**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

** **

**(Mark One)**

 

**x****       ****Quarterly Report pursuant to Section 13 or 15(d) of theSecurities Exchange Act of 1934**

** **

**For the quarterly period ended March 31, 2008**

** **

**or**

 

o**        ****Transition report pursuant to Section 13or 15(d) of the Securities Exchange Act of 1934**

** **

**For the transition period from                         to                         **

** **

**Commission File Number 0-8176**

 

 

(Exact name of registrant as specified in its charter)

 

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

** **

**One Wilshire Building**

**624 South Grand Avenue, Suite 2900**

**Los Angeles, California 90017-3782**

(Address of principal executive offices, including zip code)

 

**(213) 929-1800**

(Registrant’s telephone, including area code)

 

**None**

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

 

Indicateby check mark whether the registrant (1) has filed all reports required tobe filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.  Yes o   No x

 

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

 

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

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule 12b-2of the Act). Yes o   No x

 

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

 

| **Class**                              | ** ** | **Outstanding as of May 2, 2008** |
|----------------------------------------|------------|------------------------------------------------------------|
| Common Stock, $.01 par value per share |       | 24,467,595 shares                                          |

 

 

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**TABLE OF CONTENTS**

 
| ** **       | ** **                                                                                                               | **Page**   |
|------------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| ** **       | ** **                                                                                                               | ** ** |
| **Part I**  | **Financial Information**                                                                                                | **1**      |
|             |                                                                                                                     |       |
| Item 1.          | Financial Statements (Unaudited)                                                                                         | 1          |
|             | Report of Independent Registered Public Accounting Firm                                                                  | 1          |
|             | Condensed Consolidated Balance Sheets as of March 31, 2008 and  December 31, 2007                              | 2          |
|             | Condensed Consolidated Statements of Income for the three months  ended March 31, 2008 and 2007                     | 3          |
|             | Condensed Consolidated Statement of Changes in Stockholders’ Equity  for the three months ended March 31, 2008 | 4          |
|             | Condensed Consolidated Statements of Cash Flows for the three months  ended March 31, 2008 and 2007                 | 5          |
|             | Notes to  Condensed Consolidated Financial Statements                                                                    | 6          |
| Item 2.          | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                              | 18         |
| Item 3.          | Quantitative and Qualitative Disclosures  About Market Risk                                                              | 31         |
| Item 4.          | Controls and Procedures                                                                                                  | 31         |
|             |                                                                                                                     |       |
| **Part II** | **Other Information**                                                                                                    | **32**     |
| Item 1.          | Legal Proceedings                                                                                                        | 32         |
| Item 1A.         | Risk Factors                                                                                                             | 32         |
| Item 6.          | Exhibits                                                                                                                 | 32         |
|             |                                                                                                                     |       |
| **Signatures**   | **33**                                                                                                                   |

 

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# ** **

# **PART I– FINANCIAL INFORMATION**

# ** **

## **ITEM1.  FINANCIAL STATEMENTS**

## ** **

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

###  

The Board of Directors and StockholdersSouthWest Water Company:

 

We have reviewed the accompanying condensedconsolidated balance sheet of SouthWest Water Company and its subsidiaries asof March 31, 2008, and the related condensed consolidated statements ofincome, changes in stockholders’ equity and cash flows for the three-monthperiod ended March 31, 2008. This interim financial information is theresponsibility of the Company’s management.

 

We conducted our review in accordance withthe standards of the Public Company Accounting Oversight Board (United States).A review of interim financial information consists principally of applyinganalytical procedures and making inquiries of persons responsible for financialand accounting matters. It is substantially less in scope than an auditconducted in accordance with the standards of the Public Company AccountingOversight Board (United States), the objective of which is the expression of anopinion regarding the financial statements taken as a whole. Accordingly, we donot express such an opinion.

 

Based on our review, we are not aware of anymaterial modifications that should be made to the accompanying condensedconsolidated interim financial information for it to be in conformity withaccounting principles generally accepted in the United States of America.

 

/s/  PricewaterhouseCoopers LLP

 

Los Angeles, California

May 9, 2008

 

1

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** **

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| *** ***                                  | *** *** | ***March 31,*** | *** *** | ***December 31,*** | *** *** |
|-----------------------------------------------|--------------|----------------------|--------------|-------------------------|--------------|
| ***(In thousands)***                     | ** **   | **2008**             | ** **   | **2007**                | ** **   |
| ** **                                    |         |                 |         |                    |         |
| **ASSETS**                                    |         |                 |         |                    |         |
| ** **                                    |         |                 |         |                    |         |
| Current Assets:                               |         |                 |         |                    |         |
| Cash and cash equivalents                     |         | $                    | 2,216        |                    | $            | 2,950 |   |
| Accounts receivable, net                      |         | 27,736               |         | 26,005                  |         |
| Assets held for sale                          |         | 15,895               |         | 16,013                  |         |
| Other current assets                          |         | 16,839               |         | 16,617                  |         |
| Total current assets                          |         | 62,686               |         | 61,585                  |         |
|                                          |         |                 |         |                    |         |
| Property, Plant and Equipment, Net:           |         |                 |         |                    |         |
| Regulated utilities                           |         | 425,060              |         | 399,146                 |         |
| Non-regulated operations                      |         | 20,050               |         | 18,757                  |         |
| Total property, plant and equipment, net      |         | 445,110              |         | 417,903                 |         |
|                                          |         |                 |         |                    |         |
| Other Assets:                                 |         |                 |         |                    |         |
| Goodwill                                      |         | 17,349               |         | 17,349                  |         |
| Intangible assets                             |         | 2,443                |         | 2,539                   |         |
| Other assets                                  |         | 16,360               |         | 17,033                  |         |
|                                          |         | $                    | 543,948      |                    | $            | 516,409 |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |         |                 |         |                    |         |
| ** **                                    |         |                 |         |                    |         |
| Current Liabilities:                          |         |                 |         |                    |         |
| Accounts payable                              |         | $                    | 8,350        |                    | $            | 14,930 |   |
| Liabilities related to assets held for sale   |         | 4,297                |         | 4,297                   |         |
| Current portion of long-term debt             |         | 1,938                |         | 1,937                   |         |
| Other current liabilities                     |         | 23,298               |         | 25,020                  |         |
| Total current liabilities                     |         | 37,883               |         | 46,184                  |         |
|                                          |         |                 |         |                    |         |
| Other Liabilities and Deferred Credits:       |         |                 |         |                    |         |
| Long-term debt                                |         | 181,869              |         | 145,353                 |         |
| Deferred income taxes                         |         | 28,672               |         | 28,102                  |         |
| Advances for construction                     |         | 9,364                |         | 9,210                   |         |
| Contributions in aid of construction          |         | 114,789              |         | 115,442                 |         |
| Other liabilities and deferred credits        |         | 13,245               |         | 12,924                  |         |
|                                          |         |                 |         |                    |         |
| Commitments and Contingencies                 |         |                 |         |                    |         |
|                                          |         |                 |         |                    |         |
| Stockholders’ Equity:                    |         |                 |         |                    |         |
| Preferred stock                               |         | 458                  |         | 458                     |         |
| Common stock                                  |         | 244                  |         | 243                     |         |
| Additional paid-in capital                    |         | 146,080              |         | 145,072                 |         |
| Retained earnings                             |         | 11,262               |         | 13,336                  |         |
| Accumulated other comprehensive income        |         | 82                   |         | 85                      |         |
| Total stockholders’ equity               |         | 158,126              |         | 159,194                 |         |
|                                          |         |                 |         |                    |         |
|                                          |         | $                    | 543,948      |                    | $            | 516,409 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

2

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| *** ***                                                         | *** *** | ***Three Months Ended*** | ** ** |
|----------------------------------------------------------------------|--------------|------------------------------------|------------|
| ** **                                                           | ** **   | ***March 31,***               | ** ** |
| ***(In thousands, except per share data)*** | ** **   | **2008**                           | ** ** | **2007** | ** ** |
|                                                                 |         |                               |       |   |   |
| Revenues:                                                            |         |                               |       |   |   |
| Utility Group                                                        |         | $                                  | 22,341     |   | $ | 20,034 |   |
| Services Group                                                       |         | 28,422                             |       | 27,835 |   |
| Total revenues                                                       |         | 50,763                             |       | 47,869 |   |
|                                                                 |         |                               |       |   |   |
| Expenses:                                                            |         |                               |       |   |   |
| Utility Group operating expenses                                     |         | 13,441                             |       | 11,809 |   |
| Services Group operating expenses                                    |         | 25,910                             |       | 24,442 |   |
| Selling, general and administrative  expenses                        |         | 9,605                              |       | 8,530 |   |
| Total expenses                                                       |         | 48,956                             |       | 44,781 |   |
|                                                                 |         |                               |       |   |   |
| Operating income                                                     |         | 1,807                              |       | 3,088 |   |
|                                                                 |         |                               |       |   |   |
| Other income (expense):                                              |         |                               |       |   |   |
| Interest expense                                                     |         | (2,361                             | )          | (1,854 | ) |
| Interest income                                                      |         | 122                                |       | 135 |   |
| Other, net                                                           |         | —                             |       | (49 | ) |
|                                                                 |         |                               |       |   |   |
| Income (loss) from continuing operations  before income taxes        |         | (432                               | )          | 1,320 |   |
| Provision (benefit) for income taxes                                 |         | (118                               | )          | 480 |   |
|                                                                 |         |                               |       |   |   |
| Income (loss) from continuing operations                             |         | (314                               | )          | 840 |   |
|                                                                 |         |                               |       |   |   |
| Loss from discontinued operations, net of  tax                       |         | (287                               | )          | (226 | ) |
|                                                                 |         |                               |       |   |   |
| Net income (loss)                                                    |         | (601                               | )          | 614 |   |
|                                                                 |         |                               |       |   |   |
| Preferred stock dividends                                            |         | (6                                 | )          | (6 | ) |
|                                                                 |         |                               |       |   |   |
| Net income (loss) applicable to common  stockholders                 |         | $                                  | (607       | ) | $ | 608 |   |
|                                                                 |         |                               |       |   |   |
| Earnings per common share:                                           |         |                               |       |   |   |
| Basic:                                                               |         |                               |       |   |   |
| Income (loss) from continuing operations                             |         | $                                  | (0.01      | ) | $ | 0.03 |   |
| Loss from discontinued operations                                    |         | (0.01                              | )          | — |   |
| Net income (loss) applicable to common  stockholders                 |         | $                                  | (0.02      | ) | $ | 0.03 |   |
|                                                                 |         |                               |       |   |   |
| Diluted:                                                             |         |                               |       |   |   |
| Income (loss) from continuing operations                             |         | $                                  | (0.01      | ) | $ | 0.03 |   |
| Loss from discontinued operations                                    |         | (0.01                              | )          | — |   |
| Net income (loss) applicable to common  stockholders                 |         | $                                  | (0.02      | ) | $ | 0.03 |   |
|                                                                 |         |                               |       |   |   |
| Weighted average common shares outstanding:                          |         |                               |       |   |   |
| Basic                                                                |         | 24,385                             |       | 23,882 |   |
| Diluted                                                              |         | 24,385                             |       | 24,214 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

3

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| ** **                                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | **Accumulated** | ** ** | ** **             | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|------------------|------------|--------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                                  | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | **Other**       | ** ** | ** **             | ** ** |
| ** **                                                                  | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | **Compre–** | ** ** | **Total**    | ** ** |
| ** **                                                                  | ** ** | **Number of**       | ** ** | ** **            | ** ** | **Number of** | ** ** | ** ** | ** ** | **Paid-in**      | ** ** | **Retained** | ** ** | **hensive**     | ** ** | **Stockholders’** | ** ** |
| **(In thousands)**                                                     | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**         | ** ** | **Amount** | ** ** | **Capital**      | ** ** | **Earnings** | ** ** | **Income**      | ** ** | **Equity**             | ** ** |
|                                                                        |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Balance at  December 31, 2007                                          |       | 9                        |       | $                     | 458        |               | 24,268     |       | $          | 243              |       | $            | 145,072    |            | $          | 13,336                 |       | $ | 85 |   | $ | 159,194 |   |
|                                                                        |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Comprehensive  income (loss):                                               |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Net income (loss)                                                           |       | —                   |       | —                |       | —             |       | —     |       | —           |       | (601         | )          | —          |       | (601                   | )          |
| Other  comprehensive income, net of tax: Amortization of actuarial net gain |       | —                   |       | —                |       | —             |       | —     |       | —           |       | —       |       | (3              |  )    | (3                     |  )    |
| Comprehensive  income (loss)                                                |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       | (604                   | )          |
| Stock issuance  under dividend reinvestment and stock purchase plans        |       | —                   |       | —                |       | 65                 |       | —     |       | 761              |       | —       |       | —          |       | 761                    |       |
| Share-based  compensation expense                                           |       | —                   |       | —                |       | 116                |       | 1          |       | 233              |       | —       |       | —          |       | 234                    |       |
| Debenture  conversions                                                      |       | —                   |       | —                |       | 1                  |       | —     |       | 14               |       | —       |       | —          |       | 14                     |       |
| Cash dividends  declared                                                    |       | —                   |       | —                |       | —             |       | —     |       | —           |       | (1,473       | )          | —          |       | (1,473                 | )          |
|                                                                        |       |                     |       |                  |       |               |       |       |       |             |       |         |       |            |       |                   |       |
| Balance at  March 31, 2008                                             |       | 9                        |       | $                     | 458        |               | 24,450     |       | $          | 244              |       | $            | 146,080    |            | $          | 11,262                 |       | $ | 82 |   | $ | 158,126 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

