**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C.  20549**

**FORM 10-Q**

**(MarkOne)**
| **x**                              | **Quarterly Report pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934**                                                               |
|------------------------------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                         | ** **                                                                                                                                                 |
|                               | **For the quarterly period ended March 31, 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, Suite2900**

**Los Angeles, California90017-3782**

(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)

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

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer.  (Check one):

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

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

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.
| Class                                   | ** ** | **Outstanding as of May 4, 2007** |
|-----------------------------------------|------------|-----------------------------------|
| ** **                              | ** ** | ** **                        |
| Common Stock,  $.01 par value per share |       | 24,063,654  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 March 31, 2007 and December 31, 2006                               |       |
|           |                                                                                                                 |       |
|           | Condensed  Consolidated Statements of Income for the three months ended March 31, 2007  and 2006                     |       |
|           |                                                                                                                 |       |
|           | Condensed  Consolidated Statement of Changes in Stockholders’ Equity for the three  months ended March 31, 2007 |       |
|           |                                                                                                                 |       |
|           | Condensed  Consolidated Statements of Cash Flows for the three months ended March 31,  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 2.        | Unregistered  Sales of Equity Securities and Use of Proceeds                                                         |       |
|           |                                                                                                                 |       |
| Item  6.       | Exhibits                                                                                                             |       |
|           |                                                                                                                 |       |
| **Signatures** |                                                                                                                 |

 

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# **PART I – FINANCIAL INFORMATION**

## **ITEM 1.****     FINANCIAL STATEMENTS**

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

The Board ofDirectors and StockholdersSouthwest Water Company:

We have reviewedthe accompanying condensed consolidated balance sheet of Southwest WaterCompany and subsidiaries (“the Company”) as of March 31, 2007, the relatedcondensed consolidated statements of income for the three-month periods endedMarch 31, 2007 and 2006, the related condensed consolidated statement ofchanges in stockholders’ equity for the three-month period ended March 31,2007, and the related condensed consolidated statements of cash flows for thethree-month periods ended March 31, 2007 and 2006.  These condensed consolidated financialstatements are the responsibility of the Company’s management.

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

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

We have previouslyaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheet of the Companyas of December 31, 2006, and the related consolidated statements of income,changes in stockholders’ equity, and cash flows for the year then ended (notpresented herein); and in our report dated March 13, 2007, we expressed anunqualified opinion on those consolidated financial statements.  In our opinion, the information set forth inthe accompanying condensed consolidated balance sheet as of December 31, 2006,is fairly stated, in all material respects, in relation to the consolidatedbalance sheet from which it has been derived.
| /s/ KPMG LLP             |   |
|--------------------------|--------|
|                     |   |
| Los Angeles,  California |
| May 14, 2007             |

** **

1

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

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

| ** **                                    | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-----------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(In thousands)**                       | ** ** | **2007**           | ** ** | **2006**              | ** ** |
| ** **                                    |       |               |       |                  |       |
| **ASSETS**                                    |       |               |       |                  |       |
| ** **                                    |       |               |       |                  |       |
| Current Assets:                               |       |               |       |                  |       |
| Cash and cash equivalents                     |       | $                  | 3,013      |                  | $          | 4,294 |   |
| Accounts receivable, net                      |       | 25,603             |       | 27,512                |       |
| Other current assets                          |       | 16,407             |       | 16,451                |       |
| Total current assets                          |       | 45,023             |       | 48,257                |       |
|                                          |       |               |       |                  |       |
| Property, Plant and Equipment, Net:           |       |               |       |                  |       |
| Regulated utilities                           |       | 383,954            |       | 378,260               |       |
| Non-regulated operations                      |       | 11,292             |       | 11,365                |       |
| Total property, plant and equipment, net      |       | 395,246            |       | 389,625               |       |
|                                          |       |               |       |                  |       |
| Other Assets:                                 |       |               |       |                  |       |
| Goodwill                                      |       | 33,152             |       | 33,152                |       |
| Intangible assets                             |       | 2,727              |       | 2,844                 |       |
| Other assets                                  |       | 18,236             |       | 17,815                |       |
|                                          |       |               |       |                  |       |
|                                          |       | $                  | 494,384    |                  | $          | 491,693 |   |
|                                          |       |               |       |                  |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |       |               |       |                  |       |
| ** **                                    |       |               |       |                  |       |
| Current Liabilities:                          |       |               |       |                  |       |
| Accounts payable                              |       | $                  | 7,617      |                  | $          | 12,746 |   |
| Current portion of  long-term debt            |       | 1,502              |       | 1,423                 |       |
| Other current  liabilities                    |       | 19,076             |       | 21,661                |       |
| Total current  liabilities                    |       | 28,195             |       | 35,830                |       |
|                                          |       |               |       |                  |       |
| Other Liabilities and Deferred Credits:       |       |               |       |                  |       |
| Long-term debt                                |       | 135,709            |       | 128,624               |       |
| Deferred income taxes                         |       | 28,370             |       | 26,011                |       |
| Advances for construction                     |       | 8,253              |       | 8,413                 |       |
| Contributions in aid of  construction         |       | 110,564            |       | 110,024               |       |
| Other liabilities and  deferred credits       |       | 15,194             |       | 16,264                |       |
|                                          |       |               |       |                  |       |
| Commitments and Contingencies                 |       |               |       |                  |       |
|                                          |       |               |       |                  |       |
| Stockholders’ Equity:                    |       |               |       |                  |       |
| Preferred stock                               |       | 458                |       | 458                   |       |
| Common stock                                  |       | 240                |       | 238                   |       |
| Additional paid-in  capital                   |       | 141,071            |       | 138,728               |       |
| Retained earnings                             |       | 26,256             |       | 27,031                |       |
| Accumulated other  comprehensive income       |       | 74                 |       | 72                    |       |
| Total stockholders’  equity              |       | 168,099            |       | 166,527               |       |
|                                          |       |               |       |                  |       |
|                                          |       | $                  | 494,384    |                  | $          | 491,693 |   |

 

See accompanying notes toconsolidated financial statements.

2

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME (UNAUDITED)**
| ** **                                                         | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **March 31,**               | ** ** |
| **(In thousands, except per share data)** | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                                               |       |                             |       |   |   |
| Revenues:                                                          |       |                             |       |   |   |
| Utility Group                                                      |       | $                                | 20,034     |   | $ | 17,973 |   |
| Services Group                                                     |       | 28,040                           |       | 31,621 |   |
| Total revenues                                                     |       | 48,074                           |       | 49,594 |   |
|                                                               |       |                             |       |   |   |
| Expenses:                                                          |       |                             |       |   |   |
| Utility Group operating expenses                                   |       | 11,596                           |       | 10,397 |   |
| Services Group operating expenses                                  |       | 25,002                           |       | 27,795 |   |
| Selling, general and administrative expenses                       |       | 8,533                            |       | 8,385 |   |
| Total expenses                                                     |       | 45,131                           |       | 46,577 |   |
|                                                               |       |                             |       |   |   |
| Operating income                                                   |       | 2,943                            |       | 3,017 |   |
|                                                               |       |                             |       |   |   |
| Other income  (expense):                                           |       |                             |       |   |   |
| Interest expense                                                   |       | (2,070                           | )          | (2,131 | ) |
| Interest income                                                    |       | 140                              |       | 81 |   |
| Other, net                                                         |       | (49                              | )          | 139 |   |
|                                                               |       |                             |       |   |   |
| Income before  income taxes and change in accounting principle     |       | 964                              |       | 1,106 |   |
| Provision for  income taxes                                        |       | 350                              |       | 405 |   |
|                                                               |       |                             |       |   |   |
| Income before  change in accounting principle                      |       | 614                              |       | 701 |   |
|                                                               |       |                             |       |   |   |
| Cumulative  effect of change in accounting principle, net of tax   |       | —                           |       | 71 |   |
|                                                               |       |                             |       |   |   |
| Net income                                                         |       | 614                              |       | 772 |   |
|                                                               |       |                             |       |   |   |
| Preferred stock  dividends                                         |       | (6                               | )          | (6 | ) |
|                                                               |       |                             |       |   |   |
| Net income  applicable to common stockholders                      |       | $                                | 608        |   | $ | 766 |   |
|                                                               |       |                             |       |   |   |
| Earnings per  common share:                                        |       |                             |       |   |   |
| Basic:                                                             |       |                             |       |   |   |
| Income before change in accounting principle                       |       | $                                | 0.03       |   | $ | 0.03 |   |
| Cumulative effect of change in accounting principle                |       | —                           |       | — |   |
| Net income applicable to common stockholders                       |       | $                                | 0.03       |   | $ | 0.03 |   |
| Diluted:                                                           |       |                             |       |   |   |
| Income before change in accounting principle                       |       | $                                | 0.03       |   | $ | 0.03 |   |
| Cumulative effect of change in accounting principle                |       | —                           |       | — |   |
| Net income applicable to common stockholders                       |       | $                                | 0.03       |   | $ | 0.03 |   |
|                                                               |       |                             |       |   |   |
| Weighted average  common shares outstanding:                       |       |                             |       |   |   |
| Basic                                                              |       | 23,882                           |       | 22,293 |   |
| Diluted                                                            |       | 24,214                           |       | 23,307 |   |

 

See accompanying notes toconsolidated financial statements.

3

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)**
| ** **                                      | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | **Accumulated** | ** ** | ** **             | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|------------------|------------|--------------|------------|-----------------|------------|------------------------|------------|
| ** **                                      | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | **Other**       | ** ** | ** **             | ** ** |
| ** **                                      | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | **Compre–** | ** ** | **Total**    | ** ** |
| ** **                                      | ** ** | **Number of**       | ** ** | ** **            | ** ** | **Number of** | ** ** | ** ** | ** ** | **Paid-in**      | ** ** | **Retained** | ** ** | **hensive**     | ** ** | **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                                      |       | —                   |       | —                |       | —             |       | —     |       | —           |       | 614          |       | —          |       | 614                    |       |
| Other comprehensive income, net of tax:         |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Amortization of actuarial net gain              |       | —                   |       | —                |       | —             |       | —     |       | —           |       | —       |       | (12             | )          | (12                    | )          |
| Amortization of prior service costs             |       | —                   |       | —                |       | —             |       | —     |       | —           |       | —       |       | 14              |       | 14                     |       |
| Comprehensive income                            |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       | 616                    |       |
|                                            |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Dividend  reinvestment and stock purchase plans |       | —                   |       | —                |       | 82                 |       | 1          |       | 1,043            |       | —       |       | —          |       | 1,044                  |       |
| Proceeds from  stock options exercised          |       | —                   |       | —                |       | 128                |       | 1          |       | 364              |       | —       |       | —          |       | 365                    |       |
| Tax benefit from  stock options exercised       |       | —                   |       | —                |       | —             |       | —     |       | 382              |       | —       |       | —          |       | 382                    |       |
| Share-based  compensation expense               |       | —                   |       | —                |       | —             |       | —     |       | 408              |       | —       |       | —          |       | 408                    |       |
| Debenture  conversions                          |       | —                   |       | —                |       | 14                 |       | —     |       | 146              |       | —       |       | —          |       | 146                    |       |
| Cash dividends  declared                        |       | —                   |       | —                |       | —             |       | —     |       | —           |       | (1,389       | )          | —          |       | (1,389                 | )          |
|                                            |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Balance at March 31,  2007                      |       | 9                        |       | $                     | 458        |               | 24,026     |       | $          | 240              |       | $            | 141,071    |            | $          | 26,256                 |       | $ | 74 |   | $ | 168,099 |   |

 

See accompanying notes toconsolidated financial statements.

