**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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**(Mark One)**

 

**ý****           ****QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

## **For the quarterly periodended March 31, 2005**

 

**OR**

 

**o****           ****TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

### **For the transition periodfrom                            to                            **

 

**Commissionfile number: 0-8176**

 

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

 
| **Delaware**                                                                                 | ** ** | **95-1840947**                         |
|----------------------------------------------------------------------------------------------|------------|----------------------------------------|
| (State or  other jurisdiction of  incorporation or organization)                             | ** ** | (I.R.S.  Employer  Identification No.) |
| ** **                                                                                   | ** ** | ** **                             |
| **One  Wilshire Building  624 South Grand Avenue, Suite 2900  Los Angeles, California** | ** ** | **90017-3782**                         |
| (Address of  principal executive offices)                                                    | ** ** | (Zip Code)                             |

 

**(213) 929-1800**

(Registrant’stelephone number, including area code)

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 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 ý   No o

 

Indicate by checkmark whether the registrant is an accelerated filer (as defined in Rule 12b-2of the Act). Yes ý   No o

 

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date. On May 6, 2005, there were 19,468,298 commonshares outstanding.

 

 

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**SOUTHWESTWATER COMPANY**

 

**INDEX**

 
| **Part I.**  | **Financial Information:** | 1                                                                                                                    |
|-------------------|----------------------------|----------------------------------------------------------------------------------------------------------------------|
|              |                       |                                                                                                                 |   |
|              | Item 1.                    | Financial Statements:                                                                                                | 1 |
|              |                       |                                                                                                                 |   |
|              |                       | Condensed  Consolidated Statements of Income (unaudited) –  Three Months Ended March 31, 2005 and 2004     | 1 |
|              |                       |                                                                                                                 |   |
|              |                       | Condensed  Consolidated Balance Sheets (unaudited) –  March 31, 2005 and December 31, 2004            | 2 |
|              |                       |                                                                                                                 |   |
|              |                       | Condensed  Consolidated Statements of Cash Flows (unaudited) –  Three Months Ended March 31, 2005 and 2004 | 3 |
|              |                       |                                                                                                                 |   |
|              |                       | Notes  to Condensed Consolidated Financial Statements (unaudited)                                                    | 4 |
|              |                       |                                                                                                                 |   |
|              | Item  2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                          | 11 |
|              |                       |                                                                                                                 |   |
|              | Item  3.                   | Quantitative  and Qualitative Disclosures About Market Risk                                                          | 21 |
|              |                       |                                                                                                                 |   |
|              | Item 4.                    | Controls and Procedures                                                                                              | 22 |
|              |                       |                                                                                                                 |   |
| **Part II.** | **Other Information:**     | 23                                                                                                                   |
|              |                       |                                                                                                                 |   |
|              | Item 1.                    | Legal Proceedings                                                                                                    | 23 |
|              |                       |                                                                                                                 |   |
|              | Item 6.                    | Exhibits                                                                                                             | 23 |
|              |                       |                                                                                                                 |   |
| **Signatures**    |                       |                                                                                                                 | 24 |

 

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**PART I– FINANCIAL INFORMATION**

 

***Item1.******Financial Statements***

 

**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME****(Unaudited)**

 
| ** **                                               | ** ** | **Three Months Ended  March 31,**    | ** ** |
|----------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                               | ** ** | **(in thousands except per share  data)** | ** ** |
| **Revenues:**                                            |       |                                      |       |   |   |
| Utility  group                                           |       | $                                         | 15,459     |   | $ | 13,063 |   |
| Services group                                           |       | 31,407                                    |       | 26,664 |   |
|                                                     |       | 46,866                                    |       | 39,727 |   |
| **Expenses:**                                            |       |                                      |       |   |   |
| Operating  expenses - utility group                      |       | 9,979                                     |       | 7,618 |   |
| Operating  expenses - services group                     |       | 27,096                                    |       | 24,529 |   |
| Selling,  general and administrative expenses            |       | 8,312                                     |       | 6,647 |   |
|                                                     |       | 45,387                                    |       | 38,794 |   |
|                                                     |       |                                      |       |   |   |
| **Operating  Income**                                    |       | 1,479                                     |       | 933 |   |
|                                                     |       |                                      |       |   |   |
| **Other  Income (Expense):**                             |       |                                      |       |   |   |
| Interest  expense                                        |       | (1,949                                    | )          | (1,077 | ) |
| Interest  income                                         |       | 107                                       |       | 120 |   |
| Other                                                    |       | (13                                       | )          | 53 |   |
|                                                     |       | (1,855                                    | )          | (904 | ) |
|                                                     |       |                                      |       |   |   |
| **Income  (Loss) Before Income Taxes**                   |       | (376                                      | )          | 29 |   |
| **Income  Tax Provision (Benefit)**                      |       | (135                                      | )          | 11 |   |
| **Net  Income (Loss)**                                   |       | (241                                      | )          | 18 |   |
| **Dividends  on Preferred Shares**                       |       | 6                                         |       | 7 |   |
| **Net  Income (Loss) Applicable to Common Shareholders** |       | $                                         | (247       | ) | $ | 11 |   |
|                                                     |       |                                      |       |   |   |
| **Earnings  (Loss) Per Common Share:**                   |       |                                      |       |   |   |
| **Basic**                                                |       | $                                         | (0.01      | ) | $ | 0.00 |   |
| **Diluted**                                              |       | $                                         | (0.01      | ) | $ | 0.00 |   |
|                                                     |       |                                      |       |   |   |
| **Weighted  Average Outstanding Common Shares:**         |       |                                      |       |   |   |
| **Basic**                                                |       | 19,411                                    |       | 15,501 |   |
| **Diluted**                                              |       | 19,411                                    |       | 16,470 |   |

 

*See accompanying notes tounaudited condensed consolidated financial statements.*

 

1

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS****(Unaudited)**

 
| ** **                                                           | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------------------------------------------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **                                                           | ** ** | **(in thousands)**      | ** ** |
| ** **                                                           | ** ** | ** **              | ** ** | ** **                 | ** ** |
| **ASSETS**                                                           |       |                    |       |                       |       |
| **Current  Assets:**                                                 |       |                    |       |                       |       |
| Cash and  cash equivalents                                           |       | $                       | 5,258      |                       | $          | 1,933 |   |
| Restricted  cash                                                     |       | 31                      |       | 221                        |       |
| Trade  accounts receivable, less allowance for doubtful accounts     |       | 24,994                  |       | 23,935                     |       |
| Other  current assets                                                |       | 15,939                  |       | 19,198                     |       |
|                                                                 |       | 46,222                  |       | 45,287                     |       |
| **Property,  Plant and Equipment:**                                  |       |                    |       |                       |       |
| Utility  property, plant and equipment—at cost                  |       | 365,074                 |       | 359,375                    |       |
| Non-regulated  operations property, plant and equipment—at cost |       | 17,652                  |       | 18,485                     |       |
|                                                                 |       | 382,726                 |       | 377,860                    |       |
| Less  accumulated depreciation and amortization                      |       | 75,833                  |       | 75,264                     |       |
|                                                                 |       | 306,893                 |       | 302,596                    |       |
| **Other  Assets:**                                                   |       |                    |       |                       |       |
| Goodwill                                                             |       | 33,921                  |       | 32,837                     |       |
| Intangible  assets, net                                              |       | 9,777                   |       | 8,364                      |       |
| Other assets                                                         |       | 16,924                  |       | 15,725                     |       |
|                                                                 |       | $                       | 413,737    |                       | $          | 404,809 |   |
|                                                                 |       |                    |       |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                        |       |                    |       |                       |       |
| **Current  Liabilities:**                                            |       |                    |       |                       |       |
| Current  portion of long-term debt                                   |       | $                       | 1,708      |                       | $          | 3,372 |   |
| Accounts  payable                                                    |       | 11,358                  |       | 12,337                     |       |
| Other  current liabilities                                           |       | 19,789                  |       | 20,025                     |       |
|                                                                 |       | 32,855                  |       | 35,734                     |       |
| **Other  Liabilities and Deferred Credits:**                         |       |                    |       |                       |       |
| Long-term  debt                                                      |       | 93,526                  |       | 92,792                     |       |
| Bank lines  of credit                                                |       | 34,809                  |       | 23,035                     |       |
| Advances for  construction                                           |       | 9,152                   |       | 9,196                      |       |
| Contributions  in aid of construction                                |       | 89,511                  |       | 89,623                     |       |
| Deferred  income taxes                                               |       | 16,408                  |       | 15,578                     |       |
| Other  liabilities and deferred credits                              |       | 12,034                  |       | 12,653                     |       |
| **Total  Liabilities and Deferred Credits**                          |       | 288,295                 |       | 278,611                    |       |
|                                                                 |       |                    |       |                       |       |
| **Commitments  and Contingencies**                                   |       |                    |       |                       |       |
|                                                                 |       |                    |       |                       |       |
| **Stockholders’  Equity:**                                      |       |                    |       |                       |       |
| Preferred  stock                                                     |       | 461                     |       | 461                        |       |
| Common stock                                                         |       | 194                     |       | 194                        |       |
| Paid-in  capital                                                     |       | 101,974                 |       | 101,509                    |       |
| Retained  earnings                                                   |       | 22,813                  |       | 24,034                     |       |
| **Total  Stockholders’ Equity**                                 |       | 125,442                 |       | 126,198                    |       |
|                                                                 |       | $                       | 413,737    |                       | $          | 404,809 |   |

 

*See accompanying notes tounaudited condensed consolidated financial statements.*

 