4

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| *** ***                                                                          | *** *** | ***Three Months Ended*** | ** ** |
|---------------------------------------------------------------------------------------|--------------|------------------------------------|------------|
| ** **                                                                            | ** **   | ***March 31,***               | ** ** |
| ***(In thousands)***                                                             | ** **   | **2008**                           | ** ** | **2007** | ** ** |
| ** **                                                                            |         |                               |       |   |   |
| **Cash flows from operating activities of  continuing operations:**                   |         |                               |       |   |   |
| Net income (loss)                                                                     |         | $                                  | (601       | ) | $ | 614 |   |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities: |         |                               |       |   |   |
| Loss from discontinued operations, net of  tax                                        |         | 287                                |       | 226 |   |
| Depreciation and amortization                                                         |         | 3,642                              |       | 2,904 |   |
| Deferred income taxes                                                                 |         | 569                                |       | 350 |   |
| Share-based compensation expense                                                      |         | 234                                |       | 408 |   |
| Changes in assets and liabilities, net of  effects of acquisitions:                   |         |                               |       |   |   |
| Accounts receivable                                                                   |         | (1,731                             | )          | 1,907 |   |
| Other current assets                                                                  |         | 3,031                              |       | 2,431 |   |
| Other assets                                                                          |         | (2,708                             | )          | (509 | ) |
| Accounts payable                                                                      |         | (6,795                             | )          | (5,092 | ) |
| Other current liabilities                                                             |         | (1,065                             | )          | (2,425 | ) |
| Other liabilities                                                                     |         | 37                                 |       | (1,241 | ) |
| Other, net                                                                            |         | (44                                | )          | (27 | ) |
| Net cash used in operating activities                                                 |         | (5,144                             | )          | (454 | ) |
|                                                                                  |         |                               |       |   |   |
| **Cash flows from investing activities of  continuing operations:**                   |         |                               |       |   |   |
| Acquisitions of businesses, net of cash  acquired                                     |         | (23,330                            | )          | (558 | ) |
| Additions to property, plant and equipment                                            |         | (7,960                             | )          | (8,077 | ) |
| Proceeds from sales of equipment                                                      |         | 9                                  |       | 33 |   |
| Net cash used in investing activities                                                 |         | (31,281                            | )          | (8,602 | ) |
|                                                                                  |         |                               |       |   |   |
| **Cash flows from financing activities of  continuing operations:**                   |         |                               |       |   |   |
| Revolving lines of credit:                                                            |         |                               |       |   |   |
| Borrowings                                                                            |         | 121,500                            |       | 7,500 |   |
| Repayment of $100 million revolving line of  credit                                   |         | (84,500                            | )          | — |   |
| Capital improvement reimbursements                                                    |         | 795                                |       | 865 |   |
| Proceeds from stock option and stock  purchase plans                                  |         | 761                                |       | 1,409 |   |
| Contributions in aid of construction                                                  |         | 227                                |       | 485 |   |
| Excess tax benefit from stock options  exercised                                      |         | —                             |       | 380 |   |
| Dividends paid                                                                        |         | (1,473                             | )          | (1,389 | ) |
| Deferred financing costs                                                              |         | (527                               | )          | (3 | ) |
| Repayment of advances for construction                                                |         | (488                               | )          | (204 | ) |
| Payments on long-term debt                                                            |         | (439                               | )          | (308 | ) |
| Net cash provided by financing activities                                             |         | 35,856                             |       | 8,735 |   |
|                                                                                  |         |                               |       |   |   |
| **Cash flows from discontinued operations:**                                          |         |                               |       |   |   |
| Operating activities                                                                  |         | (165                               | )          | (643 | ) |
| Investing activities                                                                  |         | —                             |       | (317 | ) |
| Financing activities                                                                  |         | —                             |       | — |   |
| Net cash used in discontinued operations                                              |         | (165                               | )          | (960 | ) |
|                                                                                  |         |                               |       |   |   |
| Net change in cash and cash equivalents                                               |         | (734                               | )          | (1,281 | ) |
| Cash and cash equivalents at beginning of  year                                       |         | 2,950                              |       | 4,294 |   |
| Cash and cash equivalents at end of period                                            |         | $                                  | 2,216      |   | $ | 3,013 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

5

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

### **NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

###  

**Note 1.       Summaryof Significant Accounting Policies**

** **

**Basis of Presentation**

** **

These condensed consolidated interimfinancial statements are unaudited. SouthWest Water Company (the “Company”)believes the interim financial statements are presented on a basis consistentwith the audited financial statements and include all adjustments necessary fora fair presentation of the financial condition, results of operations and cashflows for such interim periods. All of these adjustments are normal recurringadjustments.

 

Preparation of these condensed consolidatedfinancial statements in conformity with U.S. generally accepted accountingprinciples (“GAAP”) requires the Company to make estimates and judgments thataffect the reported amounts of assets, liabilities and disclosure of contingentassets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expensesduring the reporting periods. Actual results could differ from thoseestimates.

 

Certain information and disclosures normallyincluded in financial statements prepared in accordance with GAAP have beenomitted in accordance with Securities and Exchange Commission’s rules andregulations for interim financial reporting. These condensed consolidatedinterim financial statements should be read in conjunction with the auditedfinancial statements and related notes included in the Company’s 2007 AnnualReport on Form 10-K. The Company’s businesses are seasonal because theyare affected by weather. As a result, operating results for interim periods donot necessarily predict the operating results for any other interim period orfor the full year.

 

The condensed consolidated financialstatements as of March 31, 2008 and for the three-month period ended March 31,2008 have been reviewed by PricewaterhouseCoopers LLP, an independentregistered public accounting firm. Their report (dated May 9, 2008) isincluded on page 1 on this report. The report of PricewaterhouseCoopersLLP states that they did not audit and they do not express an opinion on thatunaudited financial information. Accordingly, the degree of reliance on theirreport on such information should be restricted in light of the limited natureof the review procedures applied. PricewaterhouseCoopers LLP is not subject tothe liability provisions of Section 11 of the Securities Act of 1933 fortheir report on the unaudited financial information because that report is nota “report” or a “part” of the registration statement prepared or certified byPricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act.

 

**Change in Presentation**

** **

Effective January 1, 2008, the Companylaunched the first phase of its financial reporting reengineering process byimplementing a fully integrated financial module throughout the entire company.As a result, the methodology of capturing and reporting operating versusgeneral and administrative expenses as well as the classification of expensesbetween business segments has changed. As permitted by SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information*,prior year amounts have not been reclassified to conform to the 2008presentation because the information is not available and the cost to developit would be excessive.

 

Reclassifications have also been made toprior year’s financial statement presentation with respect to a component ofthe business the Company is holding for sale as a discontinued operation (Note3).

 

**Comprehensive Income (Loss)**

** **

Comprehensive income (loss) includes changesin equity that are excluded from net income (loss), such as the unfundedportion of the Company’s executive retirement plan. Comprehensive income (loss)was $(604,000) and $616,000 for the three months ended March 31, 2008 and2007, respectively.

 

6

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** **

**Note 1.       Summaryof Significant Accounting Policies (Continued)**

** **

**Accounting Pronouncement Adopted During 2008**

** **

*SFAS No. 157*

* *

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*(“SFAS 157”).This statement defines fair value, establishes a framework for using fair valueto measure assets and liabilities, and expands disclosures about fair valuemeasurements. The statement applies when other statements require or permit thefair value measurement of assets and liabilities. This statement does notexpand the use of fair value measurement. In February 2008, the FASBissued FASB Staff Position No. 157-2, *Effective Date of FASBStatement No. 157* (“FSP 157-2”). FSP 157-2 delays theeffective date of SFAS No. 157 for certain non-financial assets andliabilities to fiscal years beginning after November 15, 2008.

 

The Company adopted SFAS No. 157 asrequired on January 1, 2008 for all financial assets and liabilities, andthis statement did not have a material impact on the Company’s consolidatedresults of operations or consolidated financial position. The Company iscurrently assessing the potential effect of SFAS No. 157 on allnon-financial assets and liabilities.

 

*SFAS No. 159*

* *

The Company adopted SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*(“SFAS 159”) effective January 1, 2008. The Company did not elect thefair value option for any of its existing financial assets and liabilities. Theadoption of this statement did not have a material impact on the Company’sconsolidated results of operations or consolidated financial position.

 

**Recent Accounting Pronouncements**

** **

*SFAS No. 141(R)*

* *

In December 2007, the FASB issuedStatement No. 141 (revised 2007), *Business Combinations*(“SFAS 141(R)”). SFAS 141(R) changes the accounting for acquisitionsspecifically eliminating the step acquisition model, changing the recognitionof contingent consideration at the time of acquisition, disallowing thecapitalization of transaction costs and changes when restructurings related toacquisitions can be recognized. The statement is effective for fiscal yearsbeginning on or after December 15, 2008 and will only impact theaccounting for acquisitions that are made after adoption. Adoption of SFAS 141(R) willimpact the Company’s accounting for future business combinations in that alltransactions costs will be expensed as incurred and contingent consideration,if present, will be recorded upon acquisition.

 

*SFAS No. 160*

* *

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements, an amendment of ARB No. 51* (“SFAS 160”). SFAS 160introduces significant changes in the accounting and reporting for businessacquisitions and noncontrolling interest in a subsidiary. SFAS 160 also changesthe accounting for and reporting for the deconsolidation of a subsidiary.Companies are required to adopt the new standard for fiscal years beginningafter January 1, 2009. The Company is evaluating the impact of thisstandard and currently does not expect it to have a significant impact on itsfinancial position, results of operations or cash flows.

 

7

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** **

**Note 1.       Summaryof Significant Accounting Policies (Continued)**

** **

*SFAS No. 161*

* *

In March 2008, the FASB issued SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities—an amendment ofFASB Statement No. 133 (“SFAS 161”). This statement amends SFAS No. 133by requiring enhanced disclosures about a company’s derivative instruments andhedging activities, but does not change the scope of, or accounting under, SFASNo. 133. SFAS No. 161 requires increased qualitative, quantitativeand credit-risk disclosures about the entity’s derivative instruments andhedging activities. SFAS 161 is effective for the Company’s fiscal yearbeginning January 1, 2009. We are evaluating the potential impact of thisstatement.

 

**Note 2.       Acquisition**

** **

On January 31, 2008, the Companyacquired substantially all of the assets of a wastewater collection system andrelated treatment plant in Birmingham, Alabama. The purchase price was $23.3million in cash which the Company borrowed under its revolving line of credit.The acquisition was accounted for as a purchase and the assets acquired havebeen recorded at their estimated fair values, consisting of $20.8 million ofutility plant and $2.5 million of land, based upon preliminary valuations. TheCompany expects to finalize the purchase price allocation during 2008.

 

The consolidated financial statements reflectthe financial position and results of operations of the acquired utilitysubsequent to its acquisition date. Unaudited pro forma consolidated results ofoperations are presented in the table below for the three months ended March 31,2008 and 2007 as if the acquisition had occurred as of the beginning of eachperiod presented.

 
| *** ***                                                                | *** *** | ***Pro Forma for the*** | ** ** |
|-----------------------------------------------------------------------------|--------------|----------------------------------------|------------|
| ** **                                                                  | ** **   | ***Three Months Ended***     | ** ** |
| ** **                                                                  | ** **   | ***March 31,***                   | ** ** |
| **(In thousands)**                                                          | ** **   | **2008**                               | ** ** | **2007** | ** ** |
|                                                                        |         |                                   |       |   |   |
| Total revenues                                                              |         | $                                      | 51,170     |   | $ | 49,071 |   |
| Income (loss) from continuing operations                                    |         | (263                                   | )          | 944 |   |
| Income (loss) from continuing operations  applicable to common stockholders |         | (269                                   | )          | 938 |   |
| Net income (loss) applicable to common  stockholders                        |         | (556                                   | )          | 712 |   |
|                                                                        |         |                                   |       |   |   |
| Earnings (loss) per common share:                                           |         |                                   |       |   |   |
| From continuing operations applicable to  common stockholders:              |         |                                   |       |   |   |
| Basic                                                                       |         | $                                      | (0.01      | ) | $ | 0.04 |   |
| Diluted                                                                     |         | (0.01                                  | )          | 0.04 |   |
| Net income (loss) applicable to common stockholders:                        |         |                                   |       |   |   |
| Basic                                                                       |         | (0.02                                  | )          | 0.03 |   |
| Diluted                                                                     |         | (0.02                                  | )          | 0.03 |   |

 

The pro forma results of operations are notnecessarily indicative of the results that would have been achieved had theacquisition occurred as of the dates indicated or to project the results ofoperations for any future periods. The above information reflects adjustmentsfor historical revenues and expenses prior to the acquisition, as well asincremental operating, general and administrative, depreciation, interest andincome tax expense based on the estimated fair value of assets acquired andadditional indebtedness in connection with the acquisition.

