Table of Contents

 

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 
| **(Mark One)** |       |                                                                                                                                                                                                                                                                                                             |
|----------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|           |       |                                                                                                                                                                                                                                                                                                             |
| **x**          | ** ** | **Quarterly Report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                           |
|           |       |                                                                                                                                                                                                                                                                                                             |
|           |       | For the quarterly period  ended March 31, 2010                                                                                                                                                                                                                                                              |
|           |
| or             |
|           |
| **o**          | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                          |
|           |       |                                                                                                                                                                                                                                                                                                             |
|           |       | For the transition  period  from                                             to |

 

**CommissionFile Number 0-8176**

 

 

(Exact name ofregistrant as specified in its charter)

 

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

 

**One WilshireBuilding**

**624 SouthGrand Avenue, Suite 2900**

**LosAngeles, California 90017-3782**

(Address ofprincipal executive offices, including zip code)

 

**(213)929-1800**

(Registrant’stelephone, including area code)

 

**None**

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

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes **x**   No **o**

 

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

 

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

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

 

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

 

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

 

|   | Class                                   |   | Outstanding as of  April 30, 2010 |   |
|--------|-----------------------------------------|--------|----------------------------------------|--------|
|   |                                    |   |                                   |   |
|   | Common Stock,  $.01 par value per share |   | 27,518,707 shares                      |   |

 

 

 

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Table ofContents

 

**TABLEOF CONTENTS**

 
| ** **       | ** **                                                                                                                                  | **Page** |
|------------------|---------------------------------------------------------------------------------------------------------------------------------------------|----------|
|             |                                                                                                                                        |     |
| **Part I**  | **Financial Information**                                                                                                                   | **2**    |
|             |                                                                                                                                        |     |
| Item 1.          | Financial Statements                                                                                                                        | 2        |
|             |                                                                                                                                        |     |
|             | Condensed  Consolidated Balance Sheets (Unaudited) as of March 31, 2010 and  December 31,  2009                                   | 2        |
|             |                                                                                                                                        |     |
|             | Condensed  Consolidated Statements of Operations (Unaudited) for the three months ended  March 31, 2010 and 2009                  | 3        |
|             |                                                                                                                                        |     |
|             | Condensed  Consolidated Statement of Changes in Stockholders’ Equity (Unaudited) for the  three  months ended March 31, 2010 | 4        |
|             |                                                                                                                                        |     |
|             | Condensed  Consolidated Statements of Cash Flows (Unaudited) for the three months ended  March 31, 2010 and 2009                       | 5        |
|             |                                                                                                                                        |     |
|             | Notes to Unaudited Condensed Consolidated Financial  Statements                                                                             | 6        |
|             |                                                                                                                                        |     |
| Item 2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                 | 14       |
|             |                                                                                                                                        |     |
| Item 3.          | Quantitative  and Qualitative Disclosures About Market Risk                                                                                 | 23       |
|             |                                                                                                                                        |     |
| Item 4.          | Controls and  Procedures                                                                                                                    | 23       |
|             |                                                                                                                                        |     |
| **Part II** | **Other Information**                                                                                                                       | **28**   |
|             |                                                                                                                                        |     |
| Item 1.          | Legal Proceedings                                                                                                                           | 28       |
|             |                                                                                                                                        |     |
| Item 1A.         | Risk Factors                                                                                                                                | 28       |
|             |                                                                                                                                        |     |
| Item 2.          | Unregistered  Sales of Equity Securities and Use of Proceeds                                                                                | 28       |
|             |                                                                                                                                        |     |
| Item 6.          | Exhibits                                                                                                                                    | 28       |
|             |                                                                                                                                        |     |
| **Signatures**   |                                                                                                                                        | **29**   |

 

1

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# **PART I– FINANCIAL INFORMATION**

 

## **ITEM1.    FINANCIAL STATEMENTS**

 

**SOUTHWEST WATER COMPANY**

 

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

 
| * *                                         | ** ** | **March 31,** | ** ** | ** ** | ** ** | **December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------|------------|------------|------------|-----------------------|------------|
| *(In thousands)*                                 | ** ** | **2010**           | ** ** | ** ** | ** ** | **2009**              | ** ** |
|                                             |       |               |       |       |       |                  |       |
| **ASSETS**                                       |       |               |       |       |       |                  |       |
| Current assets:                                  |       |               |       |       |       |                  |       |
| Cash and cash  equivalents                       |       | $                  | 815        |       |       |                  | $          | 2,874 |   |
| Accounts receivable, net                         |       | 25,454             |       |       |       | 26,968                |       |
| Prepaid expenses and  other current assets       |       | 13,378             |       |       |       | 12,909                |       |
| Total current assets                             |       | 39,647             |       |       |       | 42,751                |       |
|                                             |       |               |       |       |       |                  |       |
| Property, plant and  equipment, net              |       | 312,747            |       |       |       | 313,716               |       |
| Other assets:                                    |       |               |       |       |       |                  |       |
| Goodwill                                         |       | 16,434             |       |       |       | 16,434                |       |
| Intangible assets                                |       | 2,880              |       |       |       | 2,966                 |       |
| Other assets                                     |       | 24,307             |       |       |       | 24,228                |       |
| Total assets                                     |       | $                  | 396,015    |       |       |                  | $          | 400,095 |   |
|                                             |       |               |       |       |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**   |       |               |       |       |       |                  |       |
| Current liabilities:                             |       |               |       |       |       |                  |       |
| Accounts payable                                 |       | $                  | 12,059     |       |       |                  | $          | 14,130 |   |
| Current portion of  long-term debt               |       | 2,216              |       |       |       | 2,171                 |       |
| Other current  liabilities                       |       | 19,301             |       |       |       | 21,213                |       |
| Total current  liabilities                       |       | 33,576             |       |       |       | 37,514                |       |
| Other liabilities and  deferred credits:         |       |               |       |       |       |                  |       |
| Long-term debt, less  current portion            |       | 140,990            |       |       |       | 152,820               |       |
| Deferred income taxes                            |       | 12,931             |       |       |       | 13,100                |       |
| Advances for  construction                       |       | 8,681              |       |       |       | 8,784                 |       |
| Contributions in aid of  construction            |       | 53,408             |       |       |       | 53,841                |       |
| Other liabilities and  deferred credits          |       | 18,629             |       |       |       | 18,122                |       |
|                                             |       |               |       |       |       |                  |       |
| Commitments and  contingencies                   |       |               |       |       |       |                  |       |
|                                             |       |               |       |       |       |                  |       |
| Stockholders’ equity:                       |       |               |       |       |       |                  |       |
| Preferred stock                                  |       | 458                |       |       |       | 458                   |       |
| Common stock                                     |       | 275                |       |       |       | 249                   |       |
| Additional paid-in  capital                      |       | 164,575            |       |       |       | 148,407               |       |
| Accumulated deficit                              |       | (37,508            | )          |       |       | (33,200               | )          |
| Total stockholders’  equity                 |       | 127,800            |       |       |       | 115,914               |       |
| Total liabilities and  stockholders’ equity |       | $                  | 396,015    |       |       |                  | $          | 400,095 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**SOUTHWEST WATER COMPANY**

 

### **CONDENSED CONSOLIDATEDSTATEMENTS OF OPERATIONS (UNAUDITED)**

 
| ** **                                           | ** ** | **Three  Months Ended** | ** ** |
|------------------------------------------------------|------------|-------------------------|------------|
| ** **                                           | ** ** | ** **              | ** ** |
| ** **                                           | ** ** | **March 31,**      | ** ** |
| ** **                                           | ** ** | ** **              | ** ** |
| *(In  thousands, except per share data)*             | ** ** | **2010**                | ** ** | ** ** | ** ** | **2009** | ** ** |
| Operating revenue                                    |       | $                       | 46,846     |   |   |   | $ | 50,092 |   |
| Expenses:                                            |       |                    |       |   |   |   |   |
| Operating expenses                                   |       | 45,312                  |       |   |   | 49,907 |   |
| Depreciation and  amortization                       |       | 3,867                   |       |   |   | 3,833 |   |
| Total operating expenses                             |       | 49,179                  |       |   |   | 53,740 |   |
| Operating loss                                       |       | (2,333                  | )          |   |   | (3,648 | ) |
| Other income (expense):                              |       |                    |       |   |   |   |   |
| Interest expense                                     |       | (2,370                  | )          |   |   | (1,887 | ) |
| Interest income                                      |       | 33                      |       |   |   | 36 |   |
| Loss from continuing  operations before income taxes |       | (4,670                  | )          |   |   | (5,499 | ) |
| Benefit from income  taxes                           |       | (1,742                  | )          |   |   | (2,094 | ) |
| Loss from continuing  operations                     |       | (2,928                  | )          |   |   | (3,405 | ) |
| Income from discontinued  operations, net of tax     |       | —                  |       |   |   | 172 |   |
| Net loss                                             |       | (2,928                  | )          |   |   | (3,233 | ) |
| Preferred stock  dividends                           |       | (6                      | )          |   |   | — |   |
| Net loss applicable to  common stockholders          |       | $                       | (2,934     | ) |   |   | $ | (3,233 | ) |
|                                                 |       |                    |       |   |   |   |   |
| Loss per common share -  basic and diluted           |       |                    |       |   |   |   |   |
| Loss from continuing  operations                     |       | $                       | (0.12      | ) |   |   | $ | (0.14 | ) |
| Income from discontinued  operations                 |       | —                  |       |   |   | 0.01 |   |
| Net loss applicable to  common stockholders          |       | $                       | (0.12      | ) |   |   | $ | (0.13 | ) |
|                                                 |       |                    |       |   |   |   |   |
| Weighted average common  shares outstanding:         |       |                    |       |   |   |   |   |
| Basic                                                |       | 25,105                  |       |   |   | 24,600 |   |
| Diluted                                              |       | 25,105                  |       |   |   | 24,600 |   |

 

See accompanyingnotes to condensed consolidated financial statements.

 

3

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**SOUTHWEST WATER COMPANY**

 

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

 
| ** **                                                              | ** ** | **Preferred  Stock** | ** ** | ** ** | ** ** | **Common  Stock** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** **  | ** ** |
|-------------------------------------------------------------------------|------------|----------------------|------------|------------|------------|-------------------|------------|------------|------------|----------------|------------|------------|------------|------------|------------|------------|------------|-------------|------------|
| ** **                                                              | ** ** | **Number of**        | ** ** | ** ** | ** ** | ** **        | ** ** | ** ** | ** ** | **Number of**  | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | ** ** | ** ** | **Accumulated** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                              | ** ** | **Shares**           | ** ** | ** ** | ** ** | **Amount**        | ** ** | ** ** | ** ** | **Shares**     | ** ** | ** ** | ** ** | **Amount** | ** ** | ** ** | ** ** | **Capital** | ** ** | ** ** | ** ** | **Deficit** | ** ** | ** ** | ** ** | **Total** | ** ** |
| *(In  thousands)*                                                       |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| **Balance  - December 31, 2009**                                   | ** ** | **9**                | ** ** | ** ** | ** ** | **$**             | **458**    | ** ** | ** ** | ** **     | **24,887** | ** ** | ** ** | ** ** | **$**      | **249**    | ** ** | ** **  | ** ** | **$** | **148,407** | ** ** | ** ** | ** ** | **$** | **(33,200** | **)** | ** ** | ** ** | **$** | **115,914** | ** ** |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Net loss                                                                |       | —               |       |       |       | —            |       |       |       | —         |       |       |       | —     |       |       |       | —      |       |   |   | (2,928 | ) |   |   | (2,928 | ) |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Restricted stock awards  cancelled                                      |       | —               |       |       |       | —            |       |       |       | (94            | )          |       |       | (1         | )          |       |       | 1           |       |   |   | — |   |   |   | — |   |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Common stock issuance                                                   |       | —               |       |       |       | —            |       |       |       | 2,700          |       |       |       | 27         |       |       |       | 16,092      |       |   |   |   |   |   |   | 16,119 |   |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Common stock issuances  from employee benefit plans, net of repurchases |       | —               |       |       |       | —            |       |       |       | 20             |       |       |       | —     |       |       |       | 134         |       |   |   | — |   |   |   | 134 |   |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Share-based compensation                                                |       | —               |       |       |       | —            |       |       |       | —         |       |       |       | —     |       |       |       | (59         | )          |   |   | — |   |   |   | (59 | ) |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Cash dividends declared:                                                |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Preferred stock - $0.66  per share                                      |       | —               |       |       |       | —            |       |       |       | —         |       |       |       | —     |       |       |       | —      |       |   |   | (6 | ) |   |   | (6 | ) |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| Common stock - $0.05 per  share                                         |       | —               |       |       |       | —            |       |       |       | —         |       |       |       | —     |       |       |       | —      |       |   |   | (1,374 | ) |   |   | (1,374 | ) |
|                                                                    |       |                 |       |       |       |              |       |       |       |           |       |       |       |       |       |       |       |        |       |   |   |   |   |   |   |   |   |
| **Balance  - March 31, 2010**                                      | ** ** | **9**                | ** ** | ** ** | ** ** | **$**             | **458**    | ** ** | ** ** | ** **     | **27,513** | ** ** | ** ** | ** ** | **$**      | **275**    | ** ** | ** **  | ** ** | **$** | **164,575** | ** ** | ** ** | ** ** | **$** | **(37,508** | **)** | ** ** | ** ** | **$** | **127,800** | ** ** |

 

See accompanyingnotes to condensed consolidated financial statements.

