or 0.8%, to $26.0 million for the threemonths ended September 30, 2007, from $25.8 million for the same period duringthe prior year.  The increase was primarilydue to the following:

 

•                  a $0.1 million increase at ourCalifornia utility related to a $0.5 million increase in rates that went intoeffect on July 1st of 2006, which was partially offset by decreased consumptionas a result of milder September weather; and

 

•                  a $0.7 million increase at our Texasutilities primarily resulting from a San Antonio, Texas and Mississippi areautility acquisitions, an increase in customer connections, a fourth quarter2006 rate increase at one of our other Texas utilities, and a rate increase atour Alabama waste water treatment facility; offset by

 

•                  a $0.6 million decrease due to lowerconsumption attributable to the wet weather in the Texas region during thethird quarter of 2007.

 

***ServicesGroup. ***Revenuesdecreased $1.8 million, or 5.4%, to $31.3 million for the three months endedSeptember 30, 2007 from $33.1 million for the same period during the prioryear.  The decrease in revenues wasprimarily due to the following:

 
| ** **                              | ** ** | **Three  Months Ended** | ** ** | ** ** | ** ** | ** **              | ** ** |
|-----------------------------------------|------------|-------------------------|------------|------------|------------|-------------------------|------------|
| ** **                              | ** ** | **September 30,**       | ** ** | ** ** | ** ** | **Percent of Revenues** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**                | ** ** | **2006**   | ** ** | **Change**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                    |       |                    |       |       |       |                    |       |   |   |   |   |
| Revenues from unaffiliated customers    |       | $                       | 30,562     |       | $          | 31,711                  |       | $ | (1,149 | ) | 81.0 | % | 77.6 | % |
| Intersegment revenues                   |       | 7,161                   |       | 9,158      |       | (1,997                  | )          | 19.0 | % | 22.4 | % |
| Total revenues                          |       | 37,723                  |       | 40,869     |       | (3,146                  | )          | 100.0 | % | 100.0 | % |
| Intersegment cost eliminations          |       | (6,406                  | )          | (7,764     | )          | 1,358                   |       |   |   |   |   |
| Total                                   |       | $                       | 31,317     |       | $          | 33,105                  |       | $ | (1,788 | ) |   |   |   |   |

 

Revenues from unaffiliated customersdecreased $1.1 million, or 3.6%, to $30.6 million for the three months endedSeptember 30, 2007 from $31.7 million for the same period during the prioryear.  The decrease in revenues wasprimarily due to the following:

 

•                  a $2.9 million decrease in contractoperations, maintenance, public works and construction work in our southeastregion due to contracts not renewed or canceled; offset by

 

•                  a $1.8 million increase related tonew contracts combined with our successful efforts to increase prices on someof our current contracts.

 

25

----

 

Intersegment revenues from our Utility Groupdecreased by $2.0 million, or 21.8%, to $7.2 million for the three months endedSeptember 30, 2007 from $9.2 million for the same period during the prioryear.  The decrease in revenues resultedfrom a decrease in construction projects performed for our New Mexico and Texasutilities due to a slow down in housing construction as well as a reduction incapital expenditures by our Texas utilities.

 

**Direct OperatingExpenses.**  Direct operating expenses decreased$0.2 million, or 0.4%, to $43.6 million for the three months ended September30, 2007 from $43.8 million for the same period during the prior year asfollows:

 
| ** **                              | ** ** | **Three  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** |
|-----------------------------------------|------------|-------------------------|------------|--------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**                | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                    |       |                    |       |         |       |                        |       |   |   |   |   |
| Utility Group                           |       | $                       | 15,030     |         | $          | 14,539                      |       | $ | 491 |   | 57.7 | % | 56.3 | % |
| Services Group                          |       | 28,608                  |       | 29,272       |       | (664                        | )          | 91.3 | % | 88.4 | % |
| Total                                   |       | $                       | 43,638     |         | $          | 43,811                      |       | $ | (173 | ) | 76.1 | % | 74.3 | % |

 

----

(1)          Utility Group and ServicesGroup direct operating expenses are computed as a percent of their respectiverevenues.  Total direct operatingexpenses are computed as a percentage of total revenues.

 

***UtilityGroup.*** Direct operating expenses increased $0.5 million, or 3.4%, to $15.0million for the three months ended September 30, 2007, from $14.5 million forthe same period during the prior year. The increase in direct operating expenses was primarily due to thefollowing:

 

•                  a $0.4 million increase in expensesat our New Mexico and Texas utilities resulting from a San Antonio, Texas andMississippi area utility acquisitions, an increase in depreciation expense, anincrease in contract operation fees, and higher sewage treatment expenses; and

 

•                  a $0.1 million net increase in directoperating expenses at our California utility principally resulting from anincrease in depreciation expense.

 

Direct operating expenses were 57.7% and 56.3%of related revenues for the three months ended September 30, 2007 and 2006,respectively, primarily as a result of increased costs at our New Mexico andTexas facilities as mentioned above.

 

***ServicesGroup.*** Direct operating expenses decreased $0.7 million, or 2.3%, to $28.6million for the three months ended September 30, 2007 from $29.3 million forthe same period during the prior year. The decrease in direct operating expenses was due to the following:

 

•                  a $3.5 million decrease related tocontracts not renewed or canceled in our southeast region; offset by

 

•                  a $2.1 million increase in directcosts associated with higher insurance costs and increased business activity;and

 

•                  a $0.7 million charge in anticipationof a settlement for our share of potential fines and penalties imposed by awater quality control board.

 

Direct operating expenses as a percentage ofthe related revenues increased 2.9% to 91.3% for the three months endedSeptember 30, 2007 compared to 88.4% for the same period during the prioryear.  Excluding the one-time $0.7million charge, the operating expense percentage is 89.3% for the three monthsended September 30, 2007.

 

**Gross Profit.**  Grossprofit, which we define as the difference between revenues and the relateddirect operating expenses, decreased $1.4 million, or 9.3%, to $13.7 millionfor the three months ended September 30, 2007 from $15.1 million for the sameperiod during the prior year as follows:

 

26

----

 
| ** **                              | ** ** | **Three  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|--------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**                | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                    |       |         |       |                        |       |       |       |   |   |
| Utility Group                           |       | $                       | 11,011     |         | $          | 11,300                      |       | $          | (289       | ) | 42.3 | % | 43.7 | % |
| Services Group                          |       | 2,709                   |       | 3,833        |       | (1,124                      | )          | 8.7        | %          | 11.6 | % |
| Total                                   |       | $                       | 13,720     |         | $          | 15,133                      |       | $          | (1,413     | ) | 23.9 | % | 25.7 | % |

 

----

(1)          Utility Group and ServicesGroup gross profit is computed as a percent of their respective revenues afterintersegment eliminations.  Total grossprofit is computed as a percentage of total revenues.

 

***UtilityGroup.*** Gross profit was 42.3% and 43.7% of related revenues for the threemonths ended September 30, 2007 and 2006, respectively, primarily related tothe wet weather in our Texas region as mentioned above.