 

8

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** **

**Note 3.       AssetsHeld for Sale**

** **

During 2007, the Company committed to a planto sell its wholesale water and wastewater operations in Texas and believes itcan consummate the sales during 2008. As a result, the Company has classifiedthe assets and related liabilities as held for sale in the accompanyingconsolidated balance sheet and the results of operations and cash flows forthese operations are reflected as discontinued operations for all periodspresented. The following tables summarize the financial position and results ofoperations of these operations included in the condensed consolidated financialstatements.

 
| *** ***                                  | *** *** | ***March 31,*** | *** *** | ***December 31,*** | *** *** |
|-----------------------------------------------|--------------|----------------------|--------------|-------------------------|--------------|
| **(In thousands)**                       | ** **   | **2008**             | ** **   | **2007**                | ** **   |
|                                          |         |                 |         |                    |         |
| Assets held for sale:                         |         |                 |         |                    |         |
| Accounts receivable                           |         | $                    | 89           |                    | $            | 81 |   |
| Other current assets                          |         | 168                  |         | 167                     |         |
| Property, plant and equipment, net            |         | 14,708               |         | 14,833                  |         |
| Other assets                                  |         | 930                  |         | 932                     |         |
| Assets held for sale                          |         | 15,895               |         | 16,013                  |         |
|                                          |         |                 |         |                    |         |
| Liabilities related to assets held for  sale: |         |                 |         |                    |         |
| Accounts payable                              |         | 29                   |         | 31                      |         |
| Deferred revenue                              |         | 4,268                |         | 4,266                   |         |
| Liabilities related to assets held for sale   |         | 4,297                |         | 4,297                   |         |
| Net assets held for sale                      |         | $                    | 11,598       |                    | $            | 11,716 |   |

 
| ** **                        | ** ** | ***Three Months Ended*** | ** ** |
|-----------------------------------|------------|------------------------------------|------------|
| ** **                        | ** ** | ***March 31,***               | ** ** |
| ***(In thousands)***         | ** ** | **2008**                           | ** ** | **2007** | ** ** |
| *** ***                      | ** ** | ** **                         | ** ** | ** ** | ** ** |
| Revenues                          |       | $                                  | 190        |   | $ | 205 |   |
| Expenses                          |       | 292                                |       | 350 |   |
|                              |       |                               |       |   |   |
| Operating loss                    |       | (102                               | )          | (145 | ) |
|                              |       |                               |       |   |   |
| Other income (expense):           |       |                               |       |   |   |
| Interest expense                  |       | (299                               | )          | (216 | ) |
| Interest income                   |       | 6                                  |       | 5 |   |
|                              |       |                               |       |   |   |
| Pretax loss                       |       | (395                               | )          | (356 | ) |
| Income tax benefit                |       | 108                                |       | 130 |   |
|                              |       |                               |       |   |   |
| Loss from discontinued operations |       | $                                  | (287       | ) | $ | (226 | ) |

 

In accordance with EITF 87 24, *Allocation of Interest to Discontinued Operation* (“EITF 8724”), as amended, interest expense reflects interest on debt that the Companyis required to repay as a result of the sale. In addition, and also inaccordance with EITF 87 24, costs and expenses exclude the allocation ofgeneral corporate overhead.

 

9

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** **

**Note 4.       Long-TermDebt**

** **

Long-term debt consists of the following asof March 31, 2008 and December 31, 2007:

 
| *** ***                                          | *** *** | ***March 31,*** | *** *** | ***December 31,*** | ** ** |
|-------------------------------------------------------|--------------|----------------------|--------------|-------------------------|------------|
| ***(In thousands)***                             | ** **   | **2008**             | ** **   | **2007**                | ** ** |
|                                                  |         |                 |         |                    |       |
| Revolving credit facility                             |         | $                    | 88,000       |                    | $          | 51,000 |   |
|                                                  |         |                 |         |                    |       |
| 6.85% convertible subordinated debentures  due 2021   |         | 12,034               |         | 12,053                  |       |
|                                                  |         |                 |         |                    |       |
| $ 30  million capital lease facility             |         | 4,376                |         | 4,582                   |       |
|                                                  |         |                 |         |                    |       |
| Term Loans:                                           |         |                 |         |                    |       |
| Monarch Utilities, Inc.:                         |         |                 |         |                    |       |
| 7.37% fixed rate term loan due 2022                   |         | 10,844               |         | 11,037                  |       |
| 5.77% fixed rate term loan due 2022                   |         | 746                  |         | 759                     |       |
| 6.10% fixed rate term loan due 2031                   |         | 20,000               |         | 20,000                  |       |
|                                                  |         |                 |         |                    |       |
| First Mortgage Bonds:                                 |         |                 |         |                    |       |
| Suburban Water Systems:                               |         |                 |         |                    |       |
| 9.09% series B first mortgage bond due 2022           |         | 8,000                |         | 8,000                   |       |
| 5.64% series D first mortgage bond due 2024           |         | 15,000               |         | 15,000                  |       |
| 6.30% series E first mortgage bond due 2026           |         | 10,000               |         | 10,000                  |       |
| New Mexico Utilities, Inc.:                      |         |                 |         |                    |       |
| 6.10% series C first mortgage bond due 2024           |         | 12,000               |         | 12,000                  |       |
|                                                  |         |                 |         |                    |       |
| Economic Development Revenue Bonds:                   |         |                 |         |                    |       |
| ECO Resources, Inc.:                             |         |                 |         |                    |       |
| 5.5% series 1998A due 2008                            |         | 115                  |         | 115                     |       |
| 6.0% series 1998A due 2018                            |         | 1,810                |         | 1,810                   |       |
|                                                  |         |                 |         |                    |       |
| Acquisition-related indebtedness and other            |         | 154                  |         | 176                     |       |
| Total long-term debt payment obligations              |         | 183,079              |         | 146,532                 |       |
| Unamortized Monarch term loan fair value  adjustments |         | 728                  |         | 758                     |       |
| Total long-term debt                                  |         | 183,807              |         | 147,290                 |       |
| Less current portion of long-term debt                |         | (1,938               | )            | (1,937                  | )          |
| Long-term debt, less current portion                  |         | $                    | 181,869      |                    | $          | 145,353 |   |

 

On February 15, 2008, the Companyentered into a credit agreement with several lenders including Bank of America,as lender and Administrative Agent, KeyBank, CoBank, U.S. Bank, JPMorgan ChaseBank, Comerica Bank, Bank of the West, Citibank and Union Bank of California.The credit agreement provides for a $150.0 million revolving credit facility.The Company may elect to increase the amount of the credit facility by anamount not to exceed $75.0 million during the term of the agreement providedcertain conditions are met. The Company is subject to commitment fees under thefacility as well as the maintenance of customary financial ratios, cash flowresults and other restrictive covenants. Proceeds from the initial $84.5million borrowing under the credit agreement were used to repay borrowingsunder the Company’s prior $100.0 million revolving line of credit which wasterminated upon repayment at which time unamortized deferred financing coststotaling $268,000 were written off.

 

The revolving line of credit commitment endson February 15, 2013 (if not renewed or extended), at which time allborrowings must be repaid. Borrowings under the credit facility bear interest,at the Company’s option, based on a margin either over the LIBOR rate or underthe prime rate. The margins vary depending upon the Company’s consolidated debtto equity ratio. Currently, the applicable margins are 0.750% over the LIBORrate or 0.25% under the prime rate. The weighted-average annual interest rateson all credit facility borrowings outstanding were 3.85% as of March 31,2008 and 5.74% as of December 31, 2007.

 

10

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** **

**Note 4.       Long-TermDebt (Continued)**

** **

The Company had irrevocable standby lettersof credit in the amount of $2.0 million issued and outstanding under itsrevolving credit facility as of March 31, 2008, reducing availableborrowings under the credit facility to $60.0 million as of that date.

 

**Note 5.       Commitmentsand Contingencies**

** **

**Legal Proceedings**

** **

*New Mexico Utilities, Inc.—Sewer Ratesand Return Flow Credits*

 

New Mexico Utilities, Inc. (“NMUI”), oneof the Company’s wholly-owned regulated utilities, has an agreement with theAlbuquerque Bernalillo County Water Utility Authority, a political subdivisionof the State of New Mexico (the “Water Authority”), whereby the Water Authoritytreats the effluent from NMUI’s wastewater collection system for a fee. Thetreated effluent is returned to the Rio Grande Underground Basin, creatingreturn flow credits. Return flow credits supplement NMUI’s existing waterrights, enabling it to pump additional water from the basin.

 

In August 2004, the Water Authorityincreased the fee charged to NMUI, using a different formula than had been usedto calculate fee increases in prior years. The Company believes the increaseviolates the terms of a written agreement between the parties. Subsequently,the Water Authority also claimed ownership of the return flow credits. TheCompany filed a Complaint for Declaratory Judgment in the Second JudicialDistrict Court, County of Bernalillo, State of New Mexico (the “Court”),requesting that the Court settle these disputes. In a letter ruling dated May 2,2007, the Court ruled that the Water Authority could use a new formula to setfees for NMUI. The Company filed a motion for reconsideration and that motionwas denied on October 2, 2007. The matter has now been set for trial inthe fall of 2008. The Court has not ruled on whether the new rate wasappropriate; has made no determination as to any amount NMUI may owe to theWater Authority, or ruled on the ownership of the return flow credits.

 

In September 2007, NMUI received a $0.7million retroactive billing adjustment from the Water Authority covering theperiod from August 2003 through April 2006 for the volume of wastewaterit believes NMUI discharged into the treatment system versus the amountreported by NMUI. The amounts reported by NMUI were based on a calculationmethodology that had been agreed to by both parties and used for approximately30 years. NMUI is contesting the billing adjustment.

 

Although the Company cannot give anyassurances as to the ultimate resolution of these matters, the Company does notbelieve that it is probable it will be required to pay the disputed fees andrelated late payment penalties, which totaled $6.2 million as of March 31,2008, and has not recognized a reserve for any potential liabilities in theaccompanying consolidated financial statements. In addition, should the Court rule againstNMUI, the New Mexico Public Regulation Commission has indicated its support ofNMUI’s proposal that it be permitted to establish a regulatory asset for anyamounts paid, including legal fees and late payment penalties, and recover thatasset prospectively through a rate surcharge to its customers. The Company isunable to predict the impact the resolution of the return flow creditsownership dispute will have on its consolidated financial statements.

 

On February 26, 2008, the Company wasmade aware of a “Claim of Lien” filed by the Water Authority against NMUI inthe sum of $5.8 million, allegedly for the amount of delinquent sewer chargesat the time of filing. This lien is related to the above described matterscurrently being litigated in New Mexico State Court.

 

11

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** **

**Note 5.       Commitmentsand Contingencies (Continued)**

** **

*New Mexico Utilities, Inc.—CondemnationProceedings*

 

In addition, on January 19, 2007, theWater Authority and the City of Rio Rancho, a home-rule municipalcorporation, as Petitioners, filed a Petition for Condemnation against NMUI andothers, as Defendants, in the Court (the “Petition”). The Petition seeks toacquire, by condemnation, all of the assets of NMUI, including all realproperty, through the stated power of eminent domain. The Petition also allegesthat the Petitioners need to acquire the NMUI assets for the public purposes ofproviding water and wastewater services to NMUI customers and that theacquisition of NMUI is necessary, appropriate and in the public interest. TheCompany is contesting the Petition and the matter is scheduled for trial in theApril 2009. If the Company does not prevail, the Petitioners must pay fairmarket value for the utility as determined by the Court, based on appraisals.NMUI and the Petitioners do not agree on the value of the assets which thePetitioners seek to condemn. While it is too early to predict the outcome ofthis matter, the Company believes that if the Court were to determine the fairmarket value of NMUI, it would exceed its recorded net book value as of March 31,2008.

 

*Other Matters*

 

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

 

**Investigations**

** **

On May 5, 2005, one of the Company’soperating subsidiaries received a subpoena to provide records to a grand jury.The requested records relate to the operations of the San Simeon wastewatertreatment plant in California for the period January 2002 to the date ofthe subpoena. The subsidiary has operated this facility since September 2004.The facility was also served with search warrants executed by the EPA. TheCompany cooperated fully with the investigation and the investigation wasclosed without further action in February 2008.

 

On May 18, 2005, the EPA executed asearch warrant at the Company’s Texas-based testing laboratory and on July 20,2006 the laboratory received a subpoena to provide additional records andinformation to a grand jury. The Company is cooperating fully with theinvestigation and has provided the records requested. There have been nofurther significant developments since July 20, 2006.

 

The Company received a letter dated January 28,2008 from the California State Water Resources Control Board Office ofEnforcement (the “Board”). The letter indicates that the Board has conducted aninvestigation of the operations of a subsidiary of the Company with respect tovarious California wastewater treatment facilities which are operated, but notowned, by the subsidiary. The Board alleges that the subsidiary has violatedcertain provisions of the California Water Code and may be subject to civiladministrative liability in excess of $15.0 million, and possibleadministrative action against the subsidiary’s status as a contract operator inCalifornia. The Company is undertaking its own internal review of theallegations and while, at this time, the Company believes that the summaryallegations cannot be substantiated, it cannot currently predict what, if any,actions may be taken by the Board or the effect those actions may have on itsfinancial position, results of operations or cash flows. The Company is workingcooperatively with the Board in an effort to favorably resolve this issue. Noamounts have been accrued related to any potential fines, penalties or otherliabilities.