 

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**SOUTHWEST WATER COMPANY**

 

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

 
| ** **                                                                                 | ** ** | **Three  Months Ended** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                                                 | ** ** | **March 31,**      | ** ** |
| *(In thousands)*                                                                           | ** ** | **2010**                | ** ** | ** ** | ** ** | **2009** | ** ** |
|                                                                                       |       |                    |       |   |   |   |   |
| Cash flows from  operating activities of continuing operations:                            |       |                    |       |   |   |   |   |
| Net loss                                                                                   |       | $                       | (2,928     | ) |   |   | $ | (3,233 | ) |
| Adjustments to reconcile  net loss to net cash provided by (used in) operating activities: |       |                    |       |   |   |   |   |
| Income from discontinued  operations, net of tax                                           |       | —                  |       |   |   | (172 | ) |
| Depreciation and  amortization                                                             |       | 3,867                   |       |   |   | 3,833 |   |
| Deferred income taxes                                                                      |       | (1,922                  | )          |   |   | 974 |   |
| Provision for doubtful  accounts                                                           |       | 45                      |       |   |   | 408 |   |
| Share-based compensation  expense                                                          |       | (59                     | )          |   |   | 80 |   |
| Post-vest cancellations  of non-qualified stock options                                    |       | —                  |       |   |   | (118 | ) |
| Loss on disposal of  property, plant & equipment                                  |       | 106                     |       |   |   | — |   |
| Other, net                                                                                 |       | 220                     |       |   |   | 63 |   |
| Changes in assets and  liabilities, net of effects of acquisitions                         |       |                    |       |   |   |   |   |
| Accounts receivable                                                                        |       | 1,469                   |       |   |   | 59 |   |
| Other current assets                                                                       |       | 1,284                   |       |   |   | (948 | ) |
| Other assets                                                                               |       | (204                    | )          |   |   | 171 |   |
| Accounts payable                                                                           |       | (1,396                  | )          |   |   | (369 | ) |
| Other current  liabilities                                                                 |       | (1,912                  | )          |   |   | 1,720 |   |
| Other liabilities                                                                          |       | (70                     | )          |   |   | 1,144 |   |
| Net cash provided by  (used in) operating activities                                       |       | (1,500                  | )          |   |   | 3,612 |   |
|                                                                                       |       |                    |       |   |   |   |   |
| Cash flows from  investing activities of continuing operations:                            |       |                    |       |   |   |   |   |
| Additions to property,  plant and equipment                                                |       | (3,297                  | )          |   |   | (3,843 | ) |
| Proceeds from sales of  equipment                                                          |       | 2                       |       |   |   | — |   |
| Net cash used in  investing activities                                                     |       | (3,295                  | )          |   |   | (3,843 | ) |
|                                                                                       |       |                    |       |   |   |   |   |
| Cash flows from  financing activities of continuing operations:                            |       |                    |       |   |   |   |   |
| Borrowings under lines  of credit                                                          |       | 4,700                   |       |   |   | 5,500 |   |
| Repayments under lines  of credit                                                          |       | (16,200                 | )          |   |   | — |   |
| Payments on long-term  debt                                                                |       | (553                    | )          |   |   | (644 | ) |
| Capital improvement  reimbursements                                                        |       | 324                     |       |   |   | 210 |   |
| Proceeds of stock  issuance                                                                |       | 16,200                  |       |   |   | — |   |
| Proceeds from employee  benefit plan stock issuances, net of repurchases                   |       | 134                     |       |   |   | — |   |
| Contributions in aid of  construction                                                      |       | —                  |       |   |   | 71 |   |
| Dividends paid                                                                             |       | (1,380                  | )          |   |   | (629 | ) |
| Repayment of advances  for construction                                                    |       | (370                    | )          |   |   | — |   |
| Deferred financing costs                                                                   |       | (119                    | )          |   |   | (753 | ) |
| Net cash provided by  financing activities                                                 |       | 2,736                   |       |   |   | 3,755 |   |
|                                                                                       |       |                    |       |   |   |   |   |
| Cash flows from  discontinued operations:                                                  |       |                    |       |   |   |   |   |
| Operating activities                                                                       |       | —                  |       |   |   | (1,990 | ) |
| Investing activities                                                                       |       | —                  |       |   |   | (143 | ) |
| Financing activities                                                                       |       | —                  |       |   |   | 78 |   |
| Net cash used in  discontinued operations                                                  |       | —                  |       |   |   | (2,055 | ) |
|                                                                                       |       |                    |       |   |   |   |   |
| Net increase (decrease)  in cash and cash equivalents                                      |       | (2,059                  | )          |   |   | 1,469 |   |
| Cash and cash  equivalents at beginning of period                                          |       | 2,874                   |       |   |   | 1,112 |   |
| Cash and cash  equivalents at end of period                                                |       | $                       | 815        |   |   |   | $ | 2,581 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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**SOUTHWEST WATER COMPANY**

 

### **NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**Note 1.        Basisof Presentation and Summary of Significant Accounting Policies**

 

**Basis of Presentation**

** **

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

 

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

 

Certain information anddisclosures normally included in financial statements prepared in accordancewith GAAP have been omitted in accordance with Securities and Exchange Commission’s(“SEC”) rules and regulations for interim financial reporting. Thesecondensed consolidated interim financial statements should be read inconjunction with the audited financial statements and related notes included inour 2009 Annual Report on Form 10-K. Our businesses are seasonal becausethey are affected by weather; as a result, operating results for interimperiods are not necessarily predictive of the operating results for any otherinterim period or for the full year.

 

**Merger Agreement andLong-Term Infrastructure Investment**

 

On March 2, 2010, weentered into an agreement and plan of merger (the “Merger Agreement”) with SWMerger Acquisition Corp. (“Parent”) and SW Merger Sub Corp., a directwholly-owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub arejointly owned by IIF Subway Investment LP and USA Water Services, LLC, whichare sponsored by J.P. Morgan IIF Acquisitions LLC and Water Asset Management,LLC.  Under the terms of the MergerAgreement, all of our outstanding common stock would be converted into a rightto receive $11.00 per share in cash.  Thecompletion of the merger is subject to customary closing conditions, includingstockholder approval and regulatory notice and approvals.

 

If the Merger Agreement isadopted by our stockholders and all closing conditions are met, we will be thesurviving corporation of the merger and a wholly owned subsidiary of Parent.Upon completion of the merger, our common stock will cease to be traded on theNASDAQ Global Select Market and we will no longer be a publicly heldcorporation.  The Merger Agreementcontains restrictions on our operations prior to the closing of the merger,including restrictions related to capital expenditures, the incurrence of debt,acquiring and disposing of assets, entering into material contracts and capitaltransactions.

 

In connection with theMerger Agreement, we entered into a Securities Purchase Agreement and InvestorRights Agreement (collectively, the “Investment Agreements”).  Pursuant to the Investment Agreements, Parentpurchased 2,700,000 shares of our common stock (the “Purchased Stock”) at aprice of $6.00 per share, for an aggregate purchase price of $16.2 million andwe incurred related specific incremental transactional costs of $0.1 million.  As permitted under the terms of theInvestment Agreements, the Company applied the proceeds derived from the saleof the Purchased Stock to reduce our revolving line of credit, the borrowingsof which are used for capital expenditures and working capital purposes.  The Investment Agreements entitle Parent toappoint a designee to serve on our board of directors (which right Parent hasnot exercised to date), and also to certain registration rights with respect tothe Purchased Stock in the event of the termination of the MergerAgreement.  The Investment Agreementsrestrict Parent’s ability to sell or otherwise transfer the Purchased Stockprior to the earlier of the consummation or termination of the MergerAgreement.  Except as contemplated by theMerger Agreement, Parent and Merger Sub are also prohibited from acquiring anyadditional shares of our common stock until the termination of the MergerAgreement.

 

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

** **

**Recent Accounting Pronouncements**

** **

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

** **

In February 2010, theFinancial Accounting Standards Board (FASB) issued accounting standards update(ASU) No. 2010-09,*Subsequent Events(Topic 855)—Amendments to Certain Recognition and Disclosure Requirements*(ASU No. 2010-09). Among other amendments to Topic 855, ASU No. 2010-09reiterates that SEC filers are required to evaluate subsequent events throughthe date the financial statements have been issued and eliminates therequirement that SEC filers disclose the date through which subsequent eventshave been evaluated. ASU No. 2010-09 became effective upon issuance.Adoption of ASU No. 2010-09 had no impact on our consolidated financialstatements.

 

In January 2010, theFASB issued ASU No. 2010-06,*Fair ValueMeasurements and Disclosures (Topic 820)—Improving Disclosures about FairValue Measurements* (ASU No. 2010-06). ASU No. 2010-06requires: (1) fair value disclosures of assets and liabilities by class; (2) disclosuresabout 

 

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**SOUTHWEST WATER COMPANY**

 

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

significant transfers inand out of Levels 1 and 2 on the fair value hierarchy, in addition toLevel 3; (3) purchases, sales, issuances and settlements be disclosedon gross basis on the reconciliation of beginning and ending balances ofLevel 3 assets and liabilities; and (4) disclosures about valuationmethods and inputs used to measure the fair value of Level 2 assets andliabilities. ASU No. 2010-06 became effective for the first financialreporting period beginning after December 15, 2009, except for disclosuresabout purchases, sales, issuances and settlements of Level 3 assets andliabilities, which will be effective for fiscal years beginning after December 15,2010. Adoption of the currently effective provisions of ASU No. 2010-06had no impact on our consolidated financial statements. Presently, we areassessing what impact, if any, Level 3 disclosure requirements regarding grosspresentation of purchases, sales, issuances and settlements will have on ourconsolidated financial statements.

 

**Other Comprehensive Income**

** **

**We had no accumulated other comprehensive income asof March 31, 2010 and December 31, 2009.**

** **

**Accounting Adjustments Impacting Other Periods**

 

For the quarter ended March 31,2010 we recorded a $0.1 million expense, net of tax, related to prior periods.Management has determined that the effect of recognizing this adjustment is notmaterial to our results of operations for the three months ended March 31,2010 or for any prior period.

 

**Fair Value Measurements**

 

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

 

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

 

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

 

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

 

Our revolving creditfacility and long-term debt with aggregate book values of $143.2 million and$155.0 million had fair values of approximately $134.7 million and $145.5million at March 31, 2010 and December 31, 2009, respectively.  The estimated fair values are based oncurrent rates for similar issues for debt of the same remaining maturities(Level 2). The carrying value of all other financial instruments, such as cashand cash equivalents, accounts receivable and accounts payable, approximatesfair value because of the short maturity of the instruments (Level 1). At March 31,2010 and December 31, 2009, we had no derivative financial instruments,hedging activities, financial instruments with off-balance sheet risk orfinancial instruments with concentrations of credit risks.