 

***ServicesGroup.**** *Grossprofit for the three months ended September 30, 2007 and 2006 was comprised ofthe following:

 
| ** **                              | ** ** | **Three  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|--------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**                | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                    |       |         |       |                        |       |       |       |   |   |
| Gross profit on sales to:               |       |                    |       |         |       |                        |       |       |       |   |   |
| Unaffiliated customers                  |       | $                       | 1,954      |         | $          | 2,439                       |       | $          | (485       | ) | 6.4 | % | 7.7 | % |
| Affiliated customers (intersegment)     |       | 755                     |       | 1,394        |       | (639                        | )          | 10.5       | %          | 15.2 | % |
| Total                                   |       | $                       | 2,709      |         | $          | 3,833                       |       | $          | (1,124     | ) | 7.2 | % | 9.4 | % |

 

----

(1)          Gross profit is computed as apercent of the respective revenues before intersegment eliminations.

 

Services Group gross profit on revenues fromunaffiliated customers decreased by $0.5 million, or 19.9%, to $2.0 million forthe three months ended September 30, 2007 from $2.4 million for the same periodduring the prior year.  Gross profit as apercent of revenues for 2007 was 6.4%, compared to 7.7% for 2006.  The decrease in gross margin percent isprimarily related to a slowdown in the housing market, less project work due towet weather and the $0.7 million one-time charge, partially offset by ourongoing efforts to increase prices on our existing contracts.

 

Services Group gross profit on revenues fromour Utility Group decreased by $0.6 million, or 45.8% to $0.8 million for thethree months ended September 30, 2007 from $1.4 million for the same periodduring the prior year.  The decrease isrelated to a reduction in construction projects for our Texas and New Mexicoutilities due to a slow down in housing construction as well as a reduction incapital expenditures by our Texas utilities.

 

The Services Group supports three distinctlydifferent customer bases; Texas Municipal Utility Districts or MUD’s, municipalclients through operations and maintenance contracts, and Southwest Water’s ownUtility Group.  We need to accelerate ourperformance improvements and therefore we plan to refocus this Group in early2008 along these business lines to better serve the unique demands of eachcustomer base, to focus our business development efforts for each market and toeliminate structural redundancies that may exist today.

 

***Selling,General and Administrative Expenses.***  Selling, general and administrative expensesincreased $1.3 million, or 18.6%, to $8.4 million for the three monthsended September 30, 2007 compared to $7.1 million for the same period duringthe prior year as follows:

 
| ** **                              | ** ** | **Three  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|-------------------------|------------|--------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**       | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**                | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                    |       |         |       |                        |       |       |       |   |   |
| Utility Group                           |       | $                       | 1,852      |         | $          | 1,787                       |       | $          | 65         |   | 7.1 | % | 6.9 | % |
| Services Group                          |       | 2,964                   |       | 2,650        |       | 314                         |       | 9.5        | %          | 8.0 | % |
| Corporate                               |       | 3,621                   |       | 2,678        |       | 943                         |       | —     |       | — |   |
| Total                                   |       | $                       | 8,437      |         | $          | 7,115                       |       | $          | 1,322      |   | 14.7 | % | 12.1 | % |

 

----

(1)          Utility Group and ServicesGroup expenses are computed as a percent of their respective revenues.  Total expenses are computed as a percentageof total revenues.

 

27

----

 

Selling, general and administrative expensesare relatively fixed in nature and do not fluctuate significantly with changesin revenues.  The Utility Group increaseis primarily caused by legal costs incurred in connection with the condemnationproceedings against our New Mexico utility. In accordance with New Mexico statute, costs incurred during the quarteraggregating $0.1 million ($0.4 million incurred to date) are expected to bereimbursed to us by the parties seeking condemnation should we prevail in theaction.  The Services Group expenseincrease resulted from higher salary, wages and related benefits attributableto upgrades in management and staff positions. The Corporate increase is a result of $0.4 million related to highersalary, wages and related benefits attributable to new and upgraded managementpositions and $0.5 million of costs related to our Cornerstone project incurredduring the third quarter of 2007.

 

The Cornerstone project is a company-wideinitiative to reengineer our business processes and integrate our informationsystems onto a single platform across the entire company utilizingstate-of-the-art systems and technology. Our existing systems are inefficient because, for the most part, theyare standalone legacy systems that were in place when we acquired many of ourcompanies.  These individual standalonesystems are costly to operate and maintain and make the consolidation andsharing of data between the various platforms labor intensive andtime-consuming.

 

We are investing in this new technology toenable us to gather and disseminate information on a more timely basis at reducedcosts thereby improving customer service and enhancing operationalefficiencies.  Although expendituresrelated to the information technology hardware and software portions of thisinitiative are capitalized, certain costs are expensed as incurred. We expectto recover a portion of our Cornerstone investment through the rates of ourowned utility portfolio due to the customer service enhancements and we alsobelieve the rest of the investment will result in cost savings in the ServicesGroup, resulting in improved margins.

 

***Impairmentof Goodwill.*** During the three months ended September 30, 2006, we recorded impairmentcharges totaling $0.3 million, related to our water and wastewater testinglaboratory.

 

**Other Income(Expense).** Other expense decreased $0.1 million, or 1.5%, to $1.9 million for thethree months ended September 30, 2007, compared to $2.0 million for the sameperiod during the prior year as follows:

 
| ** **          | ** ** | **Three Months Ended** | ** ** | ** **     | ** ** |
|---------------------|------------|------------------------|------------|----------------|------------|
| ** **          | ** ** | **September 30,**      | ** ** | **(Increase)** | ** ** |
| **(In  thousands)** | ** ** | **2007**               | ** ** | **2006**       | ** ** | **Decrease** | ** ** |
|                |       |                   |       |           |       |   |   |
| Interest expense    |       | $                      | (2,182     | )              | $          | (2,081 | ) | $ | (101 | ) |
| Interest income     |       | 291                    |       | 108            |       | 183 |   |
| Other, net          |       | (41                    | )          | 11             |       | (52 | ) |
| Total               |       | $                      | (1,932     | )              | $          | (1,962 | ) | $ | 30 |   |

 

***InterestExpense.*** Interest expense increased $0.1 million, or 4.9%, to $2.2 million forthe three months ended September 30, 2007, from $2.1 million for the sameperiod during the prior year.  The majorcomponents of interest expense were as follows:

 
| ** **                          | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|------------------------|------------|------------|------------|
| ** **                          | ** ** | **September 30,**      | ** ** | ** ** | ** ** |
| **(In  thousands)**                 | ** ** | **2007**               | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                |       |                   |       |       |       |   |   |
| Mortgage bonds and bank term loans  |       | $                      | 1,188      |       | $          | 1,215 |   | $ | (27 | ) |
| Revolving lines of credit           |       | 875                    |       | 647        |       | 228 |   |
| Convertible subordinated debentures |       | 208                    |       | 221        |       | (13 | ) |
| Other indebtedness                  |       | 153                    |       | 202        |       | (49 | ) |
| Total interest incurred             |       | 2,424                  |       | 2,285      |       | 139 |   |
| Less capitalized interest           |       | (242                   | )          | (204       | )          | (38 | ) |
| Total interest expense              |       | $                      | 2,182      |       | $          | 2,081 |   | $ | 101 |   |

 

28

----

 

The change in total interest incurred isprimarily due to an increase in borrowing levels on our revolving line ofcredit, offset by reduced borrowings related to our other indebtedness as wellas higher levels of capitalized interest on long-term capital projects,including the Cornerstone project.  Theaverage balance of interest bearing debt outstanding increased to $144.9million during the three months ended September 30, 2007 compared to $130.4million for the prior year.  Theadditional borrowings were used to fund capital expenditures and acquisitionsas well as to fund the capital and expense portions of the Cornerstoneproject.  The weighted average interestrate on total borrowings was approximately 6.0% for the three months endedSeptember 30, 2007 and 6.4% for the same period last year.

