** **

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark One)** |       |                                                                                                                                                       |
|----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|
|           |       |                                                                                                                                                       |
| **x**          | ** ** | **Quarterly Report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                     |
|           |       |                                                                                                                                                       |
|           |       | For the quarterly period  ended June 30, 2010                                                                                                         |
|           |       |                                                                                                                                                       |
| or             |
|           |
| **o**          | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                    |
| ** **     | ** ** | ** **                                                                                                                                                 |
| ** **     | ** ** | For the transition  period  from                    to |

 

**CommissionFile Number 0-8176**

 

(Exact name ofregistrant as specified in its charter)

 

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

 

**OneWilshire Building**

**624 SouthGrand Avenue, Suite 2900**

**LosAngeles, California 90017-3782**

(Address ofprincipal executive offices, including zip code)

 

**(213)929-1800**

(Registrant’stelephone, including area code)

 

**None**

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

 

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 thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes **x**   No **o**

 

Indicate by check markwhether the registrant has submitted electronically and posted on its corporatewebsite, if any, every Interactive Data File required to be submitted andposted pursuant to Rule 405 of Regulation S-T (**§**232.405 of this chapter) during the preceding 12 months (orfor such shorter period that the registrant was required to submit and postsuch files).    Yes  **o**    No  **o**

 

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

 
| ** ** | Large accelerated filer | **o** |   |   | Accelerated filer          | **x** |
|------------|-------------------------|-------|--------|--------|----------------------------|-------|
|       | Non-Accelerated filer   | **o** |   |   | Smaller reporting  company | **o** |

 

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

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date.

 
|   | Class                                   |   | Outstanding as of  July 31, 2010 |   |
|--------|-----------------------------------------|--------|---------------------------------------|--------|
|   |                                    |   |                                  |   |
|   | Common Stock,  $.01 par value per share |   | 27,528,870 shares                     |   |

 

 

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**TABLE OF CONTENTS**

 
| ** **       | ** **                                                                                                                              | **Page** |
|------------------|-----------------------------------------------------------------------------------------------------------------------------------------|----------|
|             |                                                                                                                                    |     |
| **Part I**  | **Financial Information**                                                                                                               | **3**    |
|             |                                                                                                                                    |     |
| Item 1.          | Financial Statements                                                                                                                    | 3        |
|             |                                                                                                                                    |     |
|             | Condensed  Consolidated Balance Sheets (Unaudited) as of June 30, 2010 and  December 31, 2009                                 | 3        |
|             |                                                                                                                                    |     |
|             | Condensed  Consolidated Statements of Operations (Unaudited) for the three and six  months ended June 30, 2010 and 2009            | 4        |
|             |                                                                                                                                    |     |
|             | Condensed  Consolidated Statement of Changes in Stockholders’ Equity (Unaudited) for the  six months ended June 30, 2010 | 5        |
|             |                                                                                                                                    |     |
|             | Condensed  Consolidated Statements of Cash Flows (Unaudited) for the six months ended  June 30, 2010 and 2009                      | 6        |
|             |                                                                                                                                    |     |
|             | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                         | 7        |
|             |                                                                                                                                    |     |
| Item 2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                             | 18       |
|             |                                                                                                                                    |     |
| Item 3.          | Quantitative  and Qualitative Disclosures About Market Risk                                                                             | 35       |
|             |                                                                                                                                    |     |
| Item 4.          | Controls and Procedures                                                                                                                 | 35       |
|             |                                                                                                                                    |     |
| **Part II** | **Other Information**                                                                                                                   | **40**   |
|             |                                                                                                                                    |     |
| Item 1.          | Legal Proceedings                                                                                                                       | 40       |
|             |                                                                                                                                    |     |
| Item 1A.         | Risk Factors                                                                                                                            | 40       |
|             |                                                                                                                                    |     |
| Item 6.          | Exhibits                                                                                                                                | 40       |
|             |                                                                                                                                    |     |
| **Signatures**   | **41**                                                                                                                                  |

 

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**PART I— FINANCIAL INFORMATION**

 

**ITEM1.    FINANCIAL STATEMENTS**

 

**SOUTHWESTWATER COMPANY**

 

**CONDENSED CONSOLIDATED BALANCE SHEETS(UNAUDITED)**

 
| *(In thousands)*                                 | ** ** | **June 30,  2010** | ** ** | **December 31,  2009** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|-----------------------------|------------|
|                                             |       |                    |       |                        |       |
| **ASSETS**                                       |       |                    |       |                        |       |
| Current  assets:                                 |       |                    |       |                        |       |
| Cash  and cash equivalents                       |       | $                       | 2,181      |                        | $          | 2,874 |   |
| Accounts  receivable, net                        |       | 28,561                  |       | 26,968                      |       |
| Prepaid  expenses and other current assets       |       | 12,944                  |       | 12,909                      |       |
| Total  current assets                            |       | 43,686                  |       | 42,751                      |       |
|                                             |       |                    |       |                        |       |
| Property,  plant and equipment, net              |       | 313,454                 |       | 313,716                     |       |
| Other  assets:                                   |       |                    |       |                        |       |
| Goodwill                                         |       | 16,434                  |       | 16,434                      |       |
| Intangible  assets                               |       | 2,793                   |       | 2,966                       |       |
| Other  assets                                    |       | 26,943                  |       | 24,228                      |       |
| Total  assets                                    |       | $                       | 403,310    |                        | $          | 400,095 |   |
|                                             |       |                    |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    |       |                    |       |                        |       |
| Current  liabilities:                            |       |                    |       |                        |       |
| Accounts  payable                                |       | $                       | 13,007     |                        | $          | 14,130 |   |
| Current  portion of long-term debt               |       | 2,211                   |       | 2,171                       |       |
| Other  current liabilities                       |       | 23,441                  |       | 21,213                      |       |
| Total  current liabilities                       |       | 38,659                  |       | 37,514                      |       |
| Other  liabilities and deferred credits:         |       |                    |       |                        |       |
| Long-term  debt, less current portion            |       | 142,507                 |       | 152,820                     |       |
| Deferred  income taxes                           |       | 12,521                  |       | 13,100                      |       |
| Advances  for construction                       |       | 9,154                   |       | 8,784                       |       |
| Contributions  in aid of construction            |       | 53,547                  |       | 53,841                      |       |
| Other  liabilities and deferred credits          |       | 18,761                  |       | 18,122                      |       |
| Commitments  and contingencies                   |       |                    |       |                        |       |
| Stockholders’  equity:                      |       |                    |       |                        |       |
| Preferred  stock                                 |       | 458                     |       | 458                         |       |
| Common  stock                                    |       | 275                     |       | 249                         |       |
| Additional  paid-in capital                      |       | 164,885                 |       | 148,407                     |       |
| Accumulated  deficit                             |       | (37,457                 | )          | (33,200                     | )          |
| Total  stockholders’ equity                 |       | 128,161                 |       | 115,914                     |       |
| Total  liabilities and stockholders’ equity |       | $                       | 403,310    |                        | $          | 400,095 |   |
|                                                  |            |                         |            |                             |            |  |  |  |  |  |

 

 

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

3

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**SOUTHWESTWATER COMPANY**

 

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS (UNAUDITED)**

 
| ** **                                                    | ** ** | **Three  Months Ended** | ** ** | **Six  Months Ended** | ** ** |
|---------------------------------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| ** **                                                    | ** ** | **June 30,**       | ** ** | **June 30,**     | ** ** |
| * *                                                      | ** ** | ** **              | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| *(In  thousands, except per share data)*                      | ** ** | **2010**                | ** ** | **2009**              | ** ** | **2010** | ** ** | **2009** | ** ** |
| Operating  revenue                                            |       | $                       | 53,883     |                  | $          | 52,416 |   | $ | 100,729 |   | $ | 102,508 |   |
| Expenses:                                                     |       |                    |       |                  |       |   |   |   |   |
| Operating  expenses                                           |       | 47,727                  |       | 50,052                |       | 93,039 |   | 99,959 |   |
| Depreciation  and amortization                                |       | 3,847                   |       | 3,857                 |       | 7,714 |   | 7,690 |   |
| Impairment  of long-lived assets                              |       | —                  |       | 8,115                 |       | — |   | 8,115 |   |
| Total  operating expenses                                     |       | 51,574                  |       | 62,024                |       | 100,753 |   | 115,764 |   |
| Operating  income (loss)                                      |       | 2,309                   |       | (9,608                | )          | (24 | ) | (13,256 | ) |
| Other  income (expense):                                      |       |                    |       |                  |       |   |   |   |   |
| Interest  expense                                             |       | (2,238                  | )          | (2,975                | )          | (4,608 | ) | (4,862 | ) |
| Interest  income                                              |       | 55                      |       | 48                    |       | 88 |   | 84 |   |
| Income  (loss) from continuing operations before income taxes |       | 126                     |       | (12,535               | )          | (4,544 | ) | (18,034 | ) |
| Provision  for (benefit from) income taxes                    |       | 69                      |       | (4,472                | )          | (1,673 | ) | (6,566 | ) |
| Income  (loss) from continuing operations                     |       | 57                      |       | (8,063                | )          | (2,871 | ) | (11,468 | ) |
| Income  from discontinued operations, net of tax              |       | —                  |       | 17,559                |       | — |   | 17,731 |   |
| Net  income (loss)                                            |       | 57                      |       | 9,496                 |       | (2,871 | ) | 6,263 |   |
| Preferred  stock dividends                                    |       | (6                      | )          | (6                    | )          | (12 | ) | (6 | ) |
| Net  income (loss) applicable to common stockholders          |       | $                       | 51         |                  | $          | 9,490 |   | $ | (2,883 | ) | $ | 6,257 |   |
|                                                          |       |                    |       |                  |       |   |   |   |   |
| Income  (loss) per common share - basic and diluted           |       |                    |       |                  |       |   |   |   |   |
| Income  (loss) from continuing operations                     |       | $                       | 0.00       |                  | $          | (0.33 | ) | $ | (0.11 | ) | $ | (0.47 | ) |
| Income  from discontinued operations                          |       | —                  |       | 0.71                  |       | — |   | 0.72 |   |
| Net  income (loss) applicable to common stockholders          |       | $                       | 0.00       |                  | $          | 0.38 |   | $ | (0.11 | ) | $ | 0.25 |   |
|                                                          |       |                    |       |                  |       |   |   |   |   |
| Weighted  average common shares outstanding:                  |       |                    |       |                  |       |   |   |   |   |
| Basic                                                         |       | 27,361                  |       | 24,608                |       | 26,240 |   | 24,604 |   |
| Diluted                                                       |       | 27,486                  |       | 24,608                |       | 26,240 |   | 24,604 |   |
|                                                               |            |                         |            |                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

4

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** **

**SOUTHWESTWATER COMPANY**

 

**CONDENSED CONSOLIDATED STATEMENT OFCHANGES IN STOCKHOLDERS’ EQUITY (UNAUDITED)**

 
| ** **                                                              | ** ** | **Preferred  Stock** | ** ** | **Common  Stock** | ** ** | **Additional** | ** ** | ** ** | ** ** | ** **  | ** ** |
|-------------------------------------------------------------------------|------------|----------------------|------------|-------------------|------------|----------------|------------|------------|------------|-------------|------------|
| ** **                                                              | ** ** | **Number  of**       | ** ** | ** **        | ** ** | **Number  of** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | **Accumulated** | ** ** | ** ** | ** ** |
| ** **                                                              | ** ** | **Shares**           | ** ** | **Amount**        | ** ** | **Shares**     | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Deficit** | ** ** | **Total** | ** ** |
| *(In thousands, except per share data)*                                 |       |                 |       |              |       |           |       |       |       |        |       |   |   |   |   |
| **Balance - December 31, 2009**                                    | ** ** | **9**                | ** ** | **$**             | **458**    | ** **     | **24,887** | ** ** | **$**      | **249**     | ** ** | **$** | **148,407** | ** ** | **$** | **(33,200** | **)** | **$** | **115,914** | ** ** |
| Net  loss                                                               |       | —               |       | —            |       | —         |       | —     |       | —      |       | (2,871 | ) | (2,871 | ) |
| Restricted  stock awards cancelled                                      |       | —               |       | —            |       | (80            | )          | (1         | )          | 1           |       | — |   | — |   |
| Common  stock issuance                                                  |       | —               |       | —            |       | 2,700          |       | 27         |       | 16,092      |       |   |   | 16,119 |   |
| Common  stock issuances from employee benefit plans, net of repurchases |       | —               |       | —            |       | 20             |       | —     |       | 197         |       | — |   | 197 |   |
| Share-based  compensation                                               |       | —               |       | —            |       | —         |       | —     |       | 188         |       | — |   | 188 |   |
| Cash  dividends declared:                                               |       |                 |       |              |       |           |       |       |       |        |       |   |   |   |   |
| Preferred  stock - $1.31 per share                                      |       | —               |       | —            |       | —         |       | —     |       | —      |       | (12 | ) | (12 | ) |
| Common  stock - $0.05 per share                                         |       | —               |       | —            |       | —         |       | —     |       | —      |       | (1,374 | ) | (1,374 | ) |
| **Balance - June 30, 2010**                                        | ** ** | **9**                | ** ** | **$**             | **458**    | ** **     | **27,527** | ** ** | **$**      | **275**     | ** ** | **$** | **164,885** | ** ** | **$** | **(37,457** | **)** | **$** | **128,161** | ** ** |
|                                                                         |            |                      |            |                   |            |                |            |            |            |             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

 

See accompanyingnotes to unaudited condensed consolidated financial statements.

 

5

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** **

**SOUTHWESTWATER COMPANY**

**CONDENSED CONSOLIDATED STATEMENTS OFCASH FLOWS (UNAUDITED)**

 
| ** **                                                                                | ** ** | **Six Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                | ** ** | **June 30,**    | ** ** |
| *(In thousands)*                                                                          | ** ** | **2010**             | ** ** | **2009** | ** ** |
|                                                                                      |       |                 |       |   |   |
| Cash  flows from operating activities of continuing operations:                           |       |                 |       |   |   |
| Net  Income (loss)                                                                        |       | $                    | (2,871     | ) | $ | 6,263 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                 |       |   |   |
| Income  from discontinued operations, net of tax                                          |       | —               |       | (17,731 | ) |
| Depreciation  and amortization                                                            |       | 7,714                |       | 7,690 |   |
| Deferred  income taxes                                                                    |       | (1,912               | )          | 2,963 |   |
| Provision  for doubtful accounts                                                          |       | 371                  |       | 998 |   |
| Share-based  compensation expense                                                         |       | 188                  |       | 331 |   |
| Post-vest  cancellations of non-qualified stock options                                   |       | —               |       | (178 | ) |
| Loss  (gain) on disposal of property, plant & equipment                          |       | 226                  |       | (598 | ) |
| Impairment  of long-lived assets                                                          |       | —               |       | 8,115 |   |
| Other,  net                                                                               |       | 445                  |       | 543 |   |
| Changes  in assets and liabilities, net of effects of acquisitions                        |       |                 |       |   |   |
| Accounts  receivable                                                                      |       | (1,964               | )          | (4,052 | ) |
| Other  current assets                                                                     |       | 1,298                |       | 2,829 |   |
| Other  assets                                                                             |       | (3,087               | )          | 1,043 |   |
| Accounts  payable                                                                         |       | (1,727               | )          | (2,872 | ) |
| Other  current liabilities                                                                |       | 2,264                |       | (484 | ) |
| Other  liabilities                                                                        |       | (318                 | )          | (1,437 | ) |
| Net  cash provided by operating activities                                                |       | 627                  |       | 3,423 |   |
|                                                                                      |       |                 |       |   |   |
| Cash  flows from investing activities of continuing operations:                           |       |                 |       |   |   |
| Additions  to property, plant and equipment                                               |       | (6,037               | )          | (6,306 | ) |
| Proceeds  from sale of business                                                           |       | —               |       | 54,436 |   |
| Proceeds  from sales of equipment                                                         |       | 93                   |       | 125 |   |
| Net  cash provided by (used in) investing activities                                      |       | (5,944               | )          | 48,255 |   |
|                                                                                      |       |                 |       |   |   |
| Cash  flows from financing activities of continuing operations:                           |       |                 |       |   |   |
| Borrowings  under lines of credit                                                         |       | 6,700                |       | 28,000 |   |
| Repayments  under lines of credit                                                         |       | (16,200              | )          | (55,600 | ) |
| Payments  on long-term debt                                                               |       | (1,032               | )          | (13,131 | ) |
| Capital  improvement reimbursements                                                       |       | 959                  |       | 3,389 |   |
| Proceeds  of stock issuance                                                               |       | 16,119               |       | — |   |
| Proceeds  from employee benefit plan stock issuances, net of repurchases                  |       | 197                  |       | — |   |
| Dividends  paid                                                                           |       | (1,380               | )          | (1,256 | ) |
| Repayment  of advances for construction                                                   |       | (619                 | )          | — |   |
| Deferred  financing costs                                                                 |       | (120                 | )          | (2,579 | ) |
| Net  cash provided by (used in) financing activities                                      |       | 4,624                |       | (41,177 | ) |
|                                                                                      |       |                 |       |   |   |
| Cash  flows from discontinued operations:                                                 |       |                 |       |   |   |
| Operating  activities                                                                     |       | —               |       | (8,095 | ) |
| Investing  activities                                                                     |       | —               |       | (291 | ) |
| Financing  activities                                                                     |       | —               |       | (1,647 | ) |
| Net  cash used in discontinued operations                                                 |       | —               |       | (10,033 | ) |
|                                                                                      |       |                 |       |   |   |
| Net  increase (decrease) in cash and cash equivalents                                     |       | (693                 | )          | 468 |   |
| Cash  and cash equivalents at beginning of period                                         |       | 2,874                |       | 1,112 |   |
| Cash  and cash equivalents at end of period                                               |       | $                    | 2,181      |   | $ | 1,580 |   |
|                                                                                           |            |                      |            |  |  |  |  |  |

See accompanying notes to unaudited condensed consolidated financialstatements.