 

**Note 2.        Dispositions**

 

As morefully described in Note 4, “Commitments and Contingencies - Legal Proceedings”,as part of a settlement of eminent domain proceedings against our New Mexicoutility, New Mexico Utilities Inc. (“NMUI”), we completed the sale of NMUI in May 2009.  As of March 31, 2010 and December 31,2009, no assets were held for sale.

 

Theresults of operations of our NMUI operations have been reclassified asdiscontinued operations for the three months ended March 31, 2009 in theconsolidated statements of operations and are summarized as follows:

 
| ** **                                       | **Three  months ended**      |
|--------------------------------------------------|------------------------------|
| ** **                                       | **March 31, 2009** |
| *(In thousands)*                                 |                         |   |   |
| Operating revenue                                |                         | $ | 2,304 |   |
|                                             |                         |   |   |
| Operating  expenses                              |                         | 1,851 |   |
|                                             |                         |   |   |
| Operating  income                                |                         | 453 |   |
|                                             |                         |   |   |
| Interest expense                                 |                         | (189 | ) |
|                                             |                         |   |   |
| Income  before taxes                             |                         | 264 |   |
|                                             |                         |   |   |
| Provision  for income taxes                      |                         | 92 |   |
|                                             |                         |   |   |
| Income  from discontinued operations, net of tax |                         | $ | 172 |   |

 

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**SOUTHWEST WATER COMPANY**

 

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

**Note 3.        Long-TermDebt**

** **

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

 
| ** **                                            | ** ** | **March 31,** | ** ** | ** ** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|------------|------------|-----------------------|------------|
| *(In thousands)*                                      | ** ** | **2010**           | ** ** | ** ** | ** ** | **2009**              | ** ** |
|                                                  |       |               |       |       |       |                  |       |   |   |
| Revolving credit  facility                            |       | $                  | 63,000     |       |       |                  | $          | 74,500 |   |
|                                                  |       |               |       |       |       |                  |       |
| 6.85% convertible  subordinated debentures due 2021   |       | 11,787             |       |       |       | 11,839                |       |
|                                                  |       |               |       |       |       |                  |       |
| Capital leases                                        |       | 3,136              |       |       |       | 3,138                 |       |
|                                                  |       |               |       |       |       |                  |       |
| Term Loans:                                           |       |               |       |       |       |                  |       |
| Monarch  Utilities, Inc.:                        |       |               |       |       |       |                  |       |
| 7.37% fixed rate  term loan due 2022                  |       | 9,304              |       |       |       | 9,497                 |       |
| 5.77% fixed rate  term loan due 2022                  |       | 640                |       |       |       | 654                   |       |
| 6.10% fixed rate term  loan due 2031                  |       | 20,000             |       |       |       | 20,000                |       |
|                                                  |       |               |       |       |       |                  |       |
| First Mortgage Bonds:                                 |       |               |       |       |       |                  |       |
| Suburban Water Systems:                               |       |               |       |       |       |                  |       |
| 9.09% series B  first mortgage bond due 2022          |       | 8,000              |       |       |       | 8,000                 |       |
| 5.64% series D  first mortgage bond due 2024          |       | 15,000             |       |       |       | 15,000                |       |
| 6.30% series E  first mortgage bond due 2026          |       | 10,000             |       |       |       | 10,000                |       |
|                                                  |       |               |       |       |       |                  |       |
| Economic Development  Revenue Bonds:                  |       |               |       |       |       |                  |       |
| 6.0% series 1998A  due 2018                           |       | 1,690              |       |       |       | 1,690                 |       |
|                                                  |       |               |       |       |       |                  |       |
| Acquisition-related  indebtedness and other           |       | 78                 |       |       |       | 78                    |       |
| Total long-term debt  payment obligations             |       | 142,635            |       |       |       | 154,396               |       |
| Unamortized Monarch term  loan fair value adjustments |       | 571                |       |       |       | 595                   |       |
| Total long-term  debt                                 |       | 143,206            |       |       |       | 154,991               |       |
| Less current  portion of long-term debt               |       | (2,216             | )          |       |       | (2,171                | )          |
| Long-term debt,  less current portion                 |       | $                  | 140,990    |       |       |                  | $          | 152,820 |   |

 

 

Our revolving line ofcredit reflects a credit agreement with several lenders, including Bank ofAmerica as lender and Administrative Agent, KeyBank, CoBank, U.S. Bank,JPMorgan Chase Bank, Comerica Bank, Bank of the West, Citibank and Union Bankof California (the “Bank Group”). The credit agreement provides for a $110.0million revolving credit facility.

 

We pay commitment feesunder the facility and must maintain customary financial ratios, prescribedcash flow results and meet other restrictive covenants. We were not incompliance with certain covenants due to our failure to timely file our March 31,2009 and June 30, 2009 Quarterly Reports on Form 10-Q.  In addition, we were in violation of ourdebt-to-capitalization ratio at March 31, 2009. However, we receivedamendments from the Bank Group which waived existing and anticipated defaults,primarily granting additional time to complete our financial filings andwaiving the debt-to-capitalization ratio for the periods of non-compliance. TheMay 28, 2009 amendment secured the facility with substantially all assetsof the Company not previously encumbered and significantly increased ourborrowing margins. Fees and expenses charged by the Bank Group for all theamendments were $3.4 million, of which $0.1 million was incurred during thethree months ended March 31, 2010. These fees were capitalized and arebeing amortized over the remaining life of the facility which extends through February 2013.

 

Borrowings under thecredit facility bear interest, at our option, based on either a margin over thedesignated LIBOR rate or the prime rate. As of March 31, 2010 ourdebt-to-capitalization ratio is 54%; therefore, the applicable margins are3.50% over the LIBOR rate and 2.50% over the prime rate. The margins decline ona sliding scale as our debt-to-capitalization ratio improves. The weightedaverage annual interest rates, excluding bank amendment and waiver fees, on allcredit facility borrowings outstanding were 4.2% as of March 31, 2010 and4.3% as of December 31, 2009.

 

As of March 31, 2010,we had irrevocable standby letters of credit in the amount of $5.0 millionissued and outstanding under our revolving credit facility and our availableborrowing capacity was $42.0 million.

 

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**SOUTHWEST WATER COMPANY**

 

**NOTES TOUNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

**Note 4.        Commitmentsand Contingencies**

** **

**Legal Proceedings**

** **

*Class ActionLitigation*

 

Perrin v. SouthWest WaterCompany, et al., Case No. CV 08-07844 (Central District of California) andrelated, consolidated cases: On November 26, 2008, an alleged purchaser ofour publicly traded common stock filed a securities class action lawsuit in theUnited States District Court for the Central District of California. Thecomplaint generally alleges that from May 10, 2005 through November 9,2008, we made false statements or omitted to state facts necessary to make ourdisclosures not misleading. Five additional and substantially similarcases were filed in the same court.  On January 26, 2009, motions forconsolidation and for the appointment of lead plaintiff and lead counsel werefiled by the plaintiffs.  On February 12, 2009, the court granted themotion for consolidation and for the appointment of lead plaintiff and leadcounsel. Pursuant to stipulation of the parties, the lead plaintiff on October 15,2009, filed a consolidated complaint. On January 12, 2010, the Companyfiled a motion to dismiss the consolidated amended complaint on the groundsthat it failed to allege a valid claim and a motion for partial summaryjudgment on certain claims alleged in it on the grounds that the plaintiffslack standing to bring those claims.  OnMarch 8, 2010, the plaintiffs filed oppositions to the Company’smotions.  On April 15, 2010, theCompany filed reply briefs in support of its motions.  A hearing on the motions is scheduled forMay 17, 2010. The Company is defending against the amended complaints asof this date and no final complaint is on file. Given the nature andpreliminary status of these cases, we cannot yet determine the amount or even areasonable range of potential loss in these matters, if any.

 

*DerivativeLitigation*

 

Sherman v. Christie, etal., Case No. BC404946 (Los Angeles County Superior Court) and relatedcases: On January 2, 2009, an alleged shareholder of our publicly tradedcommon stock filed a shareholder derivative case, alleging breach of fiduciaryduty arising from the announcement of our intent to restate financialstatements against certain present and former members of our Board ofDirectors. Two additional, substantially similar cases were filed. Stipulations were entered extending the time to respond to thecomplaints.  On April 23, 2009, the court found that the threederivative suits were “complex” and related and transferred the cases to asingle judge for all purposes and ordered an initial status conference for December 3,2009. The cases were consolidated on May 19, 2009. The leadplaintiff by stipulation of the parties filed a consolidated complaint on October 8,2009. On December 7, 2009, the Company filed a demurrer to theconsolidated complaint on the grounds that the consolidated complaint failed toallege sufficient facts to state a valid cause of action and failed to allegefacts showing that presuit demand on the board of directors should be excusedas futile.  On January 21, 2010, theplaintiffs filed an opposition to the demurrer. On March 4, 2010, the plaintiffs filed an amended consolidatedcomplaint to add claims on behalf an alleged class of the Company’sshareholders related to the proposed merger. On April 2, 2010, the plaintiffs filed a motion to consolidate thefour class action suits pending in the Los Angeles Superior Court related tothe proposed merger.  On April 2,2010, the Company filed a motion to sever the alleged class action claimsrelated to the proposed merger from the amended consolidated complaint and ademurrer to the entire complaint on the grounds that the consolidated complaintfailed to allege sufficient facts to state a valid cause of action and failedto allege facts showing that presuit demand on the board of directors should beexcused as futile.  On April 2,2010, the Company also filed an opposition to the motion to consolidate.  On April 15, 2010, the court denied theplaintiffs’ motion to consolidate.  OnApril 20, 2010, the plaintiffs filed oppositions to the motion to severand demurrer.  On April 27, 2010,the Company filed replies in support of the motion to sever and demurrer.  On May 3, 2010, the plaintiffs agreed tosever and dismiss without prejudice claims on behalf of an alleged class of theCompany’s shareholders related to the proposed merger from the amendedconsolidated complaint.  On May 4,2010, the court entered an order dismissing without prejudice claims on behalfan alleged class of the Company’s shareholders related to the proposed mergerfrom the amended consolidated complaint. Also on May 4, 2010, the court sustained the Company’s demurrer tothe amended consolidated complaint and gave the plaintiffs 20 days to file afurther amended complaint. The Company is defending against the amendedcomplaints as of this date and no final complaint is on file. Given the natureand preliminary status of these cases, we cannot yet determine the amount oreven a reasonable range of potential loss in these matters, if any.

 

*LitigationRelated to the Merger Agreement*

 

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

 

The complaints aresubstantially similar and allege, among other things, that the merger proposedunder the Merger Agreement is the product of a flawed process and that theconsideration to be paid to our stockholders in the merger would be unfair andinadequate. The complaints further allege, among other things, that ourofficers and directors breached their fiduciary duties by, among other things,taking actions designed to deter higher offers from other potential acquirersand failing to maximize the value of SouthWest Water stock for the benefit ofour stockholders. The complaints further allege that Parent and Merger Subaided and abetted the actions of our officers and directors in breaching theirfiduciary duties. The complaints seek, among other relief, an injunctionpreventing consummation of the merger, an order rescinding the merger or any ofthe terms of the merger to the extent already implemented, costs anddisbursements of the lawsuits, including attorneys’ and experts’ fees, and suchother relief as the court might find just and proper. The Company will defenditself against the purported lawsuits. Given the nature and preliminary statusof these cases, we cannot yet determine the amount or even a reasonable rangeof potential loss in these matters, if any.

 

*NewMexico Utilities, Inc.*

 

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

 

In August 2004, theABCWUA increased the fee charged to NMUI, using a different formula than hadbeen used to calculate fee increases since 1973. The Company believed theincrease violated the terms of a 1973 written agreement between the parties.Subsequently, the ABCWUA also claimed ownership of the return flow credits. On September 13,2004, the Company filed a Complaint for Declaratory Judgment in the SecondJudicial District Court, County of Bernalillo, State of New Mexico (the “Court”),requesting that the Court settle these disputes.