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
| ** **                                                                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                        | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                                                                                        | ** ** | **(in thousands)**                     | ** ** |
| **Cash  Flows From Operating Activities:**                                                        |       |                                   |       |   |   |
| Net income  (loss)                                                                                |       | $                                      | (241       | ) | $ | 18 |   |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities:         |       |                                   |       |   |   |
| Depreciation  and amortization                                                                    |       | 2,659                                  |       | 1,819 |   |
| Stock-based  compensation expense                                                                 |       | 252                                    |       | 278 |   |
| Deferred  income taxes                                                                            |       | 830                                    |       | 10 |   |
| Changes in  assets and liabilities, net of effects of acquisitions:                               |       |                                   |       |   |   |
| Restricted  cash                                                                                  |       | 190                                    |       | 1,873 |   |
| Trade  accounts receivable                                                                        |       | (423                                   | )          | (732 | ) |
| Other  current assets                                                                             |       | 3,067                                  |       | (425 | ) |
| Other assets                                                                                      |       | (1,799                                 | )          | (166 | ) |
| Accounts  payable                                                                                 |       | (2,008                                 | )          | (2,234 | ) |
| Other  current liabilities                                                                        |       | (1,274                                 | )          | 505 |   |
| Other  liabilities                                                                                |       | (56                                    | )     | (544 | ) |
| Other                                                                                             |       | 262                                    |       | (248 | ) |
| **Net cash  provided by operating activities**                                                    |       | 1,459                                  |       | 154 |   |
|                                                                                              |       |                                   |       |   |   |
| **Cash  Flows From Investing Activities:**                                                        |       |                                   |       |   |   |
| Additions to  property, plant and equipment                                                       |       | (6,941                                 | )          | (3,159 | ) |
| Proceeds  from disposition of assets                                                              |       | —                                 |       | 42 |   |
| Purchase of  minority interest in subsidiary                                                      |       | —                                 |       | (2,900 | ) |
| Acquisition  of Novus                                                                             |       | (2,008                                 | )          | — |   |
| Other  investments, net                                                                           |       | —                                 |       | (720 | ) |
| **Net cash  used in investing activities**                                                        |       | (8,949                                 | )          | (6,737 | ) |
|                                                                                              |       |                                   |       |   |   |
| **Cash  Flows From Financing Activities:**                                                        |       |                                   |       |   |   |
| Net proceeds  from stock offering                                                                 |       | —                                 |       | 20,642 |   |
| Capital  improvement reimbursements                                                               |       | —                                 |       | 162 |   |
| Contributions  in aid of construction                                                             |       | 263                                    |       | 1,079 |   |
| Borrowings  (repayments) on bank notes payable                                                    |       | 11,774                                 |       | (16,311 | ) |
| Proceeds  from dividend reinvestment, employee stock purchase and stock option plans              |       | 202                                    |       | 187 |   |
| Dividends  paid                                                                                   |       | (977                                   | )          | (787 | ) |
| Principal  payments on long-term debt                                                             |       | (364                                   | )          | (163 | ) |
| Payments on  advances for construction                                                            |       | (83                                    | )          | (84 | ) |
| **Net cash  provided by financing activities**                                                    |       | 10,815                                 |       | 4,725 |   |
| ** **                                                                                        |       |                                   |       |   |   |
| **Net  increase (decrease) in cash and cash equivalents**                                         |       | 3,325                                  |       | (1,858 | ) |
| Cash and  cash equivalents at beginning of period                                                 |       | 1,933                                  |       | 2,570 |   |
| **Cash and  cash equivalents at end of period**                                                   |       | $                                      | 5,258      |   | $ | 712 |   |
| ** **                                                                                        |       |                                   |       |   |   |
| **Supplemental  Disclosure of Cash Flow information**                                             |       |                                   |       |   |   |
| **Cash  paid (received) during the period for:**                                                  |       |                                   |       |   |   |
| **Interest**                                                                                      |       | $                                      | 1,527      |   | $ | 784 |   |
| **Income  taxes**                                                                                 |       | $                                      | (1,419     | ) | $ | — |   |
|                                                                                              |       |                                   |       |   |   |
| **Non-cash  investing and financing activities:**                                                 |       |                                   |       |   |   |
| **Purchase  of businesses**                                                                       |       |                                   |       |   |   |
| Fair value  of assets acquired                                                                    |       | $                                      | 3,214      |   | $ | 1,531 |   |
| Acquisition  costs                                                                                |       | (2,008                                 | )          | (720 | ) |
| Notes issued                                                                                      |       | —                                 |       | (811 |   |
| Liabilities  assumed                                                                              |       | $                                      | 1,206      |   | $ | — |   |
| ** **                                                                                        |       |                                   |       |   |   |   |   |
| **Non-cash  contributions in aid of construction and advances for construction from  developers** |       | $                                      | 346        |   | $ | 836 |   |

 

*See accompanying notes tounaudited condensed consolidated financial statements.*

 

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS (unaudited)**

 

***Note1.******– Basis of Presentation***

 

Southwest Water Companyand its subsidiaries (collectively referred to in this report as “Southwest,”the “Company,” “we,” “us” or “our” except where the context otherwise requires)provide a broad range of services including water production, treatment anddistribution; wastewater collection and treatment; utility billing andcollection; utility infrastructure construction management; and public worksservices. The accompanying unaudited condensed consolidated financialstatements have been prepared in accordance with accounting principlesgenerally accepted in the United States of America (“US GAAP”) for interimfinancial information and with the instructions to Form 10-Q and with Rule 10-01of Regulation S-X; accordingly, they do not include all information and notesrequired by US GAAP for complete financial statements. Except as disclosedherein, there have been no material changes in the information disclosed in thenotes to the consolidated financial statements contained in our Annual Reporton Form 10-K for the year ended December 31, 2004 (the “2004Annual Report”). The unaudited condensed consolidated financial statementsreflect all adjustments which, in our opinion, are necessary to present fairlythe financial position of Southwest as of March 31, 2005, and our resultsof operations and cash flows for the three months ended March 31, 2005 and2004.  These adjustments are of a normalrecurring nature.

 

The results of interimperiods are not necessarily indicative of results that may be expected for anyother interim period or for the full year.

 

Southwest Water Companywas incorporated in California in 1954 and reincorporated in Delaware in 1988.

 

Certain reclassifications have been made to the prior period financialstatement presentation to conform to the current period presentation.

 

***Note2.******– Earnings Per Share***

 

We reportearnings per share (“EPS”) by computing “basic EPS” and “diluted EPS.”  Basic EPS measures our performance over thereporting period by dividing net income applicable to common stockholders bythe weighted average number of common shares outstanding during the period.Diluted EPS measures our performance over the reporting period after givingeffect to all potentially dilutive common shares that would have beenoutstanding if the dilutive common shares had been issued. Stock options,convertible debentures and warrants give rise to potentially dilutive commonshares.  In July 2001, we issued$20.0 million of 6.85% fixed-rate convertible subordinate debentures. Thedebentures are convertible at any time prior to maturity in 2021, unlesspreviously redeemed, at a conversion price of $11.569. At such time as theassumed conversion of the debentures has a dilutive effect on earnings pershare, the debentures will be included in the calculation of diluted earningsper share, after adjusting net income for the after-tax effect of the debentureinterest expense.

 

We incurred aloss for the three months ended March 31, 2005.  Options to purchase 875,000 shares of commonstock for the quarter ended March 31, 2005 are considered antidilutiveand, therefore, are not included in the computation of weighted average sharesused in computing diluted loss per share for this period.

 

We declared a 5% stockdividend on January 3, 2005. All per share amounts and numbers of sharesoutstanding reflect this dividend.  Thefollowing table is a reconciliation of the numerators (income or loss) anddenominators (shares) used in both basic and diluted EPS calculations:

 

4

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(inthousands except per share data)

 
| ** **                                                             | ** ** | **Three Months Ended  March 31,**   | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                             | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(in thousands except per share data)** | ** ** |
| **Earnings  (loss) per share - basic**                                 |       |                                     |       |   |   |
| Net income  (loss)                                                     |       | $                                        | (241       | ) | $ | 18 |   |
| Less:  dividends on preferred shares                                   |       | (6                                       | )          | (7 | ) |
| Net income  (loss) applicable to common shares                         |       | $                                        | (247       | ) | $ | 11 |   |
|                                                                   |       |                                     |       |   |   |
| Weighted  average outstanding common shares                            |       | 19,411                                   |       | 15,501 |   |
|                                                                   |       |                                     |       |   |   |
| Earnings  (loss) per common share - basic                              |       | $                                        | (0.01      | ) | $ | 0.00 |   |
|                                                                   |       |                                     |       |   |   |
| ** **                                                             | ** ** | **Three Months Ended  March 31,**   | ** ** |
| ** **                                                             | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(in thousands except per share data)** | ** ** |
| **Earnings  (loss) per share - assuming dilution**                     |       |                                     |       |   |   |
| Net income  (loss) applicable to common shares                         |       | $                                        | (247       | ) | $ | 11 |   |
|                                                                   |       |                                     |       |   |   |
| Weighted  average outstanding common shares                            |       | 19,411                                   |       | 15,501 |   |
| Plus: shares  issued on assumed exercise of stock options and warrants |       | —                                   |       | 969 |   |
| Weighted  average outstanding common shares                            |       | 19,411                                   |       | 16,470 |   |
|                                                                   |       |                                     |       |   |   |
| Earnings  (loss) per common share - diluted                            |       | $                                        | (0.01      | ) | $ | 0.00 |   |

 

***Note3.******– Common Stock Issued***

 

During the three months ended March 31, 2005, approximately$14,000 of our 6.85% fixed-rate convertible subordinate debentures were converted into approximately 1,232 shares of our commonstock.