 

6

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**SOUTHWESTWATER COMPANY**

 

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**Note1.    Basis of Presentation and Summary ofSignificant Accounting Policies**

 

**Basis of Presentation**

 

These condensedconsolidated interim financial statements of SouthWest Water Company areunaudited. We believe the interim financial statements are presented on a basisconsistent with the audited consolidated financial statements for the yearended December 31, 2009 and include all adjustments necessary for a fairpresentation of the financial condition, results of operations and cash flowsfor such interim periods. Unless context indicates otherwise, references to “we”,“us”, “our”, the “Company” or SouthWest Water” mean SouthWest Water Company andits subsidiaries.

 

The December 31, 2009condensed consolidated balance sheet data was derived from the auditedfinancial statements, but does not include all disclosures required byaccounting principles generally accepted in the United States of America (“GAAP”).

 

Certain information anddisclosures normally included in financial statements prepared in accordancewith GAAP have been omitted in accordance with Securities and ExchangeCommission’s (“SEC”) rules and regulations for interim financialreporting. These condensed consolidated interim financial statements should beread in conjunction with the audited financial statements and related notesincluded in our 2009 Annual Report on Form 10-K. Our businesses areseasonal because they are affected by weather; as a result, operating resultsfor interim periods are not necessarily predictive of the operating results forany other interim period or for the full year.

 

**Merger Agreement and Long-Term Infrastructure Investment**

 

On March 2, 2010, weentered into an agreement and plan of merger (the “Merger Agreement”) with SWMerger Acquisition Corp. (“Parent”) and SW Merger Sub Corp., a directwholly-owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub arejointly owned by IIF Subway Investment LP and USA Water Services, LLC, whichare sponsored by J.P. Morgan IIF Acquisitions LLC and Water Asset Management,LLC.  Under the terms of the MergerAgreement, all of our outstanding common stock would be converted into a rightto receive $11.00 per share in cash.  On August 6,2010, the Merger Agreement was adopted by an affirmative vote of a majority ofthe combined voting power of our outstanding common stock and Series Apreferred stock as of June 14, 2010, voting together as a singleclass.  The completion of the merger is subjectto customary closing conditions, including regulatory notice and approvals.

 

If all remaining closingconditions are met, we will be the surviving corporation of the merger and awholly owned subsidiary of Parent. Upon completion of the merger, our commonstock will cease to be traded on the NASDAQ Global Select Market and we will nolonger be a publicly held corporation. The Merger Agreement contains restrictions on our operations prior tothe closing of the merger, including restrictions related to capitalexpenditures, the incurrence of debt, acquiring and disposing of assets,entering into material contracts and capital transactions.

 

In connection with theMerger Agreement, we entered into a Securities Purchase Agreement and InvestorRights Agreement (collectively, the “Investment Agreements”).  Pursuant to the Investment Agreements andeffective March 16, 2010, Parent purchased 2,700,000 shares of our commonstock (the “Purchased Stock”) at a price of $6.00 per share, for an aggregatepurchase price of $16.2 million and we incurred related specific incrementaltransactional costs of $0.1 million.  Aspermitted under the terms of the Investment Agreements, the Company applied theproceeds derived from the sale of the Purchased Stock to reduce our revolvingline of credit, the borrowings of which are used for capital expenditures andworking capital purposes.  The InvestmentAgreements entitle Parent to appoint a designee to serve on our board ofdirectors (which right Parent has not exercised to date), and also to certainregistration rights with respect to the Purchased Stock in the event of thetermination of the Merger Agreement.  TheInvestment Agreements restrict Parent’s ability to sell or otherwise transferthe Purchased Stock prior to the earlier of the consummation or termination ofthe Merger Agreement.  Except ascontemplated by the Merger Agreement, Parent and Merger Sub are also prohibitedfrom acquiring any additional shares of our common stock until the terminationof the Merger Agreement.

 

As the offering and saleof the Purchased Stock pursuant to the Investment Agreements was not registeredunder the Securities Act of 1933 or applicable state securities laws, thePurchased Stock may not be offered or sold in the United States absentregistration or an applicable exemption from such registration requirements.

 

**Recent Accounting Pronouncements**

 

7

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We only discuss recentaccounting pronouncements that will or could have a significant effect on ourfinancial statements or disclosures currently or in the near term.

 

In February 2010, theFinancial Accounting Standards Board (FASB) issued accounting standards update(ASU) No. 2010-09,*Subsequent Events(Topic 855)—Amendments to Certain Recognition and Disclosure Requirements*(ASU No. 2010-09). Among other amendments to Topic 855, ASUNo. 2010-09 reiterates that SEC filers are required to evaluate subsequentevents through the date the financial statements have been issued andeliminates the requirement that SEC filers disclose the date through whichsubsequent events have been evaluated. ASU No. 2010-09 became effectiveupon issuance. Adoption of ASU No. 2010-09 had no impact on ourconsolidated financial statements.

 

In January 2010, theFASB issued ASU No. 2010-06,*Fair ValueMeasurements and Disclosures (Topic 820)—Improving Disclosures about FairValue Measurements* (ASU No. 2010-06). ASU No. 2010-06requires: (1) fair value disclosures of assets and liabilities by class;(2) disclosures about significant transfers in and out of Levels 1and 2 on the fair value hierarchy, in addition to Level 3;(3) purchases, sales, issuances and settlements be disclosed on grossbasis on the reconciliation of beginning and ending balances of Level 3assets and liabilities; and (4) disclosures about valuation methods andinputs used to measure the fair value of Level 2 assets and liabilities.ASU No. 2010-06 became effective for the first financial reporting periodbeginning after December 15, 2009, except for disclosures about purchases,sales, issuances and settlements of Level 3 assets and liabilities, whichwill be effective for fiscal years beginning after December 15, 2010.Adoption of the currently effective provisions of ASU No. 2010-06 had noimpact on our consolidated financial statements. Presently, we are assessingwhat impact, if any, Level 3 disclosure requirements regarding grosspresentation of purchases, sales, issuances and settlements will have on ourconsolidated financial statements.

 

**Other Comprehensive Income**

 

We had no accumulated other comprehensive income asof June 30, 2010 and December 31, 2009.

 

**Accounting Adjustments Impacting Other Periods**

 

For the quarter ended June 30,2010 we recorded adjustments with a net impact of $0.1 million expense, net oftax, related to prior periods. Management has determined that the effect ofrecognizing these adjustments are not material to our results of operations forthe three months ended June 30, 2010 or for any prior period.  For the six months ended June 30, 2010we recorded adjustments with a net impact of $0.2 million expense, net of tax,related to prior periods. Management has determined that the effect ofrecognizing these adjustments are not material to our results of operations forthe six months ended June 30, 2010 or for any prior periods.

 

**Fair Value Measurements**

 

We use a valuationhierarchy for disclosures of fair value measurement. The three levels aredefined as follows:

 

·                   Level 1Inputs – Unadjusted quoted market prices for identical assets and liabilitiesin an active market that the Company has the ability to access.

 

·                   Level 2Inputs – Inputs, other than the quoted prices in active markets, that areobservable either directly or indirectly.

 

·                   Level 3Inputs – Inputs based on prices or valuation techniques that are bothunobservable and significant to the overall fair value measurements.

 

Our total long-term debtwith aggregate book values of $144.7 million and $155.0 million had fair valuesof approximately $137.5 million and $145.5 million at June 30, 2010 andDecember 31, 2009, respectively. The estimated fair values are based on current rates for similar issuesfor debt of the same remaining maturities. The carrying value of all otherfinancial instruments, such as cash and cash equivalents, accounts receivableand accounts payable, approximates fair value because of the short maturity ofthe instruments.  At June 30, 2010and December 31, 2009, we had no derivative financial instruments, hedgingactivities, financial instruments with off-balance sheet risk or financialinstruments with concentrations of credit risks.

 

**Note2.    Dispositions and Impairments**

 

*New Mexico Utilities, Inc.*

 

As more fully described inNote 4, “Commitments and Contingencies - Legal Proceedings”, as part of asettlement of eminent domain proceedings against our New Mexico utility, NewMexico Utilities Inc. (“NMUI”), we completed the 

 

8

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sale of NMUI inMay 2009. As of June 30, 2010 and December 31, 2009, no assetswere held for sale. The results of operations of our NMUI operations have beenreclassified as discontinued operations for the three months and six monthsended June 30, 2009 in the consolidated statements of operations and aresummarized as follows:

 
| ** **                                                     | ** ** | **Three  months ended** | ** ** | **Six  months ended**   | ** ** |
|----------------------------------------------------------------|------------|-------------------------|------------|-------------------------|------------|
| ** **                                                     | ** ** | **June 30,  2009** | ** ** | **June 30,  2009** | ** ** |
| *(In thousands)*                                               |       |                    |       |                    |       |
| Operating  revenue                                             |       |                    | $          | 2,425                   |       |   | $ | 4,729 |   |
| Operating  expenses                                            |       |                    |       | 1,034                   |       |   |   | 2,895 |   |
| Operating  income                                              |       |                    |       | 1,391                   |       |   |   | 1,834 |   |
| Interest  expense                                              |       |                    |       | (91                     | )          |   |   | (270 | ) |
| Income  from continuing operations before income taxes         |       |                    |       | 1,300                   |       |   |   | 1,564 |   |
| Provision  for income taxes                                    |       |                    |       | 469                     |       |   |   | 561 |   |
| Income  before gain on sale of discontinued operations         |       |                    |       | 831                     |       |   |   | 1,003 |   |
| Gain  on sale of discontinued operations, net of tax of $9,361 |       |                    |       | 16,728                  |       |   |   | 16,728 |   |
| Income  from discontinued operations, net of tax               |       |                    | $          | 17,559                  |       |   | $ | 17,731 |   |
|                                                                |            |                         |            |                         |            |  |  |  |  |  |  |

 

**Note3.    Long-Term Debt**

 

Long-termdebt consists of the following as of June 30, 2010 and December 31,2009:

 
| ** **                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| *(In thousands)*                                      | ** ** | **2010**          | ** ** | **2009**              | ** ** |
|                                                  |       |              |       |                  |       |
| Revolving  credit facility                            |       | $                 | 65,000     |                  | $          | 74,500 |   |
|                                                  |       |              |       |                  |       |
| 6.85%  convertible subordinated debentures due 2021   |       | 11,766            |       | 11,839                |       |
|                                                  |       |              |       |                  |       |
| Capital  leases                                       |       | 2,897             |       | 3,138                 |       |
|                                                  |       |              |       |                  |       |
| Term  Loans:                                          |       |              |       |                  |       |
| Monarch  Utilities, Inc.:                        |       |              |       |                  |       |
| 7.37%  fixed rate term loan due 2022                  |       | 9,112             |       | 9,497                 |       |
| 5.77%  fixed rate term loan due 2022                  |       | 627               |       | 654                   |       |
| 6.10%  fixed rate term loan due 2031                  |       | 20,000            |       | 20,000                |       |
|                                                  |       |              |       |                  |       |
| First  Mortgage Bonds:                                |       |              |       |                  |       |
| Suburban  Water Systems:                              |       |              |       |                  |       |
| 9.09%  series B first mortgage bond due 2022          |       | 8,000             |       | 8,000                 |       |
| 5.64%  series D first mortgage bond due 2024          |       | 15,000            |       | 15,000                |       |
| 6.30%  series E first mortgage bond due 2026          |       | 10,000            |       | 10,000                |       |
|                                                  |       |              |       |                  |       |
| Economic  Development Revenue Bonds:                  |       |              |       |                  |       |
| 6.0%  series 1998A due 2018                           |       | 1,690             |       | 1,690                 |       |
|                                                  |       |              |       |                  |       |
| Acquisition-related  indebtedness and other           |       | 78                |       | 78                    |       |
| Total  long-term debt payment obligations             |       | 144,170           |       | 154,396               |       |
| Unamortized  Monarch term loan fair value adjustments |       | 548               |       | 595                   |       |
| Total  long-term debt                                 |       | 144,718           |       | 154,991               |       |
| Less  current portion of long-term debt               |       | (2,211            | )          | (2,171                | )          |
| Long-term  debt, less current portion                 |       | $                 | 142,507    |                  | $          | 152,820 |   |
|                                                       |            |                   |            |                       |            |  |  |  |  |  |

 

Our revolving line ofcredit reflects a credit agreement with several lenders, including Bank ofAmerica as lender and Administrative Agent, KeyBank, CoBank, U.S. Bank,JPMorgan Chase Bank, Comerica Bank, Bank of the West, 

 

9

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Citibank and Union Bank ofCalifornia (the “Bank Group”). The credit agreement provides for a $110.0million revolving credit facility.

 

Borrowings under thecredit facility bear interest, at our option, based on either a margin over thedesignated LIBOR rate or the prime rate. As of June 30, 2010 ourdebt-to-capitalization ratio is 54%; therefore, the applicable margins are3.50% over the LIBOR rate and 2.50% over the prime rate. The margins decline ona sliding scale as our debt-to-capitalization ratio improves. The weightedaverage annual interest rates, excluding bank amendment and waiver fees, on allcredit facility borrowings outstanding were 3.85% as of June 30, 2010 and4.3% as of December 31, 2009.

 

As of June 30, 2010,we had irrevocable standby letters of credit in the amount of $5.0 millionissued and outstanding under our revolving credit facility and our availableborrowing capacity was $40.0 million.

 

**Note4.    Commitments and Contingencies**

 

**Legal Proceedings**

 

*Class ActionLitigation*

 

Perrin v. SouthWest WaterCompany, et al., Case No. CV 08-07844 (Central District of California) andrelated, consolidated cases: On November 26, 2008, an alleged purchaser ofour publicly traded common stock filed a securities class action lawsuit in theUnited States District Court for the Central District of California. Thecomplaint generally alleges that from May 10, 2005 through November 9,2008, we made false statements or omitted to state facts necessary to make ourdisclosures not misleading. Five additional and substantially similarcases were filed in the same court.  On January 26, 2009, motions forconsolidation and for the appointment of lead plaintiff and lead counsel werefiled by the plaintiffs.  On February 12, 2009, the court granted themotion for consolidation and for the appointment of lead plaintiff and leadcounsel. Pursuant to stipulation of the parties, the lead plaintiff on October 15,2009, filed a consolidated complaint. On January 12, 2010, the Companyfiled a motion to dismiss the consolidated amended complaint on the groundsthat it failed to allege a valid claim and a motion for partial summaryjudgment on certain claims alleged in it on the grounds that the plaintiffslack standing to bring those claims.  OnMarch 8, 2010, the plaintiffs filed oppositions to the Company’smotions.  On April 15, 2010, theCompany filed reply briefs in support of its motions.  The hearing on the motions was set for June 21,2010, but the Court took the matter off the calendar. On June 30, 2010,the Court ruled on the motions, denying the Company’s motion for partialsummary judgment and granting the Company’s motion to dismiss in its entiretyas to the entire complaint.  On July 30,2010, Plaintiffs filed an amended complaint. Given the nature and preliminary status of these cases, we cannot yetdetermine the amount or even a reasonable range of potential loss in thesematters, if any.

 

*DerivativeLitigation*

 

Sherman v. Christie, etal., Case No. BC404946 (Los Angeles County Superior Court) and relatedcases: On January 2, 2009, an alleged shareholder of our publicly tradedcommon stock filed a shareholder derivative case, alleging breach of fiduciaryduty arising from the announcement of our intent to restate financialstatements against certain present and former members of our Board ofDirectors. Two additional, substantially similar cases were filed. Stipulations were entered extending the time to respond to thecomplaints.  On April 23, 2009, the court found that the threederivative suits were “complex” and related and transferred the cases to asingle judge for all purposes and ordered an initial status conference forDecember 3, 2009. The cases were consolidated on May 19,2009. The lead plaintiff by stipulation of the parties filed aconsolidated complaint on October 8, 2009. On December 7, 2009, theCompany filed a demurrer to the consolidated complaint on the grounds that theconsolidated complaint failed to allege sufficient facts to state a valid causeof action and failed to allege facts showing that presuit demand on the boardof directors should be excused as futile. On January 21, 2010, the plaintiffs filed an opposition to thedemurrer.  On March 4, 2010, theplaintiffs filed an amended consolidated complaint to add claims on behalf ofan alleged class of the Company’s shareholders related to the proposedmerger.  On April 2, 2010, theplaintiffs filed a motion to consolidate the four class action suits pending inthe Los Angeles Superior Court related to the proposed merger.  On April 2, 2010, the Company filed amotion to sever the alleged class action claims related to the proposed mergerfrom the amended consolidated complaint and a demurrer to the entire complainton the grounds that the consolidated complaint failed to allege sufficientfacts to state a valid cause of action and failed to allege facts showing thatpresuit demand on the board of directors should be excused as futile.  On April 2, 2010, the Company also filedan opposition to the motion to consolidate. On April 15, 2010, the court denied the plaintiffs’ motion toconsolidate.  On April 20, 2010, theplaintiffs filed oppositions to the motion to sever and demurrer.  On April 27, 2010, the Company filedreplies in support of the motion to sever and demurrer.  On May 3, 2010, the plaintiffs agreed tosever and dismiss without prejudice claims on behalf of an alleged class of theCompany’s shareholders related to the proposed merger from the amendedconsolidated complaint.  On May 4,2010, the court entered an order dismissing without prejudice claims on behalfan alleged class of the Company’s shareholders related to the proposed mergerfrom the amended 

 

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consolidatedcomplaint.  Also on May 4, 2010, thecourt sustained the Company’s demurrer to the amended consolidated complaintand gave the plaintiffs 20 days to file a further amended complaint.  The Plaintiffs failed to timely file anamended complaint, effectively ending this litigation.

 

*LitigationRelated to the Merger Agreement*

 

We are aware of sevenpurported class action lawsuits related to the proposed merger filed againstthe Company, some or all of our directors, Parent, and Merger Sub in theSuperior Court of the State of California, County of Los Angeles, the Court ofChancery of the State of Delaware, or the United States District Court for theCentral District of California.