 

In addition, in January 2007,the ABCWUA and the City of Rio Rancho, a home-rule municipal corporation,as Petitioners, filed a Petition for Condemnation against NMUI and others, asdefendants, in the Court (the “Petition”). The Petition sought to acquire, bycondemnation, all of the assets of NMUI, including all real property, throughthe stated power of eminent domain. The Petition also alleged that thePetitioners need to acquire the NMUI assets for the public purposes ofproviding water and wastewater services to NMUI customers and that theacquisition of NMUI is necessary, appropriate and in the public interest. TheCompany contested the Petition.

 

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

 

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**SOUTHWEST WATER COMPANY**

 

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

On January 29, 2009,NMUI and the ABCWUA entered into a Settlement, Arbitration Award, andAcquisition Agreement (the “Agreement”) to resolve all outstanding claims,demands and existing lawsuits between them. Under the Agreement, the ABCWUAacquired certain of the assets of NMUI necessary for the ABCWUA to own, operateand maintain the water and wastewater system of NMUI in settlement ofcondemnation. In consideration of the assets acquired, the ABCWUA agreed to payto NMUI at the Closing as full, final and complete consideration the sum of: (i) $60.0 million;(ii) an amount equal to the NMUI accounts receivable at the date ofClosing; and (iii) an amount equal to the unbilled services at the date ofClosing. The Agreement closed on May 8, 2009.

 

NMUI also received theright to customer billings previously placed into escrow. The total amountreceived by the Company on May 12, 2009 from these escrow funds was $0.9million.

 

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

 

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

 

*Investigations*

 

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

 

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

 

*EnvironmentalMatters*

 

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

 

In May 2002, asettlement agreement was reached between some of the parties allegedlyresponsible for the contamination (“Cooperating Respondents”) and certain waterentities, including our California water utility. As a result of thissettlement agreement, we have received payments during the last several years,and we continued to receive payments until the completion of remediation. Thesepayments represent the incremental cost of purchasing water over the cost thatwould have been incurred by us to pump water from our wells had they not beenshut down as a result of contamination. The settlement agreement provided forongoing reimbursement of our excess water costs and we bill and collect thisreimbursement monthly. These monthly reimbursements are recorded as a reductionto operating expenses. The reimbursements were $0.2 million and $0.1 millionfor the three months ended March 31, 2010 and 2009, respectively.

 

The settlement agreementalso provides for contributions by the Cooperating Respondents for constructionof new wells and interconnections with nearby water sources. Thesecontributions were $0.1 million for the three months ended March 31, 2009and were recorded as contributions in aid of construction. There were nocontributions for the three months ended March 31, 2010. On April 20,2010 a mediation was conducted at which the parties resolved all outstandingissues without further costs to our California water utility, essentiallyending all disputes.

 

*OtherMatters*

 

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

 

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**SOUTHWEST WATER COMPANY**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

 

**CertainContractual Commitments and Indemnities**

 

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

 

 

**Note5.        Earnings per Share**

** **

Thefollowing table is a reconciliation of the numerators (income) and denominators(shares) used in both the basic and diluted earnings per share calculations.

 
| * *                                                           | ** ** | **Three Months Ended** | ** ** | ** ** |
|--------------------------------------------------------------------|------------|------------------------|------------|------------|
| * *                                                           | ** ** | **March 31,**     | ** ** | ** ** |
| * (In thousands)*                                             | ** ** | **2010**               | ** ** | ** ** | ** ** | **2009** | ** ** | ** ** | ** ** |
|                                                               |       |                   |       |       |   |   |   |   |   |
| Numerators—Net  loss applicable to common stockholders:       |       |                   |       |       |   |   |   |   |   |
| Loss  from continuing operations                                   |       | $                      | (2,928     | )          |   |   | $ | (3,405 | ) |   |   |
| Less  preferred stock dividends                                    |       | (6                     | )          |       |   | – |   |   |   |
| Loss  from continuing operations applicable to common stockholders |       | (2,934                 | )          |       |   | (3,405 | ) |   |   |
| Income  from discontinued operations, net of tax                   |       | -                      |       |       |   | 172 |   |   |   |
| Loss  applicable to common stockholders                            |       | $                      | (2,934     | )          |   |   | $ | (3,233 | ) |   |   |
|                                                               |       |                   |       |       |   |   |   |   |   |
| Denominators—                                                 |       |                   |       |       |   |   |   |   |   |
| Basic  weighted average common shares outstanding                  |       | 25,105                 |       |       |   | 24,600 |   |   |   |
| Diluted  weighted average common shares outstanding                |       | 25,105                 |       |       |   | 24,600 |   |   |   |

 

TheCompany has $11.8 million of 6.85% fixed-rate convertible subordinatedebentures outstanding as March 31, 2010. The debentures are convertibleinto common stock at any time prior to maturity, unless previously redeemed, ata conversion price of $11.018 per share which totals 1.1 million shares at March 31,2010. At such time as the assumed conversion of the debentures has a dilutiveeffect on earnings per share, the debentures will be included in thecalculation of diluted earnings per share after adjusting net income for theafter-tax effect of the debenture interest expense.

 

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

** **

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

 
| ** **                                                                   | ** ** | **Three Months Ended** | ** ** |
|------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                   | ** ** | **March 31,**     | ** ** |
| *(In thousands)*                                                             | ** ** | **2010**               | ** ** | ** ** | ** ** | **2009** | ** ** | ** ** |
|                                                                         |       |                   |       |   |   |   |   |   |
| Cash  paid during the period for:                                            |       |                   |       |   |   |   |   |   |
| Interest                                                                     |       | $                      | 2,155      |   |   |   | $ | 1,677 |   |   |
| Income  taxes paid                                                           |       | 11                     |       |   |   | 67 |   |   |
| Non-cash  investing and financing activities:                                |       |                   |       |   |   |   |   |   |
| Non-cash  contributions in aid of construction and advances for construction |       |                   |       |   |   |   |   |   |   |   |
| conveyed  to Company by developers                                           |       | $                      | 88         |   |   |   | $ | — |   |   |

 

 

**Note 7.        Dividend Reinvestment and Direct StockPurchase Plan (“DRIP / DSPP”)**

 

We have a dividendreinvestment and stock purchase plan that gives common stockholders the optionof receiving their dividends in cash or in common stock at a discount fromprevailing market prices (“DRIP”). The plan also permits existing stockholdersto purchase additional common stock, up to a maximum of $10,000 per month, at adiscount (“DSPP”); new investors may participate in the plan, subject to a $250minimum initial investment. The Company may, at its sole discretion, permitpurchases above the $10,000 stated maximum. The discounts may range from 0% to5%, as determined from time to time by the Company. As of March 31,2010, there are 3.7 million shares authorized for issuance under the plan,of which 0.7 million shares remain available for issuance. However, underthe terms of the Merger Agreement, we have agreed that we will not issue anyadditional shares of common stock or other equivalent interest until theconsummation of the Merger, at which time the plan will be terminated.

 

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**SOUTHWEST WATER COMPANY**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

**Note 8.        Segment Information**

** **

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

 

The following tablepresents information about the operations of each segment for the three-monthperiods ended March 31, 2010 and 2009:

 
| * *                                    | ** ** | ** **    | ** ** | ** ** | ** ** | **Texas**     | ** ** | ** ** | ** ** | **O&M**  | ** ** | ** ** | ** ** | **Texas  MUD** | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | **Consol-** | ** ** |
|---------------------------------------------|------------|---------------|------------|------------|------------|---------------|------------|------------|------------|--------------|------------|------------|------------|----------------|------------|------------|------------|------------------|------------|------------|------------|-------------|------------|
| *(In  thousands)*                           | ** ** | **Utilities** | ** ** | ** ** | ** ** | **Utilities** | ** ** | ** ** | ** ** | **Services** | ** ** | ** ** | ** ** | **Services**   | ** ** | ** ** | ** ** | **Corp.****(1)** | ** ** | ** ** | ** ** | **idated**  | ** ** |
| **Three  Months Ended March 31, 2010** | ** ** | ** **    | ** ** | ** ** | ** ** | ** **    | ** ** | ** ** | ** ** | ** **   | ** ** | ** ** | ** ** | ** **     | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | ** **  | ** ** |
|                                        |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Revenue                                     |       | $             | 13,223     |       |       |          | $          | 8,675      |       |         |       | $          | 9,047      |           |       |       | $          | 15,901           |       |       |       | $           | —     |   |   |   | $ | 46,846 |   |
|                                        |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Expenses:                                   |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Operations  and maintenance                 |       | 8,682         |       |       |       | 6,571         |       |       |       | 8,827        |       |       |       | 15,484         |       |       |       | 5,748            |       |       |       | 45,312      |       |
| Depreciation  and amortization              |       | 2,045         |       |       |       | 1,180         |       |       |       | 147          |       |       |       | 179            |       |       |       | 316              |       |       |       | 3,867       |       |
| Total  expenses                             |       | 10,727        |       |       |       | 7,751         |       |       |       | 8,974        |       |       |       | 15,663         |       |       |       | 6,064            |       |       |       | 49,179      |       |
|                                        |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Operating  income (loss)                    |       | 2,496         |       |       |       | 924           |       |       |       | 73           |       |       |       | 238            |       |       |       | (6,064           | )          |       |       | (2,333      | )          |
|                                        |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Interest  expense(2)                        |       | (400          | )          |       |       | (624          | )          |       |       | (24          | )          |       |       | (83            | )          |       |       | (1,239           | )          |       |       | (2,370      | )          |
| Interest  income                            |       | 30            |       |       |       | 3             |       |       |       | —       |       |       |       | —         |       |       |       | —           |       |       |       | 33          |       |
| Income  (loss) from continuing              |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| operations  before income taxes             |       | $             | 2,126      |       |       |          | $          | 303        |       |         |       | $          | 49         |           |       |       | $          | 155              |       |       |       | $           | (7,303     | ) |   |   | $ | (4,670 | ) |

 
| ** **                                 | ** ** | ** **    | ** ** | ** ** | ** ** | **Texas**     | ** ** | ** ** | ** ** | **O&M**  | ** ** | ** ** | ** ** | **Texas  MUD** | ** ** | ** ** | ** ** | ** **       | ** ** | ** ** | ** ** | **Consol-** | ** ** |
|--------------------------------------------|------------|---------------|------------|------------|------------|---------------|------------|------------|------------|--------------|------------|------------|------------|----------------|------------|------------|------------|------------------|------------|------------|------------|-------------|------------|
| ** **                                 | ** ** | **Utilities** | ** ** | ** ** | ** ** | **Utilities** | ** ** | ** ** | ** ** | **Services** | ** ** | ** ** | ** ** | **Services**   | ** ** | ** ** | ** ** | **Corp.****(1)** | ** ** | ** ** | ** ** | **idated**  | ** ** |
| **Three Months Ended March 31, 2009** |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
|                                       |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Revenue                                    |       | $             | 13,379     |       |       |          | $          | 8,591      |       |         |       | $          | 9,147      |           |       |       | $          | 18,975           |       |       |       | $           | —     |   |   |   | $ | 50,092 |   |
|                                       |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Expenses:                                  |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Operations  and maintenance                |       | 8,388         |       |       |       | 5,052         |       |       |       | 8,877        |       |       |       | 18,327         |       |       |       | 9,263            |       |       |       | 49,907      |       |
| Depreciation  and amortization             |       | 1,953         |       |       |       | 1,160         |       |       |       | 133          |       |       |       | 214            |       |       |       | 373              |       |       |       | 3,833       |       |
| Total  expenses                            |       | 10,341        |       |       |       | 6,212         |       |       |       | 9,010        |       |       |       | 18,541         |       |       |       | 9,636            |       |       |       | 53,740      |       |
|                                       |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Operating  income (loss)                   |       | 3,038         |       |       |       | 2,379         |       |       |       | 137          |       |       |       | 434            |       |       |       | (9,636           | )          |       |       | (3,648      | )          |
|                                       |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| Interest  expense(2)                       |       | (460          | )          |       |       | (587          | )          |       |       | (90          | )          |       |       | (77            | )          |       |       | (673             | )          |       |       | (1,887      | )          |
| Interest  income                           |       | 27            |       |       |       | 4             |       |       |       | 1            |       |       |       | 3              |       |       |       | 1                |       |       |       | 36          |       |
| Income  (loss) from continuing             |       |          |       |       |       |          |       |       |       |         |       |       |       |           |       |       |       |             |       |       |       |        |       |
| operations  before income taxes            |       | $             | 2,605      |       |       |          | $          | 1,796      |       |         |       | $          | 48         |           |       |       | $          | 360              |       |       |       | $           | (10,308    | ) |   |   | $ | (5,499 | ) |

 

(1)       Reflects corporateheadquarters, general and administrative expenses and interest expense, net ofinterest income charged on intercompany debt.