 

***InterestIncome.*** Interest income increased $0.2 million for the three months endedSeptember 30, 2007 principally as a result of receiving $0.2 million ofinterest with the final contract retainage payment on the Capistrano ValleyWater District construction project.

 

**Provision for IncomeTaxes.**  Oureffective consolidated income tax rate increased to 38.1% for the three monthsended September 30, 2007 compared to 36.6% for the prior year as a result of anincrease in our effective state income tax rate attributable to changes instate apportionment factors.

 

#### **Nine MonthsEnded September 30, 2007 Compared to 2006**

#### ** **

**Revenues.**  Revenues decreased $2.4 million, or 1.5%, to$160.4 million for nine months ended September 30, 2007 from $162.8 million forthe same period during the prior year. By segment, revenues changed as follows:

 
| ** **                              | ** ** | **Nine  Months Ended** | ** ** | ** **   | ** ** | ** **              | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|--------------|------------|-------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**               | ** ** | **2006**     | ** ** | **(Decrease)**          | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                   |       |         |       |                    |       |       |       |   |   |
| Utility Group                           |       | $                      | 69,629     |         | $          | 64,602                  |       | $          | 5,027      |   | 43.4 | % | 39.7 | % |
| Services Group                          |       | 90,778                 |       | 98,232       |       | (7,454                  | )          | 56.6       | %          | 60.3 | % |
| Total                                   |       | $                      | 160,407    |         | $          | 162,834                 |       | $          | (2,427     | ) | 100.0 | % | 100.0 | % |

 

***UtilityGroup.*** Revenues increased $5.0 million, or 7.8%, to $69.6 million for the ninemonths ended September 30, 2007, from $64.6 million for the same period duringthe prior year.  The increase wasprimarily due to the following:

 

•                  a $4.3 million increase at ourCalifornia utility related to increased consumption and an increase in ratesthat went into effect on July 1st of 2006; and

 

•                  a $1.6 million increase at our Texasutilities primarily resulting from a San Antonio, Texas and Mississippi areautility acquisitions, an increase in customer connections, a fourth quarter2006 rate increase at one of our other Texas utilities, and a rate increase atour Alabama waste water treatment facility; offset by

 

•                  a $0.9 million decrease due to lowerconsumption attributable to the wet weather in the Texas region during thethird quarter of 2007.

 

***ServicesGroup. ***Revenuesdecreased $7.5 million, or 7.6%, to $90.8 million for the nine months endedSeptember 30, 2007 from $98.2 million for the same period during the prioryear.  The decrease in revenues wasprimarily due to the following:

 
| ** **                              | ** ** | **Nine  Months Ended** | ** ** | ** ** | ** ** | ** **              | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|------------|------------|-------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**      | ** ** | ** ** | ** ** | **Percent of Revenues** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**               | ** ** | **2006**   | ** ** | **Change**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                   |       |       |       |                    |       |       |       |   |   |
| Revenues from unaffiliated customers    |       | $                      | 87,794     |       | $          | 93,783                  |       | $          | (5,989     | ) | 81.0 | % | 78.2 | % |
| Intersegment revenues                   |       | 20,645                 |       | 26,217     |       | (5,572                  | )          | 19.0       | %          | 21.8 | % |
| Total revenues                          |       | 108,439                |       | 120,000    |       | (11,561                 | )          | 100.0      | %          | 100.0 | % |
| Intersegment cost eliminations          |       | (17,661                | )          | (21,768    | )          | 4,107                   |       |       |       |   |   |
| Total                                   |       | $                      | 90,778     |       | $          | 98,232                  |       | $          | (7,454     | ) |   |   |   |   |

 

29

----

 

Revenues from unaffiliated customers decreased$6.0 million, or 6.4%, to $87.8 million for the nine months ended September 30,2007 from $93.8 million for the same period during the prior year.  The decrease in revenues was primarily due tothe following:

 

•                  a $7.4 million decrease in contractoperations, maintenance, public works and construction work in our southeastregion due to contracts not renewed or canceled; and

 

•                  a $1.4 million decrease related tolower revenues from new housing construction due to a slowdown in housingstarts as well as inclement weather compared to the prior year; offset by

 

•                  a $2.8 million increase related toincreased business activity combined with our ongoing efforts to review ourcontracts and increase prices.

 

Intersegment revenues from our Utility Groupdecreased by $5.6 million, or 21.3%, to $20.6 million for the nine months endedSeptember 30, 2007 from $26.2 million for the same period during the prioryear.  The decrease in revenues resultedfrom a decrease in construction projects performed for our New Mexico and Texasutilities due to a slow down in housing construction as well as a reduction incapital expenditures by our Texas utilities.

 

**Direct OperatingExpenses.**  Direct operating expenses decreased$1.1 million, or 0.9%, to $120.4 million for the nine months ended September30, 2007 from $121.5 million for the same period during the prior year asfollows:

 
| ** **                              | ** ** | **Nine  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|--------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**               | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                   |       |         |       |                        |       |       |       |   |   |
| Utility Group                           |       | $                      | 39,619     |         | $          | 35,442                      |       | $          | 4,177      |   | 56.9 | % | 54.9 | % |
| Services Group                          |       | 80,733                 |       | 86,021       |       | (5,288                      | )          | 88.9       | %          | 87.6 | % |
| Total                                   |       | $                      | 120,352    |         | $          | 121,463                     |       | $          | (1,111     | ) | 75.0 | % | 74.6 | % |

 

----

(1)          Utility Group and ServicesGroup direct operating expenses are computed as a percent of their respectiverevenues.  Total direct operatingexpenses are computed as a percentage of total revenues.

 

***UtilityGroup.*** Direct operating expenses increased $4.2 million, or 11.8%, to $39.6million for the nine months ended September 30, 2007, from $35.4 million forthe same period during the prior year. The increase in direct operating expenses was primarily due to thefollowing:

 

•                  a $1.7 million increase in expensesat our New Mexico and Texas utilities resulting from a San Antonio, Texas andMississippi area utility acquisitions, an increase in depreciation expense, anincrease in contract operation fees, and higher sewage treatment expenses;

 

•                  a $1.7 million net increase in directoperating expenses at our California utility principally resulting from higherwater usage related to increased consumption and higher depreciation ratesadopted under the rate case that went into effect on July 1, 2006; and

 

•                  a $0.8 million increase resultingfrom the one-time recognition of a balancing account receivable in 2006 by ourCalifornia utility pursuant to a CPUC decision which was recognized as areduction of operating expenses.