 

***Note4.******–Stock-Based Plans***

 

At March 31, 2005, Southwest had threestock-based plans: a Stock Option Plan (“SOP”), a Director Stock Option Plan (“DOP”),and an Employee Stock Purchase Plan. In accordance with the provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*,the fair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions used for grants in 2005 and 2004:

 
| ** **               | ** ** | **Three Months Ended  March 31,** | ** ** |
|--------------------------|------------|----------------------------------------|------------|
| ** **               | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| Dividend  yield          |       | 1.7                                    | %          | 1.3 | % |
| Expected  volatility     |       | 24.3                                   | %          | 24.4 | % |
| Risk free  interest rate |       | 4.1                                    | %          | 3.7 | % |
| Expected  life in years  |       | 5.7                                    |       | 6.0 |   |

 

5

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Compensationexpense arising from stock option grants as determined using the Black-Scholesfair value option model was as follows:

 
| ** **                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|-----------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                        | ** ** | **(in thousands)**                     | ** ** |
| Stock-based  compensation expense |       | $                                      | 252        |   | $ | 278 |   |
|                                   |            |                                        |            |  |  |  |  |

 

A combinedsummary of shares authorized and available for issuance under the SOP and theDOP as of March 31, 2005, is as follows:

 
| ** **                      | ** ** | **SOP**            | ** ** | **DOP** | ** ** | **Total** | ** ** |
|---------------------------------|------------|--------------------|------------|---------|------------|-----------|------------|
| ** **                      | ** ** | **(in thousands)** | ** ** |
| Shares  authorized for issuance |       | 4,453              |       | 722     |       | 5,175     |       |
| Shares  available for issuance  |       | 934                |       | 370     |       | 1,304     |       |

 

Following is a combined summary of changes in thestatus of the SOP, the DOP and warrants during the three months ended March 31,2005:

 
| ** **                             | ** ** | **Stock Options  and Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|----------------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|
| ** **                             | ** ** | **(in thousands)**              | ** ** | ** **                             | ** ** |
| Outstanding  at December 31, 2004 |       | 2,776                           |       | $                                      | 8.03       |   |
| Granted                                |       | 214                             |       | 11.95                                  |       |
| Exercised                              |       | (4                              | )     | 3.63                                   |       |
| Forfeited                              |       | —                          |       | —                                 |       |
| Outstanding  at March 31, 2005    |       | 2,986                           |       | $                                      | 8.32       |   |
|                                   |       |                            |       |                                   |       |
| Exercisable  at March 31, 2005    |       | 1,952                           |       | $                                      | 6.93       |   |

 

The following table summarizes information about stockoptions and warrants outstanding at March 31, 2005:

 
| ** **                    | ** ** | **Options and Warrants  Outstanding**             | ** ** | **Options and Warrants  Exercisable**                         | ** ** |
|-------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | **Number  Outstanding  at  March 31,  2005** | ** ** | **Weighted  Average  Remaining  Contractual  Life  in Years** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Number  Exercisable  at  March 31,  2005** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| ** **                    | ** ** | ** **                                        | ** ** | **(in thousands)**                                            | ** ** | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $                             | 1.50       |                                              | $          | 3.75                                                          |       | 217 |   | 1.3 |   | $ | 2.84 |   | 217 |   | $ | 2.84 |   |
| 3.76                          |       | 7.50                                              |       | 882                                                           |       | 3.1 |   | 5.76 |   | 815 |   | 5.66 |   |
| 7.51                          |       | 11.25                                             |       | 1,247                                                         |       | 3.6 |   | 8.78 |   | 852 |   | 8.67 |   |
| 11.26                         |       | 15.00                                             |       | 640                                                           |       | 6.3 |   | 12.81 |   | 68 |   | 13.53 |   |
| $                             | 1.50       |                                              | $          | 15.00                                                         |       | 2,986 |   | 3.9 |   | $ | 8.32 |   | 1,952 |   | $ | 6.93 |   |

 

***Employee Stock Purchase Plan (“ESPP”):***Wehave a stockholder-approved ESPP that allows eligible employees to purchase ourcommon stock through payroll deductions of up to 10% of their salary (not toexceed $25,000 per year). The purchase price of the stock is 90% of the lowerof the share price as calculated at the beginning and end of each three-monthoffering period. Under the

 

6

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ESPP, we issued 5,435 shares to employees during the three months endedMarch 31, 2005. At March 31, 2005, 1,197,000 shares had beenauthorized for issuance under the ESPP and approximately 888,000 shares remainavailable for issuance.

 

***Note 5.******– Post Retirement Benefits***

 

The Company has a non-qualified supplemental executive retirement plan(“SERP”) for certain key executive officers. The following table sets forth the components of the net periodicbenefit costs for the SERP plan:

 
| ** **                 | ** ** | **Three Months Ended  March 31,** | ** ** |
|----------------------------|------------|----------------------------------------|------------|
| ** **                 | ** ** | **2005**                               | ** ** | **2004** | ** ** |
| ** **                 | ** ** | **(in thousands)**                     | ** ** |
| Service cost               |       | $                                      | 16         |   | $ | 15 |   |
| Interest  cost             |       | 20                                     |       | 19 |   |
| Recognized  actuarial loss |       | 22                                     |       | 21 |   |
|                       |       | $                                      | 58         |   | $ | 55 |   |

 

***Note6.******– Operating Segments***

 

Southwest has two reportable segments: the Utility Group and theServices Group.  We have not changed thebasis of presentation or measurement of segment profit or loss from thatreported in our 2004 Annual Report.

 

The Utility Group owns regulated water utilities in California, NewMexico, Oklahoma and Texas, as well as wastewater facilities in New Mexico,Oklahoma and Texas.  Revenues result fromthe production and distribution of water and the collection and treatment ofsewage for residential, business, industrial and public authority use.  State, federal and local agencies issueregulations regarding standards of water quality, safety, environmental andother matters which affect these operations. The rates our regulated utilitysubsidiaries charge for water and wastewater services are established by stateauthorities.

 

The Services Group operates and manages water and wastewater treatmentfacilities owned by cities, public agencies, municipal utility districts,private entities and investor-owned utilities (including Utility Groupaffiliates). Revenues are earned by providing operations and maintenanceservices under contracts with municipalities and other clients.  The Services Group also provides constructionmanagement and utility billing services.

 

7

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The following table presents information about the operations of eachreported segment for the three months ended March 31, 2005 and 2004:

 
| ** **                                          | ** ** | **Utility Group**  | ** ** | **Services  Group (1)** | ** ** | **Total  Segments  Information** | ** ** | **Corporate and  Other (2)** | ** ** | **Total  Consolidated  Information** | ** ** |
|-----------------------------------------------------|------------|--------------------|------------|-------------------------|------------|----------------------------------|------------|------------------------------|------------|--------------------------------------|------------|
| ** **                                          | ** ** | **(in thousands)** | ** ** |
|                                                |       |               |       |                    |       |                             |       |                         |       |                                 |       |
| **For the  Three Months Ended March 31, 2005** |       |               |       |                    |       |                             |       |                         |       |                                 |       |
| **Total  revenues (1)**                             | ** ** | **$**              | **15,459** | ** **              | **$**      | **31,407**                       | ** ** | **$**                        | **46,866** | ** **                           | **$**      | **—** | ** ** | **$** | **46,866** | ** ** |
| **Segment  operating income**                       | ** ** | **3,812**          | ** ** | **1,410**               | ** ** | **5,222**                        | ** ** | **(3,743**                   | **)**      | **1,479**                            | ** ** |
| **Interest  expense**                               | ** ** | **(1,195**         | **)**      | **(689**                | **)**      | **(1,884**                       | **)**      | **(65**                      | **)**      | **(1,949**                           | **)**      |
| **Interest  income**                                | ** ** | **12**             | ** ** | **93**                  | ** ** | **105**                          | ** ** | **2**                        | ** ** | **107**                              | ** ** |
| **Other  income (expense)**                         | ** ** | **(20**            | **)**      | **21**                  | ** ** | **1**                            | ** ** | **(14**                      | **)**      | **(13**                              | **)**      |
| **Income  (loss) before income taxes**              | ** ** | **2,609**          | ** ** | **835**                 | ** ** | **3,444**                        | ** ** | **(3,820**                   | **)**      | **(376**                             | **)**      |
| ** **                                          | ** ** | ** **         | ** ** | ** **              | ** ** | ** **                       | ** ** | ** **                   | ** ** | ** **                           | ** ** |
| **For the  Three Months Ended March 31, 2004** |       |               |       |                    |       |                             |       |                         |       |                                 |       |
| Total  revenues (1)                                 |       | $                  | 13,063     |                    | $          | 26,664                           |       | $                            | 39,727     |                                 | $          | — |   | $ | 39,727 |   |
| Segment  operating income / (loss)                  |       | 3,817              |       | (732                    | )          | 3,085                            |       | (2,152                       | )          | 933                                  |       |
| Interest  expense                                   |       | (580               | )          | (107                    | )          | (687                             | )          | (390                         | )          | (1,077                               | )          |
| Interest  income                                    |       | —             |       | 99                      |       | 99                               |       | 21                           |       | 120                                  |       |
| Gain on  sales of land                              |       | —             |       | —                  |       | —                           |       | —                       |       | —                               |       |
| Other income  (expense)                             |       | 43                 |       | (352                    | )          | (309                             | )          | 362                          |       | 53                                   |       |
| Income  (loss) before income taxes                  |       | 3,280              |       | (1,092                  | )          | 2,188                            |       | (2,159                       | )          | 29                                   |       |

 

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(1)          In addition to services provided to external customers, certaincompanies in our Services Group provide construction, operations, andmaintenance services to companies in our Utility Group. In accordance with SFASNo. 71, *Accounting for the Effects ofCertain Types of Regulation*, the Company does not eliminate theintersegment profit on sales to affiliated utilities when the sales price isreasonable and it is probable that, through the rate making process, futurerevenue approximately equal to the sales price will result from the regulatedaffiliate’s use of the services. Intersegment revenue was approximately $2.1 million and $0.5million for the three months ended March 31, 2005 and 2004, respectively.