(2)       Segmentinterest expense includes inter-segment interest expense or income on relatedinter-segment payables and receivables.

 

**Note 9.        Subsequent Events**

** **

Monarch Utilities, Inc. (“Monarch”), a Texasutility company, filed a rate increase application with the TCEQ in July 2007which resulted in an all party settlement on December 12, 2008 whichprovided for a 2-year phase-in of the settled rates.  Monarch also agreedto provide a market valuation for and to negotiate the sale of our Blue Mound,Texas; Kyle, Texas; and Southmayd, Texas water and wastewater assets to therespective municipalities.  Management discussed the sale with officialsof each city; however, as of March 31, 2010 no terms had been agreedupon.  In April

 

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**SOUTHWEST WATER COMPANY**

** **

**NOTES TO UNAUDITED CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)**

 

2010, Blue Mound and Southmayd provided purchaseproposals and management now believes that sale agreements may be reached withthese two municipalities for the respective assets. Any such sale will becontingent upon the municipalities’ raising financing and will require theapproval of the Parent, Monarch’s lender and the TCEQ.  Should agreementsbe reached on the proposals provided, the sale transactions may be consummatedby the end of 2010.

 

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## **ITEM2.**              MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

## ** **

### **SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS**

### ** **

Management’sDiscussion and Analysis of Financial Condition and Results of Operations (“MD&A”)is intended to help the reader understand the results of operations, financialcondition and cash flows of SouthWest Water Company and is provided as asupplement to, and should be read in conjunction with our consolidatedfinancial statements and the accompanying notes to the financial statementsincluded in this report. This MD&A also contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, as amended, 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 2009 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 reviseforward-looking statements whether as a result of new information, futureevents, or otherwise.

 

### **OVERVIEW**

### ** **

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

 

**Merger Agreement and Long-Term InfrastructureInvestment**

 

On March 2, 2010, weentered into an agreement and plan of merger (the “Merger Agreement”) with SWMerger Acquisition Corp. (“Parent”) and SW Merger Sub Corp., a directwholly-owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub arejointly owned by IIF Subway Investment LP and USA Water Services, LLC, whichare sponsored by J.P. Morgan IIF Acquisitions LLC and Water Asset Management,LLC.  Under the terms of the MergerAgreement, all of our outstanding common stock would be converted into a rightto receive $11.00 per share in cash.  Thecompletion of the merger is subject to customary closing conditions, includingstockholder approval and regulatory notice and approvals.

 

If the Merger Agreement isadopted by our stockholders and all closing conditions are met, we will be thesurviving corporation of the merger and a wholly owned subsidiary of Parent.Upon completion of the merger, our common stock will cease to be traded on theNASDAQ Global Select Market and we will no longer be a publicly heldcorporation.  The Merger Agreementcontains restrictions on our operations prior to the closing of the merger,including restrictions related to capital expenditures, the incurrence of debt,acquiring and disposing of assets, entering into material contracts and capitaltransactions.

 

In connection with theMerger Agreement, we entered into a Securities Purchase Agreement and InvestorRights Agreement (collectively, the “Investment Agreements”).  Pursuant to the Investment Agreements, Parentpurchased 2,700,000 shares of our common stock (the “Purchased Stock”) at aprice of $6.00 per share, for an aggregate purchase price of $16.2 million andwe incurred related specific incremental transactional costs of $0.1million.  As permitted under the terms ofthe Investment Agreements, the Company applied the proceeds derived from thesale of the Purchased Stock to reduce our revolving line of credit, the borrowingsof which are used for capital expenditures and working capital purposes.  The Investment Agreements entitle Parent toappoint a designee to serve on our board of directors (which right Parent hasnot exercised to date), and also to certain registration rights with respect tothe Purchased Stock in the event of the termination of the MergerAgreement.  The Investment Agreementsrestrict Parent’s ability to sell or otherwise transfer the Purchased Stockprior to the earlier of the consummation or termination of the MergerAgreement.  Except as contemplated by theMerger Agreement, Parent and Merger Sub are also prohibited from acquiring anyadditional shares of our common stock until the termination of the MergerAgreement.

 

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

 

**Segments**

 

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

 

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**Utilities** consist of our owned water and wastewaterutilities located in California, Alabama, and Mississippi. In previous periods,the utilities segment included the business activities of our New MexicoUtility (“NMUI”) that was sold on May 8, 2009. The NMUI activities are nowincluded in discontinued operations for all periods presented. See “Note 2 -Dispositions” included in Item 1 — “Financial Statements” for the summary ofthe historical results of discontinued operations. Residential customers makeup the largest component of our Utilities customer base, with these customersrepresenting approximately 94% of our water and wastewater connections.Substantially all of our Utilities customers are metered which allows us tomeasure and bill for each customer’s water consumption. Each of the operationsin this segment has a unique service territory that is subject to state andfederal regulations regarding standards of water quality, safety, environmentaland other matters. The rates that we can charge for water and wastewaterservice include the opportunity to earn a reasonable rate of return oninvestments in these utilities. Except for some of our Alabama wastewater rateswhich are governed by our service agreements; the rates our utilities chargeare subject to the approval of state regulatory agencies. Some of thesegovernmental agencies approve a forward looking recovery of costs and someapprove recovery of costs based on a historical test year. Our Utilities operationsrequire ongoing capital investments to maintain and enhance the reliability andquality of the service we provide, as well as the opportunity for revenuegrowth from rate increases and new connections.

 

**TexasUtilities** consistsof 123 small, mostly rural systems that are grouped into nine jurisdictionalutilities across Texas and one small system in Oklahoma. Residential customersrepresent approximately 98% of our Texas water and wastewater connections.Substantially all of our Texas Utilities customers are metered which allows usto measure and bill for each customer’s water consumption. These systems arebroadly dispersed geographically. The majority of the systems are organized asone utility, known as Monarch Utilities, with a single tariff. The Monarchsystems, as well as two smaller systems acquired in 2007, were in variousstages of disrepair at the time of acquisition and we continue to spendsignificant capital to maintain regulatory compliance and to improve thequality of service. We are not yet recovering all of these costs in our ratesand, as a result, the Texas Utilities have a lower rate of return thantypically expected from a utility. We intend to actively pursue recovery ofthese costs in the rate setting process. All other aspects of operations forthese utilities are the same as our Utilities operations; therefore, as soon aswe are recovering our costs, including a reasonable rate of return oninvestment, we expect to aggregate this segment with our Utilities segment.

 

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

 

**Texas MUDServices** is a fullservice provider of utility services to a large number of small utilities inTexas that are mostly owned by municipal utility districts (“MUD”). A MUD iscreated to provide water supply, wastewater treatment and drainage service toareas where municipal services are not available. We service over 270 MUDclients with a common team of client managers, operators, customer service andbilling personnel. Therefore these contracts are allocated a proportionalamount of each cost center creating a business model that is significantlydifferent from that of

O&M Services. Under atypical MUD contract, we bill a monthly base fee to provide a specified levelof service; usually water and/or wastewater facility inspections, routineoperations, equipment maintenance, and utility customer service including meterreading, call center, dispatch, billing and collection services. We bill forany additional services provided beyond the basic contract on a time-and-materialsbasis as such services are rendered. Most contracts provide for an increase inthe monthly base fee as the number of customer connections increases andgenerally include inflation adjustments. The majority of our MUD contracts arecancelable with 30 to 60 day prior notice by either party, but tend tolast for long periods due to the close working relationships between theoperators and the clients.

 

**Impacts to Results of Operations 2010 and 2009**

 

**Utilities & Texas Utilities:**Our Utilities segments’ results ofoperations are influenced by factors that are similar to the industry ingeneral. A more complete understanding of these factors can be gained byreviewing this section along with the Risk Factors section in Part 1, Item1A, in our 2009 Annual Report on Form 10-K. As we review and discussperformance, the general areas of impact we evaluate are as follows:

 

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

 

·                  **Raterelated**: Each ofour utilities will increase rates from time to time to recover expenses andrealize a return on invested capital as allowed by the regulator or governingcontract. Rate cases can take months or years to impact results due to the timeneeded to prepare, present and ultimately receive approval from the regulator.In each of our utilities, we have a long-term rate strategy that matches ourexpectation for growth, regulatory change and demand. Our California utilitybenefited from a 1.5% step-rate increase implemented January 1, 2010. OurTexas Utilities benefited from step-rate increases at one utility in late 2009and two in the first quarter of 2010. In Alabama our Shelby County andRiverview wastewater utilities have contractual agreements with the localgovernment that provide us with the ability to request rate increases annually.Accordingly, we requested and received increases in January 2010 of 10.8%at our Shelby County utility and an approximate 2.5% increase at our Riverviewutility.

 

·                  **Demand related**: The demand for our water, a major driverof our operating results, reflects seasonal rainfall and temperature fluctuations,which vary not only season to season, but from year to year. The uniform ratedesign that regulators require for our utilities can result in unrecoveredfixed costs and lower earnings during periods 

 

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of abnormally low water use. This can occur duringabnormal weather conditions, such as when temperatures are cooler than normal,when there is greater than normal precipitation, during mandatory restrictionson water use because of drought, consumer conservation and socio-economicevents. Demand related changes often impact both the revenue of the utility andthe cost of production. We experienced lower demand at our California utilityin the first three months of 2010, largely due to weather but also due toconservation.

 

·                  **Supply related**: The cost of water and relatedcommodities is a major driver of our results. Utilities that pump and purchasewater are subject to changes in operations due to the amount and cost of thatwater. Pumped and purchased water supply changes are typically driven by longerterm climate issues such as extended drought but can also be driven byshort-term maintenance needs. In California the unit cost of water increased inthe first three months of 2010. This is related to the increased price ofMetropolitan Water District and other supply purchases and the increased costof locally produced  water following theMain San Gabriel Watermaster action of lowering the safe yield in the basin andraising the rate for replacement water for water pumped in excess of waterrights held. This caused an additional increase in cost of pumped and purchasedwater sources. It should be noted that in California pricing changes from pricelevels adopted in rate cases receive balancing account treatment and the costvariance is deferred and charged or credited to customers in a future period atcost. However, due to reduced demand in the first three months of 2010, wepumped and purchased less water resulting in lower supply costs.

 

·                  **Operation &Maintenance related**:Our operation and maintenance costs include fuel, power, labor, labor benefits,facility costs, and other ordinary costs of producing or treating water. Thesecosts are impacted by compliance with environmental and health safetystandards. They are also typically subject to inflation effects and while wecan file for recovery after inflation effects are incurred in backward lookingrate making jurisdictions, we often experience a lag between the time we incurthese costs and when we receive the rate increase to cover these costs. InCalifornia, which is a forward looking rate making environment, we estimate theimpacts of inflation in our rate filings and must absorb any costs that aredifferent than our estimates.

 

·                  **General &Administrative related**: Our general and administrative costs include management expensesdirectly incurred by the segment as well as costs for services performed bycentralized support functions that are allocated to each segment. These supportfunction costs include IT, shared financial services, and environmental healthand safety. We anticipate that in the near term we will continue to experiencehigher costs due to the remediation of our material internal control weaknesses(see “Item 4 — Controls and Procedures” for a detailed discussion of ourmaterial internal control weaknesses.