 

Direct operating expenses were 56.9% and54.9% of related revenues for the nine months ended September 30, 2007 and2006, respectively, primarily as a result of the recognition of a balancingaccount receivable in 2006 as mentioned above. Excluding the balancing account, direct operating expenses as a percentof revenue were 56.1% for the nine months ended September 30, 2006.

 

***ServicesGroup.*** Direct operating expenses decreased $5.3 million, or 6.1%, to $80.7million for the nine months ended September 30, 2007 from $86.0 million for thesame period during the prior year.  Thedecrease in direct operating expenses was due to the following:

 

30

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•                  a $7.8 million decrease related tocontracts not renewed or canceled in our southeast region net of cost increasesto correct past performance issues in that region; and

 

•                  a $1.1 million decrease primarilyrelated to lower revenues from new housing construction-related work comparedto the prior year due to inclement weather and a slowdown in the housing marketin Texas; partially offset by

 

•                  a $2.9 million increase in directcosts associated with increased business activity; and

 

•                  a $0.7 million charge in anticipationof a settlement for our share of potential fines and penalties imposed by awater quality control board.

 

Direct operating expenses as a percentage ofthe related revenues increased 1.3% to 88.9% for the nine months endedSeptember 30, 2007 compared to 87.6% for the same period during the prioryear.  Excluding the one-time $0.7million charge, the operating expense percentage is 88.2% for the nine monthsended September 30, 2007.

 

**Gross Profit.**  Grossprofit, which we define as the difference between revenues and the relateddirect operating expenses, decreased $1.3 million, or 3.2%, to $40.1 millionfor the nine months ended September 30, 2007 from $41.4 million for the sameperiod during the prior year as follows:

 
| ** **                              | ** ** | **Nine  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|--------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**               | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                   |       |         |       |                        |       |       |       |   |   |
| Utility Group                           |       | $                      | 30,010     |         | $          | 29,160                      |       | $          | 850        |   | 43.1 | % | 45.1 | % |
| Services Group                          |       | 10,045                 |       | 12,211       |       | (2,166                      | )          | 11.1       | %          | 12.4 | % |
| Total                                   |       | $                      | 40,055     |         | $          | 41,371                      |       | $          | (1,316     | ) | 25.0 | % | 25.4 | % |

 

----

(1)          Utility Group and ServicesGroup gross profit is computed as a percent of their respective revenues afterintersegment eliminations.  Total grossprofit is computed as a percentage of total revenues.

 

***UtilityGroup.*** Gross profit was 43.1% and 45.1% of related revenues for the nine monthsended September 30, 2007 and 2006, respectively, primarily related to therecognition of a balancing account receivable in 2006 as mentioned above.  Excluding the balancing account, gross profitas a percent of revenue was 43.9% for the nine months ended September 30, 2006.

 

***ServicesGroup.**** *Grossprofit for the nine months ended September 30, 2007 and 2006 was comprised ofthe following:

 
| ** **                             | ** ** | **Nine  Months Ended** | ** ** | ** **   | ** ** | ** **                   | ** ** | ** ** | ** ** |
|----------------------------------------|------------|------------------------|------------|--------------|------------|------------------------------|------------|------------|------------|
| ** **                             | ** ** | **September  30,**     | ** ** | **Increase** | ** ** | **Percent  of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**               | ** ** | **2006**     | ** ** | **(Decrease)**               | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                   |       |                   |       |         |       |                         |       |       |       |   |   |
| Gross profit on sales to:              |       |                   |       |         |       |                         |       |       |       |   |   |
| Unaffiliated customers                 |       | $                      | 7,061      |         | $          | 7,762                        |       | $          | (701       | ) | 8.0 | % | 8.3 | % |
| Affiliated customers (intersegment)    |       | 2,984                  |       | 4,449        |       | (1,465                       | )          | 14.5       | %          | 17.0 | % |
| Total                                  |       | $                      | 10,045     |         | $          | 12,211                       |       | $          | (2,166     | ) | 9.3 | % | 10.2 | % |

 

----

(1)          Gross profit is computed as apercent of the respective revenues before intersegment eliminations.

 

Services Group gross profit on revenues fromunaffiliated customers decreased by $0.7 million, or 9.0%, to $7.1 million forthe nine months ended September 30, 2007 from $7.8 million for the same periodduring the prior year.  Gross profit as apercent of revenues for 2007 was 8.0%, compared to 8.3% for 2006.  The decrease in gross margin percent isprimarily related to the slowdown in the housing market as mentioned above.

 

31

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Services Group gross profit on revenues fromour Utility Group decreased by $1.5 million, or 32.9% to $3.0 million for thenine months ended September 30, 2007 from $4.4 million for the same periodduring the prior year.  The decrease isrelated to a slow down in housing construction as well as a reduction incapital expenditures by our Texas utilities.

 

The Services Group supports three distinctlydifferent customer bases; Texas Municipal Utility Districts or MUD’s, municipalclients through operations and maintenance contracts, and Southwest Water’s ownUtility Group.  We need to accelerate ourperformance improvements and therefore we plan to refocus this Group in early2008 along these business lines to better serve the unique demands of eachcustomer base, to focus our business development efforts for each market and toeliminate structural redundancies that may exist today.

 

***Selling,General and Administrative Expenses.***  Selling, general and administrative expensesincreased $1.6 million, or 6.4%, to $26.3 million for the nine monthsended September 30, 2007 compared to $24.7 million for the same period duringthe prior year as follows:

 
| ** **                              | ** ** | **Nine  Months Ended** | ** ** | ** **   | ** ** | ** **                  | ** ** | ** ** | ** ** |
|-----------------------------------------|------------|------------------------|------------|--------------|------------|-----------------------------|------------|------------|------------|
| ** **                              | ** ** | **September 30,**      | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In  thousands, except percentages)** | ** ** | **2007**               | ** ** | **2006**     | ** ** | **(Decrease)**              | ** ** | **2007**   | ** ** | **2006** | ** ** |
|                                    |       |                   |       |         |       |                        |       |       |       |   |   |
| Utility Group                           |       | $                      | 6,241      |         | $          | 5,870                       |       | $          | 371        |   | 9.0 | % | 9.1 | % |
| Services Group                          |       | 9,213                  |       | 8,692        |       | 521                         |       | 10.1       | %          | 8.8 | % |
| Corporate                               |       | 10,828                 |       | 10,146       |       | 682                         |       | —     |       | — |   |
| Total                                   |       | $                      | 26,282     |         | $          | 24,708                      |       | $          | 1,574      |   | 16.4 | % | 15.2 | % |

 

----

(1)          Utility Group and ServicesGroup expenses are computed as a percent of their respective revenues.  Total expenses are computed as a percentageof total revenues.

