**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON, D.C. 20549**

 

----

 

**FORM 10-Q**

 

----

 

| **(Mark One)**                     |
|------------------------------------|
| ý                             |   | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                               |   | **For the quarterly period ended March 31, 2004** |
|                               |   |   |
| **OR**                             |
| o                                  |   | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|                               |   | **For the transition period from                                     to                                          ** |
|                               |   |   |
| **Commission file number: 0-8176** |

 

----

 

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

 

----

 

| **Delaware**                                                                              |   | **95-1840947**                        |
|-------------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                           |   | (I.R.S. Employer  Identification No.) |
|                                                                                      |   |                                  |
| **One Wilshire Building  624 South Grand Avenue, Suite 2900****Los  Angeles, California** |   | **90017-3782**                        |
|  (Address of principal executive offices)                                            |   | (Zip Code)                            |
|                                                                                      |   |                                  |
| **(213) 929-1800**                                                                        |
| (Registrant’s telephone number,  including area code)                                |

 

Indicate by check markwhether 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 the past90 days. Yes ý No o

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theAct). Yes ý No o

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date. On May 5, 2004, there were 16,495,998 common sharesoutstanding.

 

 

----

 

**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

 

**INDEX**

 
| **Part I.**    | **Financial Information:** |                                                                                                            |
|----------------|----------------------------|-----------------------------------------------------------------------------------------------------------------|
|           |                       |                                                                                                            |   |
|           | Item 1.                    | Financial Statements:                                                                                           |   |
|           |                       |                                                                                                            |   |
|           |                       | Condensed  Consolidated Statements of Income (unaudited) –  Three Months Ended March 31, 2004 and 2003     |   |
|           |                       |                                                                                                            |   |
|           |                       | Condensed  Consolidated Balance Sheets (unaudited) –  March 31, 2004 and December 31, 2003                 |   |
|           |                       |                                                                                                            |   |
|           |                       | Condensed  Consolidated Statements of Cash Flows (unaudited) –  Three Months Ended March 31, 2004 and 2003 |   |
|           |                       |                                                                                                            |   |
|           |                       | Notes  to Condensed Consolidated Financial Statements (unaudited)                                               |   |
|           |                       |                                                                                                            |   |
|           | 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  4.                   | Submission  of Matters to a Vote of Security Holders                                                            |   |
|           |                       |                                                                                                            |   |
|           | Item  5.                   | Other  Information                                                                                              |   |
|           |                       |                                                                                                            |   |
|           | Item 6.                    | Exhibits and  Reports on Form 8-K                                                                               |   |
|           |                       |                                                                                                            |   |
| **Signatures** |                       |                                                                                                            |

 

----

 

**PART I – FINANCIAL INFORMATION**

 

***Item 1. FinancialStatements***

 

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME (Unaudited)**

 
|                                              |   | **Three Months Ended  March 31,**         |       |
|---------------------------------------------------|--------|-------------------------------------------|------------|
|                                              |   | **2004**                                  |       | **2003** |   |
|                                              |   | **(in  thousands except per share data)** |       |
| **Revenues:**                                     |   |                                      |       |   |   |
| Services group                                    |   | **$**                                     | **26,664** |   | $ | 25,188 |   |
| Utility group                                     |   | **13,063**                                |       | 10,926 |   |
|                                              |   | **39,727**                                |       | 36,114 |   |
| **Expenses:**                                     |   |                                      |       |   |   |
| Operating expenses - services group               |   | **25,071**                                |       | 22,077 |   |
| Operating expenses - utility group                |   | **7,618**                                 |       | 7,359 |   |
| Selling, general and administrative expenses      |   | **6,105**                                 |       | 5,760 |   |
|                                              |   | **38,794**                                |       | 35,196 |   |
|                                              |   |                                      |       |   |   |
| **Operating Income**                              |   | **933**                                   |       | 918 |   |
|                                              |   |                                      |       |   |   |
| **Other Income (Expense):**                       |   |                                      |       |   |   |
| Interest expense                                  |   | **(1,077**                                | **)**      | (1,197 | ) |
| Interest income                                   |   | **120**                                   |       | 46 |   |
| Other                                             |   | **53**                                    |       | (10 | ) |
|                                              |   | **(904**                                  | **)**      | (1,161 | ) |
|                                              |   |                                      |       |   |   |
| **Income (Loss) Before Income Taxes**             |   | **29**                                    |       | (243 | ) |
| **Income Tax Provision (Benefit)**                |   | **11**                                    |       | (94 | ) |
| **Net Income (Loss)**                             |   | **18**                                    |       | (149 | ) |
| **Dividends on Preferred Shares**                 |   | **7**                                     |       | 7 |   |
| **Net Income (Loss) Available for Common Shares** |   | **$**                                     | **11**     |   | $ | (156 | ) |
|                                              |   |                                      |       |   |   |
| **Earnings (Loss) Per Common Share:**             |   |                                      |       |   |   |
| **Basic**                                         |   | **$**                                     | **0.00**   |   | $ | (0.01 | ) |
| **Diluted**                                       |   | **$**                                     | **0.00**   |   | $ | (0.01 | ) |
|                                              |   |                                      |       |   |   |
| **Weighted Average Outstanding Common Shares:**   |   |                                      |       |   |   |
| **Basic**                                         |   | **14,763**                                |       | 13,028 |   |
| **Diluted**                                       |   | **15,686**                                |       | 13,028 |   |

 

*Seeaccompanying notes to unaudited condensed consolidated financial statements.*

 

1

----

 

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED BALANCE SHEETS (Unaudited)**

 
|                                                                |   | **March 31, 2004**  |        | **December 31, 2003** |       |
|---------------------------------------------------------------------|--------|---------------------|-------------|-----------------------|------------|
|                                                                |   | **(in  thousands)** |        |
| **ASSETS**                                                          |   |                | ** **  |                  | ** ** |
| **Current Assets:**                                                 |   |                |        |                  |       |
| Cash and cash equivalents                                           |   | **$**               | **712**     |                  | $          | 2,570 |   |
| Restricted cash                                                     |   | **933**             |        | 2,806                 |       |
| Trade accounts receivable, less allowance for doubtful accounts     |   | **20,491**          |        | 19,759                |       |
| Other current assets                                                |   | **10,684**          |        | 10,259                |       |
|                                                                |   | **32,820**          |        | 35,394                |       |
| **Property, Plant and Equipment:**                                  |   |                |        |                  |       |
| Utility property, plant and equipment—at cost                  |   | **275,414**         |        | 271,502               |       |
| Non-regulated operations property, plant and equipment—at cost |   | **17,150**          |        | 15,917                |       |
|                                                                |   | **292,564**         |        | 287,419               |       |
| Less accumulated depreciation and amortization                      |   | **69,708**          |        | 67,900                |       |
|                                                                |   | **222,856**         |        | 219,519               |       |
| **Other Assets:**                                                   |   |                |        |                  |       |
| Goodwill, net                                                       |   | **21,466**          |        | 21,388                |       |
| Intangible assets, net                                              |   | **3,495**           |        | 2,026                 |       |
| Other assets                                                        |   | **16,472**          |        | 17,895                |       |
|                                                                |   | **$**               | **297,109** |                  | $          | 296,222 |   |
|                                                                |   |                |        |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                      |   |                | ** **  |                  | ** ** |
| **Current Liabilities:**                                            |   |                |        |                  |       |
| Current portion of long-term debt                                   |   | **$**               | **3,407**   |                  | $          | 2,697 |   |
| Accounts payable                                                    |   | **9,214**           |        | 11,448                |       |
| Other current liabilities                                           |   | **14,850**          |        | 17,244                |       |
|                                                                |   | **27,471**          |        | 31,389                |       |
| **Other Liabilities and Deferred Credits:**                         |   |                |        |                  |       |
| Long-term debt                                                      |   | **54,709**          |        | 56,493                |       |
| Bank lines of credit                                                |   | **298**             |        | 16,609                |       |
| Advances for construction                                           |   | **7,154**           |        | 7,238                 |       |
| Contributions in aid of construction                                |   | **82,542**          |        | 81,556                |       |
| Deferred income taxes                                               |   | **10,600**          |        | 10,590                |       |
| Other liabilities and deferred credits                              |   | **12,677**          |        | 12,680                |       |
| **Total Liabilities and Deferred Credits**                          |   | **195,451**         |        | 216,555               |       |
|                                                                |   |                |        |                  |       |
| **Commitments and Contingencies**                                   |   |                |        |                  |       |
|                                                                |   |                |        |                  |       |
| **Stockholders’ Equity:**                                      |   |                |        |                  |       |
| Preferred stock                                                     |   | **507**             |        | 507                   |       |
| Common stock                                                        |   | **161**             |        | 147                   |       |
| Paid-in capital                                                     |   | **78,793**          |        | 55,981                |       |
| Retained earnings                                                   |   | **22,197**          |        | 23,032                |       |
| **Total Stockholders’ Equity**                                 |   | **101,658**         |        | 79,667                |       |
|                                                                |   | **$**               | **297,109** |                  | $          | 296,222 |   |

 

*Seeaccompanying notes to unaudited condensed consolidated financial statements.*

 

2

----

 

 