4

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)**
| ** **                                                                         | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                         | ** ** | **March 31,**               | ** ** |
| **(In thousands)**                                                            | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                                                               |       |                             |       |   |   |
| **Cash flows from operating  activities:**                                         |       |                             |       |   |   |
| Net income                                                                         |       | $                                | 614        |   | $ | 772 |   |
| 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                                                     |       | 3,030                            |       | 2,685 |   |
| Deferred income  taxes                                                             |       | 350                              |       | 778 |   |
| Share-based  compensation expense                                                  |       | 408                              |       | 275 |   |
| Gain on sales of  land                                                             |       | —                           |       | (407 | ) |
| Changes in  assets and liabilities, net of effects of acquisitions:                |       |                             |       |   |   |
| Accounts  receivable                                                               |       | 1,909                            |       | 698 |   |
| Other current  assets                                                              |       | 2,441                            |       | 1,279 |   |
| Other assets                                                                       |       | (508                             | )          | (130 | ) |
| Accounts payable                                                                   |       | (5,128                           | )          | (3,274 | ) |
| Other current  liabilities                                                         |       | (2,980                           | )          | (1,940 | ) |
| Other  liabilities                                                                 |       | (1,203                           | )          | (447 | ) |
| Other, net                                                                         |       | (30                              | )          | (39 | ) |
| Net cash  provided by (used in) operating activities                               |       | (1,097                           | )          | 179 |   |
|                                                                               |       |                             |       |   |   |
| **Cash flows from investing  activities:**                                         |       |                             |       |   |   |
| Additions to  property, plant and equipment                                        |       | (8,394                           | )          | (7,426 | ) |
| Acquisitions of  businesses, net of cash acquired                                  |       | (558                             | )          | (1,231 | ) |
| Purchase of minority  interest                                                     |       | —                           |       | (1,010 | ) |
| Proceeds from  sales of land                                                       |       | 33                               |       | 427 |   |
| Net cash used in  investing activities                                             |       | (8,919                           | )          | (9,240 | ) |
|                                                                               |       |                             |       |   |   |
| **Cash flows from financing  activities:**                                         |       |                             |       |   |   |
| Borrowings under  lines of credit                                                  |       | 7,500                            |       | 7,000 |   |
| Proceeds from  stock option and stock purchase plans                               |       | 1,409                            |       | 2,014 |   |
| Capital  improvement reimbursements                                                |       | 865                              |       | 220 |   |
| Contributions in  aid of construction                                              |       | 485                              |       | 702 |   |
| Excess tax  benefit from stock options exercised                                   |       | 380                              |       | 362 |   |
| Dividends paid                                                                     |       | (1,389                           | )          | (1,186 | ) |
| Payments on  long-term debt                                                        |       | (308                             | )          | (303 | ) |
| Repayment of  advances for construction                                            |       | (204                             | )          | (164 | ) |
| Deferred  financing costs                                                          |       | (3                               | )          | (6 | ) |
| Net cash  provided by financing activities                                         |       | 8,735                            |       | 8,639 |   |
|                                                                               |       |                             |       |   |   |
| Net change in cash and  cash equivalents                                           |       | (1,281                           | )          | (422 | ) |
| Cash and cash equivalents  at beginning of year                                    |       | 4,294                            |       | 2,764 |   |
| Cash and cash equivalents at end of period                                         |       | $                                | 3,013      |   | $ | 2,342 |   |

 

See accompanying notes toconsolidated financial statements.

5

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

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

**Note 1.       Summaryof Significant Accounting Policies**

**Basis of Presentation**

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

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

Certaininformation and disclosures normally included in financial statements preparedin accordance with GAAP have been omitted in accordance with Securities andExchange Commission’s rules and regulations for interim financialreporting.  These interim consolidatedfinancial statements should be read in conjunction with Management’s Discussionand Analysis of Financial Condition and Results of Operations and the auditedfinancial statements and related notes included in the Company’s 2006 AnnualReport on Form 10-K.  The Company’sbusinesses are seasonal because they are affected by weather.  As a result, operating results for interimperiods do not necessarily predict the operating results for any other interimperiod or for the full year.

**Change in Presentation**

Effective January1, 2007, the Company elected to allocate a portion of its Services Group’soperating expense overhead between affiliated and unaffiliated customers forsegment reporting purposes (Note 10). In prior periods, all operating expense overhead was reflected asoperating expenses attributable to unaffiliated customers.  This change in allocation methodologyincreased the gross profit from sales to unaffiliated customers and decreasedthe gross profit from sales to affiliated customers by the same amount. Inaccordance with SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information*, prior year amounts havebeen reclassified to conform to the 2007 presentation.

In accordance withSFAS No. 71, *Accounting for the Effects of Certain Typesof Regulation* (“SFAS 71”), the Company does not eliminate theintersegment profit recognized on sales to affiliated customers because theCompany believes the sales price is reasonable and it is probable that, throughthe rate making process, future Utility Group revenue approximately equal tothe sales price will result from the regulated utilities’ use of theservices.  The Company does, however,eliminate the Services Group’s revenues from affiliated customers to the extentof its cost.  Consequently, this changeresulted in a decrease in the Services Group’s revenues and direct operatingexpenses reported in 2006 by the same amounts. Consolidated gross profit, operating income and net income areunchanged.

6

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**Accounting Guidance and PronouncementsAdopted During 2007**

***SFAS No. 158***

In September 2006,the Financial Accounting Standards Board (“FASB”) issued SFAS No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and132(R)*(“SFAS 158”).  Thisstatement requires balance sheet recognition of the funded status of pensionand postretirement benefit plans.  UnderSFAS 158, actuarial gains and losses, prior service costs or credits, and anyremaining transition assets or obligations that have not been recognized underprevious accounting standards must be recognized in accumulated othercomprehensive income (loss), net of tax effects, until they are amortized as acomponent of net periodic benefit cost. The balance sheet recognition provisions of SFAS 158 were effectivefor the Company’s fiscal year ended December 31, 2006 and, as a result, theCompany began recognizing the unamortized portion of actuarial gains and priorservice costs in accumulated other comprehensive income.  The adoption of SFAS 158 did not have amaterial effect on the consolidated financial statements.

***FIN No. 48***

On January 1,2007, the Company adopted the provisions of FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes*(“FIN 48”).  This interpretation clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes* (“SFAS 109”).  FIN 48requires companies to recognize the financial statement benefit of a taxposition only after determining the relevant tax authority would “more likelythan not” sustain the position following an examination by taxingauthorities.  For tax positions meetingthe more-likely-than-not threshold, the amount recognized in the financialstatements is the largest benefit that has a greater than 50% likelihood of beingrealized upon settlement with the relevant taxing authority.

The Companyadopted the provisions of FIN No. 48 on January 1, 2007.  On December 31, 2006 and March 31, 2007, theCompany’s liabilities for uncertain tax positions are not significant.  The Company’s policy is to recognize interestand penalties related to liabilities for uncertain tax benefits in the incometax expense line-item of the consolidated statements of income.  Net interest and penalties incurred duringthe three months ended March 31, 2007 and 2006 were insignificant.

The Company issubject to federal and various state and local income taxes.  Tax regulations within each jurisdiction aresubject to the interpretation of related tax laws and regulations and requiresignificant judgment to apply.  TheCompany is no longer subject to federal, state and local income tax returnexaminations by taxing authorities for years before 2002.  The Company’s 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 are stillsubject 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 establishesa single authoritative definition of fair value, sets out framework forestablishing fair value, and requires additional disclosures about fair valuemeasurements.  This statement appliesonly to fair value measurements that are already required or permitted by otheraccounting standards and is expected to increase the consistency of thosemeasurements.  Adoption of SFAS 157 isrequired for the Company’s fiscal year beginning January 1, 2008, and 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 forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115* (“SFAS 159”). This statement permits companies to choose to measure many financialinstruments and other specified items at fair value.  This statement is effective for the Company’sfiscal year beginning January 1, 2008 and will be applied prospectively.  While the Company is still evaluating theimpact this statement will have on its consolidated financial statements,management currently believes the impact will not be material.

**Note 2.       Acquisitions**

In February 2007,the Company acquired a small water and wastewater collection utility in a highgrowth area of northern Mississippi, just south of Memphis, Tennessee.  The purchase price was $0.6 million incash.  The assets acquired andliabilities assumed have been recorded at their estimated fair values basedupon preliminary valuations.  Theconsolidated financial statements include the operations of the utilitysubsequent to its acquisition date.  Theacquisition is not material to the Company’s consolidated results ofoperations.  The Company expects tofinalize the purchase price allocation during 2007.

In May 2007, theCompany acquired two additional water utilities in a high population growtharea northwest of San Antonio, Texas (Note 11).

On March 20, 2006,the 10% minority interest stockholder in Operations Technology, Inc. (“OpTech”),a Georgia-based non-regulated business in the Company’s Services Group,exercised its right to require the Company to purchase the remaining 10% ofOpTech stock that it did not already own for $1.0 million in cash (Note4).  In connection with this acquisition,the Company allocated $0.5 million of the purchase price to finite-livedintangible assets and the remaining $0.5 million to goodwill.  The intangible assets, principally customerrelationships and tradenames, are being amortized on a straight-line basis overa weighted-average amortization period of 8.1 years.

The acquisitionswere funded with borrowings under the Company’s revolving line of credit.