 

The complaints are substantiallysimilar and allege, among other things, that the merger proposed under theMerger Agreement is the product of a flawed process and that the considerationto be paid to our stockholders in the merger would be unfair and inadequate.  The complaints further allege, among otherthings, that our officers and directors breached their fiduciary duties by,among other things, taking actions designed to deter higher offers from otherpotential acquirers and failing to maximize the value of SouthWest Water stockfor the benefit of our stockholders. The complaints further allege that Parentand Merger Sub aided and abetted the actions of our officers and directors inbreaching their fiduciary duties.  Thecomplaints seek, among other relief, an injunction preventing consummation ofthe merger, an order rescinding the merger or any of the terms of the merger tothe extent already implemented, costs and disbursements of the lawsuits,including attorneys’ and experts’ fees, and such other relief as the courtmight find just and proper.  On July 27,2010, we and the other defendants entered into a memorandum of understandingwith the plaintiffs regarding the settlement of all of these actions.  In connection with the settlementcontemplated by the memorandum of understanding, we made certain additionaldisclosures related to the proposed merger. Subject to completion of certain confirmatory discovery by counsel tothe plaintiffs, the memorandum of understanding contemplates that the partieswill enter into a stipulation of settlement which will provide, among otherthings, for the conditional certification of a settlement class.  The stipulation of settlement will be subjectto customary conditions, including Court approval following notice to ourstockholders.  If the settlement isfinally approved by the Court, it will resolve and release on behalf of theclass all claims in all actions that were or could have been broughtchallenging any aspect of the proposed merger, the merger agreement, and anydisclosure made in connection therewith. There can be no assurance that the parties will ultimately enter into astipulation of settlement or that Court will approve the settlement, in whichsuch event the proposed settlement as contemplated by the memorandum ofunderstanding may be terminated.  Thememorandum of understanding would limit the settlement to $0.5 million in totalof which the Company’s insurance would cover $0.2 million directly and theCompany would be responsible for $0.3 million, which was accrued during thethree-month period ended June 30, 2010. If the agreement is not finalized, we would not yet be able to determinethe amount or even a reasonable range of potential loss in these matters, ifany.

 

*NewMexico Utilities, Inc.*

 

NMUI, one of the Company’swholly-owned regulated utilities, had an agreement with the AlbuquerqueBernalillo County Water Utility Authority, a political subdivision of the Stateof New Mexico (the “ABCWUA”), whereby the ABCWUA treated the effluent from NMUI’swastewater collection system for a fee. The treated effluent is returned to theRio Grande Underground Basin, creating return flow credits. Return flow creditssupplemented NMUI’s existing water rights, enabling it to pump additional waterfrom the basin.

 

In August 2004, the ABCWUAincreased the fee charged to NMUI, using a different formula than had been usedto calculate fee increases since 1973. The Company believed the increaseviolated the terms of a 1973 written agreement between the parties.Subsequently, the ABCWUA also claimed ownership of the return flow credits. OnSeptember 13, 2004, the Company filed a Complaint for Declaratory Judgmentin the Second Judicial District Court, County of Bernalillo, State of NewMexico (the “Court”), requesting that the Court settle these disputes.

 

In addition, inJanuary 2007, the ABCWUA and the City of Rio Rancho, ahome-rule municipal corporation, as Petitioners, filed a Petition forCondemnation against NMUI and others, as defendants, in the Court (the “Petition”).The Petition sought to acquire, by condemnation, all of the assets of NMUI,including all real property, through the stated power of eminent domain. ThePetition also alleged that the Petitioners need to acquire the NMUI assets forthe public purposes of providing water and wastewater services to NMUIcustomers and that the acquisition of NMUI is necessary, appropriate and in thepublic interest. The Company contested the Petition.

 

In October 2008, theCompany attempted to settle the sewer rate and return flow credit issues withan $8.0 million cash offer. The settlement offer was not accepted byABCWUA.

 

On January 29, 2009,NMUI and the ABCWUA entered into a Settlement, Arbitration Award, andAcquisition Agreement (the “Agreement”) to resolve all outstanding claims, demandsand existing lawsuits between them. Under the Agreement, the ABCWUA acquiredcertain of the assets of NMUI necessary for the ABCWUA to own, operate and 

 

11

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maintain the water andwastewater system of NMUI in settlement of condemnation. In consideration ofthe assets acquired, the ABCWUA agreed to pay to NMUI at the Closing as full,final and complete consideration the sum of: (i) $60.0 million;(ii) an amount equal to the NMUI accounts receivable at the date ofClosing; and (iii) an amount equal to the unbilled services at the date ofClosing. The Agreement closed on May 8, 2009.

 

NMUI also received theright to customer billings previously placed into escrow. The total amountreceived by the Company on May 8, 2009 from these escrow funds was $1.3million.

 

In addition, thesettlement resolves all other legal issues between NMUI and ABCWUA, includingthe dispute over the sewer fee the ABCWUA charged NMUI for the treatment ofwastewater and the ownership of the return flow credits from that treatedwastewater, as well as all other disputed amounts of the ABCWUA. As part of thesettlement, NMUI agreed to pay $7.0 million to the ABCWUA at the time ofclosing to resolve the sewer fee issue. This amount was accrued prior to theclosing of the Agreement.

 

Net cash proceeds fromsettlement were $53.9 million and the resulting gain, net of directtransactional costs of $0.1 million, was $26.1 million.  Substantially allof the utility plant assets of NMUI were pledged as collateral for $12.3million in first mortgage bonds with an original maturity of 2024 and relatedaccrued interest.  We repaid these bonds in full, including accruedinterest of $0.3 million. The remaining cash proceeds of $41.6 million were usedto pay the balance of liabilities of NMUI, and to pay down our revolving creditfacility. The sale reflects a $107.2 million reduction in assets, offset by areduction in liabilities of $79.5 million, which includes a $69.0 millionreduction in contributions in aid of construction.

 

*Investigations*

 

On May 18, 2005, theEnvironmental Protection Agency (“EPA”) executed a search warrant at ourTexas-based testing laboratory and on July 20, 2006 the laboratoryreceived a subpoena to provide additional records and information to a grandjury. We have cooperated fully with the EPA’s investigation and have providedthe records requested. We remain in close cooperation and coordination withboth Department of Justice (“DOJ”) and EPA’s counsel in an attempt to resolve thematter favorably. In April 2009, we submitted our formal request that theDOJ not pursue criminal sanctions. By letter dated November 10, 2009, thatrequest was granted. Civil action by the government is still possible but wehave not been made aware that any action will be pursued. As a result, noamounts have been accrued related to any possible civil fines, penalties orliabilities.

 

We received a letter datedJanuary 28, 2008 from the California State Water Resources Control BoardOffice of Enforcement (the “Board”). The letter indicated that the Board hasconducted an investigation of the operations of one of our subsidiaries withrespect to various California wastewater treatment facilities which areoperated, but not owned, by the subsidiary. The Board alleges that thesubsidiary has violated certain provisions of the California Water Code and maybe subject to civil administrative liability in excess of $15.0 million, andpossible administrative action against the subsidiary’s status as a contractoperator in California.  Since receipt of the letter, we have conducted aninternal investigation and worked in cooperation with the Board to resolve thematter favorably. We have reached a preliminary settlement, requiring that weimplement an acceptable compliance program valued at $0.5 million and pay finesand penalties of up to $0.75 million, all of which we have accrued.

 

*EnvironmentalMatters*

 

Some of our groundwatersources for our California water utility have been affected by the presence ofcertain groundwater contaminants. These contaminants consist mainly ofchemicals disposed of by various industrial companies in the 1940s and 1950s.In 2001 and 2002, this contamination necessitated the shutdown of a number ofour wells, and we purchased replacement water at a cost substantially higherthan the cost of water pumped from our own wells. Prior to May 2002, thesecosts were recorded as operating expenses and reduced our operating income.

 

In May 2002, asettlement agreement was reached between some of the parties allegedlyresponsible for the contamination (“Cooperating Respondents”) and certain waterentities, including our California water utility. As a result of thissettlement agreement, we have received payments during the last several years,and we continued to receive payments until the completion of remediation. Thesepayments represent the incremental cost of purchasing water over the cost thatwould have been incurred by us to pump water from our wells had they not beenshut down as a result of contamination. The settlement agreement provided forongoing reimbursement of our excess water costs and we bill and collect thisreimbursement monthly. These monthly reimbursements are recorded as a reductionto operating expenses. The reimbursements were $0.07 million and $0.24 millionfor the three months and six months ended June 30, 2010, respectively, and$0.2 million and $0.3 million for the three months and six months ended June 30,2009, respectively.

 

The settlement agreementalso provides for contributions by the Cooperating Respondents for constructionof new wells and interconnections with nearby water sources. Thesecontributions were $0.1 million for the six months ended 

 

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June 30, 2009 andwere recorded as contributions in aid of construction. There were nocontributions for the six months ended June 30, 2010. On April 20,2010 a mediation was conducted to address certain disputes raised by theCooperating Respondents related to activity in executing the May 2002settlement agreement. Through the mediation, the parties resolved alloutstanding issues without additional costs to our California water utility,essentially ending such disputes.

 

*OtherMatters*

 

We are also involved inother routine legal and administrative proceedings arising during the ordinarycourse of business. We believe that the ultimate disposition of such matterswill not have a material adverse effect on our consolidated financial position,results of operations or cash flows.  Any related legal costs are expensedwhen incurred.

 

**CertainContractual Commitments and Indemnities**

 

During the normal courseof business, we have entered into agreements containing indemnities pursuant towhich we may be required to make payments in the future. These indemnities arein connection with facility leases and liabilities and operations andmaintenance and construction contracts entered into by our contract servicesbusinesses. The duration of these indemnities, commitments and guaranteesvaries, and in certain cases, is indefinite. Substantially all of theseindemnities provide no limitation on the maximum potential future payments the Companycould be obligated to make and is not quantifiable. The Company has notrecorded any liability for these indemnities.

 

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**Note 5.        Earnings per Share**

 

The following table is areconciliation of the numerators (income or loss) and denominators (shares)used in both the basic and diluted earnings per share calculations.

 
| * *                                                                      | ** ** | ** ** | **Three  Months Ended** | ** ** |
|-------------------------------------------------------------------------------|------------|------------|-------------------------|------------|
| * *                                                                      | ** ** | ** ** | **June 30,**       | ** ** |
| *(In thousands)*                                                              | ** ** | ** ** | **2010**                | ** ** | ** ** | ** ** | **2009** | ** ** |
|                                                                          |       |       |                    |       |   |   |   |   |
| Numerators—Net  income (loss) applicable to common stockholders:         |       |       |                    |       |   |   |   |   |
| Income  (loss) from continuing operations                                     |       |       | $                       | 57         |   |   |   | $ | (8,063 | ) |
| Less  preferred stock dividends                                               |       |       | (6                      | )          |   |   | (6 | ) |
| Income  (loss) from continuing operations   applicable to common stockholders |       |       | 51                      |       |   |   | (8,069 | ) |
| Income  from discontinued operations, net of tax                              |       |       | -                       |       |   |   | 17,559 |   |
| Income  applicable to common stockholders                                     |       |       | $                       | 51         |   |   |   | $ | 9,490 |   |
|                                                                          |       |       |                    |       |   |   |   |   |
| Denominators—                                                            |       |       |                    |       |   |   |   |   |
| Basic  weighted average common shares outstanding                             |       |       | 27,361                  |       |   |   | 24,608 |   |
| Diluted  weighted average common shares outstanding                           |       |       | 27,486                  |       |   |   | 24,608 |   |

 
|                                                                         | ** ** | ** ** | **Six  Months Ended** |       |
|------------------------------------------------------------------------------|------------|------------|-----------------------|------------|
| * *                                                                     | ** ** | ** ** | **June 30,**     | ** ** |
| *(In thousands)*                                                             | ** ** | ** ** | **2010**              | ** ** | ** ** | ** ** | **2009** | ** ** |
| Numerators—Net  income (loss) applicable to common stockholders:        |       |       |                  |       |   |   |   |   |
| Loss  from continuing operations                                             |       |       | $                     | (2,871     | ) |   |   | $ | (11,468 | ) |
| Less  preferred stock dividends                                              |       |       | (12                   | )          |   |   | (6 | ) |
| Income  (loss) from continuing operations  applicable to common stockholders |       |       | (2,883                | )          |   |   | (11,474 | ) |
| Income  from discontinued operations, net of tax                             |       |       | -                     |       |   |   | 17,731 |   |
| Income  (loss) applicable to common stockholders                             |       |       | $                     | (2,883     | ) |   |   | $ | 6,257 |   |
|                                                                         |       |       |                  |       |   |   |   |   |
| Denominators—                                                           |       |       |                  |       |   |   |   |   |
| Basic  weighted average common shares outstanding                            |       |       | 26,240                |       |   |   | 24,604 |   |
| Diluted  weighted average common shares outstanding                          |       |       | 26,240                |       |   |   | 24,604 |   |

 

TheCompany has $11.8 million of 6.85% fixed-rate convertible subordinatedebentures outstanding as June 30, 2010. The debentures are convertibleinto common stock at any time prior to maturity, unless previously redeemed, ata conversion price of $11.018 per share which totals 1.1 million shares at June 30,2010. At such time as the assumed conversion of the debentures has a dilutiveeffect on earnings per share, the debentures will be included in thecalculation of diluted earnings per share after adjusting net income for theafter-tax effect of the debenture interest expense.

 

**Note 6.       Consolidated Statements of Cash Flows**

 

Thefollowing information supplements the Company’s consolidated statements of cashflows.

 
|                                                                         | ** ** | ** ** | **Six  Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|------------|-----------------------|------------|
|                                                                         | ** ** | ** ** | **June 30,**     | ** ** |
| *(In thousands)*                                                             | ** ** | ** ** | **2010**              | ** ** | **2009** | ** ** |
| Cash  paid during the period for:                                            |       |       |                  |       |   |   |
| Interest                                                                     |       |       | $                     | 4,387      |   | $ | 4,641 |   |
| Income  taxes paid                                                           |       |       | 423                   |       | 422 |   |
| Non-cash  investing and financing activities:                                |       |       |                  |       |   |   |
| Non-cash  contributions in aid of construction and advances for construction |       |       |                  |       |   |   |
| conveyed  to the Company by developers                                       |       |       | 345                   |       | — |   |
|                                                                              |            |            |                       |            |  |  |  |  |

 

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**Note 7.        DividendReinvestment and Direct Stock Purchase Plan (“DRIP / DSPP”)**

 

We have a dividendreinvestment and stock purchase plan that gives common stockholders the optionof receiving their dividends in cash or in common stock at a discount fromprevailing market prices (“DRIP”). The plan also permits existing stockholdersto purchase additional common stock, up to a maximum of $10,000 per month, at adiscount (“DSPP”); new investors may participate in the plan, subject to a $250minimum initial investment. The Company may, at its sole discretion, permitpurchases above the $10,000 stated maximum. The discounts may range from 0% to5%, as determined from time to time by the Company. As of June 30,2010, there are 3.7 million shares authorized for issuance under the plan,of which 0.7 million shares remain available for issuance. However, underthe terms of the Merger Agreement, we have agreed that we will not issue anyadditional shares of common stock or other equivalent interest until theconsummation of the Merger, at which time the plan will be terminated.

 

**Note 8.        SegmentInformation**

 

The Company’s principalbusiness activity is to operate and maintain water and wastewaterinfrastructure.  Through its operatingsubsidiaries, the Company owns 144 systems and operates hundreds more undercontract to cities, utility districts and private companies. The Company hasfour reporting segments. The Company separates its segments first by whether itowns the utility or provides contract services to others. Its owned water andwastewater utilities are referred to as its Utilities operations. In itsfinancial statements the Company reports its Texas Utilities operations as a separatereporting segment because of different economic characteristics. This isprincipally due to the fact that Texas Utilities are under-recovering theircurrent cost of service as the Company has made large investments in theseoperations that are not yet being recovered through the rates it charges. TheCompany’s contract operations are segmented by contract type into those thatare generally larger, stand-alone operations (“O&M Services”) and thosethat are small, full service contracts operated by a common team of personnelresulting in a model that proportions a fractional cost to each client (“TexasMUD Services”).

 

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The following tablepresents information about the operations of each segment for the three andsix-month periods ended June 30, 2010 and 2009:

 

 
| *(In thousands)*                                               | ** ** | ** ** | **Utilities**            | ** ** | ** ** | ** ** | **Texas    Utilities**   | ** ** | ** ** | ** ** | **O&M    Services**  | ** ** | ** ** | ** ** | **Texas  MUD   Services** | ** ** | ** ** | ** ** | **Corp.****(1)** | ** ** | ** ** | ** ** | **Consol-    idated** | ** **               |
|----------------------------------------------------------------|------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|------------|------------|---------------------------|------------|------------|------------|------------------|------------|------------|------------|-----------------------|--------------------------|
| ** **                                                     |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| **Three Months Ended June 30, 2010**                      |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Operating  Revenue                                             |       |       | $                        | 16,940     |       |       |                     | $          | 9,685      |       |                     |       | $          | 10,501     |                      |       |       | $          | 16,757           |       |       |       | $                     | —    |   |   |   | $ | 53,883 |   |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Expenses:                                                      |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Operating  expenses                                            |       |       | 9,915                    |       |       |       | 6,493                    |       |       |       | 10,402                   |       |       |       | 16,976                    |       |       |       | 3,941            |       |       |       | 47,727                |                     |
| Depreciation  and amortization                                 |       |       | 2,082                    |       |       |       | 1,099                    |       |       |       | 153                      |       |       |       | 180                       |       |       |       | 333              |       |       |       | 3,847                 |                     |
| Total  operating expenses                                      |       |       | 11,997                   |       |       |       | 7,592                    |       |       |       | 10,555                   |       |       |       | 17,156                    |       |       |       | 4,274            |       |       |       | 51,574                |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Operating  income (loss)                                       |       |       | 4,943                    |       |       |       | 2,093                    |       |       |       | (54                      | )          |       |       | (399                      | )          |       |       | (4,274           | )          |       |       | 2,309                 |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Interest  expense (2)                                          |       |       | (456                     | )          |       |       | (679                     | )          |       |       | (52                      | )          |       |       | (145                      | )          |       |       | (906             | )          |       |       | (2,238                | )                        |
| Interest  income                                               |       |       | 51                       |       |       |       | 3                        |       |       |       | —    |       |       |       | —     |       |       |       | 1                |       |       |       | 55                    |                     |
| Income  (loss) from continuing  operations before income taxes |       |       | $                        | 4,538      |       |       |                     | $          | 1,417      |       |                     |       | $          | (106       | )                         |       |       | $          | (544             | )          |       |       | $                     | (5,179                   | ) |   |   | $ | 126 |   |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| * *                                                       | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | ** **            | ** **               |
| * *                                                       | ** ** | ** ** | **Utilities**            | ** ** | ** ** | ** ** | **Texas    Utilities**   | ** ** | ** ** | ** ** | **O&M    Services**  | ** ** | ** ** | ** ** | **Texas  MUD   Services** | ** ** | ** ** | ** ** | **Corp.****(1)** | ** ** | ** ** | ** ** | **Consol-    idated** | ** **               |
| **Three Months Ended June 30, 2009**                      |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Operating  Revenue                                             |       |       | $                        | 16,433     |       |       |                     | $          | 9,005      |       |                     |       | $          | 8,981      |                      |       |       | $          | 17,997           |       |       |       | $                     | —    |   |   |   | $ | 52,416 |   |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Expenses:                                                      |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Operating  expenses                                            |       |       | 8,333                    |       |       |       | 5,785                    |       |       |       | 9,007                    |       |       |       | 17,617                    |       |       |       | 9,310            |       |       |       | 50,052                |                     |
| Depreciation  and amortization                                 |       |       | 1,998                    |       |       |       | 1,180                    |       |       |       | 140                      |       |       |       | 199                       |       |       |       | 340              |       |       |       | 3,857                 |                     |
| Impairment  of long-lived assets                               |       |       | —    |       |       |       | —    |       |       |       | —    |       |       |       | 122                       |       |       |       | 7,993            |       |       |       | 8,115                 |                     |
| Total  operating expenses                                      |       |       | 10,331                   |       |       |       | 6,965                    |       |       |       | 9,147                    |       |       |       | 17,938                    |       |       |       | 17,643           |       |       |       | 62,024                |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Operating  income (loss)                                       |       |       | 6,102                    |       |       |       | 2,040                    |       |       |       | (166                     | )          |       |       | 59                        |       |       |       | (17,643          | )          |       |       | (9,608                | )                        |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                  |                     |
| Interest  expense (2)                                          |       |       | (466                     | )          |       |       | (668                     | )          |       |       | (113                     | )          |       |       | (98                       | )          |       |       | (1,630           | )          |       |       | (2,975                | )                        |
| Interest  income                                               |       |       | 26                       |       |       |       | 16                       |       |       |       | 1                        |       |       |       | 2                         |       |       |       | 3                |       |       |       | 48                    |                     |
| Income  (loss) from continuing  operations before income taxes |       |       | $                        | 5,662      |       |       |                     | $          | 1,388      |       |                     |       | $          | (278       | )                         |       |       | $          | (37              | )          |       |       | $                     | (19,270                  | ) |   |   | $ | (12,535 | ) |

 

(1)   Reflects corporate headquarters, general and administrativeexpenses and interest expense, net of interest income charged on intercompanydebt.