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)**

 
|                                                                                                                |   | **Three  Months Ended  March 31,** |       |
|---------------------------------------------------------------------------------------------------------------------|--------|------------------------------------|------------|
|                                                                                                                |   | **2004**                           |       | **2003** |   |
|                                                                                                                |   | **(in thousands)**                 |       |
| **Cash  Flows From Operating Activities:**                                                                          |   |                               | ** ** |   | ** ** |
| Net income (loss)                                                                                                   |   | **$**                              | **18**     |   | $ | (149 | ) |
| Adjustments to reconcile  net income to net cash used in operating activities:                                      |   |                               |       |   |   |
| Depreciation and  amortization                                                                                      |   | **1,819**                          |       | 2,029 |   |
| Stock-based compensation  expense                                                                                   |   | **278**                            |       | 215 |   |
| Deferred income taxes                                                                                               |   | **10**                             |       | 71 |   |
| Changes in assets and  liabilities, net of effects of acquisitions:                                                 |   |                               |       |   |   |
| Restricted cash                                                                                                     |   | **1,873**                          |       | — |   |
| Trade accounts receivable                                                                                           |   | **(732**                           | **)**      | 1,434 |   |
| Other current assets                                                                                                |   | **(425**                           | **)**      | 64 |   |
| Other assets                                                                                                        |   | **(166**                           | **)**      | (219 | ) |
| Accounts payable                                                                                                    |   | **(2,234**                         | **)**      | (1,808 | ) |
| Other current liabilities                                                                                           |   | **505**                            | ** ** | (599 | ) |
| Other liabilities                                                                                                   |   | **(544**                           | **)**      | (202 | ) |
| Other                                                                                                               |   | **(248**                           | **)**      | 294 |   |
| **Net cash  provided by operating activities**                                                                      |   | **154**                            |       | 1,130 |   |
|                                                                                                                |   |                               |       |   |   |
| **Cash  Flows From Investing Activities:**                                                                          |   |                               |       |   |   |
| Additions to property,  plant and equipment                                                                         |   | **(3,159**                         | **)**      | (5,690 | ) |
| Proceeds from disposition  of assets                                                                                |   | **42**                             | ** ** | — |   |
| Purchase of minority  interest in subsidiary                                                                        |   | **(2,900**                         | **)**      | — |   |
| Other investments, net                                                                                              |   | **(720**                           | **)**      | (8 | ) |
| **Net cash  used in investing activities**                                                                          |   | **(6,737**                         | **)**      | (5,698 | ) |
|                                                                                                                |   |                               | ** ** |   |   |
| **Cash  Flows From Financing Activities:**                                                                          |   |                               | ** ** |   |   |
| Net proceeds from public  stock offering                                                                            |   | **20,642**                         | ** ** | — |   |
| Capital improvement  reimbursements                                                                                 |   | **162**                            | ** ** | 1,261 |   |
| Contributions in aid of  construction and LUE fees                                                                  |   | **1,079**                          | ** ** | 931 |   |
| Net (repayment of)  borrowings on bank notes payable                                                                |   | **(16,311**                        | **)**      | 2,837 |   |
| Net proceeds from dividend  reinvestment, debenture conversion, employee stock purchase and stock option  plans     |   | **187**                            | ** ** | 62 |   |
| Dividends paid                                                                                                      |   | **(787**                           | **)**      | (574 | ) |
| Net borrowings (payments)  of long-term debt                                                                        |   | **(163**                           | **)**      | (40 | ) |
| Payments on advances for  construction, net                                                                         |   | **(84**                            | **)**      | (83 | ) |
| **Net cash  provided by financing activities**                                                                      |   | **4,725**                          |       | 4,394 |   |
|                                                                                                                |   |                               |       |   |   |
| **Net  decrease in cash and cash equivalents**                                                                      |   | **(1,858**                         | )          | (174 | ) |
| Cash and cash equivalents  at beginning of period                                                                   |   | **2,570**                          |       | 1,606 |   |
| **Cash and  cash equivalents at end of period**                                                                     |   | **$**                              | **712**    |   | $ | 1,432 |   |
|                                                                                                                |   |                               |       |   |   |
| **Supplemental  Disclosure of Cash Flow information**                                                               |   |                               |       |   |   |
| **Cash paid  during the period for:**                                                                               |   |                               |       |   |   |
| **Interest**                                                                                                        |   | **$**                              | **784**    |   | $ | 1,050 |   |
| **Income  taxes**                                                                                                   |   | **$**                              | **—** |   | $ | 255 |   |
|                                                                                                                |   |                               |       |   |   |
| **Non-cash  investing and financing activities:**                                                                   |   |                               |       |   |   |
| **Purchase  of businesses**                                                                                         |   |                               |       |   |   |
| Fair value of assets acquired                                                                                       |   | **$**                              | **1,531**  | ** ** | **$** | **—** | ** ** |
| Cash paid                                                                                                           |   | **(720**                           | **)**      | **—** | ** ** |
| Notes issued                                                                                                        |   | **(811**                           | **)**      | **—** | ** ** |
| Liabilities assumed                                                                                                 |   | **$**                              | **—** | ** ** | **$** | **—** | ** ** |
|                                                                                                                |   |                               |       |   |   |
| **Non-cash  contributions in aid of construction and advances for construction conveyed  to Company by developers** |   | **$**                              | **836**    |   | $ | — |   |

 

*Seeaccompanying notes to unaudited condensed consolidated financial statements.*

 

3

----

 

#### **SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)**

 

***Note 1. – Basis of Presentation***

 

Southwest Water Company was incorporated in Californiain 1954 and reincorporated in Delaware in 1988. Southwest Water Company and oursubsidiaries (collectively referred to in this report as “Southwest Water”, the“Company”, “we”, “us” or “our”; except where the context otherwise requires)provide a broad range of services including water production and distribution,wastewater collection and treatment, public works services, water andwastewater infrastructure development, and utility  billing and collecting. The accompanying unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (USGAAP) for interim financial information and with the instructions to Form 10-Qand Rule 10-01 of Regulation S-X; accordingly, they do not include allinformation and notes required by US GAAP for complete financial statements.Except as disclosed herein, there have been no material changes in theinformation disclosed in the notes to the consolidated financial statementscontained in our Annual Report on Form 10-K for the year ended December 31,2003 (the 2003 Annual Report). The unaudited condensed consolidated financialstatements reflect all adjustments which, in our opinion, are necessary topresent fairly the financial position of Southwest Water as of March 31, 2004,and our results of operations and cash flows for the three months ended March31, 2004 and 2003. These adjustments are of a normal recurring nature.

 

***Note 2. – Earnings Per Share***

 

We recordearnings per share (EPS) by computing “basic EPS” and “diluted EPS” inaccordance with US GAAP. Basic EPS measures our performance over the reportingperiod by dividing net income available to common stockholders by the weightedaverage number of common shares outstanding during the period. Diluted EPSmeasures our performance over the reporting period after giving effect to allpotentially dilutive common shares that would have been outstanding if thedilutive common shares had been issued. Common stock equivalents such as stockoptions, convertible debentures and warrants give rise to potentially dilutivecommon shares.  In July 2001, we issued$20.0 million of 6.85% fixed-rate convertible subordinate debentures. Thedebentures are convertible at any time prior to maturity, unless previouslyredeemed, at a conversion price of $12.148. When our annual diluted earningsexceed $0.53 per share, the debentures will be considered to be common stockequivalents and will be included in the calculation of diluted earnings pershare after adjusting net income for the after-tax effect of the debentureinterest expense.

 

We incurred a loss during the three months ended March31, 2003.  Common stock equivalentsamounting to 548,000 for the quarter ended March 31, 2003 are consideredantidilutive and, therefore, are not included in the computation of weightedaverage shares used in computing diluted loss per share.

 

Our board of directors declared a 4-for-3 stock splitin the form of a dividend on January 1, 2004. All per share amounts and numbersof shares outstanding reflect this dividend. The following table is a reconciliation of the numerators (income) anddenominators (shares) used in both basic and diluted EPS calculations:

 
|                                          |   | **For the three months ended  March 31,** |     |
|-----------------------------------------------|--------|-------------------------------------------|----------|
|                                          |   | **2004**                                  |     | **2003** |   |
|                                          |   |                                      |     |   |   |
| **Net income (loss) per share**               |   |                                      |     |   |   |
| Net income (loss)                             |   | **$**                                     | **18**   |   | $ | (149 | ) |
| Less: dividends on preferred shares           |   | **(7**                                    | **)**    | (7 | ) |
| Net income (loss) available for common shares |   | **$**                                     | **11**   |   | $ | (156 | ) |
|                                          |   |                                      |     |   |   |
| Weighted average outstanding common shares    |   | **14,763**                                |     | 13,028 |   |
|                                          |   |                                      |     |   |   |
| Earnings (loss) per common share - basic      |   | **$**                                     | **0.00** |   | $ | (0.01 | ) |

 

4

----

 
|                                                                         |   | **For the three months ended****March 31,** |     |
|------------------------------------------------------------------------------|--------|---------------------------------------------|----------|
|                                                                         |   | **2004**                                    |     | **2003** |   |
|                                                                         |   |                                        |     |   |   |
| **Net income (loss) per share – assuming dilution**                     |   |                                        |     |   |   |
| Net income (loss) available for common shares                                |   | **$**                                       | **11**   |   | $ | (156 | ) |
|                                                                         |   |                                        |     |   |   |
| Weighted average outstanding common shares                                   |   | **14,763**                                  |     | 13,028 |   |
| Plus:  shares issued on  assumed exercise of stock options and warrants |   | **923**                                     |     | — |   |
| Weighted average outstanding common shares                                   |   | **15,686**                                  |     | 13,028 |   |
|                                                                         |   |                                        |     |   |   |
| Earnings (loss) per common share - diluted                                   |   | **$**                                       | **0.00** |   | $ | (0.01 | ) |

 

***Note 3. –Stock-Based Compensation***

 

At March 31, 2004, Southwest Water had threestock-based plans: the Stock Option Plan (SOP), the Director Stock Option Plan(DOP), and the Employee Stock Purchase Plan. In accordance with the provisionsof Statement of Financial Accounting Standards (SFAS) No. 123, *Accounting for Stock-Based Compensation*,the fair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions used for grants in 2004 and 2003:

 

 
|                    |   | **For the three Months Ended****March 31,** |   |
|-------------------------|--------|---------------------------------------------|--------|
|                    |   | **2004**                                    |   | **2003** |   |
| Dividend yield          |   | 1.3                                         | %      |   | 1.8 | % |   |
| Expected volatility     |   | 24.4                                        | %      |   | 26.6 | % |   |
| Risk free interest rate |   | 3.7                                         | %      |   | 2.7 | % |   |
| Expected life in years  |   | 6.0                                         |   |   | 5.5 |   |   |

 

Compensationexpense arising from stock option grants as determined using the Black-Scholesfair value option model was approximately $278,000 and $215,000, for the threemonths ended March 31, 2004 and 2003, respectively.