8

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**Note 3.       Long-TermDebt**

Long-term debtconsists of the following as of March 31, 2007 and December 31, 2006:
| ** **                                           | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(In thousands)**                              | ** ** | **2007**           | ** ** | **2006**              | ** ** |
|                                                 |       |               |       |                  |       |
| $100 million  revolving credit facility              |       | $                  | 43,500     |                  | $          | 36,000 |   |
|                                                 |       |               |       |                  |       |
| 6.85%  convertible subordinated debentures due 2021  |       | 12,457             |       | 12,610                |       |
|                                                 |       |               |       |                  |       |
| Term Loans:                                          |       |               |       |                  |       |
| Monarch Utilities, Inc.:                             |       |               |       |                  |       |
| 7.37% fixed rate term loan due 2022                  |       | 11,614             |       | 11,807                |       |
| 5.77% fixed rate term loan due 2022                  |       | 798                |       | 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          |       | 957                |       | 904                   |       |
| Total long-term debt payment obligations             |       | 136,356            |       | 129,162               |       |
| Unamortized Monarch term loan fair value adjustments |       | 855                |       | 885                   |       |
| Total long-term debt                                 |       | 137,211            |       | 130,047               |       |
| Less current portion of long-term debt               |       | (1,502             | )          | (1,423                | )          |
| Long-term debt,  less current portion                |       | $                  | 135,709    |                  | $          | 128,624 |   |

 

The $100 millionrevolving line of credit commitment ends on April 1, 2010 (if not renewed orextended), at which time all borrowings must be repaid.  Borrowings under the credit facility bearinterest, at the Company’s option, based on a margin either: a) over the LIBORrate; or b) under the prime rate.  Themargins vary depending upon the Company’s consolidated debt to equityratio.  Currently, the applicable marginsare 0.875% over the LIBOR rate or 0.25% under the prime rate.  The weighted-average interest rates on all creditfacility borrowings outstanding were 6.15% as of March 31, 2007 and 6.23% as ofDecember 31, 2006.

The Company hadirrevocable standby letters of credit in the amount of $4.1 million issued andoutstanding under its revolving credit facility as of March 31, 2007, reducingavailable borrowings under the credit facility to $52.4 million as of thatdate.

9

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**Note 4.       Commitmentsand Contingencies**

**Legal Proceedings**

New Mexico Utilities, Inc. (“NMUI”), one of theCompany’s wholly-owned regulated utilities, has an agreement  with the Albuquerque Bernalillo County WaterUtility Authority, a political subdivision of the State of New Mexico (the“Water Authority”), whereby the Water Authority treats the effluent from NMUI’swastewater collection system for a fee. The treated effluent is returned to the Rio Grande Underground Basin,creating return flow credits.  Returnflow credits supplement NMUI’s existing water rights, enabling it to pumpadditional water from the basin.

In August 2004, the Water Authority increased thefee charged to NMUI, using a different formula than had been used in prioryears.  The Company believes the increaseviolates the terms of the agreement. 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 Companyintends to file a motion for reconsideration and believes that either the Courtwill reconsider the ruling or the ruling will be reversed by the Court ofAppeals.  The Court has not ruled onwhether the new rate was appropriate; made no determination as to any amountNMUI may owe to the Water Authority, or ruled on the ownership of the returnflow credits.  Although the Companycannot give 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 disputedfees and related late payment penalties, which totaled $3.5 million as of March31, 2007, and has not recognized a reserve for any potential liabilities in theaccompanying consolidated financial statements. The Company is unable to predict the impact the resolution of the returnflow credits ownership dispute will have on its consolidated financialstatements.

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,including all real property, through the alleged 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 theacquisition of NMUI is necessary, appropriate and in the public interest.  The Company believes it has defenses to thePetition which it intends to vigorously assert. If the Company does not prevail, the Petitioners must pay fair marketvalue as determined by the court, based on appraisals.  NMUI and the Petitioners do not agree on thevalue of the assets which the Petitioners seek to condemn.  While it is too early to predict the outcomeof this matter, the Company believes that the fair market value of its NMUIutility exceeds its recorded net book value as of March 31, 2007.

10

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Southwest Water and a subsidiary were named as defendants in severallawsuits alleging various injuries as a result of water contamination in theSan Gabriel Valley Main Basin.  TheCalifornia Supreme Court ruled in February 2002 that the plaintiffs could notchallenge the adequacy of the water quality standards established by CaliforniaDepartment of Health Services.  In August2004, the case against Southwest Water and its subsidiary was dismissed;however, the plaintiffs appealed the dismissal to the Court of Appeals for theState of California, First Appellate District (1DCA Civil No.  B178283). Oral arguments for the appeal are scheduled to be held on June 20,2007.  To date, liability insurancecarriers have absorbed the costs of defense of the lawsuits.  Based upon information available at thistime, the Company does not expect that this action will have a material adverseeffect on its consolidated financial position, results of operations or cashflows.

The Company andits subsidiaries are also involved in other routine legal and administrativeproceedings arising during the ordinary course of business.  The Company believes the ultimate dispositionof such matters will not have a material adverse effect on its business,consolidated financial position, results of operations or cash flows.

**EPA Investigations**

On May 5, 2005,one of the Company’s operating subsidiaries received a subpoena to providerecords to a grand jury.  The requestedrecords relate to the operations of the San Simeon wastewater treatment plantin California for the 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 developments sinceMay 5, 2005.

On May 18, 2005,the EPA executed a search warrant at the Company’s Texas-based testinglaboratory and on July 20, 2006 the laboratory received a subpoena to provideadditional records and information to a grand jury.  The Company is cooperating fully with theinvestigation and has provided the records requested.  There have been no further developments sinceJuly 20, 2006.

11

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**Commitments Under Long-Term Service Contracts**

In 2002, the Company was retained to facilitate theengineering and construction of a $23.0 million reverse osmosis water treatmentplant in the city of San Juan Capistrano, California for the Capistrano ValleyWater District (“CVWD”).  In 2003, theCompany obtained a $3.4 million standby letter of credit as collateral toinsure its performance during the design and construction of the watertreatment plant.  Construction wascompleted during 2005 and the Company is working with the CVWD to obtain itsfinal acceptance of the completed project. The $3.4 million standby letter of credit was released on May 3,2007. Upon final acceptance of the project by the CVWD, the final $2.3 millionof the total contract price, which is included in accounts receivable, will bereleased to the Company from the construction financing escrow account.  The Company expects to receive finalacceptance during 2007.

The Company now operates the completed plant under atwenty-year operating agreement.  TheCVWD service contract contains three guarantees related to the performance ofthe Company and its subsidiary during the term of the operating agreement.  The agreement provides for the Company to payliquidated damages in the event it fails to perform for reasons other thanthose caused by “uncontrollable circumstances,” as such term is defined in theagreement.

During the term of the operating agreement, theCompany may be liable for liquidated damages relating to any lost payments froma financial assistance agreement CVWD has with a state water agency, up to amaximum 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 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 CVWDsold insured municipal bonds.  TheCompany entered into an agreement with the bond insurer to guarantee theCompany’s performance under the service contract, subject to certain liabilitycaps 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 million plus an amount no greater than the replacement cost of the actualreverse osmosis filtration unit within the facility, estimated to beapproximately $1.5 million.

**Water Supply Commitments**

One of the Company’s regulated utilities has a watersupply contract providing for the purchase of water to supplement its own watersupply.  The agreement requires theCompany 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 March 31, 2007, the minimum annualpurchase commitment is $0.5 million through 2024.  Construction of the well sites and pipe lineshas been completed and the parties are in the process of obtaining finalregulatory approval.  The Company expectsto commence purchasing water pursuant to this contract during the first half of2007.

12

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**Minority Interest Put and Call Rights**

Prior to March 20, 2006, the Company owned 90% of theoutstanding common stock of Operations Technologies, Inc. (“OpTech”).  The minority stockholder had the right torequire the Company to purchase the remaining 10% of OpTech for the greater of$1.0 million or a formula-determined amount based on the profitability ofOpTech.  The Company had the right topurchase the remaining 10% of OpTech beginning in August 2006 at the sameterms.  On March 20, 2006, the minoritystockholder elected to exercise its right and the Company acquired the sharesbased on the formula determined amount which was slightly more than the $1.0million minimum amount (Note 2).

**Note 5.       EarningsPer Share**

The following table is a reconciliation of thenumerators (income) and denominators (shares) used in both the basic anddiluted earnings per share calculations.
| ** **                                                                      | ** **   | **Three Months Ended** | ** **   |
|---------------------------------------------------------------------------------|--------------|------------------------|--------------|
| *** ***                                                                    | *** *** | **March 31,**          | *** *** |
| **(In thousands, except per share data)**                                       | ** **   | **2007**               | ** **   | **2006** | ** ** |
|                                                                            |         |                   |         |   |   |
| Numerators—Net  income applicable to common stockholders:                  |         |                   |         |   |   |
| Income before change in accounting principle                                    |         | $                      | 614          |   | $ | 701 |   |
| Less preferred stock dividends                                                  |         | (6                     | )            | (6 | ) |
| Income before change in accounting principle  applicable to common stockholders |         | 608                    |         | 695 |   |
| Cumulative effect of change in accounting principle                             |         | —                 |         | 71 |   |
| Net income applicable to common stockholders                                    |         | $                      | 608          |   | $ | 766 |   |
|                                                                            |         |                   |         |   |   |
| Denominators—Weighted  average common shares outstanding:                  |         |                   |         |   |   |
| Basic weighted average common shares outstanding                                |         | 23,882                 |         | 22,293 |   |
| Plus shares issued on assumed exercise of stock  options and warrants           |         | 332                    |         | 1,014 |   |
| Diluted weighted  average common shares outstanding                             |         | 24,214                 |         | 23,307 |   |

 

As described in Note 3, the Company has $12.5 millionof 6.85% fixed-rate convertible subordinate debentures outstanding as of March31, 2007.  The debentures are convertibleinto common stock at any time prior to maturity, unless previously redeemed, ata conversion price of $11.018 per share which totals 1.1 million shares as ofMarch 31, 2007.  At such time as theassumed conversion of the debentures has a dilutive effect on earnings pershare, the debentures will be included in the calculation of diluted earningsper share after adjusting net income for the after-tax effect of the debentureinterest expense.