 

(2)   Segment interest expense includesinter-segment interest expense or income on related inter-segment payables andreceivables.

 

16

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| *(In thousands)*                                               | ** ** | ** ** | **Utilities**            | ** ** | ** ** | ** ** | **Texas    Utilities**   | ** ** | ** ** | ** ** | **O&M    Services**  | ** ** | ** ** | ** ** | **Texas  MUD   Services** | ** ** | ** ** | ** ** | **Corp.****(1)** | ** ** | ** ** | ** ** | **Consol-  idated** | ** **               |
|----------------------------------------------------------------|------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|------------|------------|--------------------------|------------|------------|------------|---------------------------|------------|------------|------------|------------------|------------|------------|------------|---------------------|--------------------------|
| ** **                                                     |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| ** **                                                     |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| **Six Months Ended June 30, 2010**                        |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Operating  Revenue                                             |       |       | $                        | 30,163     |       |       |                     | $          | 18,360     |       |                     |       | $          | 19,548     |                      |       |       | $          | 32,658           |       |       |       | $                   | —    |   |   |   | $ | 100,729 |   |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Expenses:                                                      |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Operating  expenses                                            |       |       | 18,597                   |       |       |       | 13,064                   |       |       |       | 19,229                   |       |       |       | 32,460                    |       |       |       | 9,689            |       |       |       | 93,039              |                     |
| Depreciation  and amortization                                 |       |       | 4,127                    |       |       |       | 2,279                    |       |       |       | 300                      |       |       |       | 359                       |       |       |       | 649              |       |       |       | 7,714               |                     |
| Total  operating expenses                                      |       |       | 22,724                   |       |       |       | 15,343                   |       |       |       | 19,529                   |       |       |       | 32,819                    |       |       |       | 10,338           |       |       |       | 100,753             |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Operating  income (loss)                                       |       |       | 7,439                    |       |       |       | 3,017                    |       |       |       | 19                       |       |       |       | (161                      | )          |       |       | (10,338          | )          |       |       | (24                 | )                        |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Interest  expense (2)                                          |       |       | (856                     | )          |       |       | (1,303                   | )          |       |       | (76                      | )          |       |       | (228                      | )          |       |       | (2,145           | )          |       |       | (4,608              | )                        |
| Interest  income                                               |       |       | 81                       |       |       |       | 6                        |       |       |       | —    |       |       |       | —     |       |       |       | 1                |       |       |       | 88                  |                     |
| Income  (loss) from continuing  operations before income taxes |       |       | $                        | 6,664      |       |       |                     | $          | 1,720      |       |                     |       | $          | (57        | )                         |       |       | $          | (389             | )          |       |       | $                   | (12,482                  | ) |   |   | $ | (4,544 | ) |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| * *                                                       | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **               | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | ** **          | ** **               |
| * *                                                       | ** ** | ** ** | **Utilities**            | ** ** | ** ** | ** ** | **Texas   Utilities**    | ** ** | ** ** | ** ** | **O&M  Services**    | ** ** | ** ** | ** ** | **Texas MUD   Services**  | ** ** | ** ** | ** ** | **Corp.****(1)** | ** ** | ** ** | ** ** | **Consol-  idated** | ** **               |
| ** **                                                     |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| **Six Months Ended June 30, 2009**                             |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Operating Revenue                                              |       |       | $                        | 29,812     |       |       |                     | $          | 17,596     |       |                     |       | $          | 18,128     |                      |       |       | $          | 36,972           |       |       |       | $                   | —    |   |   |   | $ | 102,508 |   |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Expenses:                                                      |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Operating expenses                                             |       |       | 16,721                   |       |       |       | 10,837                   |       |       |       | 17,884                   |       |       |       | 35,944                    |       |       |       | 18,573           |       |       |       | 99,959              |                     |
| Depreciation and amortization                                  |       |       | 3,951                    |       |       |       | 2,340                    |       |       |       | 273                      |       |       |       | 413                       |       |       |       | 713              |       |       |       | 7,690               |                     |
| Impairment of long-lived assets                                |       |       | —    |       |       |       | —    |       |       |       | —    |       |       |       | 122                       |       |       |       | 7,993            |       |       |       | 8,115               |                     |
| Total operating expenses                                       |       |       | 20,672                   |       |       |       | 13,177                   |       |       |       | 18,157                   |       |       |       | 36,479                    |       |       |       | 27,279           |       |       |       | 115,764             |                     |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Operating income (loss)                                        |       |       | 9,140                    |       |       |       | 4,419                    |       |       |       | (29                      | )          |       |       | 493                       |       |       |       | (27,279          | )          |       |       | (13,256             | )                        |
|                                                           |       |       |                     |       |       |       |                     |       |       |       |                     |       |       |       |                      |       |       |       |             |       |       |       |                |                     |
| Interest expense (2)                                           |       |       | (926                     | )          |       |       | (1,255                   | )          |       |       | (203                     | )          |       |       | (175                      | )          |       |       | (2,303           | )          |       |       | (4,862              | )                        |
| Interest income                                                |       |       | 53                       |       |       |       | 20                       |       |       |       | 2                        |       |       |       | 5                         |       |       |       | 4                |       |       |       | 84                  |                     |
| Income (loss) from continuing operations before income taxes   |       |       | $                        | 8,267      |       |       |                     | $          | 3,184      |       |                     |       | $          | (230       | )                         |       |       | $          | 323              |       |       |       | $                   | (29,578                  | ) |   |   | $ | (18,034 | ) |

 

(1)   Reflects corporate headquarters, general and administrativeexpenses and interest expense, net of interest income charged on intercompanydebt.

 

(2)   Segment interest expense includes inter-segment interest expenseor income on related inter-segment payables and receivables.

 

17

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**Note 9.        SubsequentEvents**

 

MonarchUtilities, Inc. (“Monarch”), a Texas utility company, filed a rateincrease application with the TCEQ in July 2007 which resulted in an allparty settlement on December 12, 2008 which provided for a 2-year phase-inof the settled rates.  Monarch also agreed to provide a market valuationfor and to negotiate the sale of our Blue Mound, Texas; Kyle, Texas; andSouthmayd, Texas water and wastewater assets to the respectivemunicipalities.  Management discussed the sale with officials of eachcity; however, as of June 30, 2010 no terms had been agreed upon.  InApril 2010, Blue Mound and Southmayd provided purchase proposals andmanagement now believes a sale agreement may be reached with Southmayd for therespective assets. The company is preparing a proposal to the city of BlueMound in order to retain ownership of this system after meeting with cityofficials during May 2010. The Southmayd sale will be contingent upon themunicipality raising financing and will require the approval of Monarch’slender and the TCEQ.  Should agreement be reached on the proposalprovided, the sale transaction may be consummated by the end of 2010.

 

 

**ITEM 2.****                             ****MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**SPECIALNOTE ABOUT FORWARD-LOOKING STATEMENTS**

 

Management’s Discussionand Analysis of Financial Condition and Results of Operations (“MD&A”) isintended to help the reader understand the results of operations, financialcondition and cash flows of SouthWest Water Company and is provided as asupplement to, and should be read in conjunction with our consolidatedfinancial statements and the accompanying notes to the financial statementsincluded in this report. This MD&A also contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Allstatements contained herein that are not clearly historical in nature areforward-looking, and the words “anticipate,” “believe,” “belief,” “expect,” “estimate,”“project,” “plan,” “intend,” “continue,” “predict,” “may,” “will,” “should,” “strategy,”“will likely result,” “will likely continue,” and similar expressions aregenerally intended to identify forward-looking statements. Forward-lookingstatements are subject to risks and uncertainties that could cause actualresults to differ materially from our historical experience and our presentexpectations or projections. A detailed discussion of these and other risks anduncertainties that could cause actual results and events to differ materiallyfrom such forward-looking statements is included in the section entitled “Item1A. Risk Factors” in our 2009 Annual Report on Form 10-K. Caution shouldbe taken not to place undue reliance on any such forward-looking statementssince such statements speak only as of the date when made. Other than asrequired by applicable law, we undertake no obligation to publicly update orrevise forward-looking statements whether as a result of new information,future events, or otherwise.

 

**OVERVIEW**

 

SouthWest Water’sprincipal business activity is to operate and maintain water and wastewaterinfrastructure. Through our operating subsidiaries, we own 144 systems andoperate hundreds more under contract to cities, utility districts and privatecompanies. SouthWest Water was incorporated in California in 1954 andreincorporated in Delaware in 1988. We maintain our corporate offices in LosAngeles, California.

 

**Merger Agreement and Long-Term Infrastructure Investment**

 

On March 2, 2010, weentered into an agreement and plan of merger (the “Merger Agreement”) with SWMerger Acquisition Corp. (“Parent”) and SW Merger Sub Corp., a directwholly-owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub are jointlyowned by IIF Subway Investment LP and USA Water Services, LLC, which aresponsored by J.P. Morgan IIF Acquisitions LLC and Water Asset Management,LLC.  Under the terms of the MergerAgreement, all of our outstanding common stock would be converted into a rightto receive $11.00 per share in cash.  On August 6,2010, the Merger Agreement was adopted by an affirmative vote of a majority ofthe combined voting power of our outstanding common stock and Series Apreferred stock as of June 14, 2010, voting together as a singleclass.  The completion of the merger issubject to customary closing conditions, including regulatory notice andapprovals.

 

If all remaining closingconditions are met, we will be the surviving corporation of the merger and awholly owned subsidiary of Parent. Upon completion of the merger, our commonstock will cease to be traded on the NASDAQ Global Select Market and we will nolonger be a publicly held corporation. The Merger Agreement contains restrictions on our operations prior tothe closing of the merger, including restrictions related to capitalexpenditures, the incurrence of debt, acquiring and disposing of assets,entering into material contracts and capital transactions.

 

In connection with theMerger Agreement, we entered into a Securities Purchase Agreement and InvestorRights Agreement (collectively, the “Investment Agreements”).  Pursuant to the Investment Agreements andeffective March 

 

18

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16, 2010, Parent purchased2,700,000 shares of our common stock (the “Purchased Stock”) at a price of$6.00 per share, for an aggregate purchase price of $16.2 million and weincurred related specific incremental transactional costs of $0.1 million.  As permitted under the terms of theInvestment Agreements, the Company applied the proceeds derived from the saleof the Purchased Stock to reduce our revolving line of credit, the borrowingsof which are used for capital expenditures and working capital purposes.  The Investment Agreements entitle Parent toappoint a designee to serve on our board of directors (which right Parent hasnot exercised to date), and also to certain registration rights with respect tothe Purchased Stock in the event of the termination of the Merger Agreement.  The Investment Agreements restrict Parent’sability to sell or otherwise transfer the Purchased Stock prior to the earlierof the consummation or termination of the Merger Agreement.  Except as contemplated by the MergerAgreement, Parent and Merger Sub are also prohibited from acquiring anyadditional shares of our common stock until the termination of the MergerAgreement.

 

As the offering and saleof the Purchased Stock pursuant to the Investment Agreements was not registeredunder the Securities Act of 1933 or applicable state securities laws, thePurchased Stock may not be offered or sold in the United States absentregistration or an applicable exemption from such registration requirements.

 

**Segments**

 

We separate our fourreporting segments first by whether we own the utility or provide contractservices to others. Our owned water and wastewater utilities are referred to asour Utilities operations (“Utilities”). In our financial statements the Companyreports our Texas Utilities operations (“Texas Utilities”) as a separatereporting segment because of different economic characteristics. This isprincipally due to the fact that Texas Utilities are under-recovering theircurrent cost of service as the Company has made large investments in theseoperations that are not yet being recovered through rates it charges. Ourcontract operations are segmented by contract type into those that aregenerally larger, stand-alone operations (“O&M Services”) and those thatare small, full service contracts operated by a common team of personnelresulting in a model that proportions a fractional cost to each client (“TexasMUD Services”).

 

**Utilities** consist of our owned water and wastewaterutilities located in California, Alabama, and Mississippi. In previous periods,the utilities segment included the business activities of our New MexicoUtility (“NMUI”) that was sold on May 8, 2009. The NMUI activities are nowincluded in discontinued operations for all periods presented. See “Note 2 –Dispositions and Impairments” included in Item 1 – “Financial Statements” forthe summary of the historical results of discontinued operations. Residentialcustomers make up the largest component of our Utilities customer base, withthese customers representing approximately 94% of our water and wastewaterconnections. Substantially all of our Utilities customers are metered whichallows us to measure and bill for each customer’s water consumption. Each ofthe operations in this segment has a unique service territory that is subjectto state and federal regulations regarding standards of water quality, safety,environmental and other matters. The rates that we can charge for water andwastewater service include the opportunity to earn a reasonable rate of returnon investments in these utilities. Except for some of our Alabama wastewaterrates which are governed by our service agreements, the rates our utilitiescharge are subject to the approval of state regulatory agencies. Some of thesegovernmental agencies approve a forward looking recovery of costs and someapprove recovery of costs based on a historical test year. Our Utilitiesoperations require ongoing capital investments to maintain and enhance thereliability and quality of the service we provide, as well as the opportunityfor revenue growth from rate increases and new connections.

 

**TexasUtilities** consistsof 123 small, mostly rural systems that are grouped into nine jurisdictionalutilities across Texas and one small system in Oklahoma. Residential customersrepresent approximately 98% of our Texas water and wastewater connections.Substantially all of our Texas Utilities customers are metered which allows usto measure and bill for each customer’s water consumption. These systems arebroadly dispersed geographically. The majority of the systems are organized asone utility, known as Monarch Utilities, with a single tariff. The Monarchsystems, as well as two smaller systems acquired in 2007, were in variousstages of disrepair at the time of acquisition and we continue to spend significantcapital to maintain regulatory compliance and to improve the quality ofservice. We are not yet recovering all of these costs in our rates and, as aresult, the Texas Utilities have a lower rate of return than typically expectedfrom a utility. We intend to actively pursue recovery of these costs in therate setting process. All other aspects of operations of these utilities arethe same as our Utilities operations; therefore, as soon as we are recoveringour costs, including a reasonable rate of return on investment, we expect toaggregate this segment with our Utilities segment.

 

**O&MServices** generallyconsists of operations that are project-specific contracts with cities, publicagencies and private owners. Most contracts are stand-alone operations staffedwith project-specific personnel, with an average contract life of two to threeyears. Under a typical O&M contract, we charge a fee that covers aspecified level of service that includes facility operations and maintenanceand may include other water or wastewater related services. Services aretypically provided evenly throughout the contract period and are billed on amonthly basis. If we provide services beyond the scope of a contract, we billfor the additional services on a time-and-materials basis or negotiate a uniqueprice. These contracts are largely located in California, Colorado, Alabama,Mississippi, and Georgia.

 

19

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**Texas MUDServices** is a fullservice provider of utility services to a large number of small utilities inTexas that are mostly owned by municipal utility districts (“MUD”). A MUD iscreated to provide water supply, wastewater treatment and drainage service toareas where municipal services are not available. We service over 250 MUDclients with a common team of client managers, operators, customer service andbilling personnel. Therefore these contracts are allocated a proportionalamount of each cost center creating a business model that is significantlydifferent from that of O&M Services. Under a typical MUD contract, we billa monthly base fee to provide a specified level of service; usually waterand/or wastewater facility inspections, routine operations, equipmentmaintenance, and utility customer service including meter reading, call center,dispatch, billing and collection services. We bill for any additional servicesprovided beyond the basic contract on a time-and-materials basis as suchservices are rendered. Most contracts provide for an increase in the monthlybase fee as the number of customer connections increases and generally includeinflation adjustments. The majority of our MUD contracts are cancelable with 30to 60 day prior notice by either party, but tend to last for long periodsdue to the close working relationships between the operators and the clients.