 

Selling, general and administrative expensesare relatively fixed in nature and do not fluctuate significantly with changesin revenues.  The Utility Group increaseis caused primarily by legal costs incurred in connection with the condemnationproceedings against our New Mexico utility. In accordance with New Mexico statute, costs incurred aggregating $0.4million through September 30, 2007 are expected to be reimbursed to us by theparties seeking condemnation should we prevail in the action.  The Services Group expense increase resultedfrom higher salary, wages and related benefits attributable to upgrades inmanagement and staff positions. Corporate expenses increased as result of $0.9 million of costs incurredrelated to our Cornerstone project which commenced in the second quarter of2007 and higher salary, wages and related benefits attributable to upgrades inmanagement and staff positions, partially offset by $0.7 million of CEOrelocation expenses incurred in 2006.

 

The Cornerstone project is a company-wideinitiative to reengineer our business processes and integrate our informationsystems onto a single platform across the entire company utilizingstate-of-the-art systems and technology. Our existing systems are inefficient because, for the most part, theyare standalone legacy systems that were in place when we acquired many of ourcompanies.  These individual standalonesystems are costly to operate and maintain and make the consolidation andsharing of data between the various platforms labor intensive and time-consuming.

 

We are investing in this new technology toenable us to gather and disseminate information on a more timely basis atreduced costs thereby improving customer service and enhancing operationalefficiencies.  Although expendituresrelated to the information technology hardware and software portions of thisinitiative are capitalized, certain costs are expensed as incurred. We expectto recover a portion of our Cornerstone investment through the rates of ourowned utility portfolio due to the customer service enhancements and we alsobelieve the rest of the investment will result in cost savings in the ServicesGroup, resulting in improved margins.

 

***Impairmentof Goodwill.*** During the nine months ended September 30, 2006, we recorded impairmentcharges totaling $0.9 million, primarily related to our water and wastewatertesting laboratory.

 

32

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**Other Income(Expense).** Other expenses were $6.0 million for the nine months ended September 30,2007 and 2006 as follows:

 
| ** **          | ** ** | **Nine Months Ended** | ** ** | ** **     | ** ** |
|---------------------|------------|-----------------------|------------|----------------|------------|
| ** **          | ** ** | **September 30,**     | ** ** | **(Increase)** | ** ** |
| **(In  thousands)** | ** ** | **2007**              | ** ** | **2006**       | ** ** | **Decrease** | ** ** |
|                |       |                  |       |           |       |   |   |
| Interest expense    |       | $                     | (6,376     | )              | $          | (6,333 | ) | $ | (43 | ) |
| Interest income     |       | 507                   |       | 363            |       | 144 |   |
| Other, net          |       | (102                  | )          | —         |       | (102 | ) |
| Total               |       | $                     | (5,971     | )              | $          | (5,970 | ) | $ | (1 | ) |

 

***InterestExpense.*** Interest expense was flat for the nine months ended September 30, 2007compared to the same period during the prior year.  The major components of interest expense wereas follows:

 
| ** **                          | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                          | ** ** | **September 30,**     | ** ** | ** ** | ** ** |
| **(In  thousands)**                 | ** ** | **2007**              | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                |       |                  |       |       |       |   |   |
| Mortgage bonds and bank term loans  |       | $                     | 3,581      |       | $          | 3,648 |   | $ | (67 | ) |
| Revolving lines of credit           |       | 2,324                 |       | 1,776      |       | 548 |   |
| Convertible subordinated debentures |       | 636                   |       | 726        |       | (90 | ) |
| Other indebtedness                  |       | 492                   |       | 610        |       | (118 | ) |
| Total interest incurred             |       | 7,033                 |       | 6,760      |       | 273 |   |
| Less capitalized interest           |       | (657                  | )          | (427       | )          | (230 | ) |
| Total interest expense              |       | $                     | 6,376      |       | $          | 6,333 |   | $ | 43 |   |

 

The change in total interest incurred isprimarily due to an increase in borrowing levels on our revolving line ofcredit, offset by a decrease in borrowing levels related to our otherindebtedness as well as higher levels of capitalized interest on long-termcapital projects, including the Cornerstone project.  The average balance of interest bearing debtoutstanding increased to $142.3 million during the nine months ended September30, 2007 compared to $130.9 million for the prior year.

 

The additional borrowings were used to fundcapital expenditures and acquisitions as well as to fund the capital andexpense portions of the Cornerstone project. The weighted average interest rate on total borrowings was approximately6.0% for the nine months ended September 30, 2007 and 6.4% for the same periodin the prior year.

 

***InterestIncome.*** Interest income increased $0.1 million for the nine months endedSeptember 30, 2007 principally as a result of receiving $0.2 million ofinterest with the final contract retainage payment on the Capistrano ValleyWater District construction project.

 

**Provision for IncomeTaxes.**  Oureffective consolidated income tax rate increase to 37.0% for the nine monthsended September 30, 2007 compared to 36.6% for the prior year as a result of anincrease in our effective state income tax rate attributable to changes instate apportionment factors.

 

### **NEWACCOUNTING GUIDANCE AND PRONOUNCEMENTS ADOPTED DURING 2007**

 

#### **SFAS No. 158**

 

In September 2006, the Financial AccountingStandards Board (“FASB”) issued SFAS No. 158, *Employers’Accounting for Defined Benefit Pension and Other Postretirement Plans – anamendment of FASB Statements No. 87, 88, 106, and 132(R)* (“SFAS 158”).  This statement requires balance sheetrecognition of the funded status of pension and postretirement benefitplans.  Under SFAS 158, actuarial gainsand losses, prior service costs or credits, and any remaining transition assetsor obligations that have not been recognized under previous accountingstandards must be recognized in accumulated other comprehensive income (loss),net of tax effects, until they are amortized as a component of net periodicbenefit cost.  The balance sheetrecognition provisions of SFAS 158 were effective for our fiscal year endedDecember 31, 2006 and, as a result, we began recognizing the unamortized portionof actuarial gains and prior service costs in accumulated other comprehensiveincome.  The adoption of SFAS 158 did nothave a material effect on our consolidated financial statements.

 

33

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#### **FIN No. 48**

#### ** **

On January 1, 2007, we adopted the provisionsof FASB Interpretation No. 48, *Accounting for Uncertaintyin Income Taxes* (“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*(“SFAS 109”).  FIN 48 requires companies to recognizethe financial statement benefit of a tax position only after determining therelevant tax authority would “more likely than not” sustain the positionfollowing an examination by the taxing authority.  For tax positions meeting themore-likely-than-not threshold, the amount recognized in the financialstatements is the largest benefit that has a greater than 50% likelihood ofbeing realized upon settlement with the relevant taxing authority.

 

As of December 31, 2006 and September 30,2007, our liabilities for uncertain tax positions were not significant.  Our policy is to recognize interest andpenalties related to liabilities for uncertain tax benefits in the income taxexpense line-item of the consolidated statements of income.  Net interest and penalties incurred duringthe three months and nine months ended September 30, 2007 and 2006 wereinsignificant.