 

***Note 4. – Common Stock Issued***

 

On December 29, 2003, we fileda shelf registration statement with the Securities and Exchange Commission forthe issuance from time to time of up to $50 million aggregate principalamount of common stock, debt securities and warrants.  In March 2004, we completed a public offering of 1,610,000 sharesof our common stock off of the shelf registration statement.  These shares were sold at $13.58 per shareand our net proceeds were approximately $20.6 million.  We may offer additional securities underthis shelf registration.

 

***Note 5. –Stock Options and Warrants***

 

A combinedsummary of shares authorized and available for issuance under the SOP and theDOP as of March 31, 2004 is as follows:

 
|                           |   | **SOP**   |   | **DOP** |   | **Total** |   |
|--------------------------------|--------|-----------|--------|---------|--------|-----------|--------|
| Shares authorized for issuance |   | 4,241,178 |   | 437,555 |   | 4,678,733 |   |
| Shares available for issuance  |   | 1,496,460 |   | 173,830 |   | 1,670,290 |   |

 

5

----

 

A combined summary of the status of the SOP, the DOPand warrants as well as changes during the three months ended March 31, 2004 ispresented below:

 
|                              |   | **Stock  Options  and Warrants** |   | **Weighted  Average  Exercise  Price** |   |
|-----------------------------------|--------|----------------------------------|--------|----------------------------------------|--------|
|                              |   | **(in thousands)**               |   |                                   |   |
| Outstanding at December  31, 2003 |   | 2,491                            |   | $                                      | 6.91   |   |
| Granted                           |   | 325                              |   | 14.30                                  |   |
| Exercised                         |   | (42                              | )      | 2.14                                   |   |
| Forfeited                         |   | (67                              | )      | 4.94                                   |   |
| Outstanding at March 31,  2004    |   | 2,707                            |   | $                                      | 7.75   |   |
|                              |   |                             |   |                                   |   |
| Exercisable at March 31,  2004    |   | 1,446                            |   | $                                      | 6.29   |   |

 

The following table summarizes information about stockoptions and warrants outstanding at March 31, 2004:

 
|                          |   |                                         |   | **Options and Warrants Outstanding**                          |   | **Options and Warrants  Exercisable**  |   |
|-------------------------------|--------|----------------------------------------------|--------|---------------------------------------------------------------|--------|----------------------------------------|--------|
| **Range of  Exercise Prices** |   | **Number  Outstanding  at  March 31,  2004** |   | **Weighted  Average  Remaining  Contractual  Life  in Years** |   | **Weighted  Average  Exercise  Price** |   | **Number  Exercisable  at  March 31,  2004** |   | **Weighted  Average  Exercise  Price** |   |
|                          |   |                                         |   | **(in  thousands)**                                           |   |                                   |   |   |   | **(in  thousands)** |   |   |   |
| $                             | 1.50   |                                         | $      | 3.75                                                          |   | 265                                    |   | 0.2 |   | $ | 2.75 |   | 265 |   | $ | 2.75 |   |
| 3.75                          |   | 7.50                                         |   | 593                                                           |   | 1.9                                    |   | 5.32 |   | 550 |   | 5.30 |   |
| 7.50                          |   | 11.25                                        |   | 1,475                                                         |   | 5.3                                    |   | 8.05 |   | 609 |   | 8.54 |   |
| 11.25                         |   | 15.00                                        |   | 374                                                           |   | 6.6                                    |   | 13.97 |   | 22 |   | 11.70 |   |
| $                             | 1.50   |                                         | $      | 15.00                                                         |   | 2,707                                  |   | 4.2 |   | $ | 7.75 |   | 1,446 |   | $ | 6.29 |   |
|                               |        |                                              |        |                                                               |        |                                        |        |  |  |  |  |  |  |  |  |  |  |  |  |

 

***EmployeeStock Purchase Plan (ESPP):***We have astockholder-approved ESPP that allows eligible employees to purchase our commonstock through payroll deductions of up to 10% of their salary (not to exceed$25,000 per year). The purchase price of the stock is 90% of the lower of theshare price as calculated at the beginning and end of each three-month offeringperiod. Under the ESPP, we issued 4,914 shares to employees during the threemonths ended March 31, 2004. At March 31, 2004, 1,139,532 shares were reservedfor issuance under the ESPP and 865,335 shares were available for issuance.

 

***Note 6. – Operating Segments***

 

Southwest Water has tworeportable segments: the Services Group and the Utility Group operations.  We have not changed the basis ofsegmentation or measurement of segment profit or loss from that reported in our2003 Annual Report.

 

The Services Group operates andmanages water and wastewater treatment facilities owned by cities, publicagencies, municipal utility districts and private entities. Revenues are earnedby providing operations and maintenance services under contracts with municipalitiesand other clients.  Constructionmanagement and contract billing are also included in the Services Group. TheUtility Group owns public water utilities in California, New Mexico and Texas.  We own wastewater facilities in New Mexicoand Texas.  State and federal agenciesissue regulations regarding standards of water quality, safety, environmentaland other matters which affect these operations. In the regulated utilitysubsidiaries, the rates that we charge for water and wastewater services are establishedby state authorities.

 

6

----

 

The following table presentsinformation about the operations of each reported segment for the three monthsended March 31, 2004 and 2003:

 
|                                          |   | **Services  Group (1)** |       | **Utility  Group** |       | **Total  Segments  Information** |       | **Other (2)** |       | **Total  Consolidated  Information** |       |
|-----------------------------------------------|--------|-------------------------|------------|--------------------|------------|----------------------------------|------------|---------------|------------|--------------------------------------|------------|
|                                          |   | **(in thousands)**      |       |
| **For the Three Months Ended March 31, 2004** |   |                    |       |               |       |                             |       |          |       |                                 |       |
| **Total revenues (1)**                        |   | **$**                   | **26,664** | ** **         | **$**      | **13,063**                       | ** ** | **$**         | **39,727** | ** **                           | **$**      | **—** | ** ** | **$** | **39,727** | ** ** |
| **Segment operating income (loss)**           |   | **(732**                | **)**      | **3,011**          | ** ** | **2,279**                        | ** ** | **(1,346**    | **)**      | **933**                              | ** ** |
| **Interest income**                           |   | **99**                  | ** ** | **—**         | ** ** | **99**                           | ** ** | **21**        | ** ** | **120**                              | ** ** |
| **Interest expense**                          |   | **(107**                | **)**      | **(580**           | **)**      | **(687**                         | **)**      | **(390**      | **)**      | **(1,077**                           | **)**      |
| **Other income (expense)**                    |   | **(352**                | **)**      | **43**             | ** ** | **(309**                         | **)**      | **362**       | ** ** | **53**                               | ** ** |
| **Income (loss) before income taxes**         |   | **(1,092**              | **)**      | **2,474**          | ** ** | **1,382**                        | ** ** | **(1,353**    | **)**      | **29**                               | ** ** |
|                                               |        |                         |            |                    |            |                                  |            |               |            |                                      |            |  |  |  |  |  |

 
|                                          |   | **Services  Group (1)** |   | **Utility  Group** |   | **Total  Segments  Information** |   | **Other (2)** |   | **Total  Consolidated  Information** |   |
|-----------------------------------------------|--------|-------------------------|--------|--------------------|--------|----------------------------------|--------|---------------|--------|--------------------------------------|--------|
|                                          |   | **(in thousands)**      |   |
|                                          |   |                    |   |               |   |                             |   |          |   |                                 |   |
| **For the Three Months Ended March 31, 2003** |   |                    |   |               |   |                             |   |          |   |                                 |   |
| Total revenues (1)                            |   | $                       | 25,188 |               | $      | 10,926                           |   | $             | 36,114 |                                 | $      | — |   | $ | 36,114 |   |
| Segment operating income (loss)               |   | (1                      | )      | 1,544              |   | 1,543                            |   | (625          | )      | 918                                  |   |
| Interest income                               |   | 29                      |   | 17                 |   | 46                               |   | —        |   | 46                                   |   |
| Interest expense                              |   | (118                    | )      | (641               | )      | (759                             | )      | (438          | )      | (1,197                               | )      |
| Other income (expense)                        |   | (327                    | )      | 221                |   | (106                             | )      | 96            |   | (10                                  | )      |
| Income (loss) before income taxes             |   | (417                    | )      | 1,141              |   | 724                              |   | (967          | )      | (243                                 | )      |
|                                               |        |                         |        |                    |        |                                  |        |               |        |                                      |        |  |  |  |  |  |

 

----

(1)          Inaddition to services provided to external customers, certain companies in ourServices Group provide construction, operations and maintenance services tocompanies in our Utility Group. In accordance with SFAS No. 71, *Accounting for the Effects of Certain Types ofRegulation*, we do not eliminate the intersegment profit on the workperformed when the sales price is reasonable and it is probable that the costswill be recoverable through the rate making process. Intersegment revenueeliminated was approximately $1.1 million and $2.0 million for thethree months ended March 31, 2004 and 2003, respectively.

 

(2)          “Other”consists primarily of costs that include corporate headquarters expenses andfunctional departments whose costs are not allocated to the segments.

 

The followingtable presents information about the identifiable assets of each reportedsegment as of March 31, 2004 and December 31, 2003:

*** ***
|                |   | **March 31, 2004** |        | **December 31, 2003** |   |
|---------------------|--------|--------------------|-------------|-----------------------|--------|
|                |   | **(in thousands)** |        |
| Services Group      |   | **$**              | **66,048**  |                  | $      | 67,831 |   |
| Utility Group       |   | **225,511**        |        | 222,436               |   |
| Corporate and Other |   | **5,550**          |        | 5,955                 |   |
| Consolidated        |   | **$**              | **297,109** |                  | $      | 296,222 |   |

 

 

***Note 7. – Seasonality***

 

The results of operations forone quarter do not indicate results to be expected in another quarter.