 

**Impacts to Results of Operations2010 and 2009**

 

**Utilities & TexasUtilities:**OurUtilities segments’ results of operations are influenced by factors that aresimilar to the industry in general. A more complete understanding of thesefactors can be gained by reviewing this section along with the Risk Factorssection in Part 1, Item 1A, in our 2009 Annual Report on Form 10-K.As we review and discuss performance, the general areas of impact we evaluateare as follows:

 

·                   **Growth related**: Growth in our utilities segments isgenerally characterized by the following drivers: 1) growth in the number ofconnections served within existing utility certified service areas and2) acquisition of new service areas. In our Utilities segment, our largestutility is our California utility which is a substantially built-out systemthat does not generally see much change in connection count. The majority ofour other utilities are in markets that experienced significant new homeconstruction in the past (ranging from 2% to 8% annual growth). We have seenthis significantly decline with growth averaging less than 1% across allsystems throughout 2009 and the first six months of 2010.

 

·                   **Rate related**: Each of our utilities will increaserates from time to time to recover expenses and realize a return on investedcapital as allowed by the regulator or governing contract. Rate cases can takemonths or years to impact results due to the time needed to prepare, presentand ultimately receive approval from the regulator. In each of our utilities,we have a long-term rate strategy that matches our expectation for growth,regulatory change and demand. Our California utility benefited from a 1.5%step-rate increase implemented on January 1, 2010. Our Texas Utilitiesbenefited from step-rate increases at one utility in late 2009 and two in thefirst half of 2010. In Alabama our Shelby County and Riverview wastewaterutilities have contractual agreements with the local government that provide uswith the ability to request rate increases annually. Accordingly, we requestedand received increases in January 2010 of 10.8% at our Shelby Countyutility and an approximate 2.5% increase at our Riverview utility.

 

·                   **Demand related**: The demand for our water, a major driverof our operating results, reflects seasonal rainfall and temperaturefluctuations, which vary not only season to season, but also from year to year.The uniform rate design that regulators require for our utilities can result inunrecovered fixed costs and lower earnings during periods of abnormally lowwater use. This can occur during abnormal weather conditions, such as whentemperatures are cooler than normal, when there is greater than normal precipitation,during mandatory restrictions on water use because of drought, consumerconservation and socio-economic events. Demand related changes often impactboth the revenue of the utility and the cost of production. We experiencedlower demand at our California utility in the first six months of 2010, largelydue to weather and conservation.

 

·                   **Supply related**: The cost of water and relatedcommodities is a major driver of our results. Utilities that pump and purchasewater are subject to changes in operations due to the amount and cost of thatwater. Pumped and purchased water supply changes are typically driven by longerterm climate issues such as extended drought but can also be driven byshort-term maintenance needs. In California the unit cost of water increased inthe first six months of 2010. This is related to the increased price ofMetropolitan Water District and other supply purchases and the increased costof locally produced  water following theMain San Gabriel Watermaster action of raising the rate for replacement waterfor water pumped in excess of water rights held. This caused an additionalincrease in the cost of pumped and purchased water sources. It should be notedthat in California pricing changes from price levels adopted in rate casesreceive balancing account treatment and the cost variance is deferred andcharged or credited to customers in a future period at cost.

 

·                   **Operation & Maintenancerelated**: Ouroperation and maintenance costs include fuel, power, labor, labor benefits,facility costs, and other ordinary costs of producing or treating water. Thesecosts are impacted by compliance with environmental and health safetystandards. They are also typically subject to inflation effects 

 

20

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and while we canfile for recovery after inflation effects are incurred in backward looking ratemaking jurisdictions, we often experience a lag between the time we incur thesecosts and when we receive the rate increase to cover these costs. InCalifornia, which is a forward looking rate making environment, we estimate theimpacts of inflation in our rate filings and must absorb any costs that aredifferent than our estimates.

 

·                   **General & Administrativerelated**: Ourgeneral and administrative costs include management expenses directly incurredby the segment as well as costs for services performed by centralized supportfunctions that are allocated to each segment. These support function costsinclude IT, shared financial services, and environmental health and safety. Weanticipate that in the near term we will continue to experience higher costsdue to the remediation of our material internal control weaknesses (see “Item 4— Controls and Procedures” for a detailed discussion of our material internalcontrol weaknesses).

 

·                   **Other**: Other is reserved for unusual items thatmay impact results from time to time.

 

**O&M Services Segment**: Our O&M Services segment’s resultsof operations are generally influenced by a variety of events. As we review anddiscuss performance, the general areas of impact we evaluate are as follows:

 

·                   **Contract growth: **Growth is generally due to new contracts, additionalproject work under existing contracts and contract price increases. Our primarydriver of contract growth in the first half of 2010 has been from new contractsand expanding the scope of work provided to existing customers.

 

·                   **Lost work: **Lost work is generally driven by lost contracts or areduction in project work for existing contracts. The primary driver in thefirst half of 2010 was reduced project work.

 

·                   **General & administrativerelated**: Ourgeneral and administrative costs include management expenses directly incurredby the segment as well as costs for services performed by centralized supportfunctions that are allocated to each segment. These support function costsinclude IT, shared financial services and environmental health and safety.

 

·                   **Other: **Other is reserved for unusual items that may impactresults from time to time.

 

**Texas MUD Services Segment**: Our Texas MUD Services segment’s resultsof operations are influenced by contract growth or loss and changes in contractscope:

 

·                   **Contract growth:**New contracts, additional project work andcontract price increases are offset by lost contracts, reductions in projectwork, or a reduction in other ancillary services such as new taps andinspection services for new home construction. We lost a number of contracts inthe first half of 2010 compared to the first half of 2009 due to increasedcompetition in our service territories.

 

·                   **General & administrativerelated:** Ourgeneral and administrative costs include expenses directly incurred by thesegment such as management expense as well as costs for services performed bycentralized support functions that are then allocated to each segment. Thesesupport costs include information technology costs, shared financial servicesand environmental health and safety.

 

·                   **Other: **Other is reserved for unusual items that may impactresults from time to time.

 

**Corporate Segment**: Our corporate segment includes costsrelated to executive management, investor relations, human resources, finance,treasury, internal audit, general legal and insurance and public company needs,audit costs, and other expenses generally related to the parent organization.Most of the costs are general and administrative in nature and not subject tomuch variation.  However, in both thefirst half of 2010 and 2009, we had expenses that were not routine to on-goingoperations. In the first half of 2010, costs were primarily impacted byexpenses associated with our proposed Merger Agreement. In the first half of2009, costs were primarily impacted by expenses associated with the restatementof our historical financial results and a write-off of software assets.

 

**DiscontinuedOperations**

 

As discussed in Note 2, “Dispositionsand Impairments” in Part I, Item 1 “Financial Statements”, we completedthe sale of NMUI in May 2009 and the operating results of NMUI areincluded in discontinued operations for the three and six-month periods endedJune 30, 2009.

 

21

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**RESULTSOF OPERATIONS**

 

**Threemonths ended June 30, 2010 Compared to 2009**

 

Consolidated operatingrevenue increased $1.5 million, or 2.8%, to $53.9 million for the three-monthperiod ended June 30, 2010 from $52.4 million for the same period in the prioryear. Consolidated operating expenses decreased $10.5 million, or 16.8%, to$51.6 million for the three-month period ended June 30, 2010 from $62.0 millionfor the 2009 period. Resulting operating income increased $11.9 million to $2.3million for the three-month period ended June 30, 2010, from an operating lossof $9.6 million for the same period in the prior year.  The second quarter of 2010 operating incomeincludes the impact of $1.9 million of costs associated with proposed MergerAgreement and related retention expense, as well as other costs described belowwhile the second quarter of 2009 operating loss includes $5.2 million of costsassociated with the restatement process and $8.0 million of impairment ofCornerstone related assets.

 

 
|                     | ** ** | ** ** | **Three  Months Ended June 30,** | ** **   | ** ** | ** ** | ** **    | ** **              | **Percent  of Revenue** | ** ** |
|--------------------------|------------|------------|----------------------------------|--------------|------------|------------|---------------|-------------------------|-------------------------|------------|
|                     | ** ** | ** ** | **2010**                         | ** **   | **2009**   | ** ** | ** **    | **Increase (Decrease)** | ** **              | ** ** | **2010** | ** ** | **2009** | ** ** |
| *(In thousands)*         |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
|                     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| **Utilities**            |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                |  16,940 |       | $          |  16,433  |                    |                    | $          |  507 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 11,997                           |         | 10,331     |       |          | 1,666                   |                    |       | 70.8% |   | 62.9% |   |
| Operating  Income        |       |       | $                                |  4,943  |       | $          |  6,102   |                    |                    | $          |  (1,159 | ) |   | 29.2% |   | 37.1% |   |
|                     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| **Texas  Utilities**     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                |  9,685  |       | $          |  9,005   |                    |                    | $          |  680 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 7,592                            |         | 6,965      |       |          | 627                     |                    |       | 78.4% |   | 77.3% |   |
| Operating  Income        |       |       | $                                |  2,093  |       | $          |  2,040   |                    |                    | $          |  53 |   |   | 21.6% |   | 22.7% |   |
|                     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| **O&M  Services**    |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                |  10,501 |       | $          |  8,981   |                    |                    | $          |  1,520 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 10,555                           |         | 9,147      |       |          | 1,408                   |                    |       | 100.5% |   | 101.8% |   |
| Operating  Loss          |       |       | $                                |  (54    | )          | $          |  (166    | )                       |                    | $          |  112 |   |   | (0.5%) |   | (1.8%) |   |
|                     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| **Texas  MUD Services**  |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                |  16,757 |       | $          |  17,997  |                    |                    | $          |  (1,240 | ) |   |   |   |   |   |
| Operating  Expense       |       |       | 17,156                           |         | 17,938     |       |          | (782                    | )                       |       | 102.4% |   | 99.7% |   |
| Operating  Income (Loss) |       |       | $                                |  (399   | )          | $          |  59      |                    |                    | $          |  (458 | ) |   | (2.4%) |   | 0.3% |   |
|                     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| **Corporate**            |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                |  — |       | $          |  —  |                    |                    | $          |  — |   |   |   |   |   |   |
| Operating  Expense       |       |       | 4,274                            |         | 17,643     |       |          | (13,369                 | )                       |       |   |   |   |   |
| Operating  Loss          |       |       | $                                |  (4,274 | )          | $          |  (17,643 | )                       |                    | $          |  13,369 |   |   |   |   |   |   |
|                     |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| **Total**                |       |       |                             |         |       |       |          |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                |  53,883 |       | $          |  52,416  |                    |                    | $          |  1,467 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 51,574                           |         | 62,024     |       |          | (10,450                 | )                       |       | 95.7% |   | 118.3% |   |
| Operating  Income (Loss) |       |       | $                                |  2,309  |       | $          |  (9,608  | )                       |                    | $          |  11,917 |   |   | 4.3% |   | (18.3%) |   |

 

22

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***Utilities***

 
|                              |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|-----------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                  |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Three  months ended June 30, 2009 |   |   | $         | 16,433 |   |   |      | $      | 10,331 |   |      |   | $ | 6,102 |   |
| Growth  related                   |   |   | 93        |   |   |   | —    |   |   |   |      |   |
| Rate  related                     |   |   | 299       |   |   |   | —    |   |   |   |      |   |
| Demand  related                   |   |   | (415      | )      |   |   | —    |   |   |   |      |   |
| Balancing  account                |   |   | 530       |   |   |   | 530       |   |   |   |      |   |
| Supply  related                   |   |   | —    |   |   |   | 1,241     |   |   |   |      |   |
| O&M  related                  |   |   | —    |   |   |   | (199      | )      |   |   |      |   |
| Other                             |   |   | —    |   |   |   | 94        |   |   |   |      |   |
| Three  months ended June 30, 2010 |   |   | $         | 16,940 |   |   |      | $      | 11,997 |   |      |   | $ | 4,943 |   |

 

Operating revenueincreased $0.5 million, or 3.1 %, to $16.9 million for three months ended June30, 2010 from $16.4 million for the same period in the prior year.  The net increase was primarily due to thefollowing events:

 

·                   Growth related: A $0.1 million increaseprimarily due to connection growth in Alabama.

 

·                   Rate related: A $0.3 million increase dueto rate increases in California and Alabama, of which approximately $0.2million is due to our California utility implementing a step rate increase inJanuary 2010 and the remainder is due to rate increases in our Alabamautilities.

 

·                   Demand related: A $0.4 million decreaseprimarily due to lower consumption at our California utility resulting fromcooler weather and higher precipitation in the second quarter of 2010 comparedto the second quarter of 2009 and from continuing customer conservationefforts.

 

·                   Balancing account: A $0.5 million increaserelated to balancing account surcharges approved by the CPUC and collected inCalifornia to recover certain deferred water supply costs which is offset bythe same amount in balancing account expenses. No return is earned onsurcharges.

 

Operating expensesincreased $1.7 million, or 16.1%, to $12.0 million for the three months endedJune 30, 2010, from $10.3 million for same period in the prior year.  The net increase was primarily due to thefollowing events:

 

·                   Balancing account: A $0.5 million increasein costs recognized related to the balancing account surcharges describedabove.

 

·                   Supply related: A $1.2 million increaseprimarily due to higher production costs of delivered water in California dueto a change in pricing for Main San Gabriel Basin replacement water.

 

·                   O&M related: A $0.2 million decreaseprimarily due to increased capitalized costs and lower repairs and maintenancecosts.

 

·                   Other: A $0.1 million increase due toproposed Merger related retention expense.

 

As a result of the aboveevents, operating income decreased $1.2 million, to $4.9 million for the threemonths ended June 30, 2010, from $6.1 million for the same period in the prioryear.

 

23

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***Texas Utilities***

 
|                              |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|-----------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                  |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Three  months ended June 30, 2009 |   |   | $         | 9,005  |   |   |      | $      | 6,965  |   |      |   | $ | 2,040 |   |
| Growth  related                   |   |   | 81        |   |   |   | —    |   |   |   |      |   |
| Rate related                      |   |   | 805       |   |   |   | —    |   |   |   |      |   |
| Demand  related                   |   |   | (206      | )      |   |   | —    |   |   |   |      |   |
| O&M  related                  |   |   | —    |   |   |   | 180       |   |   |   |      |   |
| G&A  related                  |   |   | —    |   |   |   | 447       |   |   |   |      |   |
| Three  months ended June 30, 2010 |   |   | $         | 9,685  |   |   |      | $      | 7,592  |   |      |   | $ | 2,093 |   |

 

Operating revenueincreased $0.7 million, or 7.6%, to $9.7 million for three months ended June30, 2010 from $9.0 million for the same period in the prior year. The increasewas primarily due to the following events:

 

·                   Growth related: A $0.1 million increaseprimarily due to an increase in connection count and tap fees.

 

·                   Rate related: A $0.8 million increaseprimarily due to a step-rate increase in rates at three of our utilities.

 

·                   Demand related: A $0.2 million decreasedue to lower volume of delivered water as a result of more normalized weatherpatterns in the second quarter of 2010 compared to hotter and drier climaticconditions in the corresponding period of 2009.

 

Operating expensesincreased $0.6 million, or 9.0%, to $7.6 million for the three months endedJune 30, 2010, from $7.0 million for the same period in the prior year.  The increase was primarily due to thefollowing events:

 

·                   O&M related: A $0.2 million increaseprimarily due to higher repairs and maintenance costs, increases in salariesand wages associated with increased personnel in operations, and higher fueland supply costs, offset by lower expenses associated with retirement of fixedassets.

 

·                   G&A related: A $0.4 million increaseprimarily due to increases in salary and wages associated with increasedfinancial services head-count.

 

As a result of the aboveevents, operating income increased $0.1 million, to $2.1 million for the threemonths ended June 30, 2010, from $2.0 million for the same period in the prioryear.

 

***O&MServices***

 
|                              |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|-----------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                  |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Three  months ended June 30, 2009 |   |   | $         | 8,981  |   |   |      | $      | 9,147  |   |      |   | $ | (166 | ) |
| Contract  growth                  |   |   | 2,008     |   |   |   | 1,250     |   |   |   |      |   |
| Lost  work                        |   |   | (488      | )      |   |   | (309      | )      |   |   |      |   |
| G&A  related                  |   |   | —    |   |   |   | 97        |   |   |   |      |   |
| Other                             |   |   | —    |   |   |   | 370       |   |   |   |      |   |
| Three  months ended June 30, 2010 |   |   | $         | 10,501 |   |   |      | $      | 10,555 |   |      |   | $ | (54 | ) |

 

Operating revenueincreased $1.5 million, or 16.9%, to $10.5 million for the three months endedJune 30, 2010 compared to $9.0 million for the same period in the prior year:

 

·                   Contract growth: A $2.0 million increasedue to $0.9 million from new contracts in California and Alabama and $1.1million from increased project work primarily in Colorado and California.

 

·                   Lost work: A $0.5 million decrease due todecreased project work in Mississippi and lost contracts in California.

 

Operating expensesincreased $1.4 million, or 15.4%, to $10.6 million for the three months endedJune 30, 2010, from $9.1 million for the same period in the prior year:

 

24

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·                   Contract growth: A $1.3 million increasedue to new contracts and project work identified above.

 

·                   Lost work: A $0.3 million decrease due tolost contracts and reduced project work.

 

·                   G&A related: A $0.1 million increaseprimarily due to increase in insurance costs.

 

·                   Other: A $0.4 million increase due tolegal, severance, and proposed Merger related retention expense.

 

As a result of the aboveevents, operating loss was $0.1 million for the three months ended June 30,2010 compared to an operating loss of $0.2 million for the three months endedJune 30, 2009.

 

***TexasMUD Services***

 
|                              |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|-----------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                  |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Three  months ended June 30, 2009 |   |   | $         | 17,997 |   |   |      | $      | 17,938 |   |      |   | $ | 59 |   |
| Contract  growth                  |   |   | (1,240    | )      |   |   | (621      | )      |   |   |      |   |
| G&A  related                  |   |   | —    |   |   |   | (796      | )      |   |   |      |   |
| Other                             |   |   | —    |   |   |   | 635       |   |   |   |      |   |
| Three  months ended June 30, 2010 |   |   | $         | 16,757 |   |   |      | $      | 17,156 |   |      |   | $ | (399 | ) |

 

Operating revenuedecreased $1.2 million, or 6.9%, to $16.8 million for three months ended June30, 2010 from $18.0 million for the same period in the prior year. The decreasewas primarily due to the following:

 

·                   Contract growth: A $1.2 million decreasein revenue due to $0.9 million from lost contracts and $0.3 million primarilyrelated to a reduction in pass-through revenue from materials purchased forclients.