 

12

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** **

**Note 5.       Commitmentsand Contingencies (Continued)**

** **

**Settlement Agreement Liability**

** **

In 2006, the Company negotiated a settlementagreement with a municipality relating to possible fines and penalties forspecified violations occurring during the time the Company operated themunicipality’s wastewater system. The Company’s maximum payment obligation iscapped at $0.7 million under the agreement provided that total fines andpenalties levied do not exceed a specified amount. The water quality controlboard has levied fines and penalties exceeding the amount contemplated by thesettlement agreement.

 

The Company believes there are convincingarguments for negotiating a reduction in the amounts levied but elected toaccrue the $0.7 million maximum amount contemplated by the settlementagreement. The water quality control board has preliminarily agreed that thefines and penalties may be substantially reduced from the amounts originallylevied, however, the Company has not received final notice of this action. As aresult, $0.7 million remains accrued as of March 31, 2008.

 

**Commitments Under Long-Term Service Contracts**

** **

The Company operates a reverse osmosis watertreatment plant owned by the Capistrano Valley Water District (“CVWD”) under atwenty-year operating agreement. The agreement contains three guaranteesrelated to the performance of the Company and its subsidiary during the term ofthe agreement. The agreement provides for the Company to pay liquidated damagesin the event it fails to perform for reasons other than those caused by “uncontrollablecircumstances,” as such term is defined in the agreement.

 

During the term of the agreement, the Companymay be liable for liquidated damages relating to any lost payments from a financialassistance agreement CVWD has with a state water agency, up to a maximum of$1.4 million per contract year. The Company has also made guarantees to CVWDwith respect to the quantity of finished water produced by the facility. In theevent the actual number of acre feet of finished water delivered is less thanthe water delivery guarantee, the Company is required to pay liquidated damagesof approximately $600 per acre foot of shortfall, up to a maximum of 15.8 acrefeet per day. Finally, the Company has made guarantees with respect to sevenmeasurable finished water quality standards. Liquidated damages for failure tomeet these quality standards range from $100 to $400 per day per failed qualitystandard (up to a maximum of $2,800 per day), depending on the number ofviolations per contract year. The CVWD has not asserted any claims forliquidated damages pursuant to these guarantees through the date of thisreport.

 

As part of the financing for this project,the CVWD sold insured municipal bonds. The Company entered into an agreementwith the bond insurer to guarantee the Company’s performance under the servicecontract, subject to certain liability caps to the bond insurer in the event ofa default. During the twenty-year operation of the facility, such liabilitycaps will not exceed an amount equal to $4.0 million plus an amount no greaterthan the replacement cost of the actual reverse osmosis filtration unit withinthe facility, estimated to be approximately $1.5 million.

 

**Water Supply Commitment**

** **

One of the Company’s regulated utilities hasa water supply contract providing for the purchase of water to supplement itsown water supply. The agreement requires the Company to purchase minimumquantities of water annually at a specified price. The price is subject toannual adjustment for production cost increases incurred by the seller. Theminimum quantity is also subject to adjustment based on average actual waterpurchases over a moving two-year period, but the minimum will not be reducedbelow a specified threshold. As of March 31, 2008, the minimum annualpurchase commitment is $0.5 million through 2024.

 

13

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** **

**Note 6.       EarningsPer Share**

** **

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

 
| *** ***                                                                | *** *** | ***Three Months Ended*** | ** ** |
|-----------------------------------------------------------------------------|--------------|------------------------------------|------------|
| *** ***                                                                | *** *** | ***March 31,***               | ** ** |
| ***(In thousands, except per share data)***        | ** **   | **2008**                           | ** ** | **2007** | ** ** |
|                                                                        |         |                               |       |   |   |
| Numerators—Net income (loss) applicable to  common stockholders:       |         |                               |       |   |   |
| Income (loss) from continuing operations                                    |         | $                                  | (314       | ) | $ | 840 |   |
| Less preferred stock dividends                                              |         | (6                                 | )          | (6 | ) |
| Income (loss) from continuing operations  applicable to common stockholders |         | (320                               | )          | 834 |   |
| Loss from discontinued operations                                           |         | (287                               | )          | (226 | ) |
| Net income (loss) applicable to common  stockholders                        |         | $                                  | (607       | ) | $ | 608 |   |
|                                                                        |         |                               |       |   |   |
| Denominators—Weighted average common shares  outstanding:              |         |                               |       |   |   |
| Basic weighted average common shares  outstanding                           |         | 24,385                             |       | 23,882 |   |
| Plus shares issued on assumed exercise of  stock options and warrants       |         | —                             |       | 332 |   |
| Diluted weighted average common shares  outstanding                         |         | 24,385                             |       | 24,214 |   |

 

The difference between reported basic anddiluted earnings per share is the effect of stock options that, under thetreasury share method, give rise to potentially dilutive common shares. TheCompany incurred a loss during the three months ended March 31, 2008. As aresult, options to purchase 249,000 shares of common stock are consideredantidilutive and therefore are not included in the computation of diluted lossper share for this period.

 

As described in Note 4, the Company has $12.0million of 6.85% fixed-rate convertible subordinate debentures outstanding asof March 31, 2008. The debentures are convertible into common stock at anytime prior to maturity, unless previously redeemed, at a conversion price of$11.018 per share which totals 1.1 million shares as of March 31, 2008. Atsuch time as the assumed conversion of the debentures has a dilutive effect onearnings per share, the debentures will be included in the calculation ofdiluted earnings per share after adjusting net income for the after-tax effectof the debenture interest expense.

 

**Note 7.       ConsolidatedStatements of Cash Flows**

** **

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

 
| *** ***                                                                                                   | *** *** | ***Three Months Ended*** | ** ** |
|----------------------------------------------------------------------------------------------------------------|--------------|------------------------------------|------------|
| *** ***                                                                                                   | *** *** | ***March 31,***               | ** ** |
| **(In thousands)**                                                                                        | ** **   | **2008**                           | ** ** | **2007** | ** ** |
|                                                                                                           |         |                               |       |   |   |
| Cash paid during the period for:                                                                               |         |                               |       |   |   |
| Interest                                                                                                       |         | $                                  | 2,598      |   | $ | 1,801 |   |
| Income taxes paid (refunded), net                                                                              |         | 1,546                              |       | (724 | ) |
|                                                                                                           |         |                               |       |   |   |
| Components of cash paid for acquisitions:                                                                      |         |                               |       |   |   |
| Fair value of assets acquired                                                                                  |         | $                                  | 23,330     |   | $ | 565 |   |
| Liabilities assumed                                                                                            |         | —                             |       | (7 | ) |
| Cash paid for acquisitions                                                                                     |         | $                                  | 23,330     |   | $ | 558 |   |
|                                                                                                           |         |                               |       |   |   |
| Non-cash investing and financing  activities:                                                                  |         |                               |       |   |   |
| Non-cash contributions in aid of construction  and advances for construction conveyed to Company by developers |         | $                                  | —     |   | $ | 89 |   |
| Debentures converted into common stock                                                                         |         | 19                                 |       | 153 |   |

 

14

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** **

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

** **

The Company has a dividend reinvestment andstock purchase plan that gives common stockholders the option of receivingtheir dividends in cash or in common stock at a discount from prevailing marketprices (“DRIP”). The plan also permits existing stockholders to purchaseadditional common stock, up to a maximum of $10,000 per month, at a discount (“DSPP”);new investors may participate in the plan, subject to a $250 minimum initialinvestment. The Company may, at its sole discretion, permit purchases above the$10,000 stated maximum. The discounts may range from 0% to 5%, as determinedfrom time to time by the Company. The DRIP and DSPP discounts offered by theCompany are 5% for the DRIP and 0% for the DSPP as of March 31, 2008. Asof March 31, 2008, there are 3.7 million shares authorized for issuanceunder the plan of which 0.9 million shares remain available for issuance.

 

**Note 9.       EmployeeRetirement Plan**

** **

The Company has a non-qualified supplementalexecutive retirement plan (“SERP”) for certain key executive officers for thepurpose of providing supplemental income benefits to plan participants or theirsurvivors upon retirement or death. There is only one remaining participant inSERP and that individual has reached retirement age and is not receiving anyfurther increases. The plan measurement date is December 31 of each year.The following table details the components of the net periodic benefit costs:

 
| *** ***                             | *** *** | ***Three Months Ended*** | ** ** |
|------------------------------------------|--------------|------------------------------------|------------|
| *** ***                             | *** *** | ***March 31,***               | ** ** |
| ***(In thousands)***                | ** **   | **2008**                           | ** ** | **2007** | ** ** |
|                                     |         |                               |       |   |   |
| Service cost                             |         | $                                  | —     |   | $ | — |   |
| Interest cost                            |         | 15                                 |       | 16 |   |
| Amortization of actuarial (gains) losses |         | (5                                 | )          | (19 | ) |
| Amortization of prior service costs      |         | —                             |       | 22 |   |
| Net periodic benefit costs               |         | $                                  | 10         |   | $ | 19 |   |

 

The sole remaining participant in the planhas reached retirement age and the plan provides that no additional benefitsaccrue upon reaching retirement age.

 

**Note 10.     SegmentInformation**

** **

The Company’s businesses are segmented intotwo operating groups: the Utility Group and the Services Group. Each segment isa strategic business unit that offers different services. They are managedseparately since each business requires different operating and growthstrategies. The accounting policies of the segments are described in thesummary of significant accounting policies in Note 1 to the audited financialstatements included in the Company’s 2007 Form 10-K.

 

The Utility Group owns and operates publicwater and wastewater utilities in Alabama, California, Mississippi, New Mexico,Oklahoma and Texas. State and federal agencies issue regulations regardingstandards of water quality, safety, environmental and other matters whichaffect these operations. In the regulated utility subsidiaries, the rates thatthey charge for water and wastewater services are established by state or localregulatory authorities. The service areas in which the Utility Group operatesconstitute monopolies with allowable rates determined by state or localregulatory agencies.

 

15

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**Note 10.****     SegmentInformation (Continued)**

 

The Services Group operates andmanages water and wastewater treatment facilities in ten states, primarilyAlabama, California, Colorado, Georgia, Mississippi, New Mexico, South Dakotaand Texas, owned by cities, public agencies, municipal utility districts,private entities and investor-owned utilities, including some of the companiesin the Utility Group. The Services Group also provides construction andconstruction management services, certified water and wastewater laboratorytesting services, and public works services. The Services Group, while subjectto certain environmental standards, is not regulated in its pricing, marketingor rates of return.

 

The following tables present informationabout the operations of each segment for the three months ended March 31, 2008and 2007.

 
| **(In thousands)**                                       | ** ** | **Utility  Group** | ** ** | **Services  Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations(3)** | ** ** | **Consolidated** | ** ** |
|---------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|------------------------|------------|---------------------|------------|------------------|------------|
| ** **                                                    |       |               |       |                   |       |                   |       |                |       |             |       |
| **Three months ended March 31, 2008:**                   |       |               |       |                   |       |                   |       |                |       |             |       |
| Revenues:                                                     |       |               |       |                   |       |                   |       |                |       |             |       |
| Unaffiliated customers                                        |       | $                  | 22,341     |                   | $          | 27,299                 |       | $                   | —     |             | $          | — |   | $ | 49,640 |   |
| Intersegment (1) (3)                                     |       | —             |       | 6,339                  |       | —                 |       | (5,216              | )          | 1,123            |       |
| Total revenues                                                |       | 22,341             |       | 33,638                 |       | —                 |       | (5,216              | )          | 50,763           |       |
|                                                          |       |               |       |                   |       |                   |       |                |       |             |       |
| Expenses:                                                     |       |               |       |                   |       |                   |       |                |       |             |       |
| Operating expenses–unaffiliated customers                |       | 13,441             |       | 25,910                 |       | —                 |       | —              |       | 39,351           |       |
| Operating expenses–intersegment (3)                      |       | —             |       | 5,216                  |       | —                 |       | (5,216              | )          | —           |       |
| Selling, general and administrative                           |       | 2,521              |       | 1,652                  |       | 5,432                  |       | —              |       | 9,605            |       |
| Total expenses                                                |       | 15,962             |       | 32,778                 |       | 5,432                  |       | (5,216              | )          | 48,956           |       |
|                                                          |       |               |       |                   |       |                   |       |                |       |             |       |
| Operating income (loss)                                       |       | 6,379              |       | 860                    |       | (5,432                 | )          | —              |       | 1,807            |       |
|                                                          |       |               |       |                   |       |                   |       |                |       |             |       |
| Interest expense                                              |       | (1,716             | )          | 49                     |       | (694                   | )          | —              |       | (2,361           | )          |
| Interest income                                               |       | 98                 |       | 22                     |       | 2                      |       | —              |       | 122              |       |
| Income (loss) from continuing operations before  income taxes |       | $                  | 4,761      |                   | $          | 931                    |       | $                   | (6,124     | )                | $          | — |   | $ | (432 | ) |
|                                                          |       |               |       |                   |       |                   |       |                |       |             |       |
| **Three months ended March 31, 2007:**                   |       |               |       |                   |       |                   |       |                |       |             |       |
| Revenues:                                                     |       |               |       |                   |       |                   |       |                |       |             |       |
| Unaffiliated customers                                        |       | $                  | 20,034     |                   | $          | 26,316                 |       | $                   | —     |             | $          | — |   | $ | 46,350 |   |
| Intersegment (1) (3)                                     |       | —             |       | 7,220                  |       | —                 |       | (5,701              | )          | 1,519            |       |
| Total revenues                                                |       | 20,034             |       | 33,536                 |       | —                 |       | (5,701              | )          | 47,869           |       |
| Expenses:                                                     |       |               |       |                   |       |                   |       |                |       |             |       |
| Operating expenses–unaffiliated customers                |       | 11,809             |       | 24,442                 |       | —                 |       | —              |       | 36,251           |       |
| Operating expenses–intersegment (3)                      |       | —             |       | 5,701                  |       | —                 |       | (5,701              | )          | —           |       |
| Selling, general and administrative                           |       | 2,461              |       | 2,692                  |       | 3,377                  |       | —              |       | 8,530            |       |
| Total expenses                                                |       | 14,270             |       | 32,835                 |       | 3,377                  |       | (5,701              | )          | 44,781           |       |
|                                                          |       |               |       |                   |       |                   |       |                |       |             |       |
| Operating income (loss)                                       |       | 5,764              |       | 701                    |       | (3,377                 | )          | —              |       | 3,088            |       |
|                                                          |       |               |       |                   |       |                   |       |                |       |             |       |
| Interest expense                                              |       | (1,278             | )          | (350                   | )          | (226                   | )          | —              |       | (1,854           | )          |
| Interest income                                               |       | 4                  |       | 110                    |       | 21                     |       | —              |       | 135              |       |
| Other income (expense)                                        |       | (64                | )          | —                 |       | 15                     |       | —              |       | (49              | )          |
| Income (loss) from continuing operations before  income taxes |       | $                  | 4,426      |                   | $          | 461                    |       | $                   | (3,567     | )                | $          | — |   | $ | 1,320 |   |