 

Our Services Group operations can be affected byweather and rainfall. In general, heavy rainfall or storm conditions may limitour ability to perform certain billable work such as pipeline maintenance,manhole rehabilitation and other outdoor services. Severe weather conditionsmay also result in additional labor and material costs to us as we meet theterms of our operations and maintenance contracts. Depending on the specificcontractual terms, this additional work may be billable to our variousclients.  A significant portion ofrevenues of our Texas subsidiaries is earned under time and materials contractsand revenues can be affected by weather and rainfall.  Precipitation in the Services Group’s Houston base of operationswas 138% and 80% of average during the three months ended March 31, 2004 and2003, respectively.  Higher than averageprecipitation during the three months ended March 31, 2004 limited or delayedour ability to perform billable services as noted above.

 

7

----

 

Our Utility Group water operations are seasonal, asrainfall and weather conditions affect water consumption.  In our service areas the second and thirdquarters of each year typically account for the highest volume of waterconsumption when weather tends to be hot and dry. Drought conditions may resultin lower revenue due to consumer conservation efforts and a shortage of water.Drought conditions may also result in increased water costs to us, which couldadversely affect our profitability. Conversely, unusually wet conditions mayresult in decreased customer demand, lower revenues and lower profit in ourUtility Group operations.

 

***Note 8. – Commitment, Contingencies and Restrictions***

 

We own 90% ofthe outstanding common stock of Operations Technologies, Inc. (OpTech). We havethe right to acquire the remaining 10% of OpTech in August 2006 based on aformula relating to the profitability of OpTech, subject to a minimum price of  $1 million. The minority owner has theoption to sell the remaining 10% of OpTech to us using the same formula.

 

We have an 80%interest in Windermere Utility Company (Windermere) in Texas. We have the rightto acquire the remaining 20% ownership in Windermere at any point in time whenthe market value of our common stock increases to $13.61 per share (as adjustedfor stock splits and dividends), for a purchase price of $6.0 millionpayable in our common stock. The minority owner of Windermere has the right torequire us to purchase the remaining 20% after October 1, 2005, for$6.0 million payable in our common stock, subject to a limitation on themaximum and minimum number of shares issuable.

 

*Commitments Under Long-term ServiceContracts*

 

InSeptember 2002, we agreed to facilitate the engineering and constructionof a $25.0 million reverse osmosis water treatment plant in the city ofSan Juan Capistrano, California, for the Capistrano Valley Water District(CVWD). The project includes the drilling of eight new wells and thedevelopment of associated water lines. We have entered into subcontractoragreements with an engineering firm and a large construction firm to fulfillsignificant obligations of this service contract. During 2002, we deferredapproximately $570,000 in pre-contract costs and began to recognize profitunder the percentage-of-completion method of accounting.

 

Duringconstruction of the CVWD plant, we have received payments upon completion ofconstruction milestones and we expect to continue to receive such paymentsuntil final completion of the construction. In addition, the CVWD awarded to usa 20-year $20.0 million contract to operate the treatment plant aftercompletion of construction. Construction of the plant commenced in December 2002.As of March 31, 2004, the plant was approximately 75% complete. We expectconstruction to be completed in 2004, at which time we will begin to operateand maintain the facility under the 20-year contract. Upon completion, theplant will have the capacity to treat approximately 5.0 million gallons ofwater per day.

 

OnJanuary 8, 2003, we obtained an unsecured line of credit facility from acommercial bank used to issue a $3.4 million standby letter of credit ascollateral for performance under a service contract for the CVWD to manage thedesign and construction project. This standby letter of credit is in force forthe estimated two-year construction period of the project. Upon acceptance ofthe completed project by the CVWD, the standby letter of credit facility willbe terminated.

 

The CVWDservice contract contains certain guarantees related to our performance,including certain liquidated damages in the event of our failure to perform notcaused by uncontrollable circumstances as defined in the service contract.Among other things, we are obligated to produce from the completed plant aspecified volume of treated water by December 4, 2004. In the event of adelay beyond this date, not caused by a defined uncontrollable circumstance,specified delay liquidated damages are to be paid to CVWD. To mitigate theseissues, we have secured from our construction subcontractors both contractualliquidated damage provisions and performance and completion bonds. In addition,we may also be liable for liquidated damages relating to any lost payments froman agreement with a state water agency providing financial assistance to CVWD.During the 20-year operation period, we have made certain other guarantees toCVWD, including guarantees with respect to the quality and quantity of thetreated water.

 

As part of thefinancing of this project, the CVWD issued insured municipal bonds. We enteredinto an agreement with the bond insurer to guarantee our performance under theservice contract, subject to certain liability limits to the bond insurer inthe event of a default. Such liability limits will not exceed an amount equalto $6.0 million during the construction period of the project, andafterwards, during the 20-year operation of the facility, the liability limitswill not exceed an amount equal to $4.0 million plus an amount no greaterthan the replacement cost of the actual reverse osmosis filtration unit withinthe facility estimated to be approximately $1.5 million.

 

8

----

 

*Legal Proceedings*

 

SouthwestWater and a subsidiary have been named as defendants in lawsuits allegingvarious injuries as a result of water contamination in the San Gabriel ValleyMain Basin. The California Supreme Court (the Court) ruled inFebruary 2002 that the plaintiffs cannot challenge the adequacy of thewater quality standards established by the California Department of HealthServices (DOHS). The plaintiffs may sue and collect damages from CPUC-regulatedwater companies only by proving that water delivered did not meet these waterquality standards. We believe that we have complied with DOHS water qualitystandards. The Court directed that the cases be sent to a trial court forfurther proceedings. These cases have been consolidated before a single judge.The parties are now engaged in initial discovery and motions to determinewhether, in light of the ruling by the Court, the plaintiffs can plead andprove any violation of water quality standards by the CPUC regulated watercompanies. Southwest Water and its subsidiary have requested defense andindemnification from our liability insurance carriers for these lawsuits.  Our liability insurance carriers arecurrently absorbing the costs of defense of the lawsuits. We cannot predict theoutcome of these lawsuits. Based upon information available at this time, we donot expect that these actions will have a material adverse effect on ourfinancial position, results of operations or cash flows.

 

SouthwestWater and its subsidiaries are also the subjects of other litigation arising inthe ordinary course of operations. We believe the ultimate resolution of suchmatters will not materially affect our consolidated financial position, resultsof operations or cash flow.

 

*GroundwaterSettlement*

 

Oneof the water sources for our California water utility has been affected by thepresence of certain groundwater contaminants. These contaminants consist mainlyof chemicals disposed of by various industrial companies in the 1940s and1950s. In 2001 and 2002, this contamination necessitated the shutdown of anumber of our wells, and we purchased replacement water at a cost substantiallyhigher than the cost of water pumped from our own wells.

 

Asa result of this contamination, under the terms of an agreement with the responsibleparties, we have received payments from these parties, and we expect tocontinue to receive payments until completion of remediation.  These payments represent the incrementalcost of purchasing water over the cost that would have been incurred by us topump water from our wells.  Ouragreement with the responsible parties provided for ongoing reimbursement ofour excess water costs and as such we bill and collect reimbursements monthly.  These monthly reimbursements are recorded asa reduction to operating expenses — utility group, which consequently increaseour operating income.  During the threemonths ended March 31, 2004 and 2003 these reimbursements were approximately$539,000 and $860,000, respectively.

 

Thesettlement agreement also provides for contributions by the responsible partiesto construct new wells and to develop additional interconnections with nearbywater sources. Funds from the settlement agreement will also be used to developlong-term solutions that will potentially enable us to use our own less costlygroundwater supplies in the future. These contributions, recorded as contributions in aid of construction(CIAC), were approximately $162,000 and $1.1 million for the three months endedMarch 31, 2004 and 2003, respectively.

 

***Note 9. –Subsequent Events***

 

In April 2004, weobtained a firm commitment from two of our commercial banks to expand our linesof credit by an additional $30 million and to extend the maturity of our twoexisting lines from September 2005 to September 2006.  The line extension is intended to provide us with additionalfunds to use for future acquisition opportunities.

 

On April 30, 2004 we agreed toacquire two regulated water and wastewater utility companies (Tenkiller UtilityCompany and Tecon Water Companies, Inc.) from Tecon Water Holdings, L.P.  The purchase price of approximately $63million will be paid by the assumption of approximately $17 million in debt andthe remainder will be paid in cash.  Weexpect to complete the purchase of these utility companies in the third quarterof 2004, subject to the receipt of regulatory approvals.  These utility companies serve approximately21,000 water and 4,000 wastewater connections in Texas, and 250 wastewaterconnections in Oklahoma.

 

9

----

 

***Item 2:Management’s Discussion and Analysis of Financial Condition and Results ofOperations***

 

 *The information in this discussioncontains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended and Section 21E of the Securities ExchangeAct of 1934, as amended (the”34 Act”). Such statements are based upon currentexpectations that involve risks and uncertainties**including those set forth under “Risk Factors” inthis report**.  Any statements contained herein that are notstatements of historical facts may be deemed to be forward-looking statements.For example, words such as “may”, “will”, “should”, “estimates”, “predicts”,“potential”, “continue”, “strategy”, “believes”, “expects”, “anticipates”,“plans”, “intends”, and similar expressions are intended to identifyforward-looking statements. Our actual results and the timing of certain eventsmay differ significantly from the results discussed in the forward-lookingstatements.*

 

The following discussionshould be read in conjunction with the accompanying unaudited condensedconsolidated financial statements and related notes thereto and theconsolidated financial statements and the notes thereto contained in our AnnualReport on Form 10-K for the year ended December 31, 2003.