 

Operating expensesdecreased $0.8 million, or 4.4%, to $17.2 million for the three months endedJune 30, 2010, from $17.9 million for the same period in the prior year.  The net decrease was primarily due to thefollowing events:

 

·                   Contract growth: A $0.6 million decreasedue to $0.3 million from lost contracts and $0.3 million primarily related to areduction in pass-through costs from materials purchased for clients.

 

·                   G&A related: A $0.8 million decrease,primarily due to savings and efficiency gains in general and administrativecosts, particularly in the customer service center.

 

·                   Other: A $0.6 million change primarily dueto a gain on sale of our environmental testing laboratory that was realized inthe second quarter of 2009.

 

As a result of the aboveevents, operating income decreased $0.5 million to an operating loss of $0.4million for the three months ended June 30, 2010, compared to an operatingincome of $0.1 million in the same period of the prior year.

 

***Corporate***

 

Operating expensesdecreased $13.4 million, or 75.8%, to $4.3 million for the three months endedJune 30, 2010, from $17.6 million for the same period in the prior year.

 

·                   General & administrative related:A $1.3 million decrease primarily due to lower salaries and wages expenses andlower bonus accruals.

 

·                   Other: A $12.1 million decrease primarilydriven by a reduction of $5.2 million related to the financial restatementexpenses in the second quarter of 2009 and $8.0 million related to a write-offof Cornerstone assets, offset by an increase of $1.5 million in costsassociated with the proposed Merger Agreement and related retention expense.

 

**Other Income (Expense)**

 

25

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Aggregate other expensesdecreased $0.7 million, or 25.2% to $2.2 million for the three months endedJune 30, 2010, compared to $2.9 million for the same period in the prior yearas follows:

 
|              | ** ** | ** ** | **Three  Months Ended June 30,** | ** ** | ** ** | ** ** | ** ** |
|-------------------|------------|------------|----------------------------------|------------|------------|------------|------------|
|              | ** ** | ** ** | **2010**                         | ** ** | **2009**   | ** ** | ** ** | **Change** | ** ** |
| Interest  expense |       |       | $                                | (2,238     | )          | $          | (2,975     | ) |   | $ | 737 |   |
| Interest  income  |       |       | 55                               |       | 48         |       |       | 7 |   |
| Total             |       |       | $                                | (2,183     | )          | $          | (2,927     | ) |   | $ | 744 |   |

 

Interest expense decreasedby $0.7 million, or 24.7%, to $2.2 million for the three months ended June 30,2010 from $3.0 million for the same period during the prior year as a result ofthe write-off of debt financing fees of $0.4 million in 2009 and a decrease inthe average interest cost of $0.3 million.

 

**Provisionfor Income Taxes**

 

Our effective consolidatedincome tax rate on continuing operations was 54.8% for the three months endedJune 30, 2010 compared to a benefit of 35.7% for the same period in 2009. Thevariance of our effective tax rate from expected statutory rates reflects theeffects of Texas franchise tax on the small amount of net income in 2010 andnon-recurring adjustments in both periods.

 

**Income from DiscontinuedOperations**

 

Income from discontinuedoperations, net of tax, of $17.6 million during the three month period ended June 30,2009 reflects primarily the $16.7 million gain on sale of our New Mexicoutility, net of taxes. The sale reflects a $107.2 million reduction in assets,offset by reduction in liabilities which include $69.0 million of contributionsin aid of construction.

 

26

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**Sixmonths ended June 30, 2010 Compared to 2009**

 

Consolidated operatingrevenue decreased $1.8 million, or 1.7%, to $100.7 million for the six-monthperiod ended June 30, 2010 from $102.5 million for the same period in theprior year. Consolidated operating expenses decreased $15.0 million, or 13.0%,to $100.8 million for the six-month period ended June 30, 2010 from $115.8million for the 2009 period. Resulting operating income increased $13.2 millionto break-even for the six-month period ended June 30, 2010, from anoperating loss of $13.3 million for the same period in the prior year.  The operating loss for the six-month periodended June 30, 2010 includes the impact of $3.1 million of costsassociated with the proposed Merger Agreement and related retention expense, aswell as other items described below while the 2009 operating loss includes$10.6 million of costs associated with the restatement process and $8.0 millionof impairment of assets related to the Cornerstone project as well as otheritems described below.

 

 
|                     | ** ** | ** ** | **Six  Months Ended June 30,** | ** ** | ** ** | ** ** | ** ** | ** **              | **Percent  of Revenue** | ** ** |
|--------------------------|------------|------------|-------------------------------------|------------|------------|------------|------------|-------------------------|-------------------------|------------|
|                     | ** ** | ** ** | **2010**                            | ** ** | **2009**   | ** ** | ** ** | **Increase (Decrease)** | ** **              | ** ** | **2010** | ** ** | **2009** | ** ** |
| *(In thousands)*         |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
|                     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| **Utilities**            |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                   | 30,163     |       | $          | 29,812     |                    |                    | $          | 351 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 22,724                              |       | 20,672     |       |       | 2,052                   |                    |       | 75.3% |   | 69.3% |   |
| Operating  Income        |       |       | $                                   | 7,439      |       | $          | 9,140      |                    |                    | $          | (1,701 | ) |   | 24.7% |   | 30.7% |   |
|                     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| **Texas Utilities**      |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                   | 18,360     |       | $          | 17,596     |                    |                    | $          | 764 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 15,343                              |       | 13,177     |       |       | 2,166                   |                    |       | 83.6% |   | 74.9% |   |
| Operating  Income        |       |       | $                                   | 3,017      |       | $          | 4,419      |                    |                    | $          | (1,402 | ) |   | 16.4% |   | 25.1% |   |
|                     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| **O&M Services**     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                   | 19,548     |       | $          | 18,128     |                    |                    | $          | 1,420 |   |   |   |   |   |   |
| Operating  Expense       |       |       | 19,529                              |       | 18,157     |       |       | 1,372                   |                    |       | 99.9% |   | 100.2% |   |
| Operating  Income (Loss) |       |       | $                                   | 19         |       | $          | (29        | )                       |                    | $          | 48 |   |   | 0.1% |   | (0.2%) |   |
|                     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| **Texas MUD Services**   |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                   | 32,658     |       | $          | 36,972     |                    |                    | $          | (4,314 | ) |   |   |   |   |   |
| Operating  Expense       |       |       | 32,819                              |       | 36,479     |       |       | (3,660                  | )                       |       | 100.5% |   | 98.7% |   |
| Operating  Income (Loss) |       |       | $                                   | (161       | )          | $          | 493        |                    |                    | $          | (654 | ) |   | (0.5%) |   | 1.3% |   |
|                     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| **Corporate**            |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                   | —     |       | $          | —     |                    |                    | $          | — |   |   |   |   |   |   |
| Operating  Expense       |       |       | 10,338                              |       | 27,279     |       |       | (16,941                 | )                       |       |   |   |   |   |
| Operating  Income (Loss) |       |       | $                                   | (10,338    | )          | $          | (27,279    | )                       |                    | $          | 16,941 |   |   |   |   |   |   |
|                     |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| **Total**                |       |       |                                |       |       |       |       |                    |                    |       |   |   |   |   |
| Operating  Revenue       |       |       | $                                   | 100,729    |       | $          | 102,508    |                    |                    | $          | (1,779 | ) |   |   |   |   |   |
| Operating  Expense       |       |       | 100,753                             |       | 115,764    |       |       | (15,011                 | )                       |       | 100.0% |   | 112.9% |   |
| Operating  Loss          |       |       | $                                   | (24        | )          | $          | (13,256    | )                       |                    | $          | 13,232 |   |   | (0.0%) |   | (12.9%) |   |

 

27

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***Utilities***

 
|                                 |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|--------------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                     |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Six  months ended June 30, 2009 |   |   | $         | 29,812 |   |   |      | $      | 20,672 |   |      |   | $ | 9,140 |   |
| Growth  related                      |   |   | 93        |   |   |   | —    |   |   |   |      |   |
| Rate  related                        |   |   | 561       |   |   |   | —    |   |   |   |      |   |
| Demand  related                      |   |   | (979      | )      |   |   | —    |   |   |   |      |   |
| Balancing  account                   |   |   | 676       |   |   |   | 676       |   |   |   |      |   |
| Supply  related                      |   |   | —    |   |   |   | 795       |   |   |   |      |   |
| O&M  related                     |   |   | —    |   |   |   | 74        |   |   |   |      |   |
| G&A  related                     |   |   | —    |   |   |   | 238       |   |   |   |      |   |
| Other                                |   |   | —    |   |   |   | 269       |   |   |   |      |   |
| Six  months ended June 30, 2010 |   |   | $         | 30,163 |   |   |      | $      | 22,724 |   |      |   | $ | 7,439 |   |

 

Operating revenueincreased $0.4 million, or 1.2 %, to $30.2 million for the six months ended June 30,2010 from $29.8 million for the same period in the prior year.  The net increase was primarily due to thefollowing events:

 

·                   Growth related: A $0.1 million increase primarilydue to connection growth in Alabama.

 

·                   Rate related: A $0.6 million increase dueto rate increases in California and Alabama, of which approximately half is dueto our California utility implementing a step rate increase inJanuary 2010 and the remainder is primarily due to rate increases in ourAlabama utilities.

 

·                   Demand related: A $1.0 million decreaseprimarily due to lower consumption at our California utility resulting fromcooler temperatures and higher precipitation in the first half of 2010 comparedto the first half of 2009 and from continuing customer conservation efforts.

 

·                   Balancing account: A $0.7 million increaserelated to balancing account surcharges approved by the CPUC and collected inCalifornia to recover certain deferred water supply costs which is offset bythe same amount in balance account expenses. No return is earned on surcharges.

 

Operating expensesincreased $2.1 million, or 9.9%, to $22.7 million for the six months ended June 30,2010, from $20.7 million for same period in the prior year.  The increase was primarily due to thefollowing events:

 

·                   Balancing account: A $0.7 million increasein costs recognized related to the balancing account surcharges describedabove.

 

·                   Supply related: A $0.8 million increaseprimarily due to higher production costs of delivered water in Californiaoffset by lower volume of delivered water in California.

 

·                   O&M related: A $0.1 million increaseprimarily due to an increase in depreciation expense resulting from capitaladditions offset by increase in capitalized costs.

 

·                   G&A related: A $0.2 million increaseprimarily due to an increases in salaries and wages and insurance expenses.

 

·                   Other: A $0.3 million increase due tolegal fees, severance expenses, and proposed Merger related retention expense.

 

As a result of the aboveevents, operating income decreased $1.7 million, to $7.4 million for the sixmonths ended June 30, 2010, from $9.1 million for the same period in theprior year.

 

28

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***Texas Utilities***

 
|                                 |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|--------------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                     |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Six  months ended June 30, 2009 |   |   | $         | 17,596 |   |   |      | $      | 13,177 |   |      |   | $ | 4,419 |   |
| Growth  related                      |   |   | 196       |   |   |   | —    |   |   |   |      |   |
| Rate  related                        |   |   | 884       |   |   |   | —    |   |   |   |      |   |
| Demand  related                      |   |   | (316)     |   |   |   | —    |   |   |   |      |   |
| O&M  related                     |   |   | —    |   |   |   | 1,120     |   |   |   |      |   |
| G&A  related                     |   |   | —    |   |   |   | 1,046     |   |   |   |      |   |
| Six months  ended June 30, 2010 |   |   | $         | 18,360 |   |   |      | $      | 15,343 |   |      |   | $ | 3,017 |   |

 

Operating revenueincreased $0.8 million, or 4.3%, to $18.4 million for six months ended June 30,2010 from $17.6 million for the same period in the prior year. The net increasewas primarily due to the following events:

 

·                   Growth related: A $0.2 million increaseprimarily due to an increase in connection count and tap fees.

 

·                   Rate related: A $0.9 million increaseprimarily due to a step-rate increase in rates at three of our utilities.

 

·                   Demand related: A $0.3 million decreasedue to lower volume of delivered water as a result of more normalized weatherpatterns in the first half of 2010 compared to hotter and drier climaticconditions in the corresponding period of 2009.

 

Operating expensesincreased $2.2 million, or 16.4%, to $15.3 million for the six months ended June 30,2010, from $13.2 million for the same period in the prior year.  The increase was primarily due to thefollowing events:

 

·                   O&M related: A $1.1 million increaseprimarily due to higher repairs and maintenance costs, increases in salariesand wages associated with increased personnel in operations, and higher fueland supply costs.

 

·                   G&A related: A $1.0 million increasedue to increases in salary and wages associated with increased financialservices head-count as well as information technology costs and professionalfees.

 

As a result of the aboveevents, operating income decreased $1.4 million, to $3.0 million for the six monthsended June 30, 2010, from $4.4 million for the same period in the prioryear.

 

***O&M Services***

 
|                                 |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|--------------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                     |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Six  months ended June 30, 2009 |   |   | $         | 18,128 |   |   |      | $      | 18,157 |   |      |   | $ | (29 | ) |
| Contract  growth                     |   |   | 2,596     |   |   |   | 1,676     |   |   |   |      |   |
| Lost  work                           |   |   | (1,176    | )      |   |   | (675      | )      |   |   |      |   |
| G&A  related                     |   |   | —    |   |   |   | (155      | )      |   |   |      |   |
| Other                                |   |   | —    |   |   |   | 526       |   |   |   |      |   |
| Six  months ended June 30, 2010 |   |   | $         | 19,548 |   |   |      | $      | 19,529 |   |      |   | $ | 19 |   |

 

Operating revenueincreased $1.4 million to $19.5 million for the six months ended June 30,2010 compared to $18.1 million for the same period in the prior year:

 

·                   Contract growth: A $2.6 million increasedue to $1.1 million from new contracts in California and Alabama and $1.5million primarily from increased project work in Colorado and California.

 

·                   Lost work: A $1.2 million decrease due todecreased project work and lost contracts.

 

Operating expensesincreased $1.4 million, or 7.6%, to $19.5 million for the six months ended June 30,2010, from $18.2 million for the same period in the prior year.  The net increase was primarily due to thefollowing events:

 

·                   Contract growth: A $1.7 million increasedue to new contracts and project work identified above.

 

·                   Lost work: A $0.7 million decrease due tolost contracts and reduced project work.

 

29

----

 

·                   G&A related: A $0.2 million decreasedue to lower salary and wages, associated with lower head-count, and insuranceexpenses.

 

·                   Other: A $0.5 million increase related tolegal, severance, and proposed Merger related retention expense.

 

As a result of the aboveevents, operating income was essentially break-even for both the six monthsended June 30, 2010 and the six months ended June 30, 2009.

 

***Texas MUD Services***

 
|                                 |   |   | Operating |   |   |   | Operating |   |   |   | Operating |   |
|--------------------------------------|--------|--------|-----------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in thousands)*                     |   |   | Revenue   |   |   |   | Expense   |   |   |   | Income    |   |
| Six  months ended June 30, 2009 |   |   | $         | 36,972 |   |   |      | $      | 36,479 |   |      |   | $ | 493 |   |
| Contract  growth                     |   |   | (4,314    | )      |   |   | (1,989    | )      |   |   |      |   |
| G&A  related                     |   |   | —    |   |   |   | (2,538    | )      |   |   |      |   |
| Other                                |   |   | —    |   |   |   | 867       |   |   |   |      |   |
| Six  months ended June 30, 2010 |   |   | $         | 32,658 |   |   |      | $      | 32,819 |   |      |   | $ | (161 | ) |

 

Operating revenuedecreased $4.3 million, or 11.7%, to $32.7 million for six months ended June 30,2010 from $37.0 million for the same period in the prior year. The decrease wasprimarily due to the following:

 

·                   Contract growth: A $4.3 million decreasein revenue due to $2.8 million from lost contracts, $1.0 million primarilyrelated to a reduction in pass-through revenue from materials purchased forclients , and $0.5 million related to the sale of our environmental testinglaboratory on April 1, 2009, and.

 

Operating expensesdecreased $3.7 million, or 10.0%, to $32.8 million for the six months ended June 30,2010, from $36.5 million for the same period in the prior year.  The net decrease was primarily due to thefollowing events:

 

·                   Contract growth: A $2.0 million decreasedue to $0.9 million from lost contracts, $0.2 million due to the sale of ourenvironmental testing laboratory, and $0.9 million primarily related to areduction in pass-through costs from materials purchased for clients.

 

·                   G&A related: A $2.5 million decrease,primarily due to decreases in salary and wages expenses, associated with lowerhead-count, and other savings and efficiency gains in general andadministrative costs, particularly in the customer service center.

 

·                   Other: A $0.9 million increase due to gainon sale of our environmental testing laboratory that was realized in the secondquarter of 2009, legal and severance expenses, and proposed Merger relatedretention expense.

 

As a result of the aboveevents, operating income decreased $0.7 million to a loss of $0.2 million forthe six months ended June 30, 2010, compared to $0.5 million of operatingincome in the same period of the prior year.

 

***Corporate***

 

Operating expensesdecreased $16.9 million, or 62.1%, to $10.3 million for the six months ended June 30,2010, from $27.3 million for the same period in the prior year.

 

·                   General & administrative related:A $1.0 million decrease primarily due to decreases in salaries and wages andlower bonus accruals, and stock based compensation expense offset by increasesin professional fees, related to the preparation and audit of our annualfinancial statements and internal control remediation efforts.

 

·                   Other: A $16.0 million decrease primarilydriven by a reduction of $10.6 million related to the financial restatementexpenses and $8.0 million related to a write-off of Cornerstone assets offsetby a $2.7 million increase in costs associated with the proposed MergerAgreement.