 

*See accompanying notes to the segmentinformation following these tables.*

 

16

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** **

**Note 10.**     Segment Information(Continued)

** **

**Notes**

----

(1)   Some companies in the Services Group provideconstruction, operations and maintenance services to companies in the UtilityGroup and recognize a profit on those services. In accordance withSFAS 71, the Company does not eliminate the intersegment profit recognizedon these services because the Company believes the sales price is reasonableand it is probable that, through the rate making process, future Utility Grouprevenue approximately equal to the sales price will result from the regulatedutilities’ use of the services. The Company does, however, eliminate theServices Group’s revenues from affiliated customers to the extent of its cost. Consequently,Services Group revenues reflected in the condensed consolidated statements ofincome include intersegment gross profits as follows:

 
| *** ***                                                         | *** *** | ***Three Months Ended*** | ** ** |
|----------------------------------------------------------------------|--------------|------------------------------------|------------|
| *** ***                                                         | *** *** | ***March 31,***               | ** ** |
| ***(In thousands, except per share data)*** | ** **   | **2008**                           | ** ** | **2007** | ** ** |
|                                                                 |         |                               |       |   |   |
| Services Group revenues:                                             |         |                               |       |   |   |
| From unaffiliated customers                                          |         | $                                  | 27,299     |   | $ | 26,316 |   |
| Intersegment profits                                                 |         | 1,123                              |       | 1,519 |   |
| Total revenues                                                       |         | $                                  | 28,422     |   | $ | 27,835 |   |

 

(2)   Consists of costs that include headquarters expensesand any corporate functional departments whose costs are not allocated to ourreportable segments. Corporate and other assets reflect corporate headquartersassets, excluding investments in and receivables from subsidiaries.

 

(3)   Reflects the elimination of Services Group revenuesderived from the Utility Group, to the extent of costs as described in (1) above.In addition, a company in the Utility Group provides services to a company inthe Services Group. Intersegment revenues and expenses, including all profit,associated with these services are fully eliminated upon consolidation.

 

17

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## ** **

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

## ** **

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

###  

Management’s Discussion and Analysis ofFinancial Condition and Results of Operations (“MD&A”) is intended to helpthe reader understand the results of operations and financial condition ofSouthWest Water Company. This MD&A also contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. All statements containedherein that are not clearly historical in nature are forward-looking, and thewords “anticipate,” “believe,” “belief,” “expect,” “estimate,” “project,” “plan,”“intend,” “continue,” “predict,” “may,” “will,” “should,” “strategy,” “willlikely result,” “will likely continue,” and similar expressions are generallyintended to identify forward-looking statements. Forward-looking statements aresubject to risks and uncertainties that could cause actual results to differmaterially from our historical experience and our present expectations orprojections. A detailed discussion of these and other risks and uncertaintiesthat could cause actual results and events to differ materially from suchforward-looking statements is included in the section entitled “Item 1A. RiskFactors” in our 2007 Annual Report on Form 10-K. Caution should be takennot to place undue reliance on any such forward-looking statements since suchstatements speak only as of the date when made. Other than as required byapplicable law, we undertake no obligation to publicly update or revise forward-lookingstatements whether as a result of new information, future events, or otherwise.

 

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

 

### **OVERVIEW**

###  

SouthWest Water Company provides a broadrange of services including water production, treatment and distribution;wastewater collection and treatment; utility billing and collection; utilityinfrastructure construction management; and public works services. We ownregulated public utilities and also serve cities, utility districts and privatecompanies under contract. Our subsidiaries are segmented into two operatinggroups: our Utility Group and our Services Group.

 

#### **Utility Group**

#### ** **

Our Utility Group owns public water andwastewater utilities in Alabama, California, New Mexico, Oklahoma and Texasand, beginning in February 2007, Mississippi. Except for our Californiautility, our utilities are operated by companies in our Services Group, whichwe describe below. State and federal agencies issue regulations regarding standardsof water quality, safety, environmental and other matters which affect theseoperations. The rates that our regulated utility subsidiaries charge for waterand wastewater usage are established by state or local authorities.

 

Utility Group revenues reflect fees earnedfor the production and distribution of water and the collection and treatmentof sewage for residential, business, industrial and public authority use. Thegroup’s operating expenses reflect the costs associated with purchasing, producingand distributing water, collecting and treating wastewater, salaries, wages andemployee benefits, facilities costs, supplies and equipment, repairs andmaintenance, professional fees and other costs.

 

#### **Services Group**

#### ** **

Our Services Group operates our contractservice businesses in which we operate and maintain water and wastewaterfacilities owned by cities, public agencies, municipal utility districts,private entities and investor-owned utilities, including most of our ownutilities. Our Services Group operates primarily in Alabama, California,Colorado, Georgia, Mississippi, New Mexico, South Dakota and Texas. While stateand federal agencies issue regulations 

 

18

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regarding standards of water quality, safety,environmental and other matters which affect these operations, our ServicesGroup’s pricing is not subject to regulation.

 

Services Group revenues reflect fees earnedfor water and wastewater facility operations and maintenance services,equipment maintenance and repair, sewer pipeline cleaning, billing andcollection services, public works and state-certified water and wastewaterlaboratory analysis. Our Services Group also facilitates the design,construction, project management and operating aspects of various water andwastewater projects. The group’s operating expenses reflect salaries, wages andemployee benefits, facilities costs, supplies and equipment, repairs andmaintenance, professional fees and other costs. Most work performed by the ServicesGroup is required to be performed by state licensed and certified technicians.

 

Some companies in our Services Group provideconstruction, operations and maintenance services to our Utility Group andrecognize a profit on those services. In accordance with SFAS No. 71,*Accounting for the Effects of Certain Types ofRegulation* (“SFAS 71”), we do not eliminate the Services Group’sprofit because management believes the sales price is reasonable and it isprobable that, through the rate making process, future Utility Group revenueapproximately equal to the sales price will result from the regulated utilities’use of the services. We do, however, eliminate revenues to the extent of therelated costs in the consolidated financial statements in accordance with theguidance provided in SFAS 71.

 

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

#### ** **

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

 

#### **Effects ofInflation**

#### ** **

For our Utility Group, recovery for theeffects of inflation through higher rates is dependent upon receiving adequateand timely rate increases. For our Service Group, most of our contacts haveprovisions for rate increases tied to the rate of inflation. However, rateincreases are not retroactive and often lag increases in costs caused byinflation. During periods of moderate inflation, as has been experienced inrecent years, the effects of inflation have had an impact on our results ofoperations.

 

#### **Acquisitions,Assets Held for Sale and Dispositions**

#### ** **

Our financial position, results of operationsand cash flows have been affected by our history of acquisitions. Our mostrecent significant acquisitions, which affect the comparability of thehistorical financial condition and results of operations described in theMD&A, are:

 

Utility Group:

 

·      a northern Mississippi-based water and wastewaterutility serving approximately 275 water connections and servicing approximately355 wastewater connections through four collection systems in February 2007;

 

·      two San Antonio, Texas-based water utilitiesserving approximately 2,600 connections in May 2007;

 

·      a Madison County, Alabama-based wastewatercollection and treatment system servicing approximately 120 connections in November 2007;

 

·      a Birmingham, Alabama-based wastewater collectionand treatment system servicing approximately 4,100 residential and commercialconnections in January 2008.

 

During 2007, we committed to a plan to sell awholesale water and wastewater operation in Texas and believe the sale can beconsummated during 2008. As a result of this decision, the operation isclassified as a discontinued operation in our consolidated financial statementsand the discussion below reflects only continuing operations for all periods.

 

19

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#### ** **

#### **New MexicoEminent Domain Condemnation Proceedings**

#### ** **

In 2007, the Albuquerque Bernalillo CountyWater Utility Authority and the City of Rio Rancho, New Mexico, filed aPetition for Condemnation (the “Petition”) against our New Mexico regulatedutility, New Mexico Utilities, Inc. (“NMUI”). The Petition seeks toacquire, by condemnation, all of the assets of NMUI, including all realproperty, through the alleged power of eminent domain. The Petition alsoalleges that the Petitioners need to acquire the utility assets for the publicpurposes of providing water and wastewater services to  customers and that the acquisition of NMUI isnecessary, appropriate and in the public interest. We believe we have defensesto the Action which we intend to vigorously assert. If we do not prevail, thePetitioners must pay fair market value as determined by the court, based onappraisals. NMUI and the Petitioners do not agree on the value of the assetswhich the Petitioners seek to condemn. While it is too early to predict theoutcome of this matter, the Company believes that if the Court were todetermine the fair market value of NMUI, it would exceed its recorded net bookvalue as of March 31, 2008. For additional information on this matter, seeNote 5 to the condensed consolidated financial statements included in thisreport.

 

### **BUSINESSOUTLOOK**

###  

The water and wastewater industry generatesannual revenues in excess of $70 billion in the United States. Both servicesare primarily owned by government municipalities. Growing regulatory complexityand escalating water quality awareness has led to a dwindling supply oflow-cost potable water. The market is characterized by an aging anddeteriorating municipal infrastructure and there is minimal state and federalgovernment funding available to upgrade these systems to meet the higherstandards. The EPA estimates that an investment of $750 billion to $1.0trillion may be needed over the next 20 years to meet the higher standards.These factors lead us to a very positive outlook for growth in our industry asmore government entities look to the private sector to help them meet thesechallenges.

 

We intend to grow our market share of thisindustry by focusing on both increasing the number of utilities we own and onincreasing the dollars generated by operating and maintaining government-ownedutilities. Our long-term strategic plan is to increase our profitabilitythrough acquisitions and organic growth in both our Utility Group and ourServices Group.

 

The Utility Group growth strategy focuses onstrategically located acquisitions, organic customer growth and activelymanaged rate proceedings. We look to acquire strategic utilities located withinour geographic footprint, thereby expanding our presence in a region andgaining economies of scale. We also look to acquire utilities in populationgrowth areas. Historically, our utilities in population growth areas experiencenew development in their service areas which generates organic growth throughincreased customer connections. To achieve and maintain a reasonable rate ofreturn on investments in our capital assets, we manage rate proceedings throughour relationships with public utility commissions.

 

The Services Group growth strategy focuses onexpanding our client base, making strategic acquisitions and providingperipheral services such as construction of infrastructure, billing andcollection services, customer care/call centers, meter replacement andlaboratory analysis of water and wastewater samples. By pursuing new operationsand maintenance contracts with cities, municipalities and private owners of waterand wastewater utilities within our geographic footprint, we expand ourpresence in a region and gain economies of scale. We look to expand the scopeof our contracts with current clients by adding additional services such asbilling and collections and providing capital improvement project managementservices. An opportunity unique to our business model is that it includes anintegrated strategy in which the Services Group provides construction andoperation and maintenance services to our Utility Group. This provides us witheconomies of scale. We also continue to pursue acquisitions of small, strategicservice companies that expand our geographic presence and give us knowledge ofthe region’s water and wastewater needs. This local knowledge positions us forgrowth both in the service as well as the utility side of the business asmunicipalities look to form public/private partnerships or to sell theirutility assets. This was demonstrated in March 2005 by our acquisition ofNovus Utilities, a contract operations business in Alabama which gave us localknowledge and relationships in the region. This positioning in turn led to theacquisition of three wastewater utilities, one in September 2005, a secondin November 2007 and the third in January 2008.