13

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**Note 6.       ConsolidatedStatements of Cash Flows**

The following informationsupplements the Company’s consolidated statements of cash flows.

 
| ** **                                                                                                     | ** **   | **Three Months Ended** | ** **   |     |
|----------------------------------------------------------------------------------------------------------------|--------------|------------------------|--------------|----------|
| *** ***                                                                                                   | *** *** | **March 31,**          | *** *** |     |
| **(In thousands)**                                                                                             | ** **   | **2007**               | ** **   | **2006** | ** ** |   |
|                                                                                                           |         |                   |         |     |   |   |
| Cash paid during  the period for:                                                                              |         |                   |         |     |   |
| Interest                                                                                                       |         | $                      | 1,801        |     | $ | 2,208 |   |
| Income taxes paid (refunded), net                                                                              |         | (724                   | )            | (1,852   | ) |
|                                                                                                           |         |                   |         |     |   |
| Components of  cash paid for acquisitions:                                                                     |         |                   |         |     |   |
| Fair value of assets acquired                                                                                  |         | $                      | 565          |     | $ | 1,234 |   |
| Liabilities assumed                                                                                            |         | (7                     | )            | (3       | ) |
| Cash paid for acquisitions                                                                                     |         | $                      | 558          |     | $ | 1,231 |   |
|                                                                                                           |         |                   |         |     |   |
| Non-cash  investing and financing activities:                                                                  |         |                   |         |     |   |
| Non-cash contributions in aid of construction and  advances for construction conveyed to Company by developers |         | $                      | 89           |     | $ | 1,059 |   |
| Debentures  converted into common stock                                                                        |         | 153                    |         | 1,687    |   |
|                                                                                                                |              |                        |              |          |  |  |  |  |  |

 

**Note 7.       Stock-BasedCompensation Plans**

The Company has two stock-based compensation plans: anEquity Incentive Plan and an Employee Stock Purchase Plan.

As more fully described in Note 13 to the Company’sconsolidated financial statements included in its 2006 Annual Report onForm 10-K, effective January 1, 2006, the Company adopted the provisionsof 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 Incentive Plan (“EIP”)authorizes the Company to award up to 5.4 million shares of its commonstock.  As of March 31, 2007, 1.092million shares were available for granting future awards under the plan whichmay be granted until May 16, 2016.  TheCompany has reserved 2.816 million shares of its authorized common shares forissuance upon exercise of awards outstanding and future awards available forgranting under the plan.  Under the EIP,the Company may award, either qualified or non-qualified stock options, stockappreciation rights, restricted stock, restricted stock units and otherstock-based awards to officers, employees and non-employee directors.

14

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The following table summarizes the compensation expense and relatedincome tax benefit related to share-based compensation expense recognizedduring the periods:
| ** **                                    | ** **   | **Three Months Ended** | ** **   |
|-----------------------------------------------|--------------|------------------------|--------------|
| *** ***                                  | *** *** | **March 31,**          | *** *** |
| **(In thousands)**                            | ** **   | **2007**               | ** **   | **2006** | ** ** |
|                                          |         |                   |         |   |   |
| Stock options                                 |         | $                      | 398          |   | 275 |   |
| Restricted stock  awards                      |         | 10                     |         | — |   |
| Share-based compensation expense              |         | 408                    |         | 275 |   |
| Income tax benefit                            |         | (148                   | )            | (101 | ) |
| Share-based  compensation expense, net of tax |         | $                      | 260          |   | $ | 174 |   |
|                                               |              |                        |              |  |  |  |  |

 

***Stock Options***

The following table summarizes all stock optionactivity during the three months ended March 31, 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                                                                                   |       | 210        |       | 12.80         |       |
| Exercised                                                                                 |       | (183       | )          | 6.42          |       |
| Forfeited                                                                                 |       | (118       | )          | 13.65         |       |
| Expired                                                                                   |       | —     |       | —        |       |
| Outstanding at  March 31, 2007                                                            |       | 1,697      |       | 10.79         |       |
|                                                                                      |       |       |       |          |       |
| Exercisable at March  31, 2007                                                            |       | 905        |       | 8.58          |       |
|                                                                                           |            |            |            |               |            |  |

 

The fair value of each option grant is estimated onthe date of grant using the Black-Scholes option pricing model with thefollowing weighted average assumptions used for grants in 2007 and 2006:
| ** **               | ** **   | **Three Months Ended** | ** **   |
|--------------------------|--------------|------------------------|--------------|
| *** ***             | *** *** | **March 31,**          | *** *** |
| ** **               | ** **   | **2007**               | ** **   | **2006** | ** ** |
| Dividend yield           |         | 1.7                    | %            | 1.3 | % |
| Expected  volatility     |         | 34.3                   | %            | 32.7 | % |
| Risk-free  interest rate |         | 4.5                    | %            | 4.8 | % |
| Expected life in years   |         | 4.5                    |         | 3.8 |   |

 

The weighted average grant date fair value of optionsgranted using these assumptions was $3.06 and $4.83 per share for the threemonths ended March 31, 2007 and 2006, respectively.

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*Restricted Stock Awards*

Under the EIP, the Company may award shares ofrestricted stock to employees that vest and are released to the employee as thevesting 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 to date.  Restricted stock is forfeited in the event aparticipant terminates employment with the Company prior to the awardvesting.  The grant date fair value ofstock awarded is recognized as compensation expense over the vesting term.

The following table summarizes all restricted stockaward activity during the three months ended March 31, 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 March  31, 2007                                                                            |       | 27         |       | 12.76               |       |
|                                                                                                           |            |            |            |                     |            |  |

 

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

The Company has a stockholder-approved employee stockpurchase plan (“ESPP”) that allows eligible employees to purchase1.256 million shares of common stock through payroll deductions of up to 10% oftheir salary, not to exceed $25,000 per year. The purchase price of the stock is 90% of the lower of the three-dayaverage share price calculated at the beginning and end of each three-monthoffering period.  Under the ESPP,employees purchased 5,327 shares for $68,000 during the three months endedMarch 31, 2007 and 4,538 shares for $65,000 during the three months ended March31, 2006.

The fair value of ESPP shares purchased is estimated aBlack-Scholes option pricing model with the following weighted averageassumptions used for 2007 and 2006:
| ** **               | ** **   | ***Three Months Ended*** | ** **   |
|--------------------------|--------------|--------------------------|--------------|
| *** ***             | *** *** | ***March 31,***          | *** *** |
| ** **               | ** **   | **2007**                 | ** **   | **2006** | ** ** |
|                     |         |                     |         |   |   |
| Dividend yield           |         | 1.4                      | %            | 1.4 | % |
| Expected volatility      |         | 33.6                     | %            | 33.6 | % |
| Risk-free  interest rate |         | 4.8                      | %            | 4.8 | % |
| Expected life in years   |         | 0.25                     |         | 0.25 |   |

 

Compensation expense recognized by the Companyresulting from employee stock purchases pursuant to this plan was approximately$10,000 for the three months ended March 31, 2007 and 2006.  As of March 31, 2007, 0.886 million sharesremain available for future purchases.

16

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**Note 8.       DividendReinvestment and Direct Stock Purchase Plan (“DRIP / DSPP”)**

The Company has a dividend reinvestment and stockpurchase 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 March 31, 2007. As of March 31, 2007, there are 3.696 million shares authorized forissuance under the plan of which 1.030 million shares remain available forissuance.

**Note 9.       EmployeeRetirement Plan**

The Company has a non-qualified supplemental executiveretirement plan (“SERP”) for certain key executive officers for the purpose ofproviding supplemental income benefits to plan participants or their survivorsupon retirement or death.  The planmeasurement date is December 31st of each year. As discussed in Note 1, the Company adopted the balance sheetrecognition requirements of SFAS 158 on December 31, 2006 and began recognizingthe unamortized portion of actuarial gains and prior service costs inaccumulated other comprehensive income. The following table details the components of the net periodic benefitcosts:
| ** **                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------|------------|----------------------------------|------------|
| ** **                                | ** ** | **March 31,**               | ** ** |
| **(In thousands)**                   | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                      |       |                             |       |   |   |
| Service cost                              |       | $                                | —     |   | $ | 17 |   |
| Interest cost                             |       | 16                               |       | 19 |   |
| Amortization of  actuarial (gains) losses |       | (19                              | )          | 4 |   |
| Amortization of  prior service costs      |       | 22                               |       | 8 |   |
| Net periodic  benefit costs               |       | $                                | 19         |   | $ | 48 |   |

 

The sole remaining participant in the plan has reachedretirement age.  The plan provides thatno additional benefits accrue upon reaching retirement age.  Summarized in the table below is informationabout the changes in the projected benefit obligation and the liabilityrecognized in the consolidated balance sheet as of March 31, 2007.
| ** **                                                     | ** ** | **March 31,** | ** ** |
|----------------------------------------------------------------|------------|---------------|------------|
| **(In thousands)**                                             | ** ** | **2007**      | ** ** |
|                                                           |       |          |       |
| Projected  benefit obligation:                                 |       |          |       |
| Balance at December 31, 2006                                   |       | $             | 1,224      |   |
| Interest cost                                                  |       | 16            |       |
| Payment of benefit obligation                                  |       | (174          | )          |
| Balance at March 31, 2007                                      |       | $             | 1,066      |   |
|                                                           |       |          |       |
| Amounts  recognized in accumulated other comprehensive income: |       |          |       |
| Actuarial gains                                                |       | $             | (180       | ) |
| Prior service cost                                             |       | 66            |       |
| Related deferred income taxes                                  |       | 40            |       |
| Total                                                          |       | $             | (74        | ) |

 

17

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**Note 10.     SegmentInformation**

The Company’s businesses are segmented into twooperating 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 public water andwastewater utilities in Alabama, California, New Mexico, Mississippi, Oklahomaand Texas.  State and federal agenciesissue regulations regarding standards of water quality, safety, environmentaland 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 water andwastewater 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 testingservices, and public works services.  TheServices Group, while subject to certain environmental standards, is notregulated in its pricing, marketing or rates of return.

As more fully described in Note 1, effective January1, 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.