 

**Overview**

 

Southwest Water Company andsubsidiaries (“Southwest”, “we” or the “Company”) provide a broad range ofservices including water production and distribution, wastewater collection andtreatment, public works services, utility infrastructure and constructionmanagement, customer billing and service, and utility billing and collecting.We provide services to more than two million people in 35 states. Our businessis segmented into two operating groups: our Services Group and our UtilityGroup.

 

Our Services Group operates ourcontract service businesses in which we operate and maintain water supply andwastewater  facilities owned by cities,public agencies, municipal utility districts and private entities primarily inTexas, New Mexico, California, Colorado, Mississippi and Georgia. While stateand federal agencies issue regulations regarding standards of water quality,safety, environmental and other matters which affect these operations, ourServices Group prices are not subject to regulation. We also provideutility  billing and collecting servicesin numerous states.

 

Our Utility Group owns andoperates rate-regulated public water utilities in California, New Mexico andTexas. We own wastewater facilities in New Mexico and Texas. State and federalagencies issue regulations regarding standards of water quality, safety,environmental and other matters which affect these operations, as well asestablish the rates that we can charge for our water and wastewater services.

 

10

----

 

**Results of Operations**

 

Asummary of our consolidated results for the three months ended March 31, 2004and 2003 is as follows:

 

** **
|                                         |   | **Three Months Ended March 31,** |   |
|----------------------------------------------|--------|----------------------------------|--------|
|                                         |   | **2004**                         |   | **%****of  Revenue** |   | **2003** |   | **%****of  Revenue** |   |
|                                         |   | **($ amounts  in millions)**     |   |
| **Revenues:**                                |   |                             |   |   |   |   |   |   |   |
| Services group                               |   | $                                | 26.7   |   | 67 |   | $ | 25.2 |   | 70 |   |
| Utility group                                |   | 13.0                             |   | 33 |   | 10.9 |   | 30 |   |
|                                         |   | 39.7                             |   | 100 |   | 36.1 |   | 100 |   |
|                                         |   |                             |   |   |   |   |   |   |   |
| **Expenses:**                                |   |                             |   |   |   |   |   |   |   |
| Operating expenses - services group          |   | 25.1                             |   | 63 |   | 22.1 |   | 61 |   |
| Operating expenses - utility group           |   | 7.6                              |   | 19 |   | 7.3 |   | 20 |   |
| Selling, general and administrative expenses |   | 6.1                              |   | 15 |   | 5.8 |   | 16 |   |
|                                         |   | 38.8                             |   | 97 |   | 35.2 |   | 97 |   |
|                                         |   |                             |   |   |   |   |   |   |   |
| **Operating Income**                         |   | 0.9                              |   | 3 |   | 0.9 |   | 3 |   |
|                                         |   |                             |   |   |   |   |   |   |   |
| **Other Income (Expense):**                  |   |                             |   |   |   |   |   |   |   |
| Interest expense                             |   | (1.1                             | )      | 3 |   | (1.2 | ) | 3 |   |
| Interest income                              |   | 0.1                              |   | — |   | — |   | — |   |
| Other                                        |   | 0.1                              |   | — |   | — |   | — |   |
|                                         |   | (0.9                             | )      | 3 |   | (1.2 | ) | 3 |   |
|                                         |   |                             |   |   |   |   |   |   |   |
| **Income (Loss) Before Income Taxes**        |   | —                           |   | — |   | (0.3 | ) | — |   |
| **Income Tax Provision (Benefit)**           |   | —                           |   | — |   | (0.1 | ) | — |   |
| **Net Income (Loss)**                        |   | $                                | — |   | — |   | $ | (0.2 | ) | — |   |

 

**Discussion of Results of Operations for Three Months EndedMarch 31, 2004 and 2003**

 

**Revenues**

 

**Services group**

 

Services Group revenuesrepresent fees earned for water and wastewater facility operations andmaintenance (O&M) services, equipment maintenance and repair, sewerpipeline cleaning, utility billing and collection services, constructionmanagement services and state-certified water and wastewater laboratoryanalysis. Our Services Group operations can be affected by weather andrainfall. In general, heavy rainfall or storm conditions may limit our abilityto perform certain billable work such as pipeline maintenance, manholerehabilitation and other outdoor services. Severe weather conditions may alsoresult in additional labor and material costs to us as we meet the terms of ouroperations and maintenance contracts. Depending on our specific contractualterms, this additional work may be billable to our various clients.   Revenues for the three months ended March31, 2004 increased approximately $1.5 million, or 6%, to $26.7 million from$25.2 million during the same period of the prior year.  The increase was primarily due to:

 

1.               A$1.5 million dollar increase in revenues earned from our constructionmanagement project for the city of San Juan Capistrano, California.  Revenues earned during the three monthsended March 31, 2004 and 2003 were $2.5 million and $1.2 million, respectively.

 

2.               A$0.9 million increase in operations and maintenance revenue under a 10-year,$30 million contract to operate and maintain the public works department of theCity of Pascagoula, Mississippi.

 

The increases noted above were partially offset byreductions in revenues earned at our Services Group Texas operations. Asignificant portion of revenue of our Texas subsidiaries is earned under timeand materials contracts and revenues can be affected by weather andrainfall.  Precipitation in the ServicesGroup’s Houston base of operations was 138% and 80% of average during the threemonths ended March 31, 2004 and 2003, respectively.  Higher than average precipitation during the three months endedMarch 31, 2004 limited or delayed our ability to perform billable services.

 

11

----

 

In addition, during the first quarter of 2004, wedetermined that certain receivables of $0.3 million would not likely becollected.  Accordingly the receivableswere written off.

 

**Utility group**

 

Utility Grouprevenues represent fees earned for the production and distribution of water andthe collection and treatment of sewage for residential, business, industrialand public authority use. Revenues in the Utility Group increased approximately$2.1 million, or 20%, to $13.0 million during the three months ended March31, 2004 from $10.9 million during the same period of the prior year. Theincrease is primarily due to the favorable effect of rate increases in ourCalifornia and Texas utilities and increased customer connections in our NewMexico and Texas utilities.  The changesare represented as follows:

 
|                                           |   | **(in  millions)** |   |
|------------------------------------------------|--------|--------------------|--------|
| Favorable effect of rate increase in  revenues |   | $                  | 1.7    |   |
| Favorable effect of increase in connections    |   | 0.1                |   |
| Increase in water consumption                  |   | 0.3                |   |
| Net increase in revenues                       |   | $                  | 2.1    |   |

** **

**Expenses**

 

**Operatingexpenses – services group**

 

Operating expenses – servicesgroup represent salaries, wages and employee benefits, facilities costs,supplies and equipment, repairs and maintenance, professional fees and othercosts.  Operating expenses — servicesgroup represented approximately 94% of Services Group revenues for the threemonths ended March 31, 2004 and 87% of revenues for the same period of 2003.Operating expenses increased approximately $3.0 million, or 14%, to $25.1million during the three months ended March 31, 2004 from $22.1 million duringthe same period of 2003.   The increasewas due primarily to the following:

 

1.               Approximately$1.3 million of the increase was due to increased activity under ourconstruction management contract with the CVWD.

 

2.               Approximately$0.6 million of the increase was due to costs to provide service under our newcontract with the City of Pascagoula, Mississippi.

 

3.               Duringthe first quarter of 2004, we determined that we would likely incur a loss on aconstruction contract involving the rehabilitation of a wastewaterfacility in Virginia.   Therevenues and expenses under the contract have been recognized under thepercentage of completion method. Accordingly, during the three months ended March 31, 2004, we recorded acharge for the entire expected loss of approximately $0.2 million.

 

4.               Theremaining increase was due to a general growth in activity in our businesseswhich are not generally affected by weather. These included our utility billing and collection, laboratory servicesand government services businesses.

 

**Operating expenses – utility group**

 

Operatingexpenses—utility group represent the costs of purchasing and producing water,treating wastewater, salaries, wages and employee benefits, facilities costs,supplies and equipment, repairs and maintenance, professional fees and othercosts. Operating expenses—utility group represented approximately 58% and 68%of revenues from utility operations for the three months ended March 31, 2004 and2003, respectively.  The decrease inoperating expenses as a percentage of revenue was due to the aforementionedincrease in Utility Group revenues, which was primarily due to an increase inrates at our California  and Texasutilities. Operating expenses for our Utility Group increased$0.3 million, or 4%, to $7.6 million during the three months endedMarch 31, 2004 from $7.4 million during the comparable period of 2003.

 

Waterproduction costs at our California utility decreased approximately 20% from $241per acre foot for the three months ended March 31, 2003 to $193 per acre footfor the three months ended March 31, 2004. Thisdecrease resulted from a shift from higher cost purchased watertoward less expensive produced water from our own wells.  Thisincreased water production related to two new wells which were notavailable during the three months ended March 31, 2003.  The percentage of water producedfrom our own wells was 62% and 28% during the three months endedMarch 31, 2004 and 2003, respectively.

 

However the benefit from the change in mix of water sold was partiallyoffset by (i) increased utility plant maintenance and repair costs and (ii)increased energy costs.

 

Operating expenses at our New Mexico and Texas utilities increasedduring the three months ended March 31, 2004 as compared to the comparableperiod of 2003. The increase was primarily due to a slight increase in volumeand in the number of connections served by our New Mexico and Texas utilities.

 

12

----

 

**Selling, general and administrative expenses**

 

Selling, general andadministrative expenses consist mainly of personnel, facilities, insurance andprofessional services costs, which support our sales, marketing, humanresources, finance and administration functions.  Selling, general and administrative costs increased $0.3 million,or 5%, to $6.1 million for the three months ended March 31, 2004 from $5.8million during the same period of the prior year.  The increase was due to increased legal and accounting feesincurred as a result of:

 

1.               Theincreased size and complexity of our operations.

 

2.               Ourefforts to prepare for and comply with the Sarbanes Oxley Act of 2002.

 

Selling, general and administrative expensesas a percentage of revenues decreased to 15% for the three months ended March31, 2004 from 16% during the three months ended March 31, 2003.