 

20

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###  

### **RESULTSOF OPERATIONS**

###  

#### **Change inPresentation**

#### ** **

Effective January 1, 2008, we launchedthe first phase of our financial reporting reengineering process byimplementing a fully integrated financial module throughout the entire company.As a result, the methodology of capturing and reporting operating versusgeneral and administrative expenses as well as the classification of expensesbetween business segments has changed. As permitted by SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information*,prior year amounts have not been reclassified to conform to the 2008presentation because the information is not available and the cost to developit would be excessive.

 

Reclassifications have also been made toprior year’s financial statement presentation with respect to a component ofthe business we are holding for sale as a discontinued operation.

 

#### **Three monthsended March 31, 2008 Compared to 2007**

#### ** **

**Revenues.**Revenuesincreased $2.9 million, or 6.0%, to $50.8 million for the quarter ended March 31,2008 from $47.9 million for the same period during the prior year. By segment,revenues changed as follows:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | **Percent of Revenues** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | ** **                        |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                              |       |   |   |   |   |
| Utility Group                                         |       | $                                | 22,341     |         | $          | 20,034                            |       | $ | 2,307 |   | 44.0 | % | 41.9 | % |
| Services Group                                        |       | 28,422                           |       | 27,835       |       | 587                               |       | 56.0 | % | 58.1 | % |
| Total                                                 |       | $                                | 50,763     |         | $          | 47,869                            |       | $ | 2,894 |   | 100.0 | % | 100.0 | % |

 

***UtilityGroup.***Revenues increased $2.3 million, or 11.5%,to $22.3 million for the quarter ended March 31, 2008, from $20.0 millionfor the same period during the prior year. The increase was primarily due tothe following:

 

·      a $1.8 million increase primarily resulting froma fourth quarter 2007 interim rate increase at one of our Texas utilities; and

 

·      a $1.0 million increase at our Alabama utilitiesprimarily resulting from the first quarter, 2008 acquisition of a wastewatertreatment plant in the Birmingham, Alabama area; and

 

·      a $0.4 million increase resulting from utilityacquisitions in San Antonio, Texas and northern Mississippi in 2007; offset by

 

·      a $0.9 million decrease at our California utilityrelated to lower consumption as a result of wetter weather compared to theprior year.

 

***ServicesGroup.***Revenues increased $0.6 million, or 2.1%,to $28.4 million for the quarter ended March 31, 2008 from $27.8 millionfor the same period during the prior year. The increase in revenues wasprimarily due to the following:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                              |       |   |   |   |   |
| Revenues from unaffiliated customers                  |       | $                                | 27,299     |         | $          | 26,316                            |       | $ | 983 |   | 81.2 | % | 78.5 | % |
| Intersegment revenues                                 |       | 6,339                            |       | 7,220        |       | (881                              | )          | 18.8 | % | 21.5 | % |
| Total revenues                                        |       | 33,638                           |       | 33,536       |       | 102                               |       | 100.0 | % | 100.0 | % |
| Intersegment cost eliminations                        |       | (5,216                           | )          | (5,701       | )          | 485                               |       |   |   |   |   |
| Total                                                 |       | $                                | 28,422     |         | $          | 27,835                            |       | $ | 587 |   |   |   |   |   |

 

Revenues from unaffiliated customers increased$1.0 million, or 3.7%, to $27.3 million for the quarter ended March 31,2008 from $26.3 million for the same period during the prior year. The increasein revenues was primarily due to increased business activity combined with ourongoing efforts to review our contracts and increase prices.

 

21

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Intersegment revenues from our Utility Groupdecreased by $0.9 million, or 12.2%, to $6.3 million for the quarter ended March 31,2008 from $7.2 million for the same period during the prior year. The decreasein revenues resulted from a decrease in construction projects in part due to aslow down in housing construction, and less project work performed by ourServices Group on behalf of our utilities in New Mexico and Texas.  This was offset by increased activity at ourAlabama operations related to the first quarter, 2008 acquisition of awastewater treatment plant in Birmingham, Alabama.

 

**Direct OperatingExpenses.**Direct operating expenses increased $3.1million, or 8.6%, to $39.4 million for the quarter ended March 31, 2008from $36.3 million for the same period during the prior year as follows:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | ** **                                 |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                | 13,441     |         | $          | 11,809                                     |       | $ | 1,632 |   | 60.2 | % | 58.9 | % |
| Services Group                                        |       | 25,910                           |       | 24,442       |       | 1,468                                      |       | 91.2 | % | 87.8 | % |
| Total                                                 |       | $                                | 39,351     |         | $          | 36,251                                     |       | $ | 3,100 |   | 77.5 | % | 75.7 | % |

 

----

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

 

***UtilityGroup.***Direct operating expenses increased $1.6million, or 13.8%, to $13.4 million for the quarter ended March 31, 2008,from $11.8 million for the same period during the prior year. The increase indirect operating expenses was primarily due to the following:

 

·      a $0.8 million increase at our Alabama utilitiesprimarily resulting from the first quarter 2008 acquisition of a wastewatertreatment plant in the Birmingham, Alabama area;

 

·      a $0.8 million increase at our Texas and NewMexico utilities in depreciation expense, contract operation fees, and sewagetreatment expenses as well as costs associated with improving our informationtechnology support to provide better customer service; and

 

·      a $0.2 million increase in expenses resultingfrom our San Antonio, Texas and northern Mississippi utility acquisitions;offset by

 

·      a $0.2 million decrease in costs at ourCalifornia utility principally resulting from decreased consumption offset byhigher production-related costs.

 

Direct operating expenses were 60.2% and58.9% of related revenues for the quarter ended March 31, 2008 and 2007, respectively.

 

***ServicesGroup.***Direct operating expenses increased $1.5million, or 6.0%, to $25.9 million for the quarter ended March 31, 2008from $24.4 million for the same period during the prior year. The increase indirect operating expenses was due to the following:

 

·      a $1.0 million increase related to the change inmethodology of capturing direct operating versus selling, general andadministrative expenses; and

 

·      a $0.5 million increase in direct costsassociated with increased business activity.

 

Direct operating expenses as a percentage ofthe related revenues increased 3.4% to 91.2% for the quarter ended March 31,2008 compared to 87.8% for the same period during the prior year.

 

**Gross Profit.**Grossprofit, which we define as the difference between revenues and the relateddirect operating expenses, decreased $0.2 million, or 1.8%, to $11.4 millionfor the quarter ended March 31, 2008 from $11.6 million for the sameperiod during the prior year as follows:

 

22

----

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | ** **                                 |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                | 8,900      |         | $          | 8,225                                      |       | $ | 675 |   | 39.8 | % | 41.1 | % |
| Services Group                                        |       | 2,512                            |       | 3,393        |       | (881                                       | )          | 8.8 | % | 12.2 | % |
| Total                                                 |       | $                                | 11,412     |         | $          | 11,618                                     |       | $ | (206 | ) | 22.5 | % | 24.3 | % |

 

----

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

 

***UtilityGroup.***Gross profit was 39.8% and 41.1% of relatedrevenues for the quarter ended March 31, 2008 and 2007, respectively.

 

***ServicesGroup.***Gross profit for the quarter ended March 31,2008 and 2007 was comprised of the following:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |       |       |   |   |
| Gross profit on sales to:                             |       |                             |       |         |       |                                       |       |       |       |   |   |
| Unaffiliated customers                                |       | $                                | 1,389      |         | $          | 1,874                                      |       | $          | (485       | ) | 5.1 | % | 7.1 | % |
| Affiliated customers (intersegment)                   |       | 1,123                            |       | 1,519        |       | (396                                       | )          | 17.7       | %          | 21.0 | % |
| Total                                                 |       | $                                | 2,512      |         | $          | 3,393                                      |       | $          | (881       | ) | 7.5 | % | 10.1 | % |

 

----

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

 

Services Group gross profit on revenues fromunaffiliated customers decreased by $0.5 million, or 25.9%, to $1.4 million forthe quarter ended March 31, 2008 from $1.9 million for the same periodduring the prior year. Gross profit as a percent of revenues for 2008 decreasedto 5.1% compared to 7.1% for the same period for the prior year primarily dueto the change in methodology of capturing direct operating versus selling,general and administrative expense.

 

Services Group gross profit on revenues fromour Utility Group decreased by $0.4 million, or 26.1% to $1.1 million for thequarter ended March 31, 2008 from $1.5 million for the same period duringthe prior year. The decrease is related to a slow down in construction workperformed for our Texas utilities, offset by an increase in contract operationswork related to the Alabama wastewater facility purchased during the firstquarter of 2008.

 

The Services Group supports three distinctlydifferent customer bases; Texas Municipal Utility Districts or MUD’s, municipalclients through operations and maintenance contracts, and SouthWest Water’s ownUtility Group. We want to accelerate our performance improvements and thereforewe have refocused this Group in 2008 along these business lines to better servethe unique demands of each customer base, to focus our business developmentefforts for each market and to eliminate structural redundancies that may existtoday.

 

***Selling,General and Administrative Expenses.***Selling,general and administrative expenses increased $1.1 million, or 12.6%, to$9.6 million for the quarter ended March 31, 2008 compared to $8.5 millionfor the same period during the prior year as follows:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |       |       |   |   |
| Utility Group                                         |       | $                                | 2,521      |         | $          | 2,461                                      |       | $          | 60         |   | 11.3 | % | 12.3 | % |
| Services Group                                        |       | 1,652                            |       | 2,692        |       | (1,040                                     | )          | 5.8        | %          | 9.7 | % |
| Corporate                                             |       | 5,432                            |       | 3,377        |       | 2,055                                      |       | —     |       | — |   |
| Total                                                 |       | $                                | 9,605      |         | $          | 8,530                                      |       | $          | 1,075      |   | 18.9 | % | 17.8 | % |

 

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

 

23

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Selling, general and administrative expensesare relatively fixed in nature and do not fluctuate significantly with changesin revenues. That being said, we have implemented a new financial system, andre-evaluated the way we allocate our SG&A expenses. This re-evaluationprimarily affected the Services Group by lowering its SG&A costs andincreasing its Operating expenses. The Utility Group and Corporate SG&Aexpenses were not significantly affected by this re-evaluation.

 

Corporate expenses increased $2.0 million to$5.4 million for the period ending March 31, 2008 compared to $3.4 millionfor the same period in the prior year primarily as a result of $0.8 million increasein costs incurred related to our Cornerstone project, which commenced duringthe second quarter of 2007; $0.7 million increase in professional feesassociated with evaluating a strategic business opportunity that did notmaterialize, in part, because of changes in the market conditions; and $0.3million of other temporary increases associated with business processreengineering projects.

 

The Cornerstone project is a company-wideinitiative to reengineer our business processes and integrate our informationsystems onto a single platform across the entire company utilizingstate-of-the-art systems and technology. Our existing systems are standalonelegacy systems that were in place when we acquired many of our companies. Theseindividual standalone systems are costly to operate and maintain and make theconsolidation and sharing of data between the various platforms labor-intensiveand time-consuming. The financial module of the integrated platform becameoperational on January 1, 2008 and is performing as expected.

 

We are investing in this new technology toenable us to gather and disseminate information on a more timely basis atreduced costs thereby improving customer service and enhancing operationalefficiencies. Although expenditures related to the information technologyhardware and software portions of this initiative are capitalized, certaincosts are expensed as incurred. We expect we will be able to recover a portionof our Cornerstone investment through the rates charged by our owned utilitycompanies due to the customer service enhancements and we also believe the restof the investment will result in cost savings in the Services Group, resultingin improved margins.

 

**Other Income(Expense).**Other expenses increased $0.5 million, or26.6% to $2.2 million for the quarter ended March 31, 2008, compared to$1.8 million for the same period during the prior year as follows:

 
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | **(Increase)** | ** ** |
|-------------------------|------------|------------|------------|------------|------------|----------------|------------|
| **(In thousands)** | ** ** | **2008**   | ** ** | **2007**   | ** ** | **Decrease**   | ** ** |
|                    |       |       |       |       |       |           |       |
| Interest expense        |       | $          | (2,361     | )          | $          | (1,854         | )          | $ | (507 | ) |
| Interest income         |       | 122        |       | 135        |       | (13            | )          |
| Other, net              |       | 0          |       | (49        | )          | 49             |       |
| Total                   |       | $          | (2,239     | )          | $          | (1,768         | )          | $ | (471 | ) |

 

***InterestExpense.***Interest expense increased by $0.5million, or 27.3% to $2.4 million for the quarter ended March 31, 2008from $1.9 million compared to the same period during the prior year. The majorcomponents of interest expense were as follows:

 
| **(In thousands)**                                                  | ** ** | **2008** | ** ** | **2007** | ** ** | **Change** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|------------|------------|
|                                                                     |       |     |       |     |       |       |       |
| Mortgage bonds and bank term loans                                       |       | $        | 1,217      |     | $          | 1,190      |       | $ | 27 |   |
| Revolving lines of credit                                                |       | 936      |       | 660      |       | 276        |       |
| Convertible subordinated debentures                                      |       | 204      |       | 215      |       | (11        | )          |
| Other indebtedness and deferred financing  cost amortization             |       | 163      |       | 197      |       | (34        | )          |
| Total interest incurred                                                  |       | 2,520    |       | 2,262    |       | 258        |       |
| Write-off of unamortized financing costs in  connection with refinancing |       | 268      |       | —   |       | 268        |       |
| Less capitalized interest                                                |       | (128     | )          | (192     | )          | 64         |       |
| Less interest related to discontinued operations                         |       | (299     | )          | (216     | )          | (83        | )          |
| Total interest expense                                                   |       | $        | 2,361      |     | $          | 1,854      |       | $ | 507 |   |

 

24

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The increase in revolving line of creditinterest is caused by higher borrowing levels related to financing capital spendingin 2007 and 2008, including the capital and expense portions of our Cornerstoneproject, and the first quarter 2008 $23.3 million acquisition of the Alabamawastewater treatment facility. The write-off of unamortized deferred financingcosts is associated with our $100.0 million revolving credit facility werefinanced with a new $150.0 million facility in the first quarter of 2008. Theaverage balance of interest-bearing debt outstanding increased to $165.5million during the quarter ended March 31, 2008 compared to $133.6 millionfor the prior year.