 

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

 

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

 

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

 

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

 

·                  **General &administrative related**: Our general and administrative costs include management expenses directlyincurred by the segment as well as costs for services performed by centralizedsupport functions that are allocated to each segment. These support functioncosts include IT, shared financial services and environmental health andsafety.

 

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

 

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

 

·                  **Contractgrowth:**Newcontracts, additional project work and contract price increases are offset bylost contracts, reductions in project work, or a reduction in other ancillaryservices such as new taps and inspection services for new home construction. Welost a number of contracts between March 31, 2009 and March 31, 2010due to increased competition in our service territories.

 

·                  **General &administrative related:** Our general and administrative costs include expenses directly incurredby the segment such as management expense as well as costs for servicesperformed by centralized support functions that are then allocated to eachsegment. These support costs include information technology costs, sharedfinancial services and environmental health and safety.

 

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

 

**Corporate Segment**: Our corporate segment includes costs related toexecutive management, investor relations, human resources, general legal andinsurance and public company needs, audit costs, and other expenses generallyrelated to the parent organization. Most of the costs are general andadministrative in nature and not subject to much variation. In the firstquarter of 2010, costs were primarily impacted by expenses associated with ourproposed Merger Agreement and severance expenses.

 

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** **

**Discontinued Operations**

 

Asdiscussed in Note 2, “Dispositions” in Part I, Item 1 “FinancialStatements”, we completed the sale of NMUI in May 2009 and the operatingresults of NMUI are included in discontinued operations for the three monthsperiod ended March 31, 2009.

 

 

### **RESULTS OF OPERATIONS**

### ** **

#### **Three months ended March 31,2010 Compared to 2009**

#### ** **

Consolidatedoperating revenue decreased $3.2 million, or 6.5%, to $46.8 million for thethree-month period ended March 31, 2010 from $50.1 million for the sameperiod in the prior year. Consolidated operating expenses decreased $4.6million, or 8.5%, to $49.2 million for the three-month period ended March 31,2010 from $53.7 million for the 2009 period. Resulting operating loss decreased$1.3 million to a loss of $2.3 million for the three-month period ended March 31,2010, from an operating loss of $3.6 million for the same period in the prioryear.  The first quarter of 2010operating loss includes the impact of $1.2 million of costs associated withproposed Merger Agreement, as well as other costs described below while the2009 operating loss includes $5.3 million of costs associated with therestatement process.

 
| ** **             | ** ** | ** ** | **Three Months Ended March 31,** | ** ** | ** ** | ** **               | ** ** | ** ** | **Percent of Revenue** | ** ** |
|------------------------|------------|------------|------------------------------------------------------|------------|------------|--------------------------|------------|------------|----------------------------------|------------|
| ** **             | ** ** | **2010**   | ** **                                           | **2009**   | ** ** | **Increase  (Decrease)** | ** ** | **2010**   | ** **                       | **2009**   | ** ** |
| *(In thousands)*       |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| **Utilities**          |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| Operating  Revenue     |       | $          | 13,223                                               |       | $          | 13,379                   |       | $          | (156                             | )          |   |   |   |   |
| Operating  Expense     |       | 10,727     |                                                 | 10,341     |       | 386                      |       | 81.1%      |                             | 77.3%      |   |
| Operating  Income      |       | $          | 2,496                                                |       | $          | 3,038                    |       | $          | (542                             | )          | 18.9% |   | 22.7% |   |
|                   |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| **Texas Utilities**    |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| Operating  Revenue     |       | $          | 8,675                                                |       | $          | 8,591                    |       | $          | 84                               |       |   |   |   |   |
| Operating  Expense     |       | 7,751      |                                                 | 6,212      |       | 1,539                    |       | 89.3%      |                             | 72.3%      |   |
| Operating  Income      |       | $          | 924                                                  |       | $          | 2,379                    |       | $          | (1,455                           | )          | 10.7% |   | 27.7% |   |
|                   |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| **O&M Services**   |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| Operating  Revenue     |       | $          | 9,047                                                |       | $          | 9,147                    |       | $          | (100                             | )          |   |   |   |   |
| Operating  Expense     |       | 8,974      |                                                 | 9,010      |       | (36                      | )          | 99.2%      |                             | 98.5%      |   |
| Operating  Income      |       | $          | 73                                                   |       | $          | 137                      |       | $          | (64                              | )          | 0.8% |   | 1.5% |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| **Texas MUD Services** |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| Operating  Revenue     |       | $          | 15,901                                               |       | $          | 18,975                   |       | $          | (3,074                           | )          |   |   |   |   |
| Operating  Expense     |       | 15,663     |                                                 | 18,541     |       | (2,878                   | )          | 98.5%      |                             | 97.7%      |   |
| Operating  Income      |       | $          | 238                                                  |       | $          | 434                      |       | $          | (196                             | )          | 1.5% |   | 2.3% |   |
|                   |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| **Corporate**          |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| Operating  Revenue     |       | $          | —                                |       | $          | —    |       | $          | —            |       |   |   |   |   |
| Operating  Expense     |       | 6,064      |                                                 | 9,636      |       | (3,572                   | )          |       |                             |       |   |
| Operating  Loss        |       | $          | (6,064                                               | )          | $          | (9,636                   | )          | $          | 3,572                            |       |   |   |   |   |
|                   |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| **Total**              |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| ** **             |       |       |                                                 |       |       |                     |       |       |                             |       |   |
| Operating  Revenue     |       | $          | 46,846                                               |       | $          | 50,092                   |       | $          | (3,246                           | )          |   |   |   |   |
| Operating  Expense     |       | 49,179     |                                                 | 53,740     |       | (4,561                   | )          | 105.0%     |                             | 107.3%     |   |
| Operating  Loss        |       | $          | (2,333                                               | )          | $          | (3,648                   | )          | $          | 1,315                            |       | (5.0%) |   | (7.3%) |   |

 

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***Utilities***

 
|                                    |   | Operating                |   |   |   | Operating                |   |   |   | Operating |   |
|-----------------------------------------|--------|--------------------------|--------|--------|--------|--------------------------|--------|--------|--------|-----------|--------|
| *(in  thousands)*                       |   | Revenue                  |   |   |   | Expense                  |   |   |   | Income    |   |
| Three  months ended March 31, 2009 |   | $                        | 13,379 |   |   |                     | $      | 10,341 |   |      |   | $ | 3,038 |   |
| Rate  related                           |   | 262                      |   |   |   | —    |   |   |   |      |   |
| Demand  related                         |   | (564                     | )      |   |   | —    |   |   |   |      |   |
| Balancing  account                      |   | 146                      |   |   |   | 146                      |   |   |   |      |   |
| Supply  related                         |   | —    |   |   |   | (446                     | )      |   |   |      |   |
| O&M  related                        |   | —    |   |   |   | 272                      |   |   |   |      |   |
| G&A  related                        |   | —    |   |   |   | 238                      |   |   |   |      |   |
| Other                                   |   | —    |   |   |   | 176                      |   |   |   |      |   |
| Three months ended March 31,  2010 |   | $                        | 13,223 |   |   |                     | $      | 10,727 |   |      |   | $ | 2,496 |   |

 

 

Operatingrevenue decreased $0.2 million, or 1.2 %, to $13.2 million for three monthsended March 31, 2010 from $13.4 million for the same period in the prioryear.  The net decrease was primarily dueto the following events:

 

·                   Rate related: A $0.3 million increase due to rateincreases in California and Alabama, of which approximately half is due to ourCalifornia utility implementing a step rate increase in January 2010 andthe remainder is primarily due to rate increases in our Shelby County andRiverview utilities.

 

·                   Demand related: A $0.6 million decrease primarily dueto lower consumption at our California utility resulting from higherprecipitation in the first quarter of 2010 compared to the first quarter of2009 and from continuing customer conservation efforts.

 

·                   Balancing account: A $0.1 million increase related tobalancing account surcharges approved by the CPUC and collected in Californiato recover certain deferred water supply costs which is offset by the sameamount in balance account expenses. No return is earned on surcharges.

 

Operatingexpenses increased $0.4 million, or 3.7%, to $10.7 million for the three monthsended March 31, 2010, from $10.3 million for same period in the prioryear.  The net increase was primarily dueto the following events:

 

·                   Balancing account: A $0.1 million increase in costsrecognized related to the balancing account surcharges described above.

 

·                   Supply related: A $0.4 million decrease primarily dueto lower volume of delivered water in California.

 

·                   O&M related: A $0.3 million increase primarily dueto an increase in depreciation expense resulting from capital additions, andfrom higher repairs and maintenance expenses and vehicle costs.

 

·                   G&A related: A $0.2 million increase primarily dueto increases in salaries and wages and insurance expenses.

 

·                   Other: A $0.2 million increase due to legal fees andseverance expenses.

 

As aresult of the above events, operating income decreased $0.5 million, to $2.5million for the three months ended March 31, 2010, from $3.0 million forthe same period in the prior year.

 

***Texas Utilities***

 
|                                    |   | Operating                |   |   |   | Operating                |   |   |   | Operating |   |
|-----------------------------------------|--------|--------------------------|--------|--------|--------|--------------------------|--------|--------|--------|-----------|--------|
| *(in  thousands)*                       |   | Revenue                  |   |   |   | Expense                  |   |   |   | Income    |   |
| Three  months ended March 31, 2009 |   | $                        | 8,591  |   |   |                     | $      | 6,212  |   |      |   | $ | 2,379 |   |
| Growth  related                         |   | 115                      |   |   |   | —    |   |   |   |      |   |
| Rate  related                           |   | 79                       |   |   |   | —    |   |   |   |      |   |
| Demand  related                         |   | (110                     | )      |   |   | —    |   |   |   |      |   |
| O&M  related                        |   | —    |   |   |   | 940                      |   |   |   |      |   |
| G&A  related                        |   | —    |   |   |   | 599                      |   |   |   |      |   |
| Three  months ended March 31, 2010 |   | $                        | 8,675  |   |   |                     | $      | 7,751  |   |      |   | $ | 924 |   |

 

 

Operatingrevenue increased $0.1 million, or 1.0%, to $8.7 million for three months endedMarch 31, 2010 from $8.6 million for the same period in the prior year.The net increase was primarily due to the following events:

 

·                   Growth related: A $0.1 million increase primarily dueto an increase in connection count and tap fees.

 

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·                   Rate related: A $0.1 million increase primarily due toa step-rate increase in rates at two of our utilities.

 

·                   Demand related: A $0.1 million decrease due to lowervolume of delivered water as a result of more normalized weather patterns inthe first quarter of 2010 compared to hotter and drier climatic conditions inthe corresponding period of 2009.

 

Operatingexpenses increased $1.5 million, or 24.8%, to $7.8 million for the three monthsended March 31, 2010, from $6.2 million for the same period in the prioryear.  The increase was primarily due tothe following events:

 

·                   O&M related: A $0.9 million increase primarily dueto higher repairs and maintenance costs, increases in salaries and wagesassociated with increased personnel in operations, higher fuel and supplycosts, and the retirement of a well and a tank.

 

·                   G&A related: A $0.6 million increase due toincreases in salary and wages associated with increased financial serviceshead-count as well as information technology costs and professional fees.

 

As aresult of the above events, operating income decreased $1.5 million, to $0.9million for the three months ended March 31, 2010, from income of $2.4million for the same period in the prior year.