The following table presents information about theoperations of each segment for the three months ended March 31, 2007 and 2006.
| ** **                                     | ** ** | **Utility** | ** ** | **Services** | ** ** | ** **             | ** ** | ** **                | ** ** | ** **       | ** ** |
|------------------------------------------------|------------|-------------|------------|--------------|------------|------------------------|------------|---------------------------|------------|------------------|------------|
| **(In thousands)**                        | ** ** | **Group**   | ** ** | **Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations (3)** | ** ** | **Consolidated** | ** ** |
| ** **                                     |       |        |       |         |       |                   |       |                      |       |             |       |
| **Three  months ended March 31, 2007:**        |       |        |       |         |       |                   |       |                      |       |             |       |
| Revenues:                                      |       |        |       |         |       |                   |       |                      |       |             |       |
| Unaffiliated customers                         |       | $           | 20,034     |         | $          | 26,521                 |       | $                         | —     |             | $          | — |   | $ | 46,555 |   |
| Intersegment (1) (3)                           |       | 452         |       | 7,220        |       | —                 |       | (6,153                    | )          | 1,519            |       |
| Total revenues                                 |       | 20,486      |       | 33,741       |       | —                 |       | (6,153                    | )          | 48,074           |       |
|                                           |       |        |       |         |       |                   |       |                      |       |             |       |
| Expenses:                                      |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating expenses–unaffiliated customers |       | 11,596      |       | 25,002       |       | —                 |       | —                    |       | 36,598           |       |
| Operating expenses–intersegment (3)       |       | 452         |       | 5,701        |       | —                 |       | (6,153                    | )          | —           |       |
| Selling, general and administrative            |       | 2,461       |       | 2,695        |       | 3,377                  |       | —                    |       | 8,533            |       |
| Total expenses                                 |       | 14,509      |       | 33,398       |       | 3,377                  |       | (6,153                    | )          | 45,131           |       |
|                                           |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating income (loss)                        |       | 5,977       |       | 343          |       | (3,377                 | )          | —                    |       | 2,943            |       |
|                                           |       |        |       |         |       |                   |       |                      |       |             |       |
| Interest expense                               |       | (1,511      | )          | (333         | )          | (226                   | )          | —                    |       | (2,070           | )          |
| Interest income                                |       | 4           |       | 115          |       | 21                     |       | —                    |       | 140              |       |
| Other income (expense)                         |       | (64         | )          | —       |       | 15                     |       | —                    |       | (49              | )          |
| Income before  income taxes                    |       | $           | 4,406      |         | $          | 125                    |       | $                         | (3,567     | )                | $          | — |   | $ | 964 |   |

 

*Seeaccompanying notes to the segment information following these tables.*

18

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** **
| ** **                                                     | ** ** | **Utility** | ** ** | **Services** | ** ** | ** **             | ** ** | ** **                | ** ** | ** **       | ** ** |
|----------------------------------------------------------------|------------|-------------|------------|--------------|------------|------------------------|------------|---------------------------|------------|------------------|------------|
| **(In thousands)**                                        | ** ** | **Group**   | ** ** | **Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations (3)** | ** ** | **Consolidated** | ** ** |
| ** **                                                     | ** ** | ** **  | ** ** | ** **   | ** ** | ** **             | ** ** | ** **                | ** ** | ** **       | ** ** |
| **Three  months ended March 31, 2006:**                        | ** ** | ** **  | ** ** | ** **   | ** ** | ** **             | ** ** | ** **                | ** ** | ** **       | ** ** |
| Revenues:                                                      |       |        |       |         |       |                   |       |                      |       |             |       |
| Unaffiliated customers                                         |       | $           | 17,973     |         | $          | 30,425                 |       | $                         | —     |             | $          | — |   | $ | 48,398 |   |
| Intersegment (1) (3)                                           |       | 366         |       | 7,488        |       | —                 |       | (6,658                    | )          | 1,196            |       |
| Total revenues                                                 |       | 18,339      |       | 37,913       |       | —                 |       | (6,658                    | )          | 49,594           |       |
| Expenses:                                                      |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating expenses–unaffiliated customers                 |       | 10,397      |       | 27,795       |       | —                 |       | —                    |       | 38,192           |       |
| Operating expenses–intersegment (3)                       |       | 366         |       | 6,292        |       | —                 |       | (6,658                    | )          | —           |       |
| Selling, general and administrative                            |       | 2,246       |       | 2,762        |       | 3,377                  |       | —                    |       | 8,385            |       |
| Total expenses                                                 |       | 13,009      |       | 36,849       |       | 3,377                  |       | (6,658                    | )          | 46,577           |       |
|                                                           |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating income  (loss)                                       |       | 5,330       |       | 1,064        |       | (3,377                 | )          | —                    |       | 3,017            |       |
|                                                           |       |        |       |         |       |                   |       |                      |       |             |       |
| Interest expense                                               |       | (1,514      | )          | (487         | )          | (130                   | )          | —                    |       | (2,131           | )          |
| Interest income                                                |       | 9           |       | 68           |       | 4                      |       | —                    |       | 81               |       |
| Other income  (expense)                                        |       | (12         | )          | 139          |       | 12                     |       | —                    |       | 139              |       |
| Income before  income taxes and change in accounting principle |       | $           | 3,813      |         | $          | 784                    |       | $                         | (3,491     | )                | $          | — |   | $ | 1,106 |   |

 

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**Notes**

(1)          Some companies in theServices Group provide construction, operations and maintenance services tocompanies in the Utility Group and recognize a profit on those services.  In accordance with SFAS 71, the Companydoes not eliminate the intersegment profit recognized on these services becausethe Company believes the sales price is reasonable and it is probable that,through the rate making process, future Utility Group revenue approximatelyequal to the sales price will result from the regulated utilities’ use of theservices.  The Company does, however,eliminate the Services Group’s revenues from affiliated customers to the extentof its cost.  Consequently, ServicesGroup revenues reflected in the consolidated statements of income includeintersegment gross profits as follows:
|                                                                    | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **March 31,**               | ** ** |
| **(In thousands, except per share data)** | ** ** | **2007**                         | ** ** | **2006** | ** ** |
|                                                               |       |                             |       |   |   |
| Services Group  revenues:                                          |       |                             |       |   |   |
| From unaffiliated customers                                        |       | $                                | 26,521     |   | $ | 30,425 |   |
| Intersegment profits                                               |       | 1,519                            |       | 1,196 |   |
| Total revenues                                                     |       | $                                | 28,040     |   | $ | 31,621 |   |

 

(2)          Consists of costs thatinclude headquarters expenses and any corporate functional departments whosecosts are not allocated to our reportable segments.  Corporate and other assets reflect corporateheadquarters assets, excluding investments in and receivables fromsubsidiaries.

(3)          Reflects the eliminationof Services Group revenues derived from the Utility Group, to the extent ofcosts as described in (1) above.  Inaddition, a company in the Utility Group provides services to a company in theServices Group.  Intersegment revenuesand expenses, including all profit, associated with these services are fullyeliminated upon consolidation.

19

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**Note 11.     SubsequentEvent**

On May 3, 2007 the Company acquired all of the commonstock of two water utilities that serve approximately 7,500 residents in a highpopulation growth area northwest of San Antonio, Texas.  The purchase price was $4.9 million incash.  The acquisitions were funded withborrowings under the Company’s revolving line of credit.

20

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

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

Management’s Discussion and Analysis of FinancialCondition and Results of Operations (“MD&A”) is intended to help the readerunderstand the results of operations and financial condition of Southwest WaterCompany.  This MD&A also contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended.  All statements contained herein that are notclearly 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,” “will likelycontinue,” 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 reader understandthe results of operations, financial condition and cash flows of SouthwestWater Company and is provided as a supplement to, and should be read inconjunction with, our condensed consolidated financial statements and theaccompanying notes to the financial statements included in this report.

### **OVERVIEW**

Southwest Water Company provides a broad range ofservices including water production, treatment and distribution; wastewatercollection 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.

#### **UtilityGroup**

Our Utility Group owns public water and wastewaterutilities in Alabama, California, New Mexico, Oklahoma and Texas and, beginningin February 2007, Mississippi.  Exceptfor our California utility, our utilities are operated by companies in ourServices Group.  State and federalagencies 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 earned for theproduction and distribution of water and the collection and treatment of sewagefor 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 thenumber of customers we serve;

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

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

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

21

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In our pursuit of long-term Utility Group growth,during 2006 we acquired two small water utilities and the rights to providewater and wastewater utility service in developing areas located near Austin,Texas and, in February 2007, we acquired a small water and wastewater utilitylocated in northern Mississippi, just south of Memphis, Tennessee.  While these acquisitions are insignificant toour financial results, both individually and in the aggregate, they are strategicallyimportant as they expand our utility ownership in areas that are currentlyexperiencing significant population growth.

In 2007, the Albuquerque Bernalillo County WaterUtility Authority and the City of Rio Rancho, New Mexico, filed a Petition forCondemnation (the “Petition”) against our New Mexico regulated utility, NewMexico Utilities, Inc. (“NMUI”).  ThePetition seeks to acquire, by condemnation, all of the assets of NMUI,including all real property, through the alleged power of eminent domain.  The Petition also alleges that thePetitioners need to acquire the utility assets for the public purposes ofproviding water and wastewater services to customers and that the acquisition of NMUI is necessary, appropriate andin the public interest.  We believe wehave defenses to the Action which we intend to vigorously assert.  If we do not prevail, the Petitioners mustpay fair market value as determined by the court, based on appraisals.  NMUI and the Petitioners do not agree on thevalue of the assets which the Petitioners seek to condemn.  While it is too early to predict the outcomeof this matter, we believe that the fair market value of the NMUI utilityexceeds its recorded net book value as of March 31, 2007.

#### **ServicesGroup**

Our Services Group operates our contract servicebusinesses in which we operate and maintain water and wastewater facilitiesowned by cities, public agencies, municipal utility districts, private entitiesand investor-owned utilities, including most of our own utilities.  Our Services Group operates primarily inAlabama, California, Colorado, Georgia, Mississippi, New Mexico, South Dakotaand 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 earned for waterand wastewater facility operations and maintenance services, equipmentmaintenance and repair, sewer pipeline cleaning, billing and collection services,public works and state-certified water and wastewater laboratory analysis.  Our Services Group also facilitates thedesign, construction, project management and operating aspects of various waterand wastewater projects.  The group’soperating expenses reflect salaries, wages and employee benefits, facilitiescosts, supplies and equipment, repairs and maintenance, professional fees andother costs.  Most work performed by theServices Group is required 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 thenumber of clients we have contracts with;

·                  increasing thecustomer base for our existing contracts;

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

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

The relationships we build with our service contractclients can position us for additional growth when a client decides to selltheir utility.  Our 2006 acquisitions ofsmall water and wastewater utilities are examples of this growth strategy, asthey were operated by our Services Group prior to the sale.

22

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

Selling, generaland administrative expenses consist of costs related to personnel, facilities,insurance, consulting and professional services, which support our sales,marketing, human resources, finance and administration functions for the entirecompany.