 

**OtherIncome (Expense)**

 

**Interest Expense**

 

The major components of interest expense for threemonths ended March 31, 2004 and 2003 are as follows:

 
|                                                       |   | **For the Three Months Ended  March 31,** |   |
|------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                       |   | **2004**                                  |   | **2003** |   |
|                                                       |   | **(in  thousands)**                       |   |
| Interest expense – convertible subordinate debentures |   | $                                         | 326    |   | $ | 341 |   |
| Interest expense – bank lines of credit               |   | 247                                       |   | 227 |   |
| Interest expense – mortgage bonds and bank term loan  |   | 492                                       |   | 582 |   |
| Interest expense – other                              |   | 154                                       |   | 129 |   |
| Total interest expense before capitalized interest         |   | 1,219                                     |   | 1,279 |   |
| Capitalized interest                                       |   | (142                                      | )      | (82 | ) |
| Total interest expense                                     |   | $                                         | 1,077  |   | $ | 1,197 |   |

 

 

Total interest expense decreased to approximately $1.1million for the three months ended March 31, 2004, from approximately $1.2million for the comparable period in 2003, due to the following:

 

1.               Ageneral decrease in interest rates.  Oureffective interest rates for the three months ended March 31, 2004 and 2003were 5.4% and 6.2%, respectively.

 

2.               Areduction in our long-term debt.

 

3.               Anincrease in capitalized interest expense arising from internal constructionprojects.

 

**Provision for Income Taxes**

 

Our effective tax rates for the three months endedMarch 31, 2004 and 2003 were approximately 37% and 39%, respectively.

 

### **Liquidity and CapitalResources**

### ** **

Our operating activities provided approximately$154,000 in cash during the three months ended March 31, 2004.  Cash provided by the excess of revenues andcosts, excluding non-cash items, (such as depreciation, amortization and stockcompensation expense), was offset by changes in working capital.

 

Our investingactivities used cash of $6.7 million during the three months ended March 31,2004.  Approximately $3.2 millionrepresented capital expenditures for property, plant and equipment used by ourUtility Group, including new wells and transmission lines and the constructionof a lift station and water line in Texas. Approximately $2.9 million was used to acquire the minority interest ofone of our subsidiaries.  Approximately$0.7 million was used by our services group to purchase certain companies.

 

13

----

 

The following table summarizes our activity foradditions to property, plant and equipment during the three months ended March31, 2004:

 
|                                             |   | **Three Months Ended  March 31, 2004** |   |
|--------------------------------------------------|--------|----------------------------------------|--------|
|                                             |   | **(in  millions)**                     |   |
| Company-financed additions                       |   | $                                      | 1.9    |   |
| Capital improvement reimbursements               |   | 0.2                                    |   |
| Contributions paid for by developers             |   | 1.1                                    |   |
| Net cash used in investing activities            |   | 3.2                                    |   |
| Property contributed by developers               |   | 0.8                                    |   |
| Total additions to property, plant and equipment |   | $                                      | 4.0    |   |

 

Financingactivities provided cash of approximately $4.7 million during the three monthsended March 31, 2004. In March 2004, we completed a public offering of1,610,000 shares of our common stock. The 1,610,000 shares were sold at $13.58per share and our net proceeds were approximately $20.6 million.  We used proceeds from this offering toreduce amounts outstanding under our lines of credit.

 

CIACrepresents contributions in the form of cash, services or property receivedfrom developers, governmental agencies, municipalities or individuals for thepurpose of constructing utility plant. CIAC and advances for constructionprovided approximately $1.2 million in cash.

 

Cash used toreduce debt and to pay dividends was approximately $16.3 million and$0.8 million, respectively.   Itemssuch as proceeds from stock options and stock purchase plans represented theremainder of cash provided by financing activities.

 

Our liquidityis influenced primarily by cash flows from operations and by capitalexpenditures at our Utility Group for the addition, replacement and renovationof water and wastewater utility facilities. Our capital resources are used fordebt service on our bonds and debentures and are also influenced by investmentswe make, including the acquisitions.

 

**Off-BalanceSheet Arrangements**

 

We do not haveany material off-balance sheet arrangements that have, or are reasonably likelyto have, a current or future effect on our financial condition, changes infinancial conditions, revenue or expenses, results of operations, liquidity,capital expenditures or capital resources.

 

**Contractual Obligations**

 

A summary of our future contractual obligations and commercialcommitments as of March 31, 2004 is as follows:

 

 
|                                               |   | **Years ending December 31,** |   |
|----------------------------------------------------|--------|-------------------------------|--------|
|                                               |   | **2004**                      |   | **2005** |   | **2006** |   | **2007** |   | **2008 and  thereafter** |   | **Total** |   |
|                                               |   | **(in  thousands)**           |   |
| Long-term debt                                     |   |                          |   |   |   |   |   |   |   |   |   |   |   |
| Bank lines of credit                               |   | $                             | — |   | $ | 298 |   | $ | — |   | $ | — |   | $ | — |   | $ | 298 |   |
| Bank term loan                                     |   | 375                           |   | 500 |   | 500 |   | 500 |   | $ | 7,375 |   | 9,250 |   |
| Economic development revenue bonds                 |   | 90                            |   | 95 |   | 100 |   | 105 |   | 1,925 |   | 2,315 |   |
| Mortgage bonds                                     |   | 900                           |   | 900 |   | 13,500 |   | — |   | $ | 8,000 |   | 23,300 |   |
| Convertible subordinate debentures (1)             |   | —                        |   | — |   | — |   | — |   | 17,960 |   | 17,960 |   |
| Notes payable                                      |   | 1,900                         |   | 1,220 |   | 1,378 |   | 386 |   | 406 |   | 5,290 |   |
| Advances for construction                          |   | 179                           |   | 179 |   | 179 |   | 179 |   | 6,438 |   | 7,154 |   |
| Obligations under non-cancellable operating leases |   | 3,772                         |   | 4,313 |   | 3,468 |   | 2,426 |   | 12,918 |   | 26,897 |   |
| Other                                              |   | 365                           |   | 456 |   | 495 |   | 517 |   | 3,680 |   | 5,513 |   |
|                                               |   | $                             | 7,581  |   | $ | 7,961 |   | $ | 19,620 |   | $ | 4,113 |   | $ | 58,702 |   | $ | 97,977 |   |

 

----

(1)          The convertible subordinate debentures are duein 2021.  There are no intermediate putrights attached to the debentures.

 

14

----

 

On March 31, 2004, we hadworking capital of approximately $5.3 million with available cash andcash-equivalent balances of approximately $0.7 million (excludingrestricted cash balances), as well as aggregate lines of credit totaling$40.0 million consisting of three separate unsecured lines of credit fromthree commercial banks. Our total borrowing availability under lines of creditwas approximately $39.2 million on March 31, 2004. On April 13, 2004, weobtained a firm commitment from two of our commercial banks to expand our linesof credit by an additional $30 million and to extend the maturity of our twoexisting lines from September 2005 to September 2006.  The extensions are intended to provide us with additional fundsto use for future acquisitions.

 

InJanuary 2003, we expanded one of our lines of credit from one of ourcommercial banks by $3.4 million. This facility was utilized to issue astandby letter of credit in that amount as collateral for performance under aservice contract to design and construct a reverse osmosis water treatmentfacility and associated wells. This standby letter of credit is in force forthe estimated two-year construction period of the project. Upon acceptance ofthe completed project, expected in the latter portion of this year, the standbyletter of credit and the related credit facility will be terminated.

 

We anticipatethat our available lines of credit borrowing capacity and cash flows generatedfrom operations will be sufficient to fund our activities during the next12 months. If we were unable to renew our existing lines of credit or ifwe were unable to execute additional financing alternatives, our capital spendingand any future acquisitions would be reduced, eliminated or delayed.

 

We expect tomaintain our lines of credit in the normal course of business. Each of the lineof credit agreements contains certain financial covenants. During the threemonths ended March 31, 2004, we were in compliance with all applicablecovenants under each of the line of credit agreements.

 

In addition toour lines of credit, we had excess borrowing capacity under our first mortgagebond indentures of approximately $38.9 million as of March 31, 2004.However, the additional borrowing available under our current commercial linesof credit is limited by financial covenants that restrict additional borrowingto an amount no greater than the remaining unused credit line amount.

 

On December 29, 2003, we fileda shelf registration statement with the Securities and Exchange Commission forthe issuance from time to time of up to $50 million aggregate principalamount of common stock, debt securities and warrants.  As of March 31, 2004, we had approximately $28 million availableunder this shelf registration.  We mayoffer additional securities under the shelf registration statement.

 

**CriticalAccounting Policies**

 

Ourconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States (GAAP). These accountingprinciples require us to make certain estimates, judgments and assumptions. Webelieve that the estimates, judgments and assumptions are reasonable based uponinformation available to us at the time that these estimates, judgments andassumptions are made. These estimates, judgments and assumptions can affect thereported amounts of assets and liabilities as of the date of the financialstatements, as well as the reported amounts of revenues and expenses during theperiods presented. To the extent there are material differences between theseestimates, judgments or assumptions and actual results, our financialstatements will be affected. The significant accounting policies that webelieve are important to fully understanding and evaluating our reportedfinancial results include the following:

 

•                  Revenuerecognition,

•                  Valuation oflong-lived and intangible assets,

•                  Accounting forregulated business in accordance with SFAS 71,

•                  Stock-basedcompensation, and

•                  Deferred costs.

 

In many cases,the accounting treatment of a particular transaction is specifically dictatedby GAAP and does not require management’s judgment in its application. Thereare also areas in which management’s judgment in selecting among available GAAPalternatives would not produce a materially different result. Our seniormanagement has reviewed these critical accounting policies and relateddisclosures with our audit committee.

 

**Revenue recognition**

 

Water utilityrevenues are recognized when water is delivered to customers. At the end of anaccounting period, estimated amounts for unbilled revenues are accrued forwater usage since the previous billing period.