 

We are subject to federal and various stateand local income taxes.  Tax regulationswithin each jurisdiction are subject to the interpretation of related tax lawsand regulations and require significant judgment to apply.  We are no longer subject to federal, stateand local income tax return examinations by taxing authorities for years before2002.  Our federal income tax returns forthe 2002 through 2004 tax years were recently examined by the Internal RevenueService.  The examination was concludedin February 2007 and resulted in no net change for the tax years examined.  State and local income tax returns from 2002to the present and federal income tax returns from 2005 to the present arestill subject to examinations by taxing authorities.

 

### **RECENTACCOUNTING PRONOUNCEMENTS**

###  

#### **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 value measurements.  This statement applies only to fair valuemeasurements that are already required or permitted by other accountingstandards and is expected to increase the consistency of thosemeasurements.  Adoption of SFAS 157 isrequired for our fiscal year beginning January 1, 2008, and will be appliedprospectively under most circumstances. While we are still evaluating the impact this statement will have on ourconsolidated financial statements, we currently believe the impact will not bematerial.

 

#### **SFAS No. 159**

#### ** **

In February 2007, the FASB issued SFAS No.159, *The Fair Value Option for Financial Assets andFinancial Liabilities – Including an amendment of FASB Statement No. 115*(“SFAS 159”).  This statement permitscompanies to choose to measure many financial instruments and other specifieditems at fair value.  This statement iseffective for our fiscal year beginning January 1, 2008 and will be appliedprospectively.  While we are stillevaluating the impact this statement will have on our consolidated financialstatements, we currently believe the impact will not be material.

 

34

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### **LIQUIDITYAND CAPITAL RESOURCES**

 

Our overall objectives with respect toliquidity and capital resources are to:

 

•                  generate sufficient operating cashflows to service our debt and tax obligations, fund capital improvements andorganic growth, and pay dividends to our stockholders;

 

•                  utilize our credit facility for majorcapital improvements and to manage seasonal cash needs;

 

•                  obtain external financing for majoracquisitions; and

 

•                  maintain approximately equal levelsof debt and equity consistent with the investor-owned water utility industry.

 

Our statements of cash flows are summarizedas follows:

 
| ** **                                        | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                        | ** ** | **September 30,**     | ** ** | ** ** | ** ** |
| **(In  thousands)**                               | ** ** | **2007**              | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                              |       |                  |       |       |       |   |   |
| Net cash provided by (used in):                   |       |                  |       |       |       |   |   |
| Operating activities                              |       | $                     | 17,995     |       | $          | 17,861 |   | $ | 134 |   |
| Investing activities                              |       | (36,458               | )          | (32,094    | )          | (4,364 | ) |
| Financing activities                              |       | 16,588                |       | 14,695     |       | 1,893 |   |
| Increase (decrease) in cash and cash  equivalents |       | $                     | (1,875     | )          | $          | 462 |   | $ | (2,337 | ) |

 

**Cash Flows From Operating Activities.**  Net cash provided by operating activities wascomparable between periods.  Operationalaspects of our businesses that affected working capital in 2007 versus 2006 arehighlighted below:

 

•                  increased level of vendor payments in2007 for goods and services used during the fourth quarter of 2006; offset by

 

•                  increased revenues generated by ourCalifornia and Texas utilities resulting from rate increases.

 

**Cash Flows From Investing Activities.**  Cash used in investing activities totaled$36.5 million for the nine months ended September 30, 2007 compared to $32.1million for the same period during the prior year as follows:

 
| ** **                                              | ** ** | **Nine Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|-----------------------|------------|------------|------------|
| ** **                                              | ** ** | **September 30,**     | ** ** | ** ** | ** ** |
| **(In  thousands)**                                     | ** ** | **2007**              | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                                    |       |                  |       |       |       |   |   |
| Cash flows (used in) provided by investing  activities: |       |                  |       |       |       |   |   |
| Additions to property, plant and equipment              |       | $                     | (29,953    | )          | $          | (29,699 | ) | $ | (254 | ) |
| Acquisition of businesses, net of cash  acquired        |       | (6,547                | )          | (1,809     | )          | (4,738 | ) |
| Purchase of minority interest                           |       | —                |       | (1,013     | )          | 1,013 |   |
| Proceeds from sales of land                             |       | 42                    |       | 427        |       | (385 | ) |
| Net cash used in investing activities                   |       | $                     | (36,458    | )          | $          | (32,094 | ) | $ | (4,364 | ) |

 

 

The following table summarizes additions toproperty, plant and equipment additions for 2007 and 2006.

 
| *** ***                                           | ** ** | ***Nine Months Ended*** | ** ** |
|--------------------------------------------------------|------------|-------------------------|------------|
| *** ***                                           | ** ** | ***September 30,***     | ** ** |
| **(In thousands)**                                     | ** ** | **2007**                | ** ** | **2006** | ** ** |
|                                                   |       |                    |       |   |   |
| Company-financed additions                             |       | $                       | 26,547     |   | $ | 24,100 |   |
| Capital improvement reimbursements                     |       | 1,849                   |       | 2,630 |   |
| Cash contributions received in aid of  construction    |       | 1,557                   |       | 2,969 |   |
| Total cash additions to property, plant and  equipment |       | 29,953                  |       | 29,699 |   |
| Non-cash contributions in aid of  construction         |       | 5,875                   |       | 5,823 |   |
| Total additions to property, plant and  equipment      |       | $                       | 35,828     |   | $ | 35,522 |   |

 

35

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Capital projects primarily relate to theexpansion, replacement and renovation of our water and wastewater systems,particularly at our California, Texas and New Mexico utilities and, in 2007,include $6.3 million of expenditures related to our Cornerstone project.  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 2007, we expect to spend approximately$37.0 million on cash additions, principally within our Utility Group, andexpect to receive $7.0 million of CIAC resulting in total expected additions toproperty, plant and equipment of approximately $44.0 million.

 

During 2007, we have acquired a small waterand wastewater utility located in northern Mississippi, just south of Memphis,Tennessee and two water and wastewater utilities near San Antonio, Texas for anaggregate $6.5 million in cash.  During2006 we acquired two small water utilities and the rights to provide water andwastewater utility service in developing areas located near Austin, Texas foran aggregate $1.8 million in cash.  In2006, we also acquired the remaining 10% interest in Operations Technology,Inc. that we did not already own for $1.0 million in cash.  We expect we will continue to makesubstantial investments in acquisitions in the future.

 

**Cash Flows From Financing Activities.**  During 2007 we have financed our growththrough a broad range of capital initiatives:

 

•                  borrowed $16.0 million under ourrevolving line of credit;

 

•                  received $3.0 million of capitalimprovement reimbursements and contributions in aid of construction; and

 

•                  received $2.8 million of proceedsfrom our direct stock purchase plan, our employee stock purchase and optionplans and our director option plan.