 

The weighted average annual interest rate ontotal borrowings was approximately 6.0% for the quarter ended March 31,2008 and 6.5% for the same period in the prior year.

 

***InterestIncome.***Interest income was constant at $0.1million for the quarters ended March 31, 2008 and 2007.

 

**Provision for IncomeTaxes.**Our effective consolidated income tax rate oncombined continuing and discontinued operations was 27% for the quarter ended March 31,2008 compared to 36% for 2007. In 2008, we reported a consolidated pre-taxloss. The lower effective rate in 2008 is caused by state income taxes reducingthe expected overall income tax benefit at a more normalized 36% to 37%effective rate.

 

**Loss fromDiscontinued Operations.** Loss from discontinued operations, net of tax, which pertains to ourwholesale water and wastewater business we elected to sell, was $0.3 millionfor the quarter ended March 31, 2008, compared to $0.2 million for thesame period during the prior year.

 

### **ACCOUNTINGPRONOUNCEMENTS ADOPTED DURING 2008**

###  

#### **SFAS No. 157**

#### ** **

In September 2006, the FASB issued SFAS No. 157,*Fair Value Measurements*(“SFAS 157”).This statement defines fair value, establishes a framework for using fair valueto measure assets and liabilities, and expands disclosures about fair valuemeasurements. The statement applies when other statements require or permit thefair value measurement of assets and liabilities. This statement does notexpand the use of fair value measurement. In February 2008, the FASBissued FASB Staff Position No. 157-2, *Effective Date of FASBStatement No. 157* (“FSP 157-2”). FSP 157-2 delays theeffective date of SFAS No. 157 for certain non-financial assets andliabilities to fiscal years beginning after November 15, 2008.

 

We adopted SFAS No. 157 as required on January 1,2008 for all financial assets and liabilities, and this statement did not havea material impact on the Company’s consolidated results of operations orconsolidated financial position. The Company is currently assessing thepotential effect of SFAS No. 157 on all non-financial assets andliabilities.

 

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

#### ** **

We adopted SFAS No. 159, *The Fair Value Option for Financial Assets and Financial Liabilities*(“SFAS 159”) effective January 1, 2008. We did not elect the fairvalue option for any of our existing financial assets and liabilities. Theadoption of this statement did not have a material impact on the consolidatedresults of operations or consolidated financial position.

 

25

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###  

### **RECENTACCOUNTING PRONOUNCEMENTS**

###  

#### **SFAS No. 141(R)**

#### ** **

In December 2007, the FASB issuedStatement No. 141 (revised 2007), *Business Combinations*(“SFAS 141(R)”). SFAS 141(R) changes the accounting for acquisitionsspecifically eliminating the step acquisition model, changing the recognitionof contingent consideration at the time of acquisition, disallowing thecapitalization of transaction costs and changes when restructurings related toacquisitions can be recognized. The statement is effective for fiscal yearsbeginning on or after December 15, 2008 and will only impact theaccounting for acquisitions that are made after adoption. Adoption ofSFAS 141(R) will impact our accounting for future businesscombinations in that all transactions costs will be expensed as incurred andcontingent consideration, if present, will be recorded upon acquisition.

 

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

#### ** **

In February 2007, the FASB issued SFAS No. 159,*The Fair Value Option for Financial Assets andFinancial Liabilities–Including an amendment of FASB Statement No. 115*(“SFAS 159”). This statement permits companies to choose to measure manyfinancial instruments and other specified items at fair value. This statementis effective for our fiscal year beginning January 1, 2008 and will beapplied prospectively. We believe the adoption of this new statement will nothave a material impact on our consolidated financial statements.

 

#### **SFAS No. 160**

#### ** **

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements, an amendment of ARB No. 51* (“SFAS 160”). SFAS 160introduces significant changes in the accounting and reporting for businessacquisitions and noncontrolling interest in a subsidiary. SFAS 160 also changesthe accounting for and reporting for the deconsolidation of a subsidiary.Companies are required to adopt the new standard for fiscal years beginningafter January 1, 2009. We are evaluating the impact of this standard andcurrently do not expect it to have a significant impact on our financialposition, results of operations or cash flows.

 

#### **SFAS No. 161**

#### ** **

In March 2008, the FASB issued SFAS No. 161,Disclosures about Derivative Instruments and Hedging Activities—an amendment ofFASB Statement No. 133 (“SFAS 161”). This statement amends SFAS No. 133by requiring enhanced disclosures about a company’s derivative instruments andhedging activities, but does not change the scope of, or accounting under, SFASNo. 133. SFAS No. 161 requires increased qualitative, quantitativeand credit-risk disclosures about the entity’s derivative instruments andhedging activities. SFAS 161 is effective for our fiscal year beginning January 1,2009. We are evaluating the potential impact of this statement.

 

26

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###  

### **LIQUIDITYAND CAPITAL RESOURCES**

###  

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

 

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

 

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

 

·                  obtain external financing for majoracquisitions; and

 

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

 

Our statements of cash flows are summarizedas follows:

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                        | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(In thousands)**                           | ** ** | **2008**                         | ** ** | **2007**   | ** ** | **Change** | ** ** |
|                                              |       |                             |       |       |       |   |   |
| Net cash provided by (used in):                   |       |                             |       |       |       |   |   |
| Continuing operations:                            |       |                             |       |       |       |   |   |
| Operating activities                              |       | $                                | (5,144     | )          | $          | (454 | ) | $ | (4,690 | ) |
| Investing activities                              |       | (31,281                          | )          | (8,602     | )          | (22,679 | ) |
| Financing activities                              |       | 35,856                           |       | 8,735      |       | 27,121 |   |
| Total continuing operations                       |       | (569                             | )          | (321       | )          | (248 | ) |
| Discontinued operations:                          |       |                             |       |       |       |   |   |
| Operating activities                              |       | (165                             | )          | (643       | )          | 478 |   |
| Investing activities                              |       | —                           |       | (317       | )          | 317 |   |
| Total discontinued operations                     |       | (165                             | )          | (960       | )          | 795 |   |
| Increase (decrease) in cash and cash  equivalents |       | $                                | (734       | )          | $          | (1,281 | ) | $ | 547 |   |

 

**Cash Flows From Operating Activities ofContinuing Operations.**Net cash used in operatingactivities was $5.1 million for the three months ended March 31, 2008versus $0.5 million for the same period last year. Operational aspects of ourbusinesses that affected working capital in 2008 versus 2007 are highlightedbelow:

 

·                  increased level of vendor payments in2008 for goods and services received during the fourth quarter of 2007; and

 

·                  an increase in receivables as aresult of increased revenues generated by our Texas utilities due, in part, torate increases.

 

**Cash Flows From Investing Activities ofContinuing Operations.**Cash used in investingactivities totaled $31.3 million for the three months ended March 31, 2008compared to $8.6 million for the same period during the prior year as follows:

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|------------|------------|
| ** **                                              | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(In thousands)**                                 | ** ** | **2008**                         | ** ** | **2007**   | ** ** | **Change** | ** ** |
|                                                    |       |                             |       |       |       |   |   |
| Cash flows (used in) provided by investing  activities: |       |                             |       |       |       |   |   |
| Acquisition of businesses, net of cash  acquired        |       | $                                | (23,330    | )          | $          | (558 | ) | $ | (22,772 | ) |
| Additions to property, plant and equipment              |       | (7,960                           | )          | (8,077     | )          | 117 |   |
| Proceeds from sales of equipment                        |       | 9                                |       | 33         |       | (24 | ) |
| Net cash used in investing activities                   |       | $                                | (31,281    | )          | $          | (8,602 | ) | $ | (22,679 | ) |

 

27

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The principal reason for the increase was theJanuary 2008 acquisition of a Birmingham, Alabama wastewater collectionsystem and treatment plant for $23.3 million in cash. The following tablesummarizes additions to property, plant and equipment additions for 2008 and2007.

 
| *** ***                                           | *** *** | ***Three Months Ended*** | ** ** |
|--------------------------------------------------------|--------------|------------------------------------|------------|
| *** ***                                           | *** *** | ***March 31,***               | ** ** |
| ***(In thousands)***                              | ** **   | **2008**                           | ** ** | **2007** | ** ** |
|                                                   |         |                               |       |   |   |
| Company-financed additions                             |         | $                                  | 6,938      |   | $ | 6,727 |   |
| Capital improvement reimbursements                     |         | 514                                |       | 865 |   |
| Cash contributions received in aid of  construction    |         | 508                                |       | 485 |   |
| Total cash additions to property, plant and  equipment |         | 7,960                              |       | 8,077 |   |
| Non-cash contributions in aid of  construction         |         | —                             |       | 89 |   |
| Total additions to property, plant and  equipment      |         | $                                  | 7,960      |   | $ | 8,166 |   |

 

Capital projects primarily relate to theexpansion, replacement and renovation of our water and wastewater systems,particularly at our California, Texas and New Mexico utilities and, in 2008,include $1.9 million of expenditures related to our Cornerstone project.Contributions in Aid of Construction (“CIAC”) represent contributions in theform of cash, services or property received from developers, governmentalagencies, municipalities or individuals for the purpose of constructing utilityplant and is not refundable.

 

In 2008, we expect to spend approximately$29.2 million on cash additions, principally within our Utility Group, expectto receive $0.4 million of CIAC, and expect to finance an additional $14.0million of Cornerstone-related expenditures with our capital lease facilityresulting in total expected additions to property, plant and equipment of approximately$43.6 million.

 

**Cash Flows From Financing Activities ofContinuing Operations.**During the three months ended March 31,2008, we financed our growth through a broad range of capital initiatives:

 

·                  borrowed $37.0 million under ourrevolving line of credit;

 

·                  received $1.0 million of capitalimprovement reimbursements and contributions in aid of construction; and

 

·                  received $0.8 million of proceedsfrom our share-based equity incentive plans and stock purchase plans.

 

Revolving line of borrowings were primarilyused to fund our investing activities and, to a lesser extent, to fundoperations. Additional borrowing availability under our revolving creditfacility was $60.0 million as of March 31, 2008.

 

During the three months ended March 31,2008, we paid dividends totaling $1.4 million and our quarterly dividend rateis currently $0.06 per common share.

 

In February 2008, we entered into a newcredit agreement with several lenders including Bank of America, as lender andAdministrative Agent, KeyBank, CoBank, U.S. Bank, JPMorgan Chase Bank, ComericaBank, Bank of the West, Citibank and Union Bank of California. The creditagreement provides for a $150.0 million revolving credit facility. We may electto increase the amount of the credit facility by an amount not to exceed $75.0million during the term of the agreement provided certain conditions are met.The new credit agreement is more fully described in Note 4 to the condensedconsolidated financial statements included in this report.

 

The new revolving line of credit commitmentends on February 15, 2013 and our $100.0 million credit facility wascancelled upon repayment with an initial borrowing under the $150.0 millionfacility.