 

30

----

 

**OtherIncome (Expense)**

 

Aggregate other expensesdecreased $0.3 million, or 5.4% to $4.5 million for the six months ended June 30,2010, compared to $4.8 million for the same period in the prior year asfollows:

 

***Other income (expense)***

 
|              | ** ** | ** ** | **Six  Months Ended June 30,** | ** ** | ** ** | ** ** | ** ** |
|-------------------|------------|------------|-------------------------------------|------------|------------|------------|------------|
|              | ** ** | ** ** | **2010**                            | ** ** | **2009**   | ** ** | ** ** | **Change** | ** ** |
| Interest  expense |       |       | $                                   | (4,608     | )          | $          | (4,862     | ) |   | $ | 254 |   |
| Interest  income  |       |       | 88                                  |       | 84         |       |       | 4 |   |
| Total             |       |       | $                                   | (4,520     | )          | $          | (4,778     | ) |   | $ | 258 |   |

 

 

Interest expense decreasedby $0.3 million, or 5.2%, to $4.6 million for the six months ended June 30,2010 from $4.9 million for the same period during the prior year as a result ofa reduction in the average interest-bearing debt outstanding to $149.3 millionin 2010 from $171.8 million in 2009, offset by an increase in the effectiveinterest rate to 6.2% in the first two quarters of 2010 from 5.7% in the sameperiod in the prior year.

 

The increase in theeffective interest rate in 2010 over 2009 reflects the increased borrowingmargins on our credit facility due to the 2009 credit facility amendmentsdiscussed in the *“Financial Condition”* sectionbelow.

 

**Provisionfor Income Taxes**

 

Our effective consolidatedincome tax rate on continuing operations was a benefit of 36.8% for the sixmonths ended June 30, 2010 compared to a benefit of 36.4% for the sameperiod in 2009. The slight variance of our effective tax rate from expectedstatutory rates reflects non-recurring adjustments in both periods.

 

**Income from DiscontinuedOperations**

 

Income from discontinuedoperations of $17.7 million during the six month period ended June 30,2009 reflects primarily the $16.7 million gain on sale of our New Mexico utility,net of tax. The sale reflects a $107.2 million reduction in assets, offset by areduction in liabilities including a $69.0 million reduction in contributionsin aid of construction.

 

**RECENTACCOUNTING PRONOUNCEMENTS**

 

See the discussions underthe caption “Recent Accounting Pronouncements” contained in Note 1 to theconsolidated financial statements included in Part I, Item 1 of thisreport.

 

**LIQUIDITYAND CAPITAL RESOURCES**

 

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

 

·                   Generate sufficient operating cash flowsto service our debt and tax obligations, fund capital improvements and organicgrowth, and pay dividends to our stockholders;

 

·                   Utilize our credit facility for majorcapital improvements and to manage seasonal cash needs;

 

·                   Obtain external financing for majoracquisitions; and

 

·                   Maintain approximately equal levels ofdebt and equity consistent with the investor-owned water utility industry.

 

31

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Our statements of cashflows are summarized as follows:

 
|                                              | ** ** | ** ** | **Six  Months Ended June 30,** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|------------|-------------------------------------|------------|------------|------------|------------|
|                                              | ** ** | ** ** | **2010**                            | ** ** | **2009**   | ** ** | ** ** | **Change** | ** ** |
| Net  cash provided by (used in):                  |       |       |                                |       |       |       |       |   |   |
| Continuing  operations:                           |       |       |                                |       |       |       |       |   |   |
| Operating  activities                             |       |       | $                                   | 627        |       | $          | 3,423      |   |   | $ | (2,796 | ) |
| Investing  activities                             |       |       | (5,944                              | )          | 48,255     |       |       | (54,199 | ) |
| Financing  activities                             |       |       | 4,624                               |       | (41,177    | )          |       | 45,801 |   |
| Total  continuing operations                      |       |       | (693                                | )          | 10,501     |       |       | (11,194 | ) |
| Discontinued  operations:                         |       |       |                                |       |       |       |       |   |   |
| Operating  activities                             |       |       | —                              |       | (8,095     | )          |       | 8,095 |   |
| Investing  activities                             |       |       | —                              |       | (291       | )          |       | 291 |   |
| Financing  activities                             |       |       | —                              |       | (1,647     | )          |       | 1,647 |   |
| Total  discontinued operations                    |       |       | —                              |       | (10,033    | )          |       | 10,033 |   |
| Increase  (decrease) in cash and cash equivalents |       |       | $                                   | (693       | )          | $          | 468        |   |   | $ | (1,161 | ) |

 

Revolving lines of creditwere primarily used to fund our investing activities and, to a lesser extent,to fund operations. Additional borrowing availability under our revolvingcredit facility was $40.0 million as of June 30, 2010.

 

**Cash Flows from OperatingActivities of Continuing Operations.**Net cash provided by operating activities was $0.6million for the six months ended June 30, 2010 as compared to $3.4 millionfor the same period last year. Operational aspects of our businesses thataffected working capital in 2010 versus 2009 are highlighted below:

 

·                   A fluctuation of $9.1 million from netincome in 2009 of $6.2 million to a 2010 net loss of $2.9 million, offset by a$4.9 million fluctuation in non-cash adjustments from 2009 to 2010.

 

·                   $1.4 million increase in cash provided byworking capital and other balance sheet account management, primarily relatedto the timing of payments for other liabilities.

 

**Cash Flows from InvestingActivities of Continuing Operations.**Cash used in investing activities representingpurchases on property, plant and equipment, principally within our utilitysegments, decreased by $0.2 million, or 4.9%, compared to the prior yearperiod. This excludes the proceeds from the NMUI sale of $54.4 million in thesix months ended June 30, 2009.

 

**Cash Flows from FinancingActivities of Continuing Operations.**During the six months ended June 30, 2010, wereduced our total borrowing and financed our capital expenditures, workingcapital and dividend payments.

 

·                   We received $16.1 million from theissuance of 2,700,000 shares of common stock sold through the InvestmentAgreements in connection with the Merger Agreement and used the proceeds fromthe stock sale to pay down our revolving credit facility by $16.2 million. In2009 we used the proceeds from the sale of NMUI to pay down $55.6 million ofdebt.

 

·                   We borrowed $6.7 million under ourrevolving line of credit, a reduction of $21.3 million in borrowings comparedto comparable period last year;

 

·                   Borrowings were used for the purchase ofproperty, plant and equipment, as well as working capital needs, includingpaying $1.4 million in dividends during the first quarter of 2010.

 

32

----

 

 

**CONTRACTUALOBLIGATIONS**

 

The following tablesummarizes our known contractual obligations to make future cash payments as ofJune 30, 2010, as well as an estimate of the periods during which thesepayments are expected to be made.

 
|                                            | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** | **Years  Ended December 31,** | ** ** |
|-------------------------------------------------|------------|------------|------------|------------|---------------|------------|------------------------------------|------------|
|                                            | ** ** | ** ** | ** ** | ** ** | **Remainder** | ** ** | **2011**                           | ** ** | **2013** | ** ** | **2015** | ** ** |
|                                            | ** ** | ** ** | ** ** | ** ** | **of**        | ** ** | **and**                            | ** ** | **and** | ** ** | **and** | ** ** |
| *(In thousands)*                                | ** ** | ** ** | **Total**  | ** ** | **2010**      | ** ** | **2012**                           | ** ** | **2014** | ** ** | **Beyond** | ** ** |
| Long-term  debt:                                |       |       |       |       |          |       |                               |       |   |   |   |   |
| Principal  payment obligations (1)              |       |       | $          | 144,170    |          | $          | 1,224                              |       | $ | 4,063 |   | $ | 67,100 |   | $ | 71,783 |   |
| Interest  payments on fixed rate debt (2)       |       |       | 70,301     |       | 2,592         |       | 10,047                             |       | 9,664 |   | 47,998 |   |
| Interest  payments on bank line of credit (3)   |       |       | 6,564      |       | 1,250         |       | 5,001                              |       | 313 |   | - |   |
| Repayment  of advances for construction (4)     |       |       | 9,531      |       | 296           |       | 1,269                              |       | 764 |   | 7,202 |   |
| Water  purchase commitment (5)                  |       |       | 115,304    |       | 594           |       | 7,782                              |       | 9,450 |   | 97,478 |   |
| Operating  lease obligations (6)                |       |       | 19,628     |       | 2,442         |       | 7,236                              |       | 3,221 |   | 6,729 |   |
| Total  obligations as of June 30, 2010 (7) |       |       | $          | 365,498    |          | $          | 8,399                              |       | $ | 35,399 |   | $ | 90,511 |   | $ | 231,190 |   |

 

----

| (1)    |   | Excludes interest  payments, which are described in the following notes. The terms of the  long-term debt are more fully described in the notes to the consolidated  financial statements included in this report and in our 2009 Annual Report on  Form 10-K.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (2)    |   | Reflects scheduled  interest payments on all fixed rate debt obligations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (3)    |   | As of June 30,  2010, there was $65.0 million of borrowings outstanding under our $110.0  million bank line of credit which is scheduled for repayment in 2013. The  line of credit bears interest at variable rates and the principal amount  outstanding will vary from time to time in future periods. As a result, the  amount of future interest payments is uncertain. Borrowings bear interest, at  our option, based on a margin a) over the LIBOR rate, or b) over the prime  rate. The margins also vary based on our consolidated debt-to-capitalization  ratio. The interest obligations reflected in the table were computed based on  $65.0 million of borrowings outstanding at the 3.85% weighted average annual  interest rate in effect on our bank line of credit borrowings as of  June 30, 2010. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (4)    |   | Advances for  construction are non-interest bearing. Our repayment assumptions on certain  obligations are based upon forecasted connection growth. If forecasted  connections do not materialize, the related payments are not due and  corresponding amounts become contributed property.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (5)    |   | Reflects the minimum  annual contractual commitments in the Texas Utilities segment to purchase  water through 2037. The amount is subject to increases in future periods for  production costs increases and may also increase, but not decrease, if  average actual usage exceeds a specified amount.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (6)    |   | As of June 30,  2010, leased office commitment is $15.6 million of which $1.3 million is  payable during the remainder of 2010. The vehicles and machinery lease  commitment at June 30, 2010 is $4.0 million of which $1.1 million is  payable during the remainder of 2010.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            |
| (7)    |   | Excludes preferred stock  dividend obligations. Preferred stockholders are entitled to receive annual  dividends of $2.625 per share and there are 9,156 shares of preferred stock  outstanding at June 30, 2010. The preferred stock is redeemable by the  Company at any time for $52.00 per share and, from time to time, we have  elected to repurchase shares offered to us by preferred stockholders at  prices less than $52.00 per share.                                                                                                                                                                                                                                                                                                                                                                          |

 

**FINANCIALCONDITION**

 

We believe our existingsources of liquidity are adequate to meet our anticipated needs in the comingyear. Our business is capital intensive, requiring significant resources tofund operating expenses, construction expenditures, and interest and dividendpayments. During 2010 and in subsequent years, we may from time to time satisfythese requirements with a combination of cash generated by operations, borrowingsunder our revolving credit facility or funds from the capital markets asconditions allow. We expect that borrowing capacity under our revolving creditfacility will continue to be available to manage working capital during thoseperiods.

 

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At June 30, 2010, wehad working capital of $5.0 million compared to working capital of $5.2 millionat December 31, 2009.

 

We have access to $110.0million in financing under our credit facility that expires February 15,2013. A total of nine banks participate in the facility. As of June 30,2010, we had $40.0 million of borrowing capacity available under our creditfacility. The impact of the prior period restatement on our retained earnings,combined with the additional borrowings on the facility during 2008, and thelack of timeliness of SEC financial filings created a number of defaults underour credit facility agreement at March 31, 2009. The defaults were curedwith several amendments to the credit facility agreement dated fromNovember 28, 2008 through July 31, 2009. Under the amendments, ourcredit facility was reduced from $150.0 million to its current availability of$110.0 million. The facility was also secured with certain assets of the Companyand our borrowing margins were significantly increased. As of June 30,2010 our debt-to-capitalization ratio is 54%, therefore, the applicable marginsare 3.50% over the LIBOR rate and 2.50% over the prime rate. Fees and expensescharged by the Bank Group for all the amendments were $3.4 million, of which$0.1 million were charged for the six months ended June 30, 2010. Thesefees were capitalized and are being amortized as interest expense over theremaining life of the facility which extends through February 2013.

 

Our ability to comply withfinancial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well as otherfactors that may be beyond our control. The continued opportunity for operating improvements, enhanced cashmanagement and suspension of elective capital expenditures should improve ourability to comply with the revised covenants in the revolving credit facility.

 

As part of the amendedcredit agreement for our credit facility, we have agreed to utilize only $12.5million under our capital lease facility. Our California mortgage bond indentures permit the issuance of anadditional $58.4 million of first mortgage bonds as of June 30, 2010.However, the terms of our revolving credit facility do not permit additionalfirst mortgage bond indebtedness without prior consent from the credit facilitylenders. The mortgage bond indentures also limit the amount of cash andproperty dividends our California utility company pays to the parent Company.Dividends have historically averaged $5.0 million to $5.6 million per year andare less than the aggregate cumulative dividend restriction threshold by $21.1million as of June 30, 2010. The dividend payments in 2010 may represent areturn of capital as the Company is in a negative accumulated earnings andprofit position as of December 31, 2009. We were in compliance with, orhad obtained waivers for, all loan agreement covenants during the six monthsended June 30, 2010.

 

In connection with the executionof the Merger Agreement, we executed Investment Agreements under which we sold2,700,000 shares of our common stock at a purchase price of $6.00 per share,for an aggregate purchase price of $16.2 million. The Investment Agreementswere consummated on March 16, 2010. With the related proceeds, we paiddown our credit line which increased our available credit under the line.

 

We have previously filed ashelf registration statement with the SEC for the issuance of up to $50.0million aggregate principal amount of common stock, debt securities andwarrants. We issued approximately $43.6 million of common stock under the shelfregistration. However, under terms of the Merger Agreement, we have agreed notto sell additional shares of common stock or other equity interests in theCompany until the termination of the Merger Agreement.

 

**CERTAINCONTRACTUAL COMMITMENTS AND INDEMNITIES**

 

At June 30, 2010, wehad irrevocable standby letters of credit in the amount of $5.0 million issuedand outstanding under our credit facility.

 

During our normal courseof business, we have entered into agreements containing indemnities pursuant towhich we may be required to make payments in the future. These indemnities arein connection with facility leases and liabilities and operations andmaintenance contracts entered into by our contract services businesses. Theduration of these indemnities, commitments and guarantees varies, and incertain cases, is indefinite. Substantially all of these indemnities provide nolimitation on the maximum potential future payments we could be obligated tomake and is not quantifiable. We have not recorded any liability for theseindemnities.

 

**OFF-BALANCESHEET ARRANGEMENTS**

 

Through the date of thisreport, we did not have any relationships with unconsolidated entities orfinancial partnerships, such as entities often referred to as structuredfinance or special purpose entities, which would have been established for thepurpose of facilitating off-balance sheet arrangements or other contractuallynarrow or limited purposes. In addition, we do not engage in trading activitiesinvolving non-exchange traded contracts. We are not materially exposed to anyfinancing, liquidity, market or credit risk that could arise if we had engagedin these relationships. We do not have relationships or transactions withpersons or entities that derive benefits from their non-independentrelationship with us or our subsidiaries.

 

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We lease some of ourequipment and office facilities under operating leases which are deemed to beoff-balance sheet arrangements. Our future operating lease payment obligationsare more fully described under the caption “Contractual Obligations” above.

 

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

 

As of June 30, 2010,we had $144.7 million of long-term variable and fixed-rate debt. We are exposedto market risk based on changes in prevailing interest rates.

 

Market risk related to ourvariable-rate debt is estimated as the potential decrease in pre-tax earningsresulting from an increase in interest rates. We have $65.0 million oflong-term debt that bears interest at variable rates based on either the primerate or LIBOR rate. Our variable-rate debt had a weighted average annualinterest rate of 3.85% as of June 30, 2010. A hypothetical one percent(100 basis points) increase in the average annual interest rates charged on ourvariable-rate debt would reduce our pre-tax earnings by approximately $0.6million per year.

 

Our fixed-rate debt, whichhas a carrying value of $79.7million, has a fair value of $72.5 million as of June 30,2010. Market risk related to our fixed-rate debt is deemed to be the potentialincrease in fair value resulting from a decrease in prevailing interest rates.Our fixed-rate debt had a weighted average annual interest rate of 6.6% as of June 30,2010. A hypothetical ten percent decrease in annual interest rates, from 6.6%to 5.9%, would increase the fair value of our fixed-rate debt by approximately$4.6 million.

 

We do not use derivativefinancial instruments to manage or reduce these risks although we may do so inthe future. We do not enter into derivatives or other financial instruments fortrading or speculative purposes.

 

**ITEM 4.****                             ****CONTROLSAND PROCEDURES**

 

This report includes thecertifications attached as Exhibits 31.1 and 31.2 of our CEO and CFOrequired by Rule 13a-14 of the Exchange Act. This Item 4 includesinformation concerning the controls and control evaluations referred to in thosecertifications.

 

**EVALUATIONOF DISCLOSURE CONTROLS AND PROCEDURES**

 

Disclosure controls andprocedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe SecuritiesExchange Act of 1934, as amended (“Exchange Act”) aredesigned to provide reasonable assurance that information required to bedisclosed in reports we file or submit under the Exchange Act is recorded,processed, summarized and reported within the time periods specified in therules and forms of the SEC and that such information is accumulated andcommunicated to our management, including the CEO and CFO, as appropriate toallow timely decisions regarding required disclosures.

 

Our management, under thesupervision and with the participation of our CEO and CFO, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of June 30, 2010. Based on our evaluation and theidentification of the material weaknesses in internal control over financialreporting described below, our CEO and CFO concluded that, as of June 30,2010, our disclosure controls and procedures were not effective.

 

**INHERENTLIMITATIONS OF DISCLOSURE CONTROLS AND PROCEDURES**

 

We do not expect that ourdisclosure controls and procedures or our internal control over financialreporting will prevent or detect all errors. A control system, no matter howwell designed and operated, can provide only reasonable, not absolute,assurance that the control system’s objectives will be met. Further, the designof a control system must acknowledge the fact that there are resourceconstraints and the benefits of controls must be considered relative to theircosts. These inherent limitations include the realities that judgments indecision making can be faulty and that breakdowns can occur because of simpleerror or mistake. Controls can also be circumvented by the deliberate acts ofone or more persons. The design of any system of controls is based, in part,upon certain assumptions about the likelihood of future events and there can beno assurance that any design will succeed in achieving its stated goals underall potential future conditions. Over time, controls may become inadequatebecause of changes in conditions or deterioration in the degree of compliancewith associated policies or procedures. Because of the inherent limitations ina cost-effective control system, misstatements due to error or fraud may occurand not be detected.