 

(2)          “Corporate and Other” consists primarily ofcosts that include headquarters expenses and any corporate functionaldepartments whose costs are not allocated to reportable segments.

 

The following table presents information about theidentifiable assets of each reported segment as of March 31, 2005 and December 31,2004:

 
| ** **           | ** ** | **March 31, 2005** | ** ** | **December 31, 2004** | ** ** |
|----------------------|------------|-------------------------|------------|----------------------------|------------|
| ** **           | ** ** | **(in thousands)**      | ** ** |
| Utility  Group       |       | $                       | 325,391    |                       | $          | 322,548 |   |
| Services  Group      |       | 73,759                  |       | 70,336                     |       |
| Corporate  and Other |       | 14,587                  |       | 11,925                     |       |
| Consolidated         |       | $                       | 413,737    |                       | $          | 404,809 |   |

 

***Note 7.******– Seasonality and Weather***

 

As our businesses areaffected by weather, the results of operations for one quarter do not indicateresults to be expected in another quarter.

 

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

 

8

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Our Services Groupoperations are subject to the effects of weather. Heavy rainfall or stormconditions may limit our ability to perform certain billable work such aspipeline maintenance, manhole rehabilitation, construction and other outdoorservices. Severe weather conditions may also result in additional labor andmaterial costs to us as we meet the terms of our operations and maintenancecontracts. Depending on the specific contractual terms, this additional workmay be billable to certain clients.  Asignificant portion of the revenues of our Texas subsidiaries is earned undertime and materials contracts where revenues are affected by weather andrainfall.

 

***Note8.******– Commitments,Contingencies and Restrictions***

 

*Commitments Under Acquisition Agreements.*

 

We own 90% ofthe outstanding common stock of Operations Technologies, Inc. (“OpTech”).We have the right to acquire the remaining 10% of OpTech beginning in August 2006based on a formula relating to the profitability of OpTech. The minority ownerhas the option to sell the remaining 10% of OpTech to the Company using thesame formula.  However, the selling pricecannot be less than $1.0 million.

 

We have an 80%interest in Windermere Utility Company (“Windermere”) in Texas. We have theright to acquire the remaining 20% ownership in Windermere for a purchase priceof $6.0 million payable in Southwest’s common stock at any time when the marketvalue of our common stock increases to $12.96 per share (as adjusted for stocksplits and dividends).  This right hasnot yet been triggered.  The minorityowner of Windermere has the right to put the remaining 20% to us beginning in October 2005for up to 450,000 shares of Southwest’s common stock, but no less than 270,000shares, depending on the prevailing stock price, with a value not to exceed$6.0 million.

 

*CommitmentsUnder Long-term Service Contracts*

 

In September 2002,we won a bid to facilitate the engineering and construction of a reverseosmosis water treatment system in the city of San Juan Capistrano, California,for the Capistrano Valley Water District (“CVWD”). The project includes thedrilling of several new wells and the development of associated water lines. Weentered into subcontractor agreements with an engineering firm and a largeconstruction firm to fulfill significant obligations of this service contract.

 

Duringconstruction of the CVWD plant, we received payments upon completion ofconstruction milestones and we expect to continue to receive such paymentsuntil final completion of the construction project. Construction of the plantcommenced in December 2002 and was substantially complete as of December 31,2004. The plant became operational in 2004 and the Company now operates andmaintains the facility under a separate 20-year contract.

 

On January 8,2003, we obtained an unsecured line of credit facility from a commercial bankused to issue a $3.4 million standby letter of credit. This standby letterof credit is in force for the construction period of the project. Upon finalcompletion of the construction project, expected in 2005, the standby letter ofcredit facility will be terminated.

 

As part of thefinancing of this project, the CVWD issued insured municipal bonds. We enteredinto an agreement with the bond insurer to guarantee our performance under theCVWD contract, subject to certain liability limits to the bond insurer in theevent of a default. Such liability limits will not exceed an amount equal to$6.0 million during the construction period of the project, andafterwards, during the 20-year operation of the facility, the liabilitylimits will not exceed an amount equal to $4.0 million plus an amount nogreater than the replacement cost of the reverse osmosis filtration unit withinthe facility, estimated to be approximately $1.5 million.

 

*Legal Proceedings*

 

Southwest and asubsidiary were named as defendants in several lawsuits alleging variousinjuries as a result of water contamination in the San Gabriel Valley MainBasin. The California Supreme Court ruled in February 2002 that theplaintiffs cannot challenge the adequacy of the water quality standardsestablished by California Department of Health Services (“DOHS”). In August 2004the case against Southwest was dismissed; however, the plaintiffs appealed thedismissal to the Court of Appeals for the State of California, Second AppellateDistrict.  To date, liability insurancecarriers have absorbed the costs of defense of the lawsuits.  Based upon information available at thistime, we do not expect that this action will have a material adverse effect onour financial position, results of operations or cash flows.

 

On May 5, 2005, one ofthe Company’s operating subsidiaries received a subpoena to provide records toa grand jury.  The requested recordsrelate to the operations of the San Simeon Wastewater Treatment Plant for theperiod January 2002 to present.  Thefacility was also served with search warrants executed by the U.S.Environmental Protection Agency.  TheCompany’s subsidiary has operated this facility since June 2004.  The Company is cooperating with theinvestigation and has also initiated its own internal investigation.

 

Southwest and itssubsidiaries are subject to litigation arising in the ordinary course ofoperations. We believe the ultimate resolution of such matters will notmaterially adversely affect our consolidated financial position, results ofoperations or cash flows.

 

9

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*Groundwater Settlement*

 

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

 

Asa result of this contamination, under the terms of an agreement with theresponsible parties, we have received payments from these parties, and weexpect to continue to receive payments until completion of remediation or untilour production capacities have been restored. These payments represent the incremental cost of purchasing water overthe cost that would have been incurred by us to pump water from our wells.  Our agreement with the responsible partiesprovided for ongoing reimbursement of our excess water costs and, as such, webill and collect reimbursements monthly. These monthly reimbursements are recorded as a reduction to operatingexpenses–utility group.  During the threemonths ended March 31, 2005 and 2004 these reimbursements wereapproximately $0.4 million and $0.5 million, respectively.

 

Thesettlement agreement also provides for contributions by the responsible partiesto construct new wells and to develop additional interconnections with nearbywater sources. Funds from the settlement agreement will also be used to developlong-term solutions that will potentially enable us to use our own less costlygroundwater supplies in the future. These contributions, recorded as contributions in aid of construction (“CIAC”),were zero and approximately $0.2 million for the three months ended March 31,2005 and 2004.

 

***Note 9.******–Acquisitions***

 

In March 2005, wecompleted the acquisition of the assets of Novus Utility Services, Inc. (“Novus”),a Birmingham, Alabama contract operations company.  The aggregate purchase price wasapproximately $2.5 million, plus assumed liabilities in the amount ofapproximately $1.2 million.  We engaged aprofessional, independent valuation consultant to conduct a review of theacquisition in order to determine an appropriate allocation of the Novuspurchase price including intangible assets and goodwill.

 

***Note 10.******- Debt Obligations***

 

At March 31, 2005, approximately $6.5 millionof long term obligations that would normally be classified as current portionof long-term debt has been reclassified as long-term obligations.  With a new $100 million, five year creditfacility, (New Credit Facility) implemented, effective April 2005 (seeNote 11 and Management’s Discussion and Analysis of Financial Condition andResults of Operations – Debt Obligations for further information), managementhas the intention and the ability to refinance these outstanding obligationswith long term debt through the New Credit Facility.  Accordingly, these obligations have beenclassified consistent with the five-year term of the New Credit Facility.

 

***Note 11.******– Subsequent Events***

 

In April 2005, we received an offer from an unrelated third partyregarding the potential purchase of our billing and collection subsidiary,Master Tek International, Inc. (“MTI”). We are reviewing our strategic options concerning MTI.

 

The Company is not classifying MTI as an asset held for sale as of March 31,2005 as it does not meet the criteria required under Statement of FinancialAccounting Standards No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets.*

 

Effective April 1, 2005, the Company entered into a five-year,$100 million New Credit Facility with a syndicate of five banks.  The New Credit Facility replaced the $50million of committed funding under our bank lines of credit that were due toexpire in 2006.  Southwest expects to usethe New Credit Facility for general corporate purposes.  We took the following actions to reduceinterest expense:

 

1.               Issued a redemption notice to holders of$4.0 million of our New Mexico bonds on April 4, 2005 with a redemptiondate of May 9, 2005,

2.               Redeemed notes payable of approximately$1.5 million  onApril 29, 2005,

3.               Extinguished a term loan for one of ourTexas Utilities in the amount of approximately $8.8 million on April 1,2005, and

4.               Repaid a revolving credit facility forour New Mexico Utility in the amount of approximately $3.8 million on April 1,2005.