 

***O&M Services***

 
|                                    |   | Operating                |   |   |   | Operating |   |   |   | Operating |   |
|-----------------------------------------|--------|--------------------------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in  thousands)*                       |   | Revenue                  |   |   |   | Expense   |   |   |   | Income    |   |
| Three  months ended March 31, 2009 |   | $                        | 9,147  |   |   |      | $      | 9,010  |   |      |   | $ | 137 |   |
| Contract  growth                        |   | 587                      |   |   |   | 425       |   |   |   |      |   |
| Lost  work                              |   | (687                     | )      |   |   | (366      | )      |   |   |      |   |
| G&A  related                        |   | -         |   |   |   | (251      | )      |   |   |      |   |
| Other                                   |   | —    |   |   |   | 156       |   |   |   |      |   |
| Three  months ended March 31, 2010 |   | $                        | 9,047  |   |   |      | $      | 8,974  |   |      |   | $ | 73 |   |

 

 

Operatingrevenue decreased $0.1 million to $9.0 million for the three months ended March 31,2010 compared to $9.1 million for the same period in the prior year:

 

·                   Contract growth: A $0.6 million increase due to newcontracts and increased project work, primarily in California.

 

·                   Lost work: A $0.7 million decrease due to decreasedproject work and lost contracts.

 

Operatingexpenses also remained consistent at $9.0 million for the three months ended March 31,2010 and 2009:

 

·                   Contract growth: A $0.4 million increase due to newcontracts and project work identified above.

 

·                   Lost work: A $0.4 million decrease due to lostcontracts and reduced project work.

 

·                   G&A related: A $0.3 million decrease due to lowersalary and wages, associated with lower head-count, and insurance expenses.

 

·                   Other: A $0.2 million increase related to legalexpenses.

 

As aresult of the above events, operating income was $0.1 million for both thethree months ended March 31, 2010 and 2009.

 

 

***Texas MUD Services***

 
|                                    |   | Operating                |   |   |   | Operating |   |   |   | Operating |   |
|-----------------------------------------|--------|--------------------------|--------|--------|--------|-----------|--------|--------|--------|-----------|--------|
| *(in  thousands)*                       |   | Revenue                  |   |   |   | Expense   |   |   |   | Income    |   |
| Three  months ended March 31, 2009 |   | $                        | 18,975 |   |   |      | $      | 18,541 |   |      |   | $ | 434 |   |
| Contract  growth                        |   | (3,074                   | )      |   |   | (1,369    | )      |   |   |      |   |
| G&A  related                        |   | —    |   |   |   | (1,741    | )      |   |   |      |   |
| Other                                   |   | —    |   |   |   | 232       |   |   |   |      |   |
| Three  months ended March 31, 2010 |   | $                        | 15,901 |   |   |      | $      | 15,663 |   |      |   | $ | 238 |   |

 

 

Operatingrevenue decreased $3.1 million, or 16.2%, to $15.9 million for three monthsended March 31, 2010 from $19.0 million for the same period in the prioryear. The decrease was primarily due to the following:

 

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·                   Contract growth: A $3.1 million decrease in revenue dueto $1.9 million from lost contracts, $0.5 million related to the sale of ourenvironmental testing laboratory on April 1, 2009, and $0.5 millionprimarily related to a reduction in pass-through revenue from materialspurchased for clients.

 

Operatingexpenses decreased $2.9 million, or 15.5%, to $15.7 million for the threemonths ended March 31, 2010, from $18.5 million for the same period in theprior year.  The net decrease wasprimarily due to the following events:

 

·                   Contract growth: A $1.4 million decrease due to $0.6million from lost contracts, $0.2 million due to the sale of our environmentaltesting laboratory, and $0.6 million primarily related to a reduction inpass-through costs from materials purchased for clients.

 

·                   G&A related: A $1.7 million decrease, primarily dueto decreases in salary and wages expenses, associated with lower head-count,and other savings and efficiency gains in general and administrative costs,particularly in the customer service center.

 

·                   Other: A $0.2 million increase due to legal andseverance expenses.

 

As aresult of the above events, operating income decreased $0.2 million to $0.2million for the three months ended March 31, 2010, compared to $0.4million in the same period of the prior year.

 

***Corporate***

 

Operatingexpenses decreased $3.6 million, or 37.1%, to $6.1 million for the three monthsended March 31, 2010, from $9.6 million for the same period in the prioryear.

 

·                   General & administrative related: A $0.3million increase primarily due to increases in professional fees, related tothe preparation and audit of our annual financial statements and internalcontrol remediation efforts offset by decreases in salaries and wages,information technology costs and stock based compensation expense.

 

·                   Other: A $3.9 million decrease primarily driven by a reductionof $5.3 million related to the financial restatement expenses in the firstquarter of 2009 offset by a $1.2 million increase in costs associated with theproposed Merger Agreement and a $0.3 million increase related to severancecosts.

 

 

**Other Income (Expense)**

 

Aggregate other expenses increased $0.5 million, or34.5% to $2.3 million for the three months ended March 31, 2010, comparedto $1.9 million for the same period in the prior year as follows:

 
| ** **        | ** ** | **Three Months Ended March 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|-------------------|------------|------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **        | ** ** | **2010**                                             | ** ** | ** ** | ** ** | **2009**   | ** ** | ** ** | ** ** | **Change** | ** ** |
| Interest  expense |       | $                                                    | (2,370     | )          |       |       | $          | (1,887 | ) |   |   | $ | (483 | ) |
| Interest  income  |       | 33                                                   |       |       |       | 36         |       |   |   | (3 | ) |
| Total             |       | $                                                    | (2,337     | )          |       |       | $          | (1,851 | ) |   |   | $ | (486 | ) |

 

***Interest Expense***

 

Interestexpense increased by $0.5 million, or 25.6%, to $2.4 million for the three monthsended March 31, 2010 from $1.9 million for the same period during theprior year as a result of an increase in the effective interest rate to 6.1% inthe first quarter 2010 from 3.9% in the same period in the prior year, offsetby a reduction in the average interest-bearing debt outstanding from $197.8million to $154.6 million in the same periods.

 

Theincrease in the effective interest rate in 2010 over 2009 reflects theincreased borrowing margins on our credit facility due to the 2009 creditfacility amendments discussed in the *“Financial Condition”*section below as well as increased amortization of debt financial fees of $0.2million.

 

**Provision for Income Taxes**

 

Our effective consolidated income tax rate oncontinuing operations was a benefit of 37.3% for the three months ended March 31,2010 compared to a benefit of 38.1% for the same period in 2009. The slightvariance of our effective tax rate from expected statutory rates reflectsnon-recurring adjustments in both periods.

 

**Income from Discontinued Operations**

 

Incomefrom discontinued operations during the three month period ended March 31,2009, which pertains to NMUI, which was sold in May 2009, was $0.2million.

 

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### **RECENT ACCOUNTING PRONOUNCEMENTS**

 

See thediscussions under the caption “Recent Accounting Pronouncements” contained inNote 1 to the consolidated financial statements included in Part I, Item 1of this report.

 

### **LIQUIDITY AND CAPITAL RESOURCES**

### ** **

Ouroverall objectives with respect to liquidity and capital resources are to:

 

·                   Generate sufficient operating cash flows to service ourdebt and tax obligations, fund capital improvements and organic growth, and paydividends to our stockholders;

 

·                   Utilize our credit facility for major capitalimprovements and to manage seasonal cash needs;

 

·                   Obtain external financing for major acquisitions; and

 

·                   Maintain approximately equal levels of debt and equityconsistent with the investor-owned water utility industry.

 

Our statements of cash flows are summarized as follows:

 
| ** **                                        | ** ** | **Three  Months Ended March 31,** | ** ** | ** ** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|----------------------------------------|------------|------------|------------|------------|------------|
| ** **                                        | ** ** | **2010**                               | ** ** | ** ** | ** ** | **2009**   | ** ** | ** ** | ** ** | **Change** | ** ** |
| Net  cash provided by (used in):                  |       |                                   |       |       |       |       |       |   |   |   |   |
| Continuing  operations:                           |       |                                   |       |       |       |       |       |   |   |   |   |
| Operating  activities                             |       | $                                      | (1,500     | )          |       |       | $          | 3,612 |   |   |   | $ | (5,112 | ) |
| Investing  activities                             |       | (3,295                                 | )          |       |       | (3,843     | )          |   |   | 548 |   |
| Financing  activities                             |       | 2,736                                  |       |       |       | 3,755      |       |   |   | (1,019 | ) |
| Total  continuing operations                      |       | (2,059                                 | )          |       |       | 3,524      |       |   |   | (5,583 | ) |
| Discontinued  operations:                         |       |                                   |       |       |       |       |       |   |   |   |   |
| Operating  activities                             |       | —                  |       |       |       | (1,990     | )          |   |   | 1,990 |   |
| Investing  activities                             |       | —                  |       |       |       | (143       | )          |   |   | 143 |   |
| Financing  activities                             |       | —                  |       |       |       | 78         |       |   |   | (78 | ) |
| Total  discontinued operations                    |       | —                  |       |       |       | (2,055     | )          |   |   | 2,055 |   |
| Increase  (decrease) in cash and cash equivalents |       | $                                      | (2,059     | )          |       |       | $          | 1,469 |   |   |   | $ | (3,528 | ) |

 

Revolvinglines of credit were primarily used to fund our investing activities and, to alesser extent, to fund operations. Additional borrowing availability under ourrevolving credit facility was $42.0 million as of March 31, 2010.

 

**Cash Flowsfrom Operating Activities of Continuing Operations.**Net cash used by operating activities was$1.5 million for the three months ended March 31, 2010; net cash providedby operations was $3.6 million for the same period last year. Operationalaspects of our businesses that affected working capital in 2010 versus 2009 arehighlighted below:

 

·                   $2.3 million increase in the net loss adjusted fornon-cash items;

 

·                   $2.6 million increase in cash used for balance sheetmanagement, primarily related to the timing of payments for other liabilities.

 

 

**Cash Flowsfrom Investing Activities of Continuing Operations.**Cash used in investing activitiesrepresenting purchases on property, plant and equipment, principally within ourutility segments, decreased by $0.5 million, or 14.3%, compared to the prioryear period.

 

**Cash Flowsfrom Financing Activities of Continuing Operations.**During the three months ended March 31,2010, we reduced our total borrowing and financed our capital expenditures,working capital and dividend payments.

 

·                   We received $16.2 million from the issuance of2,700,000 shares of common stock sold through the Investment Agreements inconnection with the Merger Agreement and used the proceeds from the stock saleto pay down our revolving credit facility by $16.2 million;

 

·                   We borrowed $4.7 million under our revolving line ofcredit, a reduction of $0.8 million in borrowings compared to comparable periodlast year;

 

·                   Borrowings were used for the purchase of property,plant and equipment, as well as working capital needs, including paying $1.4million in dividends, an increase of $0.8 million over dividends paid in thecomparable period last year.