### **RESULTSOF OPERATIONS**

#### **ThreeMonths Ended March 31, 2007 Compared to 2006**

**Revenues.**  Revenues decreased $1.5 million, or 3.1%, to$48.1 million for three months ended March 31, 2007 from $49.6 million for thesame period during the prior year.  Bysegment, revenues changed as follows:
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)**                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                             |       |         |       |                              |       |   |   |   |   |
| Utility Group                                         |       | $                                | 20,034     |         | $          | 17,973                            |       | $ | 2,061 |   | 41.7 | % | 36.2 | % |
| Services Group                                        |       | 28,040                           |       | 31,621       |       | (3,581                            | )          | 58.3 | % | 63.8 | % |
| Total                                                 |       | $                                | 48,074     |         | $          | 49,594                            |       | $ | (1,520 | ) | 100.0 | % | 100.0 | % |

 

***Utility Group.***  Revenues increased $2.0 million, or 11.5%, to$20.0 million for the three months ended March 31, 2007, from$18.0 million for the same period during the prior year.  The increase was primarily due to thefollowing:

·                  a $1.7 millionincrease at our California utility related to increased consumption and anincrease in rates that went into effect on July 1st of 2006; and

·                  a $0.3 millionincrease at our New Mexico and Texas utilities primarily resulting from anincrease in the number of connections and a fourth quarter 2006 rate increaseat one of our Texas utilities.

***Services Group. ***Revenuesdecreased $3.6 million, or 11.3%, to $28.0 million for the three months endedMarch 31, 2007 from $31.6 million for the same period during the prioryear.  The decrease in revenues wasprimarily due to the following:
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** | ** **                        | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | ** ** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **Change**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                             |       |       |       |                              |       |   |   |   |   |
| Revenues from  unaffiliated customers                 |       | $                                | 26,521     |       | $          | 30,425                            |       | $ | (3,904 | ) | 78.6 | % | 80.2 | % |
| Intersegment revenues                                 |       | 7,220                            |       | 7,488      |       | (268                              | )          | 21.4 | % | 19.8 | % |
| Total revenues                                        |       | 33,741                           |       | 37,913     |       | (4,172                            | )          | 100.0 | % | 100.0 | % |
| Intersegment  cost eliminations                       |       | (5,701                           | )          | (6,292     | )          | 591                               |       |   |   |   |   |
| Total                                                 |       | $                                | 28,040     |       | $          | 31,621                            |       | $ | (3,581 | ) |   |   |   |   |

 

Revenues fromunaffiliated customers decreased $3.9 million, or 12.8%, to $26.5 million forthe three months ended March 31, 2007 from $30.4 million for the same periodduring the prior year.  The decrease inrevenues was primarily due to the following:

·                  a $2.6 milliondecrease in contract operations, maintenance, public works and constructionwork in our southeast region due to contracts not renewed or canceled; and

·                  a $1.3 milliondecrease related to lower revenues from new housing construction-related workdue primarily to inclement weather in the first quarter of 2007 compared to theprior year.

Intersegmentrevenues received from our Utility Group decreased by $0.3 million, or 3.6%, to$7.2 million for the three months ended March 31, 2007 from $7.5 million forthe same period during the prior year. The decrease in revenues results from a slight decrease in constructionprojects performed for our New Mexico and Texas utilities.

23

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**DirectOperating Expenses.**  Direct operating expenses decreased$1.6 million, or 4.2%, to $36.6 million for the three months ended March 31,2007 from $38.2 million for the same period during the prior year as follows:
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                | 11,596     |         | $          | 10,397                                     |       | $ | 1,199 |   | 57.9 | % | 57.8 | % |
| Services Group                                        |       | 25,002                           |       | 27,795       |       | (2,793                                     | )          | 89.2 | % | 87.9 | % |
| Total                                                 |       | $                                | 36,598     |         | $          | 38,192                                     |       | $ | (1,594 | ) | 76.1 | % | 77.0 | % |

 

----

(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.

***Utility Group.***  Direct operating expenses increased $1.2million, or 11.5%, to $11.6 million for the three months ended March 31, 2007,from $10.4 million for the same period during the prior year.  The increase in direct operating expenses wasprimarily due to the following:

·                  a $0.5 millionincrease in expenses at our New Mexico and Texas utilities resulting from anincrease in depreciation expense, an increase in contract operation fees, andhigher sewage treatment expenses; and

·                  a $0.7 millionnet increase in direct operating expenses at our California utility principallyresulting from higher depreciation rates adopted under the rate case that wentinto effect on July 1, 2006 and a $0.4 million gain on sale of land recorded in2006.

Direct operatingexpenses were 57.9% and 57.8% of related revenues for the three months March31, 2007 and 2006, respectively.

***Services Group.***  Direct operating expenses decreased $2.8 million,or 10.0%, to $25.0 million for the three months ended March 31, 2007 from $27.8million for the same period during the prior year.  The decrease in direct operating expenses wasdue to the following:

·                  a $2.4 milliondecrease related to non-renewed and canceled contracts in our southeast region;and

·                  a $0.9 milliondecrease primarily related to lower revenues from new housingconstruction-related work compared to the prior year due to inclement weather;partially offset by

·                  a $0.5 millionincrease in expenditures to correct past performance issues and to close out contractsin our southeast region.

Direct operatingexpenses as a percentage of the related revenues increased 1.3% to 89.2% forthe three months ended March 31, 2007 compared to 87.9% for the same periodduring the prior year.

**GrossProfit.**  Gross profit, which we define as thedifference between revenues and the related direct operating expenses,increased $0.1 million, or 0.6%, to $11.5 million for the three months endedMarch 31, 2007 from $11.4 million for the same period during the prior year asfollows:
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                | 8,438      |         | $          | 7,576                                      |       | $ | 862 |   | 42.1 | % | 42.2 | % |
| Services Group                                        |       | 3,038                            |       | 3,826        |       | (788                                       | )          | 10.8 | % | 12.1 | % |
| Total                                                 |       | $                                | 11,476     |         | $          | 11,402                                     |       | $ | 74 |   | 23.9 | % | 23.0 | % |

 

----

(1)          Utility Groupand Services Group gross profit is computed as a percent of their respectiverevenues after intersegment eliminations. Total gross profit is computed as a percentage of total revenues.

***Utility Group.***  Gross profit was 42.1% and 42.2% of relatedrevenues for the three months ended March 31, 2007 and 2006, respectively,which is comparable between periods.

24

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***Services Group.**** *Gross profit for the three monthsended March 31, 2007 and 2006 was comprised of the following:
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |   |   |   |   |
| Gross profit on  sales to:                            |       |                             |       |         |       |                                       |       |   |   |   |   |
| Unaffiliated customers                                |       | $                                | 1,519      |         | $          | 2,630                                      |       | $ | (1,111 | ) | 5.7 | % | 8.6 | % |
| Affiliated customers (intersegment)                   |       | 1,519                            |       | 1,196        |       | 323                                        |       | 21.0 | % | 16.0 | % |
| Total                                                 |       | $                                | 3,038      |         | $          | 3,826                                      |       | $ | (788 | ) | 9.0 | % | 10.1 | % |

 

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

Services Groupgross profit on revenues from unaffiliated customers decreased by $1.1 million,or 42.2%, to $1.5 million for the three months ended March 31, 2007 from $2.6million for the same period during the prior year.  Gross profit as a percent of revenues for2007 was 5.7%, compared to 8.6% for 2006. The decrease in gross margin percent is primarily related to theincreased expenditures in our southeast region to correct past performanceissues and to close out contracts.

Services Groupgross profit on revenues from our Utility Group increased by $0.3 million, or27.0% to $1.5 million for the three months ended March 31, 2007 from $1.2million for the same period during the prior year.  The small increase is related to oursuccessful efforts in managing costs of construction projects for our Texas andNew Mexico utilities.

***Selling, General and Administrative Expenses.***  Selling, general and administrative expensesincreased $0.1 million, or 1.8%, to$8.5 million for the three months ended March 31, 2007 compared to $8.4 millionfor the same period during the prior year as follows:
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                            | ** ** | ** **                       | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Utility Group                                         |       | $                                | 2,461      |         | $          | 2,246                                      |       | $ | 215 |   | 12.3 | % | 12.5 | % |
| Services Group                                        |       | 2,695                            |       | 2,762        |       | (67                                        | )          | 9.6 | % | 8.7 | % |
| Corporate                                             |       | 3,377                            |       | 3,377        |       | —                                     |       | — |   | — |   |
| Total                                                 |       | $                                | 8,533      |         | $          | 8,385                                      |       | $ | 148 |   | 17.7 | % | 16.9 | % |

 

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(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, generaland administrative expenses are relatively fixed in nature and do not fluctuatesignificantly with changes in revenues. The Utility Group increase is caused entirely by legal costs incurred inconnection with the condemnation proceedings against our New Mexico utility.  In accordance with New Mexico statue, costs aggregating$0.2 million are expected to be reimbursed to us by the parties seekingcondemnation should we prevail in the action.

**OtherIncome (Expense).** Other expense increased $0.1 million, or 3.6%, to $2.0 million for thethree months ended March 31, 2007 from $1.9 million for the same period duringthe prior year as follows:
| ** **              | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** |
|-------------------------|------------|----------------------------------|------------|--------------|------------|
| ** **              | ** ** | **March 31,**               | ** ** | **Increase** | ** ** |
| **(In thousands)** | ** ** | **2007**                         | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** |
|                    |       |                             |       |         |       |   |   |
| Interest expense        |       | $                                | (2,070     | )            | $          | (2,131 | ) | $ | 61 |   |
| Interest income         |       | 140                              |       | 81           |       | 59 |   |
| Other, net              |       | (49                              | )          | 139          |       | (188 | ) |
| Total                   |       | $                                | (1,979     | )            | $          | (1,911 | ) | $ | (68 | ) |

*** ***

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***Interest Expense.***  Interest expense decreased $0.1 million, or2.9%, for the three months ended March 31, 2007 compared to the same periodduring the prior year.  The majorcomponents of interest expense were as follows:
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                           | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(In thousands)**              | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                 |       |                             |       |       |       |   |   |
| Mortgage bonds  and bank term loans  |       | $                                | 1,190      |       | $          | 1,232 |   | $ | (42 | ) |
| Revolving lines  of credit           |       | 660                              |       | 522        |       | 138 |   |
| Convertible  subordinated debentures |       | 215                              |       | 278        |       | (63 | ) |
| Other  indebtedness                  |       | 197                              |       | 191        |       | 6 |   |
| Total interest incurred              |       | 2,262                            |       | 2,223      |       | 39 |   |
| Less capitalized interest            |       | (192                             | )          | (92        | )          | (100 | ) |
| Total interest  expense              |       | $                                | 2,070      |       | $          | 2,131 |   | $ | (61 | ) |

 

The decrease in total interest incurred is primarilydue to a decrease in borrowings levels on our mortgage bonds and bank termloans, and debentures that have been converted into common stock, offset by anincrease in interest rates and borrowing levels related to our revolving lineof credit.  The average balance ofinterest bearing debt outstanding increased to $133.6 million during the threemonths ended March 31, 2007 compared to $129.6 million for the prior year.  The additional borrowings were used to fundcapital expenditures and acquisitions. The weighted average interest rate on total borrowings was approximately6.5% for the three months ended March 31, 2007 and 2006.