 

10

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*** ******Item 2: Management’s Discussion and Analysis ofFinancial Condition and Results of Operations***

 

*Theinformation in this discussion contains forward-looking statements within themeaning of Section 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended (the”34 Act”). Suchstatements are based upon current expectations that involve risks anduncertainties includingthose set forth under “Risk Factors” in this report and under “Business-RiskFactors” in our 2004 Annual Report**.  Factors that could affect forward-lookingstatements relating to the resolution of the material weakness with respect tointernal controls discussed in Item 9A of the 2004 Annual Report include, amongother things: the Company’s ability to design and maintain policies andprocedures which enable the Company to avoid any reoccurrence of the matterswhich gave rise to the material weakness and the Company’s ability to identifyand retain qualified and experienced financial personnel.*  *Any statements contained herein that are not statements of historicalfacts may be deemed to be forward-looking statements. For example, words suchas “may”, “will”, “should”, “estimates”, “predicts”, “potential”, “continue”, “strategy”,“believes”, “expects”, “anticipates”, “plans”, “intends”, and similarexpressions are intended to identify forward-looking statements. Our actualresults and the timing of certain events may differ significantly from theresults discussed in the forward-looking statements. We undertake no obligationto publicly update or revise any forward-looking statements to reflect currentor future events or circumstances.*

 

The following discussion should be read inconjunction with the accompanying unaudited condensed consolidated financialstatements and related notes thereto and the consolidated financial statementsand the notes thereto contained in our 2004 Annual Report.

 

**Overview**

 

Southwest Water Company and subsidiaries (“Southwest,” “we,” “us,” “our”or the “Company,” unless the context otherwise requires) provide a broad rangeof water and waste water services including water production, treatment anddistribution; wastewater collection and treatment; utility billing andcollection; utility infrastructure construction management; and public worksservices. We provide services to more than two million people. Our business issegmented into two operating groups: our Utility Group and our Services Group.

 

Our Utility Group owns and manages rate-regulated public waterutilities in California, New Mexico, Oklahoma and Texas and owns and manageswastewater facilities in New Mexico, Oklahoma and Texas.  State and federal agencies issue regulationsregarding standards of water quality, safety, environmental and other matterswhich affect these operations, as well as establish the rates that we cancharge for our water and wastewater services.

 

Our Services Group operates our contract service businesses in which weoperate and maintain water supply and wastewater facilities owned by cities,public agencies, municipal utility districts, private entities andinvestor-owned utilities (including Utility Group affiliates) primarily inAlabama, California, Colorado, Georgia, Mississippi, New Jersey, New Mexico,South Dakota and Texas. While state and federal agencies issue regulationsregarding standards of water quality, safety, environmental and other matterswhich affect these operations, our Services Group prices are not subject toregulation. We also provide utility billing and collecting services in numerousstates.

 

In July 2004, weacquired a Texas utility consisting of a collection of approximately 86 ruralregulated water systems and 11 wastewater systems serving approximately 21,000water connections and 3,500 wastewater connections from Tecon Water Holdings,L.P. for approximately $66 million, and renamed the utility Monarch Utilities, Inc.(“Monarch”).

 

11

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**Results of Operations**

 

A summary of ourconsolidated results for the three months ended March 31, 2005 and 2004 isas follows:

 
| ** **                                    | ** ** | **Three Months Ended March 31,** | ** ** |
|-----------------------------------------------|------------|---------------------------------------|------------|
| ** **                                    | ** ** | **2005**                              | ** ** | **%****of  Revenue** | ** ** | **2004** | ** ** | **% of  Revenue** | ** ** |
| ** **                                    | ** ** | **($****amounts in millions)**        | ** ** |
| **Revenues:**                                 |       |                                  |       |   |   |   |   |   |   |
| Utility  group                                |       | $                                     | 15.5       |   | 33 |   | $ | 13.0 |   | 33 |   |
| Services  group                               |       | 31.4                                  |       | 67 |   | 26.7 |   | 67 |   |
|                                          |       | 49.9                                  |       | 100 |   | 39.7 |   | 100 |   |
|                                          |       |                                  |       |   |   |   |   |   |   |
| **Expenses:**                                 |       |                                  |       |   |   |   |   |   |   |
| Operating  expenses - utility group           |       | 10.0                                  |       | 21 |   | 7.6 |   | 19 |   |
| Operating  expenses - services group          |       | 27.1                                  |       | 58 |   | 24.5 |   | 62 |   |
| Selling,  general and administrative expenses |       | 8.3                                   |       | 18 |   | 6.6 |   | 17 |   |
|                                          |       | 45.4                                  |       | 97 |   | 38.7 |   | 98 |   |
|                                          |       |                                  |       |   |   |   |   |   |   |
| **Operating  Income**                         |       | 1.5                                   |       | 3 |   | 1.0 |   | 2 |   |
|                                          |       |                                  |       |   |   |   |   |   |   |
| **Other  Income (Expense):**                  |       |                                  |       |   |   |   |   |   |   |
| Interest  expense                             |       | (2.0                                  | )          | (4 | ) | (1.1 | ) | (2 | ) |
| Interest  income                              |       | 0.1                                   |       | — |   | 0.1 |   | — |   |
| Other                                         |       | —                                |       | — |   | — |   | — |   |
|                                          |       | (1.9                                  | )          | (4 | ) | (1.0 | ) | (2 | )  |
|                                          |       |                                  |       |   |   |   |   |   |   |
| **Income  (Loss) Before Income Taxes**        |       | (0.4                                  | )          | (1 | ) | — |   | — |   |
| **Income  Tax Provision (Benefit)**           |       | (0.1                                  | )          | — |   | — |   | — |   |
| **Net  Income (Loss)**                        |       | $                                     | (0.3       | ) | (1 | ) | $ | — |   | — |   |

 

**Discussion of Resultsof Operations for Three Months Ended March 31, 2005 and 2004**

 

**Revenues**

 

**Utility Group**

 

Utility Group revenuesare derived from the production and distribution of water and the collectionand treatment of sewage for residential, industrial and commercial use. OurUtility Group water operations are seasonal, as rainfall and weather conditionsaffect water consumption.  In our serviceareas, the second and third quarters of each year typically account for thehighest volume of water consumption when weather tends to be hot and dry.Drought conditions may result in lower revenue due to consumer conservationefforts and a shortage of water. Drought conditions may also result inincreased water costs to us, which could adversely affect our profitability.Conversely, unusually wet conditions may result in decreased customer demand,lower revenues and lower profit in our Utility Group operations.

 

Revenues in the UtilityGroup increased approximately $2.5 million, or 19%, to $15.5 millionduring the three months ended March 31, 2005, from $13.0 millionduring the same period of the prior year. The increase in Utility Group revenuewas primarily due to the following:

 

1.               A $3.4 millionincrease in revenues attributable to Monarch which we acquired in July 2004.

2.               An increase inrevenue from our other Texas utilities of $0.2 million primarily due to increasedconnections.

3.               The above increaseswere partially offset by a decrease in our California utility of $1.2 milliondue to significantly higher rainfall during the first quarter of 2005.  Rainfall in Southern California was more thandouble the historical average precipitation for the first quarter.  The heavy rainfall decreased customer demand,resulting in lower revenues of $1.2 million and lower profit of $0.3 million inour California utility operations compared to the same period in the prior year.

 

12

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**Services Group**

 

Services Group revenues represent fees earned for water and wastewaterfacility operations and maintenance (O&M) services, equipment maintenanceand repair, sewer pipeline cleaning, utility billing and collection services,construction management services, state-certified water and wastewaterlaboratory analysis and public works. Revenues for the three months ended March31, 2005 increased approximately $4.7 million, or 18%, to $31.4 million from$26.7 million during the same period of the prior year.

 

The increase in Services Group revenues was primarily due to thefollowing:

 

1.               A $5.9 million increase in revenueassociated with contract operations, primarily those performed for our UtilityGroup, as well as increased construction work.

2.               A $0.7 million increase due to theacquisition of a laboratory and other operations.

3.               These revenue increases were partiallyoffset by a decrease of $2.3 million in construction work related to the reverseosmosis plant which has been under construction since 2003 and wassubstantially completed as of December 31, 2004.

 

**Expenses**

 

**Operatingexpenses – utility group**

 

Operatingexpenses—utility group represent the costs of purchasing and producing water,treating wastewater, salaries, wages and employee benefits, facilities costs,power and electricity supplies and equipment, repairs and maintenance,professional fees and other costs. Operating expenses for our Utility Groupincreased $2.4 million, or 32%, to $10.0 million during the three monthsended March 31, 2005, from $7.6 million during the comparable period of2004.  The increase in operating expenseswas primarily due to the following:

 

1.               Operatingcosts of approximately $2.8 million attributable to Monarch.

2.               Thisincrease was offset in part by reduced operating expenses of $0.4 million atour California utility due to lower production as a result of above averagerainfall.

 

Operating expenses—utility group represented approximately 65% and 58% ofrevenues from utility operations for the three months ended March 31, 2005 and2004, respectively.  The increase wasprimarily due to the impact of Monarch which incurs higher operating expensesas a percentage of revenue, as we had anticipated, combined with a higherpercentage of operating expenses at our California utility due to reducedrevenues.

 

**Operating expenses – services group**

 

Operating expenses–services group include salaries, wages and employeebenefits, fleet expenses, facilities costs, supplies and equipment, repairs andmaintenance and professional fees. Operating expenses–services group increased approximately $2.6 million,or 11%, to $27.1 million during the three months ended March 31, 2005 from $24.5million during the same period of 2004. The increase in operating expense–services group was due to theincreased staffing and fleet expense related to additional contract work, someof which was delayed from 2004.  Thestaffing increase resulted in higher salary and wage expenses as well asbenefits and other related costs.

 

Operating expenses – services group, as a percentage of the relatedrevenues decreased to 86% for the three months ended March 31, 2005 compared to92% for the same period of 2004.   Thedecrease was due to the increase in revenues relative to expenses foradditional construction, operating and maintenance work.