 

Revolving line of borrowings were primarilyused to fund our investing activities and, to a lesser extent, to fundoperations.  Additional borrowingavailability under our revolving credit facility was $46.0 million as ofSeptember 30, 2007.

 

During the nine months ended September 30,2007, we paid dividends totaling $4.2 million and our quarterly dividend rateis currently $0.0576 per common share.

 

36

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### **CONTRACTUALOBLIGATIONS**

 

The following table summarizes our knowncontractual obligations to make future cash payments as of September 30,2007, as well as an estimate of the periods during which these payments areexpected to be made.

 
| ** **                                       | ** ** | **Years Ending December 31,** | ** ** |
|--------------------------------------------------|------------|-------------------------------|------------|
| ** **                                       | ** ** | ** **                    | ** ** | **Remainder** | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** |
| ** **                                       | ** ** | ** **                    | ** ** | **of** | ** ** | **and** | ** ** | **and** | ** ** | **and** | ** ** |
| **(In  thousands)**                              | ** ** | **Total**                     | ** ** | **2007** | ** ** | **2009** | ** ** | **2011** | ** ** | **Beyond** | ** ** |
|                                             |       |                          |       |   |   |   |   |   |   |   |   |
| Long-term debt (1):                              |       |                          |       |   |   |   |   |   |   |   |   |
| Bank line of credit (2)                          |       | $                             | 52,000     |   | $ | — |   | $ | — |   | $ | 52,000 |   | $ | — |   |
| Mortgage bonds (3)                               |       | 45,000                        |       | — |   | — |   | — |   | 45,000 |   |
| Bank term loans (4)                              |       | 32,001                        |       | 205 |   | 1,645 |   | 1,646 |   | 28,505 |   |
| Convertible subordinated debentures (5)          |       | 12,060                        |       | — |   | — |   | — |   | 12,060 |   |
| Economic development revenue bonds (6)           |       | 2,030                         |       | 105 |   | 235 |   | 260 |   | 1,430 |   |
| Notes payable and other (7)                      |       | 709                           |       | 127 |   | 582 |   | — |   | — |   |
| Total long-term debt                             |       | 143,800                       |       | 437 |   | 2,462 |   | 53,906 |   | 86,995 |   |
|                                             |       |                          |       |   |   |   |   |   |   |   |   |
| Repayment of advances for construction (8)       |       | 8,975                         |       | 518 |   | 1,538 |   | 928 |   | 5,991 |   |
| Water purchase commitment (9)                    |       | 7,742                         |       | 115 |   | 920 |   | 920 |   | 5,787 |   |
| Lease assignment obligations (10)                |       | 1,084                         |       | 47 |   | 1,037 |   | — |   | — |   |
| Operating lease obligations                      |       | 26,937                        |       | 1,639 |   | 8,367 |   | 5,436 |   | 11,495 |   |
| Total obligations as of September 30, 2007  (11) |       | $                             | 188,538    |   | $ | 2,756 |   | $ | 14,324 |   | $ | 61,190 |   | $ | 110,268 |   |

 

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(1)               Excludes interest payments,which are described in the following notes. The terms of the long-term debt are more fully described in the notes tothe consolidated financial statements included in this report and our 2006Annual Report on Form 10-K.

 

(2)               The bank lines of credit bearinterest at variable rates and therefore the amount of future interest paymentsare uncertain.  Borrowings bear interest,at our option, based on a margin either: a) over the LIBOR rate; or b) underthe prime rate.  The margins vary basedon our consolidated debt to equity ratio. The weighted-average interest rate on our bank line of credit borrowingswas 6.32% as of September 30, 2007.

 

(3)               Interest on the mortgagebonds is fixed at a weighted-average annual interest rate of 6.52% and ispayable semiannually.

 

(4)               Interest on the bank termloans is fixed at a weighted-average annual interest rate of 6.54% and ispayable monthly.

 

(5)               Interest on the convertibledebentures is fixed at a 6.85% annual rate and is payable quarterly.  The debentures are convertible, at the optionof the holder, into shares of our common stock at any time prior to theirmaturity.

 

(6)               Interest on the economicdevelopment bonds is fixed at a weighted-average annual interest rate of 5.95%and is payable semiannually.

 

(7)               Interest is payable eithermonthly or quarterly at rates ranging from 5.0% to 8.0% per year.

 

(8)               Advances for construction arenon-interest bearing.

 

(9)               Reflects the minimum annualcontractual commitment to purchase water through 2024.  The amount is subject to increases in futureperiods for production costs increases and may also increase, but not decrease,if average actual usage exceeds a specified amount.

 

(10)         Interest on the leaseassignment obligations is fixed at a weighted-average interest rate of 8.39%and is payable monthly.

 

(11)         Excludes preferred stockdividend obligations.  Preferredstockholders are entitled to receive annual dividends of $2.625 per share andthere are 9,155 shares of preferred stock outstanding as of September 30,2007.  The preferred stock is redeemableby the Company at any time for $52.00 per share and, from time to time, we haveelected to repurchase shares offered to us by preferred stockholders at pricesless than $52.00 per share.

 

### **FINANCIALCONDITION AND LIQUIDITY**

###  

As of September 30, 2007, we had $7.8 millionof working capital and $1.8 million of operating lease and water purchase obligationspayable during the remainder of 2007.  Asof September 30, 2007, we also had $46.0 million of additional borrowingsavailable under our line of credit facility, which expires on April 1, 2010.  In addition to our line of credit, ourCalifornia and New Mexico mortgage bond indentures permit the issuance of anadditional $90.2 million of first mortgage bonds as of September 30,2007.  However, the terms of our creditfacility do not permit additional first mortgage bond indebtedness withoutprior consent from the credit facility lenders. The mortgage bond indentures also limit the amount of cash and propertydividends our California and New Mexico utilities may pay to the parent companyto fund its payment obligations. Dividends have averaged $4.0 to $5.0 million per year and are 

 

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less than the aggregate cumulative dividendrestriction threshold by $49.8 million as of September 30, 2007.  We were in compliance with all loan agreementcovenants during the nine months ended September 30, 2007.

 

We also have on file a registration statementwith the Securities and Exchange Commission, which is effective for theissuance of up to $50.0 million aggregate principal amount of common stock,debt securities and warrants.  To date wehave issued approximately $43.6 million of common stock under the shelfregistration, and about $6.4 million remains available for issuance as ofSeptember 30, 2007.  We may offer any ofthese securities for sale at any time and from time to time.

 

We believe that our expected operating cashflows, together with borrowings under our credit facility ($46.0 million ofwhich was available as of September 30 2007 and expires on April 1, 2010) willbe sufficient to meet our operating expenses, working capital and capitalexpenditure requirements as well as our debt service and other contractualobligations for the next twelve months. However, our ability to comply with debt financial covenants, pay principalor interest and refinance our debt obligations will depend on our futureoperating performance as well as competitive, legislative, regulatory, businessand other factors beyond our control.