**Provisionfor Income Taxes.**  Oureffective consolidated income tax rate was 36.3% for the three months endedMarch 31, 2007 and is comparable to 36.6% for the prior year.

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

#### **SFASNo. 158**

In September 2006, the Financial Accounting StandardsBoard (“FASB”) issued SFAS No. 158, *Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans — an amendment of FASBStatements 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 sheet recognitionprovisions of SFAS 158 were effective for our fiscal year ended December 31,2006 and, as a result, we began recognizing the unamortized portion ofactuarial gains and prior service costs in accumulated other comprehensiveincome.  The adoption of SFAS 158 did nothave a material effect on the consolidated financial statements.

#### **FINNo. 48**

On January 1, 2007, we adopted the provisions of FASBInterpretation No. 48, Accounting for Uncertainty in Income Taxes (“FIN 48”).  This interpretation clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes* (“SFAS 109”).  FIN 48requires companies to recognize the financial statement benefit of a taxposition only after determining the relevant tax authority would “more likelythan not” sustain the position following an examination by taxingauthorities.  For tax positions meetingthe more-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.

We adopted the provisions of FIN No. 48 on January 1,2007.  On December 31, 2006 and March 31,2007, our liabilities for uncertain tax positions are 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 ended March 31, 2007 and 2006 were insignificant.

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We are subject to federaland various state and local income taxes. Tax regulations within each jurisdiction are subject to theinterpretation of related tax laws and regulations and require significantjudgment to apply.  We are no longersubject to federal, state and local income tax return examinations by taxingauthorities for years before 2002.  Ourfederal income tax returns for the 2002 through 2004 tax years were recentlyexamined by the Internal Revenue Service. The examination was concluded in February 2007 and resulted in no netchange for the tax years examined.  Stateand local income tax returns from 2002 to the present and federal income taxreturns from 2005 to the present are still subject to examinations by taxingauthorities.

### **RECENTACCOUNTING PRONOUNCEMENTS**

#### **SFASNo. 157**

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

#### **SFASNo. 159**

In February 2007, the FASB issued SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities –Including an amendment of FASB Statement No. 115* (“SFAS 159”).  This statement permits companies to choose tomeasure many financial instruments and other specified items at fairvalue.  This statement is effective forour fiscal year beginning January 1, 2008 and will be appliedprospectively.  While we are stillevaluating the impact this statement will have on the consolidated financialstatements, we currently believe the impact will not be material.

### **LIQUIDITYAND CAPITAL RESOURCES**

Our overall objectives with respect to liquidity andcapital resources are to:

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

·                  utilizeour credit facility for major capital improvements and to manage seasonal cashneeds;

·                  obtainexternal financing for major acquisitions; and

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

Our statements of cash flows are summarized asfollows:
| ** **                            | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                            | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(In thousands)**               | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **Change** | ** ** |
| ** **                            | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net cash provided by (used in):       |       |                             |       |       |       |   |   |
| Operating activities                  |       | $                                | (1,097     | )          | $          | 179 |   | $ | (1,276 | ) |
| Investing activities                  |       | (8,919                           | )          | (9,240     | )          | 321 |   |
| Financing activities                  |       | 8,735                            |       | 8,639      |       | 96 |   |
| Decrease in cash and cash equivalents |       | $                                | (1,281     | )          | $          | (422 | ) | $ | (859 | ) |

 

**Cash Flows From Operating Activities.**  Net cash used in operating activitiesincreased by $1.3 million during the three months ended March 31, 2007 comparedto the same period during the prior year. Operational aspects of our businesses that affected working capital in2007 versus 2006 are highlighted below:

·                  increased levelof vendor payments in 2007 for goods and services used during the fourth quarterof 2006; offset by

·                  the benefit fromincreased consumption and higher water rates at our California utility; and

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·                  increasedrevenues generated by our New Mexico and Texas utilities resulting fromcustomer connection growth.

**Cash Flows From Investing Activities.**  Cash used in investing activities totaled$9.0 million for the three months ended March 31, 2007 compared to $9.2 millionfor the same period during the prior year as follows:
| ** **                                              | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                              | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(In thousands)**                                 | ** ** | **2007**                         | ** ** | **2006**   | ** ** | **Change** | ** ** |
| ** **                                              | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash flows (used  in) provided by investing activities: |       |                             |       |       |       |   |   |
| Additions to property, plant and equipment              |       | $                                | (8,394     | )          | $          | (7,426 | ) | $ | (968 | ) |
| Acquisition of businesses, net of cash acquired         |       | (558                             | )          | (1,231     | )          | 673 |   |
| Purchase of minority interest                           |       | —                           |       | (1,010     | )          | 1,010 |   |
| Proceeds from sales of land                             |       | 33                               |       | 427        |       | (394 | ) |
| Net cash used  for investing activities                 |       | $                                | (8,919     | )          | $          | (9,240 | ) | $ | 321 |   |

 

The following table summarizes additions to property,plant and equipment additions for 2007 and 2006.
| ** **                                             | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** |
| **(In thousands)**                                | ** ** | **2007**                         | ** ** | **2006** | ** ** |
| ** **                                             | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Company-financed  additions                            |       | $                                | 7,044      |   | $ | 6,504 |   |
| Capital  improvement reimbursements                    |       | 865                              |       | 220 |   |
| Cash  contributions received in aid of construction    |       | 485                              |       | 702 |   |
| Total cash additions to property, plant and  equipment |       | 8,394                            |       | 7,426 |   |
| Non-cash contributions in aid of construction          |       | 89                               |       | 1,059 |   |
| Total additions  to property, plant and equipment      |       | $                                | 8,483      |   | $ | 8,485 |   |

 

Capital projects primarily relate to the expansion,replacement and renovation of our water and wastewater systems, particularly atour Texas and New Mexico utilities. Contributions in Aid of Construction (“CIAC”) represent contributions inthe form of cash, services or property received from developers, governmentalagencies, municipalities or individuals for the purpose of constructing utilityplant and is not refundable.  In 2007, weexpect to spend approximately $29.0 million on cash additions, principallywithin our Utility Group, and expect to receive $7.0 million of CIAC resultingin total expected additions to property, plant and equipment of approximately$36.0 million.

In March 2006, we acquired the remaining 10% interestin Operations Technology, Inc. that we did not already own for $1.0 million incash.  We also made substantial investmentsin acquisitions during 2007 and 2006 and expect we will continue to do so inthe future.

**Cash Flows From Financing Activities.**  During the first three months of 2007, wefinanced our growth through a broad range of capital initiatives:

·                  borrowed $7.5million under our revolving line of credit;

·                  received $1.4million of proceeds from our direct stock purchase plan, our employee stockpurchase and option plans and our director option plan; and

·                  received $1.4million of capital improvement reimbursements and contributions in aid ofconstruction.

Revolving line of borrowings were primarily used tofund our investing activities and, to a lesser extent, to fund operations.  Additional borrowing availability under ourrevolving credit facility was $52.4 million as of March 31, 2007.

During the three months ended March 31, 2007, we paiddividends totaling $1.4 million and our quarterly dividend rate is currently$0.0576 per common share.

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### **CONTRACTUALOBLIGATIONS**

The following table summarizes our known contractualobligations to make future cash payments as of March 31, 2007, as well as anestimate of the periods during which these payments are expected 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)                      |       | $                                            | 43,500     |   | $ | — |   | $ | — |   | $ | 43,500 |   | $ | — |   |
| Mortgage bonds (3)                           |       | 45,000                                       |       | — |   | — |   | — |   | 45,000 |   |
| Bank term loans (4)                          |       | 32,413                                       |       | 617 |   | 1,645 |   | 1,646 |   | 28,505 |   |
| Convertible subordinated debentures (5)      |       | 12,457                                       |       | — |   | — |   | — |   | 12,457 |   |
| Economic development revenue bonds (6)       |       | 2,030                                        |       | 105 |   | 235 |   | 260 |   | 1,430 |   |
| Notes payable and other (7)                  |       | 956                                          |       | 451 |   | 505 |   | — |   | — |   |
| Total long-term debt                         |       | 136,356                                      |       | 1,173 |   | 2,385 |   | 45,406 |   | 87,392 |   |
|                                         |       |                                         |       |   |   |   |   |   |   |   |   |
| Repayment of  advances for construction (8)  |       | 9,183                                        |       | 770 |   | 1,494 |   | 928 |   | 5,991 |   |
| Water purchase  commitment (9)               |       | 7,972                                        |       | 345 |   | 920 |   | 920 |   | 5,787 |   |
| Lease assignment  obligations (10)           |       | 1,177                                        |       | 140 |   | 1,037 |   | — |   | — |   |
| Operating lease  obligations                 |       | 28,245                                       |       | 4,733 |   | 7,593 |   | 4,692 |   | 11,227 |   |
| Total  obligations as of March 31, 2007 (11) |       | $                                            | 182,933    |   | $ | 7,161 |   | $ | 13,429 |   | $ | 51,946 |   | $ | 110,397 |   |

 

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(1)          Excludesinterest payments, which are described in the following notes.  The terms of the long-term debt are morefully described in the notes to the consolidated financial statements includedin this report and our 2006 Annual Report on Form 10-K.

(2)          The bank linesof credit bear interest at variable rates and therefore the amount of futureinterest payments are uncertain.  Borrowingsbear interest, at our option, based on a margin either: a) over the LIBOR rate;or b) under the prime rate.  The marginsvary based on our consolidated debt to equity ratio.  The weighted-average interest rate on ourbank line of credit borrowings was 6.15% as of March 31, 2007.

(3)          Interest on themortgage bonds is fixed at a weighted-average annual interest rate of 6.52% andis payable semiannually.

(4)          Interest on thebank term loans is fixed at a weighted-average annual interest rate of 6.55%and is payable semiannually.