 

28

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###  

### **CONTRACTUALOBLIGATIONS**

###  

The following table summarizes our knowncontractual obligations to make future cash payments as of March 31, 2008,as well as an estimate of the periods during which these payments are expectedto be made.

 
| ** **                                        | ** ** | **Years Ending December 31,** | ** ** |
|---------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                        | ** ** | ** **                                   | ** ** | **Remainder** | ** ** | **2009** | ** ** | **2011** | ** ** | **2013** | ** ** |
| ** **                                        | ** ** | ** **                                   | ** ** | **of** | ** ** | **and** | ** ** | **and** | ** ** | **and** | ** ** |
| **(In thousands)**                           | ** ** | **Total**                                    | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** | **Beyond** | ** ** |
|                                              |       |                                         |       |   |   |   |   |   |   |   |   |
| Long-term debt (1):                               |       |                                         |       |   |   |   |   |   |   |   |   |
| Bank line of credit (2)                           |       | $                                            | 88,000     |   | $ | — |   | $ | — |   | $ | — |   | $ | 88,000 |   |
| Mortgage bonds (3)                                |       | 45,000                                       |       | — |   | — |   | — |   | 45,000 |   |
| Bank term loans (4)                               |       | 31,590                                       |       | 617 |   | 1,646 |   | 1,645 |   | 27,682 |   |
| Convertible subordinated debentures (5)           |       | 12,034                                       |       | — |   | — |   | — |   | 12,034 |   |
| Capital lease obligations (6)                     |       | 4,376                                        |       | 631 |   | 1,790 |   | 1,955 |   | — |   |
| Economic development revenue bonds (7)            |       | 1,925                                        |       | 115 |   | 245 |   | 280 |   | 1,285 |   |
| Notes payable and other (8)                       |       | 154                                          |       | 140 |   | 14 |   | — |   | — |   |
| Total long-term debt                              |       | 183,079                                      |       | 1,503 |   | 3,695 |   | 3,880 |   | 174,001 |   |
|                                              |       |                                         |       |   |   |   |   |   |   |   |   |
| Repayment of advances for construction (9)        |       | 10,297                                       |       | 957 |   | 1,366 |   | 864 |   | 7,110 |   |
| Water purchase commitment (10)                    |       | 7,512                                        |       | 345 |   | 920 |   | 920 |   | 5,327 |   |
| Operating lease obligations                       |       | 29,278                                       |       | 5,096 |   | 9,514 |   | 5,207 |   | 9,461 |   |
| Total obligations as of March 31, 2008  (11) |       | $                                            | 230,166    |   | $ | 7,901 |   | $ | 15,495 |   | $ | 10,871 |   | $ | 195,899 |   |

 

----

(1)          Excludes interest payments,which are described in the following notes. The terms of the long-term debt aremore fully described in the notes to the condensed consolidated financialstatements included in this report and in our 2007 Annual Report on Form 10-K.

 

(2)          The bank lines of credit bearinterest at variable rates and therefore the amount of future interest paymentsare uncertain. Borrowings bear interest, at our option, based on a margineither: a) over the LIBOR rate; or b) under the prime rate. The margins varybased on our consolidated debt to equity ratio. The weighted-average annualinterest rate on our bank line of credit borrowings was 3.85% as of March 31,2008.

 

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

 

(4)          Interest on the bank termloans is fixed at a weighted-average annual interest rate of 6.53% and ispayable semiannually.

 

(5)          Interest on the convertibledebentures is fixed at a 6.85% annual rate and is payable quarterly. Thedebentures are convertible, at the option of the holder, into shares of ourcommon stock at any time prior to their maturity.

 

(6)          Interest on the capital leaseobligations is imputed at a weighted-average annual interest rate of 4.43% andis payable monthly.

 

(7)          Interest on the economicdevelopment bonds is fixed at a weighted-average annual interest rate of 5.97%and is payable semiannually.

 

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

 

(9)          Advances for construction arenon-interest bearing.

 

(10)    Reflects the minimum annualcontractual commitment to purchase water through 2024. The amount is subject toincreases in future periods for production costs increases and may alsoincrease, but not decrease, if average actual usage exceeds a specified amount.

 

(11)    Excludes preferred stockdividend obligations. Preferred stockholders are entitled to receive annualdividends of $2.625 per share and there are 9,156 shares of preferred stockcurrently outstanding. The preferred stock is redeemable by the Company at anytime for $52.00 per share and, from time to time, we have elected to repurchaseshares offered to us by preferred stockholders at prices less than $52.00 pershare.

 

### **FINANCIALCONDITION AND LIQUIDITY**

###  

As of March 31, 2008, we had $24.8million of working capital and $5.1 million of operating lease obligationspayable during the remainder of 2008. As of March 31, 2008, we also had$60.0 million of additional borrowings available under our line of creditfacility, which expires on February 15, 2013. In addition to our line ofcredit, we also have $25.4 million of capital available under our $30.0 millioncapital lease facility. Our California and New Mexico mortgage bond indenturesalso permit the issuance of an additional $92.1 million of first mortgage bondsas of March 31, 2008. However, the terms of our credit facility donot permit additional first mortgage bond indebtedness without prior consentfrom the credit facility lenders. The mortgage bond indentures also limit theamount of cash and property dividends our California and New Mexico utilitiesmay pay to the parent company to fund its payment obligations. Dividends haveaveraged $4.2 million to $5.2 million per year and are less than the aggregatecumulative 

 

29

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dividend restriction threshold by $50.6million as of March 31, 2008. We were in compliance with all loanagreement covenants during the three months ended March 31, 2008.

 

We also have on file a registration statementwith the Securities and Exchange Commission, which is effective for theissuance of up to $50.0 million aggregate principal amount of common stock,debt securities and warrants. To date we have issued approximately $43.6 millionof common stock under the shelf registration.

 

We believe that our expected operating cashflows, together with borrowings under our credit facility ($60.0 million ofwhich was available as of March 31, 2008 and expires on February 15,2013) and $25.4 million available under our capital lease facility will besufficient to meet our operating expenses, working capital and capitalexpenditure requirements as well as our debt service and other contractualobligations for the next twelve months. However, our ability to comply withdebt financial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well ascompetitive, legislative, regulatory, business and other factors beyond ourcontrol.

 

### **CERTAINCONTRACTUAL COMMITMENTS AND INDEMNITIES**

###  

We operate a reverse osmosis water treatmentplant owned by the Capistrano Valley Water District (“CVWD”) under atwenty-year operating agreement. The agreement contains three guaranteesrelated to our performance during the term of the agreement. The agreementprovides for us to pay liquidated damages in the event we fail to perform forreasons other than those caused by “uncontrollable circumstances,” as such termis defined in the agreement.

 

During the term of the agreement, we may beliable for liquidated damages relating to any lost payments from a financialassistance agreement CVWD has with a state water agency, up to a maximum of$1.4 million per contract year. We have also made guarantees to CVWD withrespect to the quantity of finished water produced by the facility. In theevent the actual number of acre feet of finished water delivered is less thanthe water delivery guarantee, we are required to pay liquidated damages ofapproximately $600 per acre foot of shortfall, up to a maximum of 15.8 acrefeet per day. Finally, we have made guarantees with respect to seven measurablefinished water quality standards. Liquidated damages for failure to meet thesequality standards range from $100 to $400 per day per failed quality standard(up to a maximum of $2,800 per day), depending on the number of violations percontract year. The CVWD has not asserted any claims for liquidated damagespursuant to these guarantees through the date of this report.

 

As part of the financing for this project,the CVWD sold insured municipal bonds. We entered into an agreement with thebond insurer to guarantee our performance under the service contract, subjectto certain liability caps to the bond insurer in the event of a default. Duringthe twenty-year operation of the facility, such liability caps will not exceedan amount equal to $4.0 million plus an amount no greater than the replacementcost of the actual reverse osmosis filtration unit within the facility, estimatedto be approximately $1.5 million.

 

### **OFF-BALANCESHEET ARRANGEMENTS**

###  

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

 

We lease some of our equipment and officefacilities under operating leases which are deemed to be off-balance sheetarrangements. Our future operating lease payment obligations are more fullydescribed under the caption “—Contractual Obligations” above.

 

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## ** **

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

## ** **

As of March 31, 2008, we had $183.8million of long-term variable and fixed-rate debt. We are exposed to marketrisk based on changes in prevailing interest rates.

 

Market risk related to our variable-rate debtis estimated as the potential decrease in pre-tax earnings resulting from anincrease in interest rates. We have $88.0 million of long-term debt that bearsinterest at variable rates based on either the prime rate or LIBOR rate. Ourvariable-rate debt had a weighted average annual interest rate of 3.85% as of March 31,2008. A hypothetical one percent (100 basis points) increase in the averageannual interest rates charged on our variable-rate debt would reduce ourpre-tax earnings by approximately $0.9 million per year.

 

Our fixed-rate debt, which has a carryingvalue of $95.8 million, has a fair value of $97.9 million as of March 31, 2008.Market risk related to our fixed-rate debt is deemed to be the potentialincrease in fair value resulting from a decrease in prevailing interest rates.Our fixed-rate debt had a weighted average annual interest rate of 6.5% as of March 31,2008. A hypothetical ten percent decrease in annual interest rates, from 6.5%to 5.9%, would increase the fair value of our fixed-rate debt by approximately$5.8 million.

 

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

 

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

## ** **

### **DISCLOSURECONTROLS AND PROCEDURES**

###  

Under the supervision and with theparticipation of our management, including the Chief Executive Officer andChief Financial Officer, we have evaluated the effectiveness of our disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-15(b) as ofthe end of the period covered by this report. Based on that evaluation, theChief Executive Officer and Chief Financial Officer have concluded that thesedisclosure controls and procedures are effective. There were no changes in ourinternal control over financial reporting during the quarter ended March 31, 2008that have materially affected, or are reasonably likely to materially affect,our internal control over financial reporting.

 

### **CHANGESIN INTERNAL CONTROL OVER FINANCIAL REPORTING**

###  

There were changes, as described below, inour internal control over financial reporting (as that term is defined in Rules 13a-15(f) or15d-15(f) under the Exchange Act) during the quarter to which this reportrelates that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

During the first quarter of 2008, weimplemented a series of Oracle financial modules, including a new generalledger and chart of accounts as well as a new accounts payable system and newconsolidations and financial reports. The implementation of these ERP modulesresulted in changes to our financial reporting controls and procedures, withsuch changes being identified during the design and implementation of themodules. Therefore, as appropriate, we are modifying the design and documentationof internal control process and procedures relating to the new system tosupplement and complement existing internal controls over financial reporting.The system changes were undertaken to integrate systems and consolidateinformation, and were not undertaken in response to any actual or perceiveddeficiencies in our internal control over financial reporting.

 

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# ** **

# **PART II – OTHER INFORMATION**

# ** **

## **ITEM 1.**                  LEGAL PROCEEDINGS

## ** **

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

 

## **ITEM1A.**               RISK FACTORS

## ** **

There have been no material changes in ourrisk factors, except as noted below, since we last reported under Part I,Item 1A, in our Annual Report on Form 10-K for the year ended December 31,2007.

 

**Capital Market Transactions**

 

**Because of a late Form 8-K filing, wewill loose our eligibility to use Form S-3 Registration Statements toregister securities which, in turn, will adversely affect our ability to accesscapital markets to finance our capital requirements for the next twelve months.We may also be required to suspend our Dividend Reinvestment and Direct StockPurchase Plans for a period of time.**

 

We were unable to timely file a CurrentReport on Form 8-K (the “Form 8-K”) related to our January 2008acquisition of the assets of a sewer system and related wastewater treatmentplant (commonly referred to as the “Riverview System”). This failure was due toour inability to provide the audited financial statements for the RiverviewSystem required by the Securities Exchange Act of 1934 (the “Exchange Act”).The independent accountants we retained to perform the audit were unable toexpress an opinion of the historical cost of the assets acquired because theprior owners did not retain sufficient historical transactional records tosupport the recorded values. We have been in contact with the Securities andExchange Commission (“SEC”) and plan to file the required Form 8-K withalternate audited financial information, per our discussions with the SEC, bythe end of May 2008.

 

The late filing of the Form 8-K hasadversely affected our eligibility to use Registration Statements on Form S-3for registration of our securities with the SEC. Use of Form S-3 requires,among other things, that the issuer be current and timely in its reports underthe Exchange Act for at least twelve months. Because of our inability to use Form S-3,we will have to meet more demanding requirements to register additionalsecurities, which will make it more difficult for us to effect public offeringtransactions, and our range of available financing alternatives could also benarrowed. It is also likely we will be required to suspend our DividendReinvestment and Direct Stock Purchase Plans after the filing of our 2008 Form 10-Kuntil we regain Form S-3 eligibility twelve months after the filing of theForm 8-K because we will not be in a position to file a registrationstatement covering those shares prior to regaining Form S-3 eligibility.

 

## **ITEMS1A, 2, 3, 4 AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.**

## ** **

## **ITEM6.**  EXHIBITS

 
| **Exhibit** | ** ** | ** **                                                                                                   |
|-------------|------------|--------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                 |
|        |       |                                                                                                         |
| 15          | *          | Letter regarding unaudited interim financial information from  Independent Registered Public Accounting Firm |
|        |       |                                                                                                         |
| 31.1        | *          | Certification of Principal Executive Officer Pursuant to Section 302  of the Sarbanes Oxley Act of 2002 |
|        |       |                                                                                                         |
| 31.2        | *          | Certification of Principal Financial Officer Pursuant to Section 302  of the Sarbanes Oxley Act of 2002 |
|        |       |                                                                                                         |
| 32.1        | *          | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes Oxley Act of 2002     |
|        |       |                                                                                                         |
| 32.2        | *          | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes Oxley Act of 2002     |

 

----

*                 Filed herewith

 

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# ** **

# **SIGNATURES**

# ** **

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

 

 
|                     | **SOUTHWEST WATER COMPANY (REGISTRANT)** |
|--------------------------|------------------------------------------|
|                     |                                     |
|                     |                                     |
| Dated: May 12, 2008 | /s/ CHERYL L. CLARY                      |
|                     | Cheryl L. Clary                          |
|                     | Chief Financial Officer                  |

 

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