 

**Selling, general and administrative expenses**

 

Selling, general and administrative expenses consist mainly ofpersonnel, facilities, insurance and professional services costs, which supportour sales, marketing, human resources, finance andadministration functions.  Selling,general and administrative expenses increased $1.7 million, or 26%, to $8.3million for the three months ended March 31, 2005 compared to $6.6 millionduring the same period of 2004.  Selling, generaland administrative expenses increased to 18% of revenues for the three monthsended March 31, 2005 from 17% during the three months ended March 31, 2004.  The increase in selling, general and administrativeexpenses was primarily due to the following:

 

1.               An increase in audit fees of $0.4million.

2.               An increase of $0.4 million attributableto the acquisition of Monarch in July 2004.

 

13

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3.               $0.3 million increase in costs comparedto the prior period related to our efforts to comply with the Sarbanes-OxleyAct of 2002 and related regulations, primarily compliance testing.

4.               Approximately $0.6 million increaseprimarily due to legal fees, outside services and salaries and wages.

 

**Other Income (Expense)**

 

**Interest Expense**

 

Interest expense increased approximately $0.9 million,or 81%, during the three months ended March 31, 2005 compared to the sameperiod in 2004.  The major components ofinterest expense are as follows:

 
| ** **                                             | ** ** | **For the Three Months Ended  March 31,** | ** ** |
|--------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                             | ** ** | **2005**                                  | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                        | ** ** |
| Interest expense - convertible subordinate  debentures |       | $                                         | 296        |   | $ | 326 |   |
| Interest expense - bank lines of credit                |       | 329                                       |       | 247 |   |
| Interest expense - mortgage bonds and bank  term loan  |       | 1,086                                     |       | 492 |   |
| Interest expense - other                               |       | 308                                       |       | 154 |   |
| Total interest expense before capitalized  interest    |       | 2,019                                     |       | 1,219 |   |
| Capitalized interest                                   |       | (70                                       | )          | (142 | ) |
| Total interest expense                                 |       | $                                         | 1,949      |   | $ | 1,077 |   |

 

The increase in total interest expense is primarily due to an increasein our long-term debt.  Our averagebalances of long-term debt outstanding were approximately $126 million and $72million for the three months ended March 31, 2005 and 2004, respectively.  The increase in our average balances oflong-term debt was driven primarily by debt assumed in our acquisition ofMonarch in July 2004 and $27 million of first mortgage bonds issued by ourCalifornia and New Mexico utilities in the fourth quarter of 2004.  In addition, our effective weighted averageborrowing rate decreased slightly to 6.5% during the three months ended March31, 2005 from 6.6% during the three months ended March 31, 2004.

 

**Provision for Income Taxes**

 

Our effective income tax rates for the three monthsended March 31, 2005 and 2004 were approximately 36% and 37%, respectively.

 

**Liquidityand Capital Resources**

 

Our corporate objectives with respect to liquidity and capitalresources are to:  (i) generatesufficient operating cash to provide for dividends, principal and interestrequirements, capital improvements, and taxes; (ii) obtain external financingfor long term capital improvements and acquisitions; (iii) utilize our creditfacilities to manage seasonal cash needs; and (iv) maintain approximately equallevels of debt and equity.

 

Our statements of cash flows are summarized as follows:

 
| ** **                                            | ** ** | **Three Months Ended  March 31,** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| ** **                                            | ** ** | **(in thousands)**                | ** ** |
| Net cash provided by operating activities             |       | $                                 | 1,459      |   | $ | 154 |   |
| Net cash used in investing activities                 |       | (8,949                            | )          | (6,737 | ) |
| Net cash provided by financing activities             |       | 10,815                            |       | 4,725 |   |
| Net increase (decrease) in cash and cash  equivalents |       | $                                 | 3,325      |   | $ | (1,858 | ) |

 

Despite a net loss for the quarter, net cash flow increased by $3.3million for the three months ended Mach 31, 2005 as compared to a decrease of$1.9 million in 2004.  The increase innet cash flow was primarily the result of increased borrowings of $11.8million, increased revenues in our Utility and Services Groups along with anincrease in depreciation and amortization expense which are non-cashcharges.  (For further discussion onoperating revenues and expenses see Results of Operations.) This increase incash flow was partially offset by plant, property and equipment additions andthe purchase of Novus.

 

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*Cash Flows FromOperating Activities*

 

Net cash provided by operating activities during the three months endedMarch 31, 2005 consisted of a net loss of $0.2 million adjusted for certainnon-cash items including $2.7 million of depreciation and amortization expense,stock based compensation expense of $0.3 million**,**and an increase in deferred income taxes of $0.8million.  Operating cash flow increaseddue to other current assets which decreased by $3.1 million.  Operating cash flow was reduced primarily by$1.8 million due to an increase in other assets and a decrease in accountspayable of $2.0 million and a decrease in other current liabilities of $1.3million.

 

Net cash provided by operating activities during the three months endedMarch 31, 2004 consisted of net income of $0.02 million adjusted for certainnon-cash items including $1.8 million of depreciation and amortization expenseand stock based compensation expense of $0.3 million.  Operating cash flow was increased byrestricted cash of $1.9 million. Operating cash flow was reduced by a decrease accounts payable of $2.2million, and an increase in accounts receivable of $0.7 million.

 

*Cash Flows from Investing Activities*

 

Cash used in investing activities totaled $8.9 million in the firstquarter of 2005 and was the result of capital improvements in our utilitybusiness and acquisitions in our services business.  Capital expenditures of $6.9 million were primarilyinvested in regulated water utility assets for purposes of expansion,replacement or renovation.  The followingtable summarizes property, plant and equipment additions for each of the firstquarters in 2005 and 2004.

 
| ** **                                        | ** ** | **Three Months Ended  March 31,** | ** ** |
|---------------------------------------------------|------------|-----------------------------------|------------|
| ** **                                        | ** ** | **2005**                          | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(in thousands)**                | ** ** |
| Company-financed additions                        |       | $                                 | 6,678      |   | $ | 1,918 |   |
| Capital improvement reimbursements                |       | —                            |       | 162 |   |
| Contributions paid for by developers              |       | 263                               |       | 1,079 |   |
| Net cash used in investing activities             |       | 6,941                             |       | 3,159 |   |
| Property contributed by developers                |       | 346                               |       | 836 |   |
| Total additions to property, plant and  equipment |       | $                                 | 7,287      |   | $ | 3,995 |   |

 

Cash payments for acquisitions during the first quarter of  2005 and 2004included:

 

•                  $2.0 million in2005 in cash towards the purchase of Novus, and

 

•                  $2.9million in 2004 to acquire the remaining minority interest of a Services Groupsubsidiary.

 

*Cash Flows FromFinancing Activities*

 

Our financing activities involved the following events during the firstthree months ended in 2005 and 2004 as follows:

 

•                  The netborrowings on our revolving lines of credit in 2005 by $11.8 million.

 

•                  A publicoffering of approximately 1.7 million shares of our common stock in March 2004,which generated net proceeds of approximately $20.6 million.

 

•                  Cash was used in2004 to repay borrowings of approximately $16.3 million.

 

Aggregate borrowings under our revolving lines of credit were $34.8million as of March 31, 2005, an increase of approximately $11.8 million due tocapital expenditures, the impact of our seasonally low first quarter cash flow and preparation for therefinancing of our credit facility.  Ourtotal borrowing availability under lines of credit was approximately$15 million as of March 31, 2005.

 

As more fully discussed below, we entered into a new 5-year creditfacility with a syndicate of banks in April 2005, which provides for a $100million revolving credit facility.  InApril 2005, we used a portion of our borrowings from the New Credit Facility torepay amounts outstanding, and to extinguish, our lines of credit and certainother indebtedness.

 

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During 2005, we paid dividends totaling approximately $1.0 million. Ourquarterly dividend rate is currently $0.05 per common share.  Common stockholders may elect to participatein our Dividend Reinvestment and Stock Purchase Plan, which gives them theoption of receiving their dividends in either cash or common stock at a 5%discount from current market value.  Thisplan also permits optional cash purchases of stock at current market values ofup to $3,000 per stockholder each quarter.

 

Contributions in Aid of Construction (CIAC) represent contributions inthe form of cash, services or property received from developers, governmentalagencies, municipalities or individuals for the purpose of constructing utilityplant.

 

Our capital resources are used for debt service on our bonds anddebentures and are also influenced by investments we make in new businessventures, including the acquisition of companies and acquisition of contractoperations. We have historically generated reasonably stable operating cashflows.

 

We expect to expend approximately $14 million for cashcapital expenditures for the remainder of 2005, primarily for utility property,plant and equipment.  We plan to fundthose expenditures with cash flow from operations, borrowings under our NewCredit Facility and other sources.

 

We augmentedour operating cash flow with borrowings under our lines of credit.  At March 31, 2005, we had a working capitalof approximately $13.4 million including available cash andcash-equivalent balances of approximately $5.3 million (excludingrestricted cash balances).  EffectiveApril 1, 2005, we implemented the New Credit Facility and took the followingactions to reduce interest expense.

 

1)              Issueda redemption notice to holders of $4.0 million of our New Mexico bonds on April4, 2005 with a redemption date of May 9, 2005,

2)              Redeemednotes payable of approximately $1.5 million  on April 29, 2005,

3)              Extinguisheda term loan for our Texas Utility in the amount of approximately $8.8 millionon April 1, 2005, and

4)              Repaida revolving credit facility for our New Mexico Utility in the amount ofapproximately $3.8 million on April 1, 2005.

 

**Off-BalanceSheet Arrangements**

 

We do not haveany material off-balance sheet arrangements other than leases that have beenclassified as operating leases in accordance with accounting principlesgenerally accepted in the United States of America (“US GAAP”) for interimfinancial information.