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

(6)          Interest on theeconomic development bonds is fixed at a weighted-average annual interest rateof 5.95% and is payable semiannually.

(7)          Interest ispayable either monthly or quarterly at rates ranging from 5.0% to 8.0% peryear.

(8)          Advances for constructionare non-interest bearing.

(9)          Reflects theminimum annual contractual 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.  Construction of the well sites and pipe lineshas been completed and the parties are in the process of obtaining finalregulatory approval.  We expect tocommence purchasing water pursuant to this contract during the first half of2007; the commitment reflected above for 2007 is for the remainder of 2007(nine months).

(10)    Interest on thelease assignment obligations is fixed at a weighted-average interest rate of8.39% and is payable monthly.

(11)    Excludes preferredstock dividend obligations.  Preferredstockholders are entitled to receive annual dividends of $2.625 per share andthere are 9,158 shares of preferred stock outstanding as of March 31, 2007.  The preferred stock is redeemable by theCompany 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 March 31, 2007, we had $16.8 million of workingcapital and $5.1 million of operating lease and water purchase obligationspayable during the remainder of 2007.  Asof March 31, 2007, we also had $52.4 million of additional borrowings availableunder 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 $84.7 million of first mortgage bonds as of March 31, 2007.  However, the terms of our credit facility donot permit additional first mortgage bond indebtedness without prior consentfrom the credit facility lenders.  Themortgage bond indentures also limit the amount of cash and property dividendsour California and New Mexico utilities may pay to the parent company to fund itspayment obligations.  Dividends haveaveraged $4.0 to $5.0 million per year and are less than

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the aggregate cumulative dividend restrictionthreshold by $46.3 million as of March 31, 2007.  We were in compliance with all loan agreementcovenants during the three months ended March 31, 2007.

We also have on file a registration statement with theSecurities and Exchange Commission, which is effective for the issuance of upto $50.0 million aggregate principal amount of common stock, debt securitiesand warrants.  To date we have issuedapproximately $43.6 million of common stock under the shelf registration, andabout $6.4 million remains available for issuance as of March 31, 2007.  We may offer any of these securities for saleat any time and from time to time.

We believe that our expected operating cash flows,together with borrowings under our credit facility ($52.4 million of which wasavailable as of March 31, 2007 and expires on April 1, 2010) will be sufficientto meet our operating expenses, working capital and capital expenditurerequirements as well as our debt service and other contractual obligations forthe next twelve months.  However, ourability to comply with debt financial covenants, pay principal or interest andrefinance our debt obligations will depend on our future operating performanceas well as competitive, legislative, regulatory, business and other factorsbeyond our control.

### **CERTAINCONTRACTUAL COMMITMENTS AND INDEMNITIES**

In 2002, we were retained to facilitate theengineering and construction of a $23.0 million reverse osmosis water treatmentplant in the city of San Juan Capistrano, California for the Capistrano ValleyWater District (“CVWD”).  In 2003, weobtained a $3.4 million standby letter of credit as collateral to insure ourperformance during the design and construction of the water treatmentplant.  Construction was completed during2005 and we are working with the CVWD to obtain its final acceptance of theproject.  The $3.4 million standby letterof credit was released on May 3, 2007 and we expect to receive final acceptanceduring 2007.

We now operate the completed plant under a twenty-yearoperating agreement.  The CVWD servicecontract contains three guarantees related to our performance during the termof the operating agreement.  Theagreement provides for liquidated damages in the event we fail to perform forreasons other than those caused by “uncontrollable circumstances,” as such termis defined in the agreement.

During the term of the operating agreement, we may beliable for liquidated damages relating to any lost payments from a financialassistance agreement CVWD has with a state water agency, up to a maximum of$1.4 million per contract year.  We havealso made guarantees to CVWD with respect to the quantity of finished waterproduced by the facility.  In the eventthe actual number of acre feet of finished water delivered is less than thewater delivery guarantee, we are required to pay liquidated damages ofapproximately $600 per acre foot of shortfall, up a maximum of 15.8 acre feetper day.  Finally, we have madeguarantees 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 CVWDsold insured municipal bonds.  We enteredinto an agreement with the bond insurer to guarantee our performance under theservice contract, subject to certain liability caps to the bond insurer in theevent of a default.  During thetwenty-year operation of the facility, such liability caps will not exceed anamount equal to $4.0 million plus an amount no greater than the replacementcost of the actual reverse osmosis filtration unit within the facility,estimated to be approximately $1.5 million.

As of March 31, 2007, we had irrevocable standbyletters of credit in the amount of $4.1 million issued and outstanding underour credit facility, including the CVWD letter of credit described above.

During our normal course of business, we have enteredinto agreements containing indemnities pursuant to which we may be required tomake payments in the future.  These indemnitiesare in connection with facility leases and liabilities and operations andmaintenance and construction contracts entered into by our Services Group.  The duration of these indemnities,commitments and guarantees varies, and in certain cases, is indefinite.  Substantially all of these indemnitiesprovide no limitation on the maximum potential future payments we could beobligated to make and is not quantifiable. We have not recorded any liability for these indemnities.

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In connection with the sale of a subsidiary in 2005,we made indemnities to the buyer with respect to a number of customary, andcertain 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 not have anyrelationships with unconsolidated entities or financial partnerships, such asentities often referred to as structured finance or special purpose entities,which would have been established for the purpose of facilitating off-balancesheet arrangements or other contractually narrow or limited purposes.  In addition, we do not engage in tradingactivities involving non-exchange traded contracts.  We are not materially exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin these relationships.  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 office facilitiesunder operating leases which are deemed to be off-balance sheetarrangements.  Our future operating leasepayment obligations are more fully described under the caption “— ContractualObligations” above.

## **ITEM3.  QUANTITATIVE AND QUALITATIVEDISCLOSURE ABOUT MARKET RISK**

As of March 31, 2007, we had $137.2 million oflong-term variable and fixed-rate debt. We are exposed to market risk based on changes in prevailing interestrates.

Market risk related to our variable-rate debt isestimated as the potential decrease in pre-tax earnings resulting from anincrease in interest rates.  We have$43.5 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 6.15% as ofMarch 31, 2007.  A hypothetical onepercent (100 basis points) increase in the average interest rates charged onour variable-rate debt would reduce our pre-tax earnings by approximately $0.4million per year.

Our fixed-rate debt, which has a carrying value of$93.7 million, has a fair value of $93.6 million as of March 31,2007.  Market risk related to ourfixed-rate debt is deemed to be the potential increase in fair value resultingfrom a decrease in prevailing interest rates. Our fixed-rate debt had a weighted average interest rate of 6.5% as ofMarch 31, 2007.  A hypothetical tenpercent decrease in interest rates, from 6.5% to 5.9%, would increase the fairvalue of our fixed-rate debt by approximately $6.0 million.

We do not use derivative financial instruments tomanage or reduce these risks although we may do so in the future.  We do not enter into derivatives or otherfinancial instruments for trading or speculative purposes.

## **ITEM4.  CONTROLS AND PROCEDURES**

Under the supervision and with the participation ofour management, including the Chief Executive Officer and Chief FinancialOfficer, we have evaluated the effectiveness of our disclosure controls andprocedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the periodcovered by this report.  Based on thatevaluation, the Chief Executive Officer and Chief Financial Officer haveconcluded that these disclosure controls and procedures are effective.  There were no changes in our internal controlover financial reporting during the quarter ended March 31, 2007 that havematerially affected, or are reasonably likely to materially affect, ourinternal control over financial reporting.

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# **PART II – OTHER INFORMATION**

## **ITEM1.  LEGAL PROCEEDINGS**

Information required by this Item 1 is contained inNote 4 to the consolidated financial statements, Part I, Item 1 of this report,under the captions “Legal Proceedings” and “EPA Investigations.”  The text under those captions is incorporatedby reference into thisItem 1.

## **ITEM2.  UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

The following table summarizes the Company’srepurchases of its common stock during the quarter ended March 31, 2007.
| **Period**                                 | ** ** | **Total  Number********of Shares******Purchased (1) | ** ** | **Average********Price Paid******per Share | ** ** | **Total  Number of********Shares Purchased********as Part of  Publicly********Announced Plans******or Programs | ** ** | **Maximum  Number (or********Approximate Dollar  Value)********of Shares that May  Yet Be********Purchased Under  the Plans******or Programs |   |
|--------------------------------------------|------------|-----------------------------------------------------|------------|--------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|
|                                       |       |                                                |       |                                       |       |                                                                                                           |       |                                                                                                                                         |   |
| January 1, 2007  – January 31, 2007   |       | None                                                |       | None                                       |       | None                                                                                                           |       | None                                                                                                                                         |   |
|                                       |       |                                                |       |                                       |       |                                                                                                           |       |                                                                                                                                         |   |
| February 1, 2007  – February 28, 2007 |       | None                                                |       | None                                       |       | None                                                                                                           |       | None                                                                                                                                         |   |
|                                       |       |                                                |       |                                       |       |                                                                                                           |       |                                                                                                                                         |   |
| March 1, 2007 –  March 31, 2007       |       | 55,075                                              |       | $                                          | 14.74      |                                                                                                           | None       |                                                                                                                                         | None   |   |
|                                       |       |                                                |       |                                       |       |                                                                                                           |       |                                                                                                                                         |   |
| Total                                      |       | 55,075                                              |       | $                                          | 14.74      |                                                                                                           | None       |                                                                                                                                         | None   |   |

 

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(1)                      All of the shares purchasedduring the period were shares attested to the Company in satisfaction of theexercise price and tax withholding obligations by holders of employee stockoptions, who exercised options granted pursuant to the Company’s stock optionplan.

## **ITEM6.  EXHIBITS**

| **Exhibit** | ** ** | ** **                                                                                                   |
|-------------|------------|--------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                      |
| ** **  | ** ** | ** **                                                                                                   |
| 15          | *          | Letter regarding unaudited interim financial  information from Independent Registered Public Accounting Firm |
|        |       |                                                                                                         |
| 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

## **ITEMS1A, 3, 4 AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.**

32

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# **SIGNATURES**

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned, thereto duly authorized.
|                      | **Southwest Water  Company (Registrant)** |
|----------------------|-------------------------------------------|
| ** **           | ** **                                |
| ** **           | ** **                                |
| Dated: May 14,  2007 | /s/ Cheryl L.  Clary                      |   |
|                 | Cheryl L. Clary                           |
|                 | Chief Financial  Officer                  |

 

33

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