 

**MANAGEMENT’SREPORT ON INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting as such term is defined in Rules 13a-15(f) and15d-15(f) under the Exchange Act. Internal control over financialreporting is a 

 

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process designed toprovide reasonable assurance regarding the reliability of financial reportingand the preparation of financial statements for external purposes in accordancewith generally accepted accounting principles (“GAAP”). Internal control overfinancial reporting includes those policies and procedures that(i) pertain to the maintenance of records that, in reasonable detail,accurately and fairly reflect the transactions and dispositions of our assets;(ii) provide reasonable assurance that our transactions are recorded asnecessary to permit preparation of financial statements in accordance withGAAP, and that our receipts and expenditures are being made only in accordancewith authorizations of management and our directors; and (iii) providereasonable assurance regarding prevention or timely detection of unauthorizedacquisition, use, or disposition of our assets that could have a materialeffect on the financial statements.

 

Because of its inherentlimitations, internal control over financial reporting may not prevent ordetect misstatements. Also, projections of any evaluation of effectiveness tofuture periods are subject to the risk that controls may become inadequatebecause of changes in conditions, or that the degree of compliance with thepolicies or procedures may deteriorate.

 

Under the supervision andwith the participation of our management, including our CEO and CFO, weconducted an assessment of our internal control over financial reporting as of June 30,2010. In making this assessment, we used the criteria set forth in InternalControl-Integrated Framework issued by the Committee of SponsoringOrganizations of the Treadway Commission (COSO).

 

A material weakness is adeficiency, or a combination of deficiencies, in internal control overfinancial reporting, such that there is a reasonable possibility that amaterial misstatement of our annual or interim financial statements will not beprevented or detected on a timely basis. In connection with management’sassessment of our internal control over financial reporting described above,management has identified control deficiencies that constituted materialweaknesses in our internal control over financial reporting as ofDecember 31, 2009 as described below:

 

1.  We did not maintain an effective control environmentbecause of the following material weaknesses:

 

· We did not maintain an environment thatconsistently emphasized strict adherence to GAAP. This control deficiency, incertain instances, led to inappropriate accounting decisions and audit adjustmentsthat have been recorded in 2009 and 2008.  This control deficiency was magnified in prior years by thedecentralized nature of the accounting function that existed at our variousoperating locations.

 

· In certain areas (internal audit,finance, tax and accounting departments), we did not maintain a sufficientcomplement of resources with an appropriate level of accounting knowledge,experience and training commensurate with our structure and financial reportingrequirements.

 

· We did not maintain complete and accuratebusiness documentation to support certain transactions and accounting records.The controls in these areas with respect to the creation, maintenance andretention of complete and accurate business records were not effective.

 

2.  We did not maintain effective monitoring ofcontrols in certain areas, including period end financial reporting process,goodwill, regulatory accounting, stock-based compensation, lease accounting,property, plant and equipment, estimates and accruals. This deficiency resultedin either not having adequate controls designed and in place or not achievingthe intended operating effectiveness of controls.

 

3.  We did not maintain effective controls overrisk assessments. Specifically, we did not maintain processes to evaluatecertain business and fraud risks. This deficiency resulted in either not havingadequate controls designed and in place or not achieving the intended operatingeffectiveness of controls.

 

The material weaknesses inour control environment, monitoring of controls and risk assessments describedabove contributed to the material weaknesses set forth below:

 

4.  We did not maintain effective controls overaccounting policies and application of GAAP. Specifically, we did not maintain and communicate sufficient andconsistent accounting policies, which limited our ability to make accountingdecisions and to detect and correct accounting errors.  This deficiency contributed to other controldeficiencies, some of which have resulted in material weaknesses, as furtherdescribed below.

 

5.  We did not maintain effective controls overthe recording of journal entries, both recurring and non-recurring.Specifically, effective controls were not in place to ensure that journalentries were properly prepared with sufficient supporting documentation or werereviewed and approved to ensure the accuracy and completeness of the journalentries. This deficiency contributed to other control deficiencies, some ofwhich have resulted in material weaknesses, as further described below.

 

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6. We did not maintaineffective controls over the completeness and accuracy of key spreadsheets andsystem-generated reports. Specifically, effective controls were not designedand in place to ensure that key spreadsheets and system-generated reports wereproperly reviewed for accuracy and completeness.  This deficiency contributed to other controldeficiencies, some of which have resulted in material weaknesses, as furtherdescribed below.

 

7.  We did not maintain effective controls overthe completeness and accuracy of our accounting for acquisitions. Specifically,we did not design and maintain effective controls with respect to theapplication of relevant GAAP and the deficiency resulted in errors, includingaudit adjustments in 2008, in the allocation of the purchase price to theunderlying assets acquired, including goodwill and liabilities assumed.  This deficiency affected property, plant andequipment, deferred income tax and liabilities, goodwill and long-termliability accounts.

 

8.  We did not maintain effective controls overthe completeness and accuracy of our accounting estimates related toself-insurance. Specifically, we did not design and maintain effective controlswith respect to the maintenance and reconciliation of claims and the review ofactuarial valuations.  This deficiencyaffected accrued liabilities and expense accounts in prior years.  This control deficiency resulted inadjustments identified through additional procedures performed by management in2009 and audit adjustments in 2008.

 

9.  We did not maintain effective controls overthe completeness and accuracy of our accounting for the impairment of goodwill.Specifically, we did not design and maintain effective controls to ensureproper identification of reporting units, triggering events and fair valueestimates.  This control deficiencyresulted in audit adjustments in 2008.

 

10.  We did not maintain effective controls overthe completeness and accuracy of our accounting for regulated entities.Specifically, we did not design and maintain effective controls with respect tothe application of relevant GAAP in the areas of regulatory assets andliabilities.  This control deficiencyresulted in audit adjustments in 2009 and 2008.

 

11.  We did not maintain effective controls over theaccuracy and valuation of stock-based compensation. Specifically, we did notmaintain effective controls over the assumptions used in the calculation ofstock-based compensation.  This controldeficiency resulted in audit adjustments in 2008.

 

12.  We did not maintain effective controls overthe completeness and accuracy of property, plant and equipment and relateddepreciation expense. Specifically, we did not design and maintain effectivecontrols to ensure that there was timely transfer of property, plant andequipment additions from construction work in progress; that retirements wereproperly recorded; that depreciation expense was accurately recorded based onappropriate useful lives assigned to the related property, plant and equipment;that assets are capitalized properly; that contributions of cash were timelytransferred to CIAC for amortization; and that impairment losses are timelyidentified and determined.   This controldeficiency resulted in adjustments identified through additional proceduresperformed by management in 2009 and audit adjustments in 2008.

 

13.  We did not maintain effective controls overthe completeness and accuracy of unbilled revenue. Specifically, we did notmaintain effective controls to standardize a process and methodology ofcalculating and recording unbilled revenue in the proper period.  This control deficiency resulted in auditadjustments in 2009 and 2008 and adjustments identified through additionalprocedures performed by management in 2009.

 

14.  We did not maintain effective controls toensure the completeness of the recording of accounts payable and accruedliabilities on a timely basis. Specifically, we did not review and approveinvoices and their supporting documentation on a timely basis.  This control deficiency resulted in auditadjustments in 2008.

 

15.  We did not maintain effective controls toensure the completeness, accuracy and valuation of the revenue recorded by ourSoutheast Utility operation. Specifically, we did not maintain appropriate controls over the designor identify appropriate controls over the systems, invoicing, and otherprocesses performed at the Southeast Utilities. This control deficiency could result in a misstatement of accountsreceivable and revenue that would result in a material misstatement in ourannual or interim consolidated financial statements that would not be preventedor detected in a timely manner.

 

16.  We did not maintain effective controls overthe completeness, accuracy and valuation of our deferred tax assets andliabilities.  Specifically, we did notdesign and maintain effective controls with respect to accounting for thedifference between book and tax basis of the company’s property, plant andequipment and intangible assets. This control deficiency could result in amisstatement of deferred tax assets and liabilities, and the tax provision thatwould result in a material misstatement in our annual or interim consolidatedfinancial statements that would not be prevented or detected in a timelymanner.

 

The material weaknessesdescribed above could result in misstatements of substantially all of theaccounts and disclosures related to it that would result in a materialmisstatement in our annual or interim consolidated financial 

 

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statements that would notbe prevented or detected in a timely manner. Although the deficiencies did notresult in the identification of a material misstatement in the first half of2010, management has not performed comprehensive testing of the controls inplace as of June 30, 2010 and, therefore, is not able to conclude that they aresufficiently designed and effectively operating to prevent or detect suchmisstatement. Accordingly, management has determined that each of the controldeficiencies above constitutes a material weakness and concluded that we didnot maintain effective internal control over financial reporting as of June 30,2010.

 

Based on the performanceof additional procedures by management designed to ensure the reliability ofour financial reporting, we believe the consolidated financial statementsincluded in this report as of and for the periods ended June 30, 2010 arefairly stated in all material respects.

 

**PLANS FORREMEDIATION OF MATERIAL WEAKNESSES**

 

We have engaged in and arecontinuing to engage in efforts to improve our internal control over financialreporting and our disclosure controls and procedures. Specific initiatives todate have been focused on the following:

 

(i)                                     Communicating, both internally andexternally, our commitment to a strong effective control environment, highethical standards and financial reporting integrity, emphasizing a strictadherence to GAAP accounting;

 

(ii)                                  Implementing a comprehensive review andapproval of all material accounting decisions by the Principal FinancialOfficer, including the documentation of key accounting issues which are used totrain our accounting staff;

 

(iii)                               Taking certain personnel actions includingsupplementing existing accounting staff with additional permanent or contractemployees;

 

(iv)                               Improving and standardizingsystem-generated financial reports, developed to support operations managementand financial reporting;

 

(v)                                  Specific training for Finance andAccounting Department personnel to reinforce the importance of our controlenvironment in addition to internal controls training to all Managers acrossthe Company which reinforced the importance of controls;

 

(vi)                               Implementing of policies and procedures toensure that we retain business and accounting records and documenting theapplication of GAAP for business transactions;

 

(vii)                            Implementing period end reportingprocesses including a consolidated monthly close checklist, journal entryapproval, account reconciliations with supporting documentation, documentationsupporting accruals and estimates, additional processes for the valuation andrecognition of utility unbilled revenue and additional processes aroundmanually prepared spreadsheets;

 

(viii)                         Implementing formal procedures over valuation of ouraccounting estimates related to our claims process associated with medical,automobile and workers’ compensation self-insurance, including the increaseduse of outside actuarial experts, the systematic review of claims by theappropriate department manager and the review and roll forward of actuarialanalyses;

 

(ix)                                Implemented a risk assessment process toevaluate the business and fraud risks within the company to ensure we havecontrol activities that are designed and operating effectively to address theareas considered at-risk that have been determined by the risk assessment;

 

(x)                                   Documented narratives for all significantprocesses to generate an accurate representation of current processes providinga baseline for performing risk analysis, internal controls testing, andimplementing process improvements;

 

(xi)                                Engaged a professional services firm toassist with conducting the evaluation of the design and implementation of theinternal controls environment and to assist with identifying opportunities toimprove the design and effectiveness of the control environment; and

 

(xii)                             Implemented a monthly business process andcontrols certification process requiring the respective process owners attestto the design and operating effectiveness of their controls.

 

We have also implemented aremediation plan (the “Plan”) to address the material weaknesses for each ofthe affected areas presented above. The Plan ensures that each area affected bya material weakness is put through a 

 

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comprehensive remediationprocess. The remediation process entails a thorough analysis which includes thefollowing phases:

 

(a)                                   Define and assess the control deficiency:ensure a thorough understanding of the “as is” state, process owners, and gapsin the control deficiency;

 

(b)                                  Design and evaluate a remediation actionfor each weakness for each affected area: validate or improve the relatedpolicy and procedures, evaluate skills of the process owners with regards tothe policy and adjust as required;

 

(c)                                   Implement specific remediation actions:train process owners; allow time for process adoption and adequate transactionvolume for next steps;

 

(d)                                  Test and measure the design andeffectiveness of the remediation plan, and test and provide feedback on thedesign and operating effectiveness of the updated controls; and

 

(e)                                   Management review and acceptance ofcompletion of the remediation effort.

 

The Plan is administeredby key leaders from cross functional portions of the organization, includingthe CFO. The Committee reports on progress quarterly (or more frequently, asneeded) to the Audit Committee of our Board of Directors.

 

We believe the steps takento date have improved the effectiveness of many of our internal controls overfinancial reporting; however, we have not completed all of the correctiveprocesses, procedures and related evaluation or remediation identified herein,that we believe are necessary. As we continue to monitor the effectiveness ofour internal control over financial reporting in the areas affected by thematerial weaknesses described above, we will perform additional proceduresprescribed by management, including the use of manual mitigating controlprocedures, to ensure that our financial statements continue to be fairlystated in all material respects.

 

**CHANGESIN INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

As of June 30, 2010, weimplemented certain measures to improve our internal controls over financialreporting and to remediate previously identified material weaknesses.  Specifically, we have segregatedresponsibility for the initiation and approval of wire transfer requestsbetween treasury and accounting personnel and have implemented controls overconfirmation and review of the executed wire transfers.

 

Although we have begun totake other specific actions to improve the overall effectiveness of ourinternal controls over financial reporting during the quarter ended June 30,2010, there were no other changes that have materially affected, or are reasonablylikely to materially affect, our internal controls over financialreporting.  Furthermore, the design or operating effectiveness ofadditional changes in internal control over financial reporting have not yetbeen evaluated through our remediation process.

** **

**REMEDIATION OF PREVIOUSLYREPORTED MATERIAL WEAKNESS**

 

As previously reported inour Annual Report on Form 10-K for the fiscal year ended December 31, 2009and Quarterly Report on Form 10-Q for quarter ended March 31, 2010, wedetermined that our internal controls and procedures around the wire transferprocess was ineffective resulting in a material weakness. The material weaknesswas the result of inadequate policies and procedures and ineffective internalcontrols and inadequate policies and procedures regarding the initiation,approval and confirmation of wire transfers. Specifically, we did not maintainadequate segregation of duties allowing a single individual exclusive rights toexecute wire transfers without independent review or confirmation.  As a result, this control deficiency couldhave resulted in unauthorized or inappropriate cash disbursements.  As of June 30, 2010, the following measuresto remediate the control deficiency have been implemented:

 

(1)          We implemented a formal wire transferpolicy requiring an authorized manager, independent from the requestor, reviewand approve all wire transfer requests.

 

(2)   The chief financial officer delegated approval authority to thegroup controller for wire transfers.

 

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(3)          We implemented a process documenting callinginstruction for the wire transfer confirmation from our bank that is anindependent authorized manager.

 

(4)          We implemented a settlement process that requires thecash management function to reconcile the approved and confirmed wire transferagainst the daily bank transaction report.

 

Based on theimplementation of the additional processes and internal controls discussedabove and the subsequent substantive testing of those internal controls for asufficient period of time, management has concluded that the material weaknesshas been remediated and that our wire transfer procedures and the relatedinternal control over financial reporting are now effective.

 

We have evaluated the effectivenessof the design and operation of our wire transfer controls and procedures as ofJune 30, 2010. Based on that evaluation the Chief Executive Officer and theChief Financial Officer have concluded that our wire transfer procedures andthe related internal control activity are effective in initiating, approving,confirming and reconciling wire transfers with adequate segregation offunctions.

 

**PART II— OTHER INFORMATION**

 

**ITEM 1.                  LEGAL PROCEEDINGS**

 

Other than those stated in“Part 1- Item 1- Note 4. Commitments and Contingencies — LegalProceedings,” there have been no new, material developments to or terminationsof legal proceedings, other than ordinary routine litigation incidental to thebusiness, to which the Company or any of its subsidiaries is a party or ofwhich any of their property is the subject during the period covered by thisQuarterly Report.

 

**ITEM 1A.               RISK FACTORS**

 

There have been nomaterial changes in our risk factors since we last reported under Part I,Item 1A, in our Annual Report on Form 10-K for the year endedDecember 31, 2009.

 

**ITEMS 2, 3, 4 AND 5 ARE NOT APPLICABLE AND HAVEBEEN OMITTED.**

 

 

**ITEM 6.                  EXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                  |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                                                                                                                                                |
|        |       |                                                                                                                                                                                                                                        |
| 3.1         |       | Certificate of Amendment  to Restated Certificate of Incorporation of SouthWest Water Company  (incorporated by reference to Exhibit 3.1 included in the Company’s  Form 8 K filed with the Commission on May 22, 2008) |
| 3.1.1       |       | Certificate of Amendment  to Certificate of Incorporation of SouthWest Water Company (incorporated by  reference to Exhibit 3.1 included in the Company’s Form 8-K filed  on May 22, 2008                               |
| 3.2         |       | Amended and Restated  Bylaws of SouthWest Water Company dated August 20, 2009 (incorporated by  reference to Exhibit 3.2 included in the Company’s Form 10-Q filed  with the Commission on September 18, 2009)     |
| 31.1        | *          | Certification of  Principal Executive Officer Pursuant to Section 302 of the Sarbanes  Oxley Act of 2002                                                                                                                               |
| 31.2        | *          | Certification of  Principal Financial Officer Pursuant to Section 302 of the Sarbanes  Oxley Act of 2002                                                                                                                               |
| 32.1        | *          | Certification of Chief  Executive Officer pursuant to Section 906 of the Sarbanes Oxley Act of  2002                                                                                                                                   |
| 32.2        | *          | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes Oxley Act of  2002                                                                                                                                   |

 

----

*                  Filed herewith

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereto dulyauthorized.

 

 
|                        | SOUTHWEST WATER COMPANY  (REGISTRANT**)**               |
|-----------------------------|---------------------------------------------------------|
|                        |                                                    |
|                        |                                                    |
| Dated:  August 6, 2010 | /s/  BEN SMITH                                     |   |
|                        | Ben Smith                                               |
|                        | Chief Financial Officer

(Principal Financial  Officer) |

 

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