 

Revenues forcontract operations are billed based on a monthly fee to provide a specificlevel of service as outlined in each individual contract. We generally bill foradditional services provided beyond the scope of the base contract on atime-and-materials basis as

 

15

----

 

such servicesare rendered.

 

Revenues forutility billing and collecting services are recognized and billed at the end ofthe month in which services are performed. Revenues for installation of utilitybilling and collection equipment are accounted for using thepercentage-of-completion method.

 

Revenues forconstruction projects are recorded using the percentage-of-completion method ofaccounting. The percentage of completion method recognizes revenue and incomeas work progresses on a project based on the expected total project costs andthe expected total project revenues. This method is based on an estimate of therevenue and income earned to date, less the revenue and income recognized inearlier periods. If management determines we will ultimately suffer a loss on aconstruction project, the entire estimated loss is recorded in the period sucha determination is made.

 

We providedesign, build and operation services under time-and-material and fixed-pricecontracts, which may extend up to 20 or more years.  Many of these contracts include multiple deliverables.

 

If a contractinvolves the provision of a single element, revenue is generally recognizedwhen the product or service is provided and the amount becomes billable. Ifservices are provided evenly during the contract term but service billings areirregular, revenue is recognized on a straight-line basis over the contractterm.

 

If a contractinvolves the provision of multiple elements, total estimated contract revenueis allocated to each element based on the relative fair value of each element,provided the elements qualify for separation under Emerging Issues Task Force(EITF) 00-21, *Accounting for RevenueArrangements with Multiple Deliverables*. The amount of revenueallocated to each element is limited to the amount that is not contingent uponthe delivery of another element in the future. Revenue is then recognized foreach element as described above for single-element contracts, except revenuerecognized on a straight-line basis for a non-construction service will notexceed amounts currently billable unless the excess revenue is recoverable fromthe client upon any contract termination event. If the amount of revenueallocated to a construction service is less than its relative fair value, coststo deliver such service, limited to the difference between allocated revenueand the relative fair value, are deferred and amortized over the contract term.If total construction service costs are estimated to exceed the relative fair valuefor the construction service contained in a multiple-element arrangement, thena provision for the estimated loss is made in the period in which the lossfirst becomes apparent.

 

**Valuation of long-lived and intangible assets**

 

Ouracquisitions have been accounted for using the purchase method of accounting.In accordance with SFAS No. 144, *Accountingfor the Impairment of Long-Lived Assets and for Long-Lived Assets to beDisposed of,*we assess intangible assets and other long-lived assetsfor recoverability whenever events or changes in circumstances indicate thattheir carrying value may not be recoverable through the estimated undiscountedfuture cash flows resulting from the use of the assets. If we determine thatthe carrying value of intangible assets or other long-lived assets may not berecoverable, we measure impairment by using the projected discounted cash-flowmethod in accordance with Statement No. 144.

 

We have madeacquisitions in the past that resulted in recording goodwill and intangible assets.In June 2001, the Financial Accounting Standards Board (FASB) issued SFASNo. 142,*Goodwill and Other IntangibleAssets.*SFAS No. 142 requires that goodwill and intangibleassets with indefinite useful lives are not amortized, but instead are tested forimpairment at least annually. For intangible assets with definite useful lives,SFAS No. 142 requires amortization over their estimated useful lives. SFASNo. 142 became effective for fiscal years beginning afterDecember 15, 2001. At March 31, 2004, other assets includeapproximately $22.2 million of goodwill, which was no longer subject toamortization beginning in 2002. There were no impairment charges to goodwill asof March 31, 2004 and no events have occurred during the three months endedMarch 31, 2004 that indicated diminution in the value of recorded goodwill.

 

Under theprovisions of SFAS No. 141, *BusinessCombinations*, we identified approximately $0.2 million ofintangible contract costs in connection with our acquisition of Aqua Servicesand approximately $1.1 million of intangible contract costs in connectionwith our acquisition of OpTech. We are amortizing these intangible contractcosts over a period of four years, which is the average estimated life of thecontracts.

 

**Accounting for regulated businesses**

 

Our regulatedbusinesses, which include our utilities in California, New Mexico and Texas,are required to be accounted for under the provisions of SFAS No. 71, *Accounting for the Effects of Certain Types ofRegulation,* which specifies certain revenue, expense and balancesheet treatment as required by each state regulatory authority. Each stateauthority establishes rates which are intended to permit each utility torecover its costs and earn a reasonable rate of return. Each utility may fileand process general rate applications on a periodic basis. Since theestablished rates may be in effect for several years, our utilities attempt toanticipate cost increases and apply for rates sufficient to permit recovery ofthose cost increases when incurred, where permitted by state law.

 

16

----

 

One of ourServices Group subsidiaries has contracted with our utilities in Texas and NewMexico to perform operating services, maintenance, and construction work, andto manage capital projects. These contracts were established utilizing termsand conditions equivalent to prevailing industry rates for similar workperformed by our Services Group for non-affiliated customers. In accordancewith SFAS No. 71, our Services Group recognizes profit from work performedand does not eliminate the intercompany profit when the contract sales price isreasonable and it is probable that the costs and capital will be recoverable bythe utility through the rate-making process. Accordingly, the intercompanyprofit, for construction as well as O&M services, and the relatedreceivables and payables, on such work have not been eliminated in theaccompanying condensed consolidated financial statements. However, all revenuein excess of profits has been eliminated in consolidation.

 

Our Californiawater utility recorded a balancing account receivable in the amount ofapproximately $2.3 million, representing the difference between actualwater production costs incurred and CPUC-adopted water production costs.Historically, the CPUC allowed such balancing accounts in the income statementsof water utilities, with a corresponding liability or asset on the balancesheet. However, the CPUC changed this policy by eliminating the use of balancingaccounts as of November 29, 2001. In December 2002, the CPUC issued adecision that we believe will allow our water utility in California to recoverthe $2.3 million that was held in the balancing account as ofNovember 29, 2001, but there can be no assurance that this will be thecase.

 

Beginning inDecember 2001, our water utility has recognized all water costs asincurred. Currently the differences between actual and CPUC-adopted waterproduction costs are expensed as incurred. These differences are tracked in amemorandum account and we will attempt to recover these expenses in future ratehearings.

 

**Stock-BasedCompensation**

 

In 2002, weadopted the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*,which requires valuation of stock options issued based upon an option pricingmodel and recognition of this value as an expense over the period in which theoptions vest. In accordance with the provisions of SFAS No. 148, *Accounting for Stock-Based Compensation — Transitionand Disclosure, an amendment of FASB Statement No. 123*, we electedto recognize stock-based compensation using the retroactive restatement method.Under this change in accounting method, we restated our condensed consolidatedfinancial statements for periods prior to 2002 to reflect stock-basedcompensation expense under a fair value based accounting method for all optionsgranted, modified or settled in fiscal years beginning after December 15,1994.

 

We use theBlack-Scholes option valuation model to estimate the fair value of our stockoptions. This option valuation model was developed for use in estimating thefair value of traded options that do not have vesting restrictions and that arefully transferable. Option valuation models require subjective assumptions suchas the expected future volatility of the stock price. Because the stock optionswe grant have characteristics that are significantly different from those oftraded options, and because changes in the subjective input assumptions can materiallyaffect the calculated results, in management’s opinion, the stock optionvaluation models, including Black-Scholes, may not necessarily provide areliable single measure of the fair value of employee stock options.

 

**Stock Dividends and Splits**

 

All information regardingcommon stock, stock options, warrants, other common stock equivalents andrelated per share amounts has been restated for a 4-for-3 stock split in theform of a stock dividend on January 1, 2004.

 

**Deferred Costs**

 

We defercertain costs incurred in anticipation of future contract sales.  These costs include but are not limited tothe costs of mobilization, engineering, architectural, or other servicesincurred on the basis of commitments or other indications of interest innegotiating a contract.  Costs to make,buy or use assets in connection with anticipated contracts are alsoincluded.  We subsequently amortizethese deferred contract acquisition costs on a straight-line basis over theremaining original contract term unless revenue patterns indicate a moreaccelerated method is appropriate. Deferred contract costs are shown net ofaccumulated amortization in other assets. The recoverability of all long-livedassets associated with a particular contract, including deferred contract costs,is analyzed on a periodic basis. If long-lived assets are determined to beimpaired, impairment is recognized for the amount by which the carrying valueof the long-lived assets exceeds the fair value of those assets.

 

17

----

 

**RISK FACTORS**

 

The following factors, which are described more fullyin our 2003 Annual Report, represent risks and uncertainties that could causeactual results to differ materially from our historical experience and ourpresent expectations or projections. Factors that could affect forward-lookingstatements relating to the resolution of the reportable condition with respectto internal controls discussed in Item 4 below and Item 9A of our 2003 AnnualReport, include among other things: our ability to fully resolve thedeficiencies during 2004; our ability to identify and retain qualified andexperienced financial personnel at the Services Group; our ability to designand maintain policies and procedures which enable us to avoid any reoccurrenceof the matters which gave rise to the reportable condition; and our ability toimplement policies and procedures including documentation that meets theinternal control over financial reporting requirements of the rules adopted bythe Securities and Exchange Commission pursuant to Section 404 of theSarbanes-Oxley Act of 2002. See “Risk Factors” in our 2003 Annual Report forfurther disclosure related to risk factors:

 

**RisksRelated to Our Common Stock**

•                  *Our outstanding indebtedness may adversely affect ourfinancial condition and the value of our common stock.*

 

•                  *We are a holding company that depends on cash flowfrom our subsidiaries to meet our obligations.*

 

•                  *The market price of our shares of common stock couldbe volatile.*

 

**RisksRelated to Our Business**

 

**Riskfactors that affect our Services Group operations**

*•**                  Weatherconditions can affect the financial results of our Services Group.*

* *

*•**                  We operate in acompetitive market with low operating margins.*

* *

*•**                  Our revenuegrowth depends on our ability to enter into new, and maintain our existing,operating contracts with cities, agencies and municipal utility districts.*