 

**Debt Obligations**

 

Following is a summary of our debt obligations and commitments due inthe remaining nine months of 2005 and in the specified periods thereafter.  Amounts represent the expected cash principalpayments related to our long-term debt.

 
| ** **                         | ** ** | ** **         | ** ** | **Years Ending December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------------|------------|-------------------------------|------------|------------|------------|
| ** **                         | ** ** | **2005**           | ** ** | **2006**                      | ** ** | **2007**   | ** ** | **2008** | ** ** | **2009 and  thereafter** | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **(in thousands)** | ** ** |
| Long-term debt                     |       |               |       |                          |       |       |       |   |   |   |   |   |   |
| Bank lines of credit (1)           |       | $                  | —     |                          | $          | —     |       | $ | — |   | $ | — |   | $ | 34,809 |   | $ | 34,809 |   |
| Bank term loans (2)                |       | 715                |       | 946                           |       | 938        |       | 931 |   | 20,410 |   | 23,940 |   |
| Economic development revenue bonds |       | 95                 |       | 100                           |       | 105        |       | 115 |   | 1,810 |   | 2,225 |   |
| Mortgage bonds                     |       | —             |       | 8,000                         |       | —     |       | — |   | 39,000 |   | 47,000 |   |
| Convertible subordinate debentures |       | —             |       | —                        |       | —     |       | — |   | 17,241 |   | 17,241 |   |
| Notes payable (1)                  |       | 693                |       | 397                           |       | 420        |       | 1,597 |   | 1,721 |   | 4,828 |   |
|                               |       | $                  | 1,503      |                          | $          | 9,443      |       | $ | 1,463 |   | $ | 2,643 |   | $ | 114,991 |   | $ | 130,043 |   |

 

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(1)          As described above, we repaid the outstanding amounts on our lines ofcredit with the proceeds from our new $100 million 5 year credit facilityentered into on April 1, 2005.  As of May5, 2005, there was approximately $48.5 million outstanding under our New CreditFacility.

(2)          At March 31, 2005, approximately $6.5 million of long term obligationsthat would normally be classified as current portion of long term debt has beenreclassified as long term obligations due to management’s intent and ability torefinance these obligations.  Accordingly, we have reflected this debt aslong-term debt consistent with the five-year term of the New Credit Facility.

 

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In April 2005, we entered into the New CreditFacility.  The New Credit Facilityprovides for a $100 million revolving credit facility, which includes a $40million letter of credit subfacility and a $10 million swingline subfacility. The New Credit Facility contains customary covenants, as well as customaryevents of default.  Certain of oursubsidiaries have guaranteed our obligation to repay borrowings under the NewCredit Facility.

 

Loans under the New Credit Facility (other thanswingline loans) will bear interest at a rate equal to (i) LIBOR plus theapplicable margin (as provided for in the New Credit Facility), or (ii) a baserate (as defined) minus the applicable margin. At May 5, 2005, we had $48.5 million of outstanding borrowings under ourNew Credit Facility and the adjusted average borrowing rate was approximately4.0%.  The New Credit Facility replacedour existing lines of credit which had provided for up to $50.0 million ofborrowings and we used the New Credit Facility to repay amounts outstandingunder those lines of credit.  As of March31, 2005, we were in compliance with all applicable covenants under our thenoutstanding line of credit agreements.

 

In January 2003, we had a $3.4 million line of credit withone of our commercial banks that we used to issue a standby letter of credit inthat amount as collateral for performance under a contract to design andconstruct a reverse osmosis water treatment facility.  Upon final completion of the project, expectedin 2005, the standby letter of credit will be terminated.  On April 1, 2005, the standby letter ofcredit was transferred to the New Credit Facility and the standby line ofcredit was cancelled.

 

In addition to the foregoing, the indentures governingthe first mortgage bonds for our California and New Mexico utilities permittedthe issuance of approximately $58.1million of first mortgage bonds at theseutilities as of March 31, 2005.

 

We anticipate that our available credit facilityborrowing capacity and cash flows generated from operations will be sufficientto fund our activities during the next 12 months, however we cannotguarantee that will be the case.  If weneeded additional financing and were unable to obtain it, our capital spendingand any future acquisitions would be delayed, reduced, or eliminated.

 

We have an effective registration statement on filewith the Securities and Exchange Commission (“SEC”), under which we may issueup to $50 million aggregate principal amount of common stock, debtsecurities and warrants. During 2004, we issued approximately $44 millionof common stock under the shelf registration, and approximately $6 millionremains available for issuance as of March 31, 2005. We may offer any of thesesecurities for sale at any time and from time to time.

 

**CriticalAccounting Policies**

 

Ourconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States (“US GAAP”). Theseaccounting principles require us to make certain estimates, judgments andassumptions. We believe that the estimates, judgments and assumptions arereasonable based upon information available to us at the time that theseestimates, judgments and assumptions are made. These estimates, judgments and assumptionscan affect the reported amounts of assets and liabilities as of the date of thefinancial statements, as well as the reported amounts of revenues and expensesduring the periods presented. To the extent there are material differencesbetween these estimates, judgments or assumptions and actual results, ourfinancial statements will be affected. The significant accounting policies thatwe believe are important to fully understanding and evaluating our reportedfinancial results include the following:

 

•                  Revenuerecognition,

•                  Valuation oflong-lived and intangible assets,

•                  Accounting forregulated businesses,

•                  Stock-basedcompensation, and

•                  Deferred costs.

 

In many cases,the accounting treatment of a particular transaction is specifically dictatedby GAAP and does not require management’s judgment in its application. Thereare also areas which require management’s judgment in selecting among availableGAAP alternatives. Our senior management has reviewed these critical accountingpolicies and related disclosures with the audit committee of the Board ofDirectors.

 

**Revenuerecognition**

 

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

 

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Revenues forcontract operations are recognized and billed at the end of the month based ona monthly fee to provide a specific level of service as outlined in eachindividual contract. We generally bill for additional services provided beyondthe scope of the base contract on a time-and-materials basis as such servicesare rendered.

 

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

 

Revenues formultiple-family utility billing and collecting services are recognized andbilled at the end of the month in which services are performed. Revenues forinstallation of multiple-family utility billing and collection equipment areaccounted for using the percentage-of-completion method.

 

If a contractinvolves the provision of a single product or service, revenue is generallyrecognized when the product or service is provided and the amount becomesbillable. If services are provided evenly during the contract term but servicebillings are irregular, revenue is recognized on a straight-line basis over thecontract term.

 

Certainnon-refundable activation fees in our non-regulated wholesale water operationsare accounted for on a completed contract basis and subsequently deferred andrecognized over the expected period of performance.

 

If a contractinvolves the provision of multiple products or services (elements), totalestimated contract revenue is allocated to each element based on the relativefair value of each service, provided the services qualify for separation underEmerging Issues Task Force (EITF) 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*. The amount ofrevenue allocated to each service is limited to the amount that is notcontingent upon the delivery of another element in the future. Revenue is thenrecognized for each element as described above for single-element contracts,except revenue recognized on a straight-line basis for a non-construction servicewill not exceed amounts currently billable unless the excess revenue isrecoverable from the client upon any contract termination event. If the amountof revenue allocated to a construction service is less than its relative fairvalue, costs to deliver such service, limited to the difference betweenallocated revenue and the relative fair value, are deferred and amortized overthe contract term. If total construction service costs are estimated to exceedthe relative fair value for the construction service contained in amultiple-element arrangement, then a provision for the estimated loss is madein the period in which the loss first becomes apparent.

 

**Valuationof long-lived and intangible assets**

 

In accordancewith SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets,*we assess intangibleassets and other long-lived assets, excluding goodwill, for recoverabilitywhenever events or changes in circumstances indicate that their carrying valuemay not be recoverable through the estimated undiscounted future cash flowsresulting from the use of the assets. If we determine that the carrying valueof intangible assets or other long-lived assets may not be recoverable, wemeasure impairment by using the projected discounted cash-flow method inaccordance with Statement No. 144.

 

We have madeacquisitions in the past that resulted in recording goodwill and intangibleassets. In June 2001, the Financial Accounting Standards Board (FASB)issued SFAS No. 142,*Goodwill and OtherIntangible Assets.*SFAS No. 142 requires that goodwill andintangible assets with indefinite useful lives are not amortized, but insteadare tested for impairment at least annually. For intangible assets with finiteuseful lives, SFAS No. 142 requires amortization over their estimateduseful lives. SFAS No. 142 became effective for fiscal years beginningafter December 15, 2001. The Company engaged an independent professionalvaluation consultant to conduct a goodwill impairment review in accordance withSFAS No. 142.  We evaluated goodwillimpairment using discounted cash flow methodologies, transaction values forcomparable companies, and other valuation techniques for our reporting unitswith significant goodwill balances.  Ourreporting units, generally subsidiaries one level below operating segments,constitute separate businesses for which we maintain discrete financialinformation that is regularly reviewed by segment and chief operating decisionmaker.  There were no impairment chargesto goodwill as of March 31, 2005 and no events have occurred thatindicated diminution in the value of recorded goodwill.

 

Under theprovisions of SFAS No. 141, *BusinessCombinations*, we have identified intangible assets apart fromgoodwill such as contract costs and account lists.  These intangible assets are amortized overtheir estimated useful lives ranging from four to eight years.

 

**Accountingfor regulated businesses**

 

Our regulatedbusinesses, which include our utilities in California, New Mexico, and Texas,are required to be accounted for under the

 

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provisionsof SFAS No. 71, *Accounting for theEffects of Certain Types of Regulation,* which specifies certainrevenue, expense and balance sheet treatment as required by each state’s regulatoryauthority. Each state authority establishes rates which are intended to permiteach utility to recover its costs and earn a reasonable rate of return.