 

### **CERTAINCONTRACTUAL COMMITMENTS AND INDEMNITIES**

###  

In 2002, we were retained to facilitate the engineeringand construction of a $23.0 million reverse osmosis water treatment plant inthe city of San Juan Capistrano, California for the Capistrano Valley WaterDistrict (“CVWD”).  In 2003, we obtaineda $3.4 million standby letter of credit as collateral to insure our performanceduring the design and construction of the water treatment plant.  Construction was completed during 2005 andthe $3.4 million standby letter of credit was released on May 3, 2007.  We obtained final acceptance of the completedproject from the CVWD and payment of the final $2.3 million of the totalcontract price in July 2007.

 

We now operate the completed plant under atwenty-year operating agreement.  TheCVWD service contract contains three guarantees related to our performanceduring the term of the operating agreement. The agreement provides for liquidated damages in the event we fail toperform for reasons other than those caused by “uncontrollable circumstances,”as such term is defined in the agreement.

 

During the term of the operating agreement,we may be liable for liquidated damages relating to any lost payments from afinancial assistance agreement CVWD has with a state water agency, up to amaximum of $1.4 million per contract year. We have also made guarantees to CVWD with respect to the quantity offinished water produced by the facility. In the event the actual number of acre feet of finished water deliveredis less than the water delivery guarantee, we are required to pay liquidateddamages of approximately $600 per acre foot of shortfall, up to a maximum of15.8 acre feet per day.  Finally, we havemade guarantees with respect to seven measurable finished water qualitystandards.  Liquidated damages forfailure to meet these quality standards range from $100 to $400 per day perfailed quality standard (up to a maximum of $2,800 per day), depending on thenumber of violations per contract year. The CVWD has not asserted any claims for liquidated damages pursuant tothese guarantees through the date of this report.

 

As part of the financing for this project,the CVWD sold insured municipal bonds. We entered into an agreement with the bond insurer to guarantee ourperformance under the service contract, subject to certain liability caps tothe bond insurer in the event of a default. During the twenty-year operation of the facility, such liability capswill not exceed an amount equal to $4.0 million plus an amount no greater thanthe replacement cost of the actual reverse osmosis filtration unit within thefacility, estimated to be approximately $1.5 million.

 

As of September 30 2007, we had irrevocablestandby letters of credit in the amount of $2.0 million issued and outstandingunder our credit facility.

 

During our normal course of business, we haveentered into agreements containing indemnities pursuant to which we may berequired to make payments in the future. These indemnities are in connection with facility leases and liabilitiesand operations and maintenance and construction contracts entered into by our ServicesGroup.  The duration of theseindemnities, commitments and guarantees varies, and in certain cases, isindefinite.  Substantially all of theseindemnities provide no limitation on the maximum potential future payments wecould be obligated to make and is not quantifiable.  We have not recorded any liability for theseindemnities.

 

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In connection with the sale of a subsidiaryin 2005, we made indemnities to the buyer with respect to a number of customary,and certain other specific, representations and warranties.  Our indemnities with respect to these mattersare limited in terms of duration to periods ranging from one year to theexpiration of the applicable statue of limitations.

 

### **OFF-BALANCESHEET ARRANGEMENTS**

###  

Through the date of this report, we did nothave any relationships with unconsolidated entities or financial partnerships,such as entities often referred to as structured finance or special purposeentities, which would have been established for the purpose of facilitatingoff-balance sheet arrangements or other contractually narrow or limitedpurposes.  In addition, we do not engagein trading activities involving non-exchange traded contracts.  We are not materially exposed to any financing,liquidity, market or credit risk that could arise if we had engaged in theserelationships.  We do not haverelationships or transactions with persons or entities that derive benefitsfrom their non-independent relationship with our subsidiaries or us.

 

We lease some of our equipment and officefacilities under operating leases which are deemed to be off-balance sheetarrangements.  Our future operating leasepayment obligations are more fully described under the caption “—ContractualObligations” above.

 

## **ITEM 3.**                             QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

## ** **

As of September 30, 2007, we had $144.6million of long-term variable and fixed-rate debt.  We are exposed to market risk based onchanges in prevailing interest rates.

 

Market risk related to our variable-rate debtis estimated as the potential decrease in pre-tax earnings resulting from anincrease in interest rates.  We have$52.0 million of long-term debt that bears interest at variable rates based oneither the prime rate or LIBOR rate.  Ourvariable-rate debt had a weighted average interest rate of 6.32% as ofSeptember 30, 2007.  A hypotheticalone percent (100 basis points) increase in the average interest rates chargedon our variable-rate debt would reduce our pre-tax earnings by approximately$0.5 million per year.

 

Our fixed-rate debt, which has a carryingvalue of $92.6 million, has a fair value of $89.4 million as ofSeptember 30, 2007.  Market riskrelated to our fixed-rate debt is deemed to be the potential increase in fair valueresulting from a decrease in prevailing interest rates.  Our fixed-rate debt had a weighted averageinterest rate of 6.5% as of September 30, 2007.  A hypothetical ten percent decrease ininterest rates, from 6.5% to 5.9%, would increase the fair value of ourfixed-rate debt by approximately $6.1 million.

 

We do not use derivative financialinstruments to manage or reduce these risks although we may do so in thefuture.  We do not enter into derivativesor other financial instruments for trading or speculative purposes.

 

## **ITEM 4.**                             CONTROLS AND PROCEDURES

## ** **

Under the supervision and with theparticipation of our management, including the Chief Executive Officer andChief Financial Officer, we have evaluated the effectiveness of our disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-15(b) as of the endof the period covered by this report. Based on that evaluation, the Chief Executive Officer and ChiefFinancial Officer have concluded that these disclosure controls and proceduresare effective.  There were no changes inour internal control over financial reporting during the quarter endedSeptember 30, 2007 that have materially affected, or are reasonably likelyto materially affect, our internal control over financial reporting.

 

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# **PART II – OTHER INFORMATION**

 

## **ITEM 1.**   LEGAL PROCEEDINGS

 

Information required by this Item 1 iscontained in Note 5 to the consolidated financial statements, Part I, Item 1 ofthis report, under the captions “Legal Proceedings” and “EPA Investigations.”  The text under those captions is incorporatedby reference into this Item 1.

 

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

 

## **ITEM 6.**   EXHIBITS

 
| **Exhibit** | ** ** | ** **                                                                                                   |
|-------------|------------|--------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Exhibit  Description**                                                                                     |
| ** **  | ** ** | ** **                                                                                                   |
| 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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*                 Filed herewith

 

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# **SIGNATURES**

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the Registrant has duly caused this report tobe signed on its behalf by the undersigned, thereto duly authorized.

 

 
| ** **                    | ** ** | **SOUTHWEST WATER COMPANY (REGISTRANT)** |
|-------------------------------|------------|------------------------------------------|
|                          |       |                                     |
|                          |       |                                     |
| Dated:  November 9, 2007 |       | /s/ CHERYL L. CLARY                      |   |
|                          |       | Cheryl L. Clary                          |
|                          |       | Chief Financial Officer                  |

 

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