* *

*•**                  Our businessdepends on trained, qualified employees.*

* *

*•**                  Events such ashurricanes, tornadoes and floods may affect our results of operations.*

* *

*•**                  Our ServicesGroup contracts have certain performance risks.*

* *

*•**                  Services Groupcontracts for the design and construction of water and wastewater projects mayexpose us to certain completion and performance risks.*

* *

*•**                  We use thirdparty equipment and subcontractors.*

* *

*•**                  Our ServicesGroup is subject to environmental and water quality risks.*

* *

*•**                  We operate alarge fleet of vehicles that could expose us to liabilities.*

* *

*•**                  Our operatingcosts may rise faster than our revenues.*

* *

*•**                  Our operatingcontracts may be canceled, reducing our revenues and backlog.*

 

***Risk Factors that affect our Utility Group operations***

 

*•**                  Weatherconditions can affect the financial results of our Utility Group.*

 

*•**                  Changes in theregulatory environment, including restrictions on the rates we are allowed tocharge customers, may adversely affect our results of operations.*

 

*•**                  We may discoveradditional sources of contamination of our water sources which may adverselyaffect our operations.  We may notrecover costs incurred or revenues lost due to such contamination from partiesresponsible or from rate payers.*

 

18

----

 

*•**                  We own assets inareas subject to natural disasters.*

 

*•**                  We are subjectto regulatory and environmental risks and may not be able to provide anadequate supply of water to our customers.*

 

*•**                  We need accessto capital to continue to invest in our utility assets.*

 

**OtherRisk Factors**

*•**                  Our capitalresources may restrict our ability to operate and expand our business.*

 

*•**                  If we continueto grow, we may fail to effectively manage our growth or we may fail toeffectively manage the growth we have experienced.*

 

*•**                  Our business maybe affected by the general economic conditions of real estate development inthe United States.*

 

*•**                  We are subjectto increasing costs of producing products and services.*

 

*•**                  Our operationsare subject to certain risks due to their location.*

 

***Item 3.Quantitative and Qualitative Disclosures about Market Risk***

 

We have certain indebtedness that is subject to variablerate interest. As a result, Southwest Water’s interest expense is affected bychanges in the general level of interest rates. The interest expense we pay onour line of credit borrowings and certain term loans is determined based upon arate formula that fluctuates with short-term LIBOR rates and cannot exceed thebanks’ prime rate minus one-quarter percent.

 

We completed a$20.0 million, 20-year convertible subordinate debenture offering inJuly 2001, which bears a fixed interest rate of 6.85% per annum. Theproceeds were used to pay down certain variable rate indebtedness. Ourlong-term debentures were sold with a fixed interest rate, and are not subjectto market fluctuation of interest rates. Our debentures are convertible intoSouthwest Water common stock and at such time as our annual diluted earningsexceed $0.53 per share, the debentures will be considered to be common stockequivalents and will be included in the calculation of diluted earnings pershare after adjusting net income for the after-tax effect of the debentureinterest expense.

 

 

***Item 4. Controlsand Procedures***

 

We maintaindisclosure controls and procedures designed to ensure that information requiredto be disclosed in our Exchange Act reports is recorded, processed, summarizedand reported within the time periods specified by the Securities and ExchangeCommission and that such information is accumulated and communicated tomanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily is required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

As required byRule 13a-15(b) under the Exchange Act, management conducted an evaluationwith the participation of the Chief Executive Officer and Chief FinancialOfficer of the effectiveness of our disclosure controls and procedures as ofMarch 31, 2004, the end of the period covered by this Report. Based upon thatevaluation, including the consideration of the reportable condition discussedbelow, the Chief Executive Officer and the Chief Financial Officer concludedthat the disclosure controls and procedures were effective at the reasonableassurance level as of March 31, 2004.

 

As reported in our 2003 AnnualReport, in March 2004, management, in consultation with our independentaccountants, identified deficiencies in certain aspects of the monitoring andanalysis components of the internal control procedures in our Services Groupsegment which constituted a reportable condition (as defined in AU 325,Communication of Internal Control Related Matters Noted in An Audit of theAICPA Professional Standards). These identified deficiencies impacted thequality and timeliness of the reporting and reconciliation of certaintransactions in the Services Group. The matters involving the reportablecondition have been discussed in detail among management, the audit committeeof our board of directors, and our independent accountants. The identifieddeficiencies

 

19

----

 

did not require any restatementof our consolidated financial statements for any prior period. As discussed inour 2003 Annual Report, management is implementing changes which we expect willrectify these deficiencies during 2004.

 

In the first quarter of 2004, no change occurred inour internal controls over financial reporting that has materially affected, oris reasonably likely to materially affect, our internal controls over financialreporting.

 

20

----

 

**PART II - OTHER INFORMATION**

 

***Item 1. LegalProceedings***

 

Southwest Water and a subsidiary have been named asdefendants in twelve lawsuits alleging various injuries as a result of watercontamination in the San Gabriel Valley Main Basin. The California SupremeCourt (the Court) ruled in February 2002 that the plaintiffs cannotchallenge the adequacy of the water quality standards established by CaliforniaDepartment of Health Services (DOHS). The plaintiffs may sue and collectdamages from CPUC-regulated water companies only by proving that waterdelivered did not meet these water quality standards. Our subsidiary believesthat it has complied with DOHS water quality standards. The Court directed thatthe cases be sent to a trial court for further proceedings. At this time anumber of cases, including the twelve involving Southwest and its subsidiary,have been consolidated before a single judge. The parties are now engaged ininitial discovery and motions to determine whether, in light of the ruling bythe Court, the plaintiffs can plead and prove any violation of water qualitystandards by the CPUC regulated water companies. Southwest Water and thissubsidiary have requested defense and indemnification from our liabilityinsurance carriers for these lawsuits. Several of the liability insurancecarriers are currently absorbing the costs of defense of the lawsuits. Wecannot predict the outcome of these lawsuits. Based upon information availableat this time, we do not expect that these actions will have a material adverseeffect on our financial position, results of operations or cash flows.

 

Southwest Water and its subsidiaries are the subjectsof litigation arising from the ordinary course of operations. We believe theultimate resolution of such matters will not materially affect our financialposition, results of operations or cash flows.

 

***Item 4. Submissionof Matters to a Vote of Security Holders.***

 

None.

 

***Item 5. OtherInformation***

** **

**SubsequentEvents**

 

On April 13, 2004 weobtained a firm commitment from two of our commercial banks to expand our linesof credit by an additional $30 million and to extend the maturity of our twoexisting lines from September 2005 to September 2006.  The extensions were intended to provide us with additional fundsto use for acquisition opportunities.

 

On April 30, 2004 we enteredinto a definitive agreements to acquire two regulated water and wastewaterutility companies (Tenkiller Utility Company and Tecon Water Companies, Inc.)from Tecon Water Holdings, L.P.  Thepurchase price of approximately $63 million will be paid by the assumption ofapproximately $17 million in debt and we will pay the remainder in cash.  We expect the purchase of these utility companiesto be completed in the third quarter of 2004, subject to the receipt ofregulatory approvals.  These utilitycompanies currently serve approximately 21,000 water and 4,000 wastewaterconnections in Texas, and 250 wastewater connections in Oklahoma.

 

***Item 6. Exhibitsand Reports on Form 8-K***

 

        
| (a)    |   | Exhibits:            |
|--------|--------|----------------------|
|   |   | 31.1                 | Certification of Chief  Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and  15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002. |
|   |   |                 |   |
|   |   | 31.2                 | Certification of Chief  Financial Officer pursuant to Securities Exchange Act Rules 13a-14(a) and  15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of  2002. |
|   |   |                 |   |
|   |   | 32.1                 | Certification of Chief  Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
|   |   |                 |   |
|   |   | 32.2                 | Certification of Chief  Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002. |
|   |   |                 |   |
|   |   |                 |   |
| (b)    |   | Reports on Form 8-K: |

 

21

----

 
|   |   |   | On March 16, 2004, we  filed a Current Report on Form 8-K furnishing an earnings release with  respect to our financial results for the three months and the year ended  December 31, 2003.                                                                                                  |
|--------|--------|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |   |                                                                                                                                                                                                                                                                                         |
|   |   |   | On March 22, 2004, we  filed a Current Report on Form 8-K furnishing a press earnings release  announcing the proposed sale of 1,400,000 shares of Southwest Water’s common  stock, par value $.01 per share, pursuant to a Registration Statement on Form  S-3.                        |
|   |   |   |                                                                                                                                                                                                                                                                                         |
|   |   |   | On March 24, 2004, we  filed a Current Report on Form 8-K furnishing the Underwriting Agreement,  dated March 24, 2004, relating to the public offering of up to 1,610,000  shares of our common stock, par value $0.01 per share, pursuant to our  Registration Statement on Form S-3. |
|   |   |   |                                                                                                                                                                                                                                                                                         |
|   |   |   | On March 29, 2004, we  filed a Current Report on Form 8-K furnishing a press earnings release  announcing the completion of the sale of 1,610,000 shares of Southwest  Water’s common stock, par value $.01 per share, pursuant to a Registration  Statement on Form S-3.               |
|   |   |   |                                                                                                                                                                                                                                                                                         |
|   |   |   | On May 3, 2004, we  filed a Current Report on Form 8-K furnishing a press release announcing our  definitive agreement to acquire regulated water and wastewater utility  companies from Tecon Water Holdings, L.P.                                                                          |

 

22

----

**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 thereunto duly authorized.

 
|                      | SOUTHWEST WATER COMPANY                                                                                        |
|---------------------------|----------------------------------------------------------------------------------------------------------------|
|                      | (Registrant)                                                                                                   |
|                      |                                                                                                           |
| Dated:  May 10, 2004 | /s/ RICHARD J. SHIELDS                                                                                         |   |
|                      | **Richard J. Shields****Chief  Financial Officer  (Principal Financial Officer and Chief Accounting Officer)** |

 

23

----