 

Our Services Group has contracted with our utilities in Texas and NewMexico to perform operating services, maintenance, construction work, and tomanage capital projects.  In accordancewith SFAS No. 71, our Services Group recognizes profit on sales toregulated affiliates and does not eliminate the intercompany profit when thesales price is reasonable and it is probable that, through the rate makingprocess, future revenue approximately equal to the sales price will result fromthe regulated affiliate’s use of the services. However, all revenue in excess of profits is eliminated.  Accordingly, the intercompany profit forconstruction as well as operations and maintenance services provided to UtilityGroup affiliates has not been eliminated in the accompanying consolidatedfinancial statements.  Based upon ourServices Group’s experience of providing operations and maintenance services inmore than 400 contracts with unaffiliated customers, and a history of regulatorapproval of the construction service fees charged by the Services Group toutility affiliates, we believe that the contract sales prices between ourServices Group and our Texas and New Mexico utilities are reasonable and thatit is probable that the price of these services will be recovered in therate-making process.

 

**Stock-based compensation**

 

In 2002, weadopted the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*,which requires valuation of stock options issued based upon an option pricingmodel and recognition of this value as an expense over the period in which theoptions vest. In accordance with the provisions of SFAS No. 148, weelected to recognize stock-based compensation using the retroactive restatementmethod. Under this change in accounting method, we restated our accompanyingconsolidated financial statements for periods prior to 2002 to reflectstock-based compensation expense under a fair value based accounting method forall options granted, modified or settled in fiscal years beginning afterDecember 15, 1994.

 

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

 

**Deferred Costs**

 

We defer andsubsequently amortize certain direct contract acquisition costs related toactivities that enable the provision of contracted services to our customers.Deferred contract acquisition costs are amortized on a straight-line basis overthe remaining original contract term unless revenue patterns indicate a moreaccelerated method is appropriate. The recoverability of all long-lived assetsassociated with a particular contract, including deferred contract costs, isanalyzed on a periodic basis. If we conclude that long-lived assets are impaired,an impairment loss is recognized for the amount by which the carrying value ofthe long-lived assets exceeds the fair value of those assets.

 

**RISK FACTORS**

 

The following factors, which are described more fullyin our 2004 Annual Report, represent risks and uncertainties that could causeactual results to differ materially from our historical experience and ourpresent expectations or projections. Factors that could affect forward-lookingstatements relating to the resolution of the material weakness with respect tointernal controls discussed in Item 4 below and Item 9A of our 2004 AnnualReport, include among other things: our ability to identify and retainqualified and experienced financial personnel and our ability to design andmaintain policies and procedures which enable us to avoid any reoccurrence ofthe matters which gave rise to the material weakness.   See “Risk Factors” in our 2004 Annual Reportfor further disclosure related to risk factors.

 

**Risks Related to Our Business**

 

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

 

•                  *Weather conditions can affect the financial resultsof our Utility Group.*

 

•                  *Changes in the regulatory environment, includingrestrictions on rates we are allowed to charge customers, may adversely affectour results of operations.  Changes inpolicies allowing our Services Group to provide services to our regulatedutilities, at fair market values, may adversely impact our operating results.*

 

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•                  *We may discover additional contamination of our watersources which may adversely affect our operations.  We may not recover costs incurred or revenueslost due to such contamination from responsible parties or from rate payers.*

 

•                  *We own assets in areas subject to natural disastersor that may be the target of terrorist activities.*

 

•                  *We are subject to regulatory and environmental risksand we may not be able to provide an adequate supply of water to our customers.*

 

•                  *We need access to capital to continue to invest inour utility assets.*

 

•                  *We may be limited in our ability to mitigate water costs related tonon-paying customers due to environmental considerations*.

 

***Risk factors that affect our Services Group operations***

 

•                  *We operate in a competitive market with low operatingmargins.*

 

•                  *Our revenue growth depends on our ability to enterinto new, and maintain our existing, operating contracts with cities, agenciesand municipal utility districts.*

 

•                  *Our business depends on trained, qualified employees.*

 

•                  *Events such as heavy rain, hurricanes, tornadoes andfloods may adversely affect our results of operations.*

 

•                  *Our Services Group’s contracts have certainperformance risks.*

 

•                  *Services Group contracts for the design andconstruction of water and wastewater facilities may expose us to certaincompletion and performance risks.*

 

•                  *We use third party equipment and subcontractors.*

 

•                  *Our Services Group is subject to environmental andwater quality risks.*

 

•                  *We operate a large fleet of vehicles that couldexpose us to liabilities.*

 

•                  *Our operating costs may rise faster than ourrevenues.*

 

•                  *Our operating contracts may be canceled, reducing ourrevenues and backlog. Also we may not secure new construction and constructionmanagement projects on a consistent basis, leading to fluctuations in revenuesand backlog.*

 

**Risks Related to Our Common Stock**

 

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

 

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

 

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

 

•                  *Our results could fall below the expectations ofmarket analysts or investors.*

 

•                  *We may issue additional shares of our common stock.*

 

**Other Risk Factors**

 

•                  *Our capital resources may restrict our ability tooperate and expand our business.*

 

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•                  *If we continue to grow, we may fail to effectivelymanage our growth or we may fail to effectively manage the growth we haveexperienced.*

 

•                  *Our business may be affected by the general economicconditions of real estate development in the United States.*

 

•                  *We are subject to debt covenants.*

 

•                  *Rating agencies may downgrade our debt.*

 

•                  *We are subject to increasing costs of producingproducts and services.*

 

•                  *Our operations are subject to certain risks due totheir locations.*

 

•                  *Internal control weaknesses could have an adverseeffect on us.  We may not be able toremediate the material weakness noted in the 2004 10-K in a timely manner.*

 

•                  *We rely on a number of complex business systems thatcould malfunction.*

 

•                  *We retain certain risks not covered by our insurancepolicies.*

 

***Item3.******Quantitative and Qualitative Disclosures aboutMarket Risk***

 

We have no material changes to the disclosure on thismatter made in our 2004 Annual Report.

 

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***Item4.******Controls and Procedures***

 

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

 

As discussed inour 2004 Annual Report, filed with the SEC on March 31, 2005, accounting errorswere identified during the fourth quarter of 2004 that were caused by lack ofan effective review, by appropriate accounting personnel, of the accounting forcertain non-routine transactions.  Suchtransactions involved a) purchase accounting for an acquisition, b) balancesheet classification of long-term debt, and c) accounting for a gaincontingency.  As a result of thisinternal control deficiency, there was more than a remote likelihood that theCompany’s interim or annual financial statements could have been materiallymisstated, and accordingly, such deficiency was considered a material weaknessin internal control over financial reporting as of December 31, 2004.  A material weakness is a control deficiency,or combination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements would not be prevented or detected. Because of the material weakness described above, management concludedthat, as of December 31, 2004, our internal control over financial reportingwas not effective.

 

We are in the process of implementing improvements toour internal controls to address the aforementioned material weakness.  We are implementing procedures in ouraccounting review and approval processes over non-routine transactions.  These include implementation of additionalchecklists, more timely review and accounting for non-routine transactions andtimely identification of non-routine issues with our auditors.  We are evaluating appropriate staffing andexperience levels in our corporate controllership function and are activelysearching for the additional personnel. We believe that the material weaknessidentified above has not yet been rectified.

 

There were no other changes in the Company’s internalcontrol over financial reporting for the first quarter 2005 that havematerially affected, or are reasonably likely to materially affect the Company’sinternal control over financial reporting.

 

For thequarter ended March 31, 2005, the Company carried out an evaluation, under thesupervision and with the participation of the Company’s management, includingthe Company’s Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures. Based on the foregoing, the Company’s Chief Executive Officerand Chief Financial Officer concluded that the Company’s disclosure controlsand procedures were not effective as of March 31, 2005.

 

While we continue to devote significant resources to meeting theinternal control over financial reporting requirements of the rules adopted bythe SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we cannotassure you that the policies and procedures we have adopted and our continuedefforts will successfully remediate the material weakness we have identifiedand any control deficiencies or material weaknesses that we or our outside auditorsmay identify before the end of our fiscal year.

 

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**PART II - OTHER INFORMATION**

 

***Item1.******Legal Proceedings***

 

Southwest and a subsidiary were named as defendants inseveral lawsuits alleging various injuries as a result of water contaminationin the San Gabriel Valley Main Basin. The California Supreme Court ruled inFebruary 2002 that the plaintiffs cannot challenge the adequacy of thewater quality standards established by California Department of Health Services(“DOHS”). In August 2004 the case against Southwest was dismissed; however, theplaintiffs appealed the dismissal to the Court of Appeals for the State ofCalifornia, Second Appellate District. To date, liability insurance carriers have absorbed the costs of defenseof the lawsuits.  Based upon informationavailable at this time, we do not expect that this action will have a materialadverse effect on our financial position, results of operations or cash flows.Southwest Water and its subsidiaries are subject to litigation arising in theordinary course of operations. 

 

On May 5, 2005, one of the Company’s operatingsubsidiaries received a subpoena to provide records to a grand jury.  The requested records relate to theoperations of the San Simeon Wastewater Treatment Plant for the period January2002 to present.  The facility was alsoserved with search warrants executed by the U.S. Environmental ProtectionAgency.  The Company’s subsidiary hasoperated this facility since June 2004. The Company is cooperating with the investigation and has also initiatedits own internal investigation.

 

Southwest and its subsidiaries are subject tolitigation arising in the ordinary course of operations. We believe theultimate resolution of such matters will not materially adversely affect ourconsolidated financial position, results of operations or cash flows.

 

***Item 6.******Exhibits***

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

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 
|                | SOUTHWEST WATER COMPANY                                                     |   |
|---------------------|-----------------------------------------------------------------------------|--------|
|                | (Registrant)                                                                |
|                |                                                                        |
| Dated: May 10, 2005 | /s/ CHERYL L. CLARY                                                         |   |
|                | **Cheryl L. Clary  Chief Financial Officer  (Principal Financial Officer)** |
|                     |                                                                             |        |  |

 

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