 

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### **CONTRACTUAL OBLIGATIONS**

 

The following table summarizes our known contractualobligations to make future cash payments as of March 31, 2010, as well asan estimate of the periods during which these payments are expected to be made.

 
| ** **                                       | ** ** | ** ** | ** ** | ** ** | ** **    | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|---------------|------------|-----------------------------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** ** | **Remainder** | ** ** | **2011**                          | ** ** | **2013** | ** ** | **2015** | ** ** |
| ** **                                       | ** ** | ** ** | ** ** | **of**     | ** **    | **and**    | ** **                        | **and**    | ** ** | **and** | ** ** |
| *(In  thousands)*                                | ** ** | ** ** | **Total**  | ** ** | **2010**      | ** ** | **2012**                          | ** ** | **2014** | ** ** | **Beyond** | ** ** |
| Long-term  debt:                                 |       |       |       |       |          |       |                              |       |   |   |   |
| Principal  payment obligations  (1)              |       | $          | 142,635    |       | $             | 1,720      |                              | $          | 4,027 |   | $ | 65,084 |   | $ | 71,804 |   |
| Interest  payments on fixed rate debt (2)        |       | 74,459     |       | 3,914      |          | 10,054     |                              | 9,674      |   | 50,817 |   |
| Interest  payments on bank line of credit (3)    |       | 7,691      |       | 2,006      |          | 5,350      |                              | 334        |   | —    |   |
| Repayment  of advances for construction (4)      |       | 9,117      |       | 274        |          | 1,157      |                              | 665        |   | 7,020 |   |
| Water  purchase commitment (5)                   |       | 116,279    |       | 852        |          | 7,718      |                              | 9,448      |   | 98,261 |   |
| Operating  lease obligations (6)                 |       | 20,383     |       | 3,569      |          | 6,956      |                              | 3,129      |   | 6,729 |   |
| Total  obligations as of March 31, 2010 (7) |       | $          | 370,564    |       | $             | 12,336     |                              | $          | 35,262 |   | $ | 88,335 |   | $ | 234,632 |   |

 

----

| (1)    | Excludes interest  payments, which are described in the following notes. The terms of the  long-term debt are more fully described in the notes to the consolidated  financial statements included in this report and in our 2009 Annual Report on  Form 10-K.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|--------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (2)    | Reflects  scheduled interest payments on all fixed rate debt obligations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (3)    | As of March 31,  2010, there was $63.0 million of borrowings outstanding under our $110.0  million bank line of credit which is scheduled for repayment in 2013. The  line of credit bears interest at variable rates and the principal amount  outstanding will vary from time to time in future periods. As a result, the  amount of future interest payments is uncertain. Borrowings bear interest, at  our option, based on a margin a) over the LIBOR rate, or b) over the prime  rate. The margins also vary based on our consolidated debt-to-capitalization  ratio. The interest obligations reflected in the table were computed based on  $63.0 million of borrowings outstanding at the 4.2% weighted average annual  interest rate in effect on our bank line of credit borrowings as of  March 31, 2010. |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (4)    | Advances for  construction are non-interest bearing. Our repayment assumptions on certain  obligations are based upon forecasted connection growth. If forecasted  connections do not materialize, the related payments are not due and  corresponding amounts become contributed property.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                      |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (5)    | Reflects the minimum  annual contractual commitments in the Texas Utilities segment to purchase  water through 2037. The amount is subject to increases in future periods for  production costs increases and may also increase, but not decrease, if  average actual usage exceeds a specified amount.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (6)    | As of March 31,  2010, leased office commitment is $16.3 million of which $2.1 million is  payable during the remainder of 2010. The vehicles and machinery lease  commitment at March 31, 2010 is $4.0 million of which $1.5 million is  payable during the remainder of 2010.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        |
|   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             |
| (7)    | Excludes preferred stock  dividend obligations. Preferred stockholders are entitled to receive annual  dividends of $2.625 per share and there are 9,156 shares of preferred stock  outstanding at March 31, 2010. The preferred stock is redeemable by the  Company at any time for $52.00 per share and, from time to time, we have  elected to repurchase shares offered to us by preferred stockholders at  prices less than $52.00 per share.                                                                                                                                                                                                                                                                                                                                                                          |

 

### **FINANCIAL CONDITION**

### ** **

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

 

At March 31,2010, we had working capital of $6.1 million compared to working capital of$5.2 million at December 31, 2009.

 

We have access to $110.0million in financing under our credit facility that expires February 15,2013. A total of nine banks participate in the facility. As of March 31,2010, we had $42.0 million of borrowing capacity available under our creditfacility. The impact of the prior period restatement on our retained earnings,combined with the additional borrowings on the facility during 2008, and thelack of timeliness of SEC financial filings created a number of defaults underour credit facility agreement at March 31, 2009. The defaults were curedwith several amendments to the credit facility agreement dated from November 28,2008 through July 31, 2009. Under the amendments, our credit facility wasreduced from $150.0 million to its current availability of $110.0 million. Thefacility was also secured with certain assets of the Company and our borrowingmargins were significantly increased. As of March 31, 2010 ourdebt-to-capitalization ratio is 54%, therefore, the applicable margins are3.50% over the LIBOR rate and 2.50% over the prime rate. Fees and expensescharged by the Bank Group for all the amendments were $3.4 million, of which$0.1 million were charged during the three months ended March 31, 2010.These fees were capitalized and are being amortized as interest expense overthe remaining life of the facility which extends through February 2013.

 

Our ability to comply withfinancial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well as otherfactors that may be beyond our control. The continued opportunity for operating improvements, enhanced cash

 

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management and suspensionof elective capital expenditures should improve our ability to comply with therevised covenants in the revolving credit facility.

 

As part of the amendedcredit agreement for our credit facility, we have agreed to utilize only $12.5million under our capital lease facility. Our California mortgage bond indentures permit the issuance of anadditional $40.8 million of first mortgage bonds as of December 31, 2009.However, the terms of our revolving credit facility do not permit additionalfirst mortgage bond indebtedness without prior consent from the credit facilitylenders. The mortgage bond indentures also limit the amount of cash andproperty dividends our California utility company pays to the parent Company.Dividends have averaged $5.0 million to $5.6 million per year and are less thanthe aggregate cumulative dividend restriction threshold by $19.9 million as of March 31,2010. The dividend payments in 2010 may represent a return of capital as theCompany is in a negative accumulated earnings and profit position as of December 31,2009. We were in compliance with, or had obtained waivers for, all loanagreement covenants during the three months ended March 31, 2010.

 

In connection with theexecution of the Merger Agreement, we executed Investment Agreements under whichwe sold 2,700,000 shares of our common stock at a purchase price of $6.00 pershare, for an aggregate purchase price of $16.2 million. The InvestmentAgreements were consummated on March 16, 2010. With the related proceeds,we paid down our credit line which increased our available credit under theline.

 

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

 

### **CERTAIN CONTRACTUAL COMMITMENTS AND INDEMNITIES**

### ** **

At March 31,2010, we had irrevocable standby letters of credit in the amount of $5.0million issued and outstanding under our credit facility.

 

Duringour normal course of business, we have entered into agreements containingindemnities pursuant to which we may be required to make payments in thefuture. These indemnities are in connection with facility leases andliabilities and operations and maintenance contracts entered into by ourcontract services businesses. The duration of these indemnities, commitmentsand guarantees varies, and in certain cases, is indefinite. Substantially allof these indemnities provide no limitation on the maximum potential futurepayments we could be obligated to make and is not quantifiable. We have notrecorded any liability for these indemnities.

 

### **OFF-BALANCE SHEET ARRANGEMENTS**

### ** **

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

 

Welease some of our equipment and office facilities under operating leases whichare deemed to be off-balance sheet arrangements. Our future operating leasepayment obligations are more fully described under the caption “ContractualObligations” above.

 

## **ITEM3.**              QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

## ** **

As of March 31,2010, we had $143.2 million of long-term variable and fixed-rate debt. We are exposedto market risk based on changes in prevailing interest rates.

 

Marketrisk related to our variable-rate debt is estimated as the potential decreasein pre-tax earnings resulting from an increase in interest rates. We have $63.0million of long-term debt that bears interest at variable rates based on eitherthe prime rate or LIBOR rate. Our variable-rate debt had a weighted averageannual interest rate of 4.2% as of March 31, 2010. A hypothetical onepercent (100 basis points) increase in the average annual interest ratescharged on our variable-rate debt would reduce our pre-tax earnings byapproximately $0.6 million per year.

 

Ourfixed-rate debt, which has a carrying value of $80.2 million, has a fair valueof $71.7 million as of March 31, 2010. Market risk related to ourfixed-rate debt is deemed to be the potential increase in fair value resultingfrom a decrease in prevailing interest rates. Our fixed-rate debt had aweighted average annual interest rate of 6.6% as of March 31, 2010. Ahypothetical ten percent decrease in annual interest rates, from 6.6% to 5.9%,would increase the fair value of our fixed-rate debt by approximately $4.7million.

 

We donot use derivative financial instruments to manage or reduce these risksalthough we may do so in the future. We do not enter into derivatives or otherfinancial instruments for trading or speculative purposes.

 

## **ITEM4.**              CONTROLSAND PROCEDURES

## ** **

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

 

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**EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES**

 

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

 

Our management, under thesupervision and with the participation of our CEO and CFO, evaluated theeffectiveness of the design and operation of our disclosure controls andprocedures as of March 31, 2010. Based on our evaluation and theidentification of the material weaknesses in internal control over financialreporting described below, our CEO and CFO concluded that, as of March 31,2010, our disclosure controls and procedures were not effective.

 

**INHERENT LIMITATIONS OF DISCLOSURE CONTROLS AND PROCEDURES**

 

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

 

**MANAGEMENT’S REPORT ON INTERNAL CONTROL OVER FINANCIALREPORTING**

 

Management is responsiblefor establishing and maintaining adequate internal control over financialreporting as such term is defined in Rules 13a-15(f) and 15d-15(f) underthe Exchange Act. Internal control over financial reporting is a processdesigned to provide reasonable assurance regarding the reliability of financialreporting and the preparation of financial statements for external purposes inaccordance with generally accepted accounting principles (“GAAP”). Internalcontrol over financial reporting includes those policies and procedures that (i) pertainto the maintenance of records that, in reasonable detail, accurately and fairlyreflect the transactions and dispositions of our assets; (ii) providereasonable assurance that our transactions are recorded as necessary to permitpreparation of financial statements in accordance with GAAP, and that ourreceipts and expenditures are being made only in accordance with authorizationsof management and our directors; and (iii) provide reasonable assuranceregarding prevention or timely detection of unauthorized acquisition, use, ordisposition of our assets that could have a material effect on the financialstatements.

 

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

 

Under the supervision andwith the participation of our management, including our CEO and CFO, weconducted an assessment of our internal control over financial reporting as of March 31,2010. In making this assessment, we used the criteria set forth in Internal Control-IntegratedFramework issued by the Committee of Sponsoring Organizations of the TreadwayCommission (COSO).

 

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

 

1.  We did not maintain an effective controlenvironment because of the following material weaknesses:

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

16.  We did not maintain effective controls overthe completeness, accuracy and valuation of our deferred tax assets andliabilities.  Specifically, we did notdesign and maintain effective controls with respect to accounting for thedifference between book and tax basis of the company’s property,

 

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plant and equipment andintangible assets. This control deficiency could result in a misstatement ofdeferred tax assets and liabilities, and the tax provision that would result ina material misstatement in our annual or interim consolidated financialstatements that would not be prevented or detected in a timely manner.

 

17.  We did not maintain effective controls overthe segregation of duties related to the initiation and approval of wiretransfers.  Specifically, we did notmaintain adequate segregation of duties allowing a single individual exclusiveright to execute wire transfers without independent confirmation or review.This control deficiency could result in unauthorized or inappropriate cashdisbursements.

 

The material weaknessesdescribed above could result in misstatements of substantially all of theaccounts and disclosures related to it that would result in a materialmisstatement in our annual or interim consolidated financial statements thatwould not be prevented or detected in a timely manner. Although thedeficiencies did not result in the identification of a material misstatement inthe first quarter of 2010, management has not performed comprehensive testingof the controls in place as of March 31, 2010 and, therefore, is not ableto conclude that they are sufficiently designed and effectively operating toprevent or detect such misstatement. Accordingly, management has determinedthat each of the control deficiencies above constitutes a material weakness andconcluded that we did not maintain effective internal control over financial reportingas of March 31, 2010.

 

Based on the performanceof additional procedures by management designed to ensure the reliability ofour financial reporting, we believe the consolidated financial statementsincluded in this report as of and for the periods ended March 31, 2010 arefairly stated in all material respects.

 

**PLANS FORREMEDIATION OF MATERIAL WEAKNESSES**

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

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

 

(vii)                            Implementing formal procedures overvaluation of our accounting estimates related to our claims process associatedwith medical, automobile and workers’ compensation self-insurance, includingthe increased use of outside actuarial experts, the systematic review of claimsby the appropriate department manager and the review and roll forward ofactuarial analyses.

 

 

We have also implemented aremediation plan (the “Plan”) to address the material weaknesses for each ofthe affected areas presented above. The Plan ensures that each area affected bya material weakness is put through a comprehensive remediation process. Theremediation process entails a thorough analysis which includes the followingphases:

 

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

 

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

 

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

 

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

 

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

 

The Plan is administeredby a Controls Committee comprised of key leaders from cross functional portionsof the organization, including the CFO. The Committee reports on progressquarterly (or more frequently, as needed) to the Audit Committee of our Boardof Directors.

 

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

 

**CHANGES IN INTERNAL CONTROL OVER FINANCIAL REPORTING**

 

Although we have begun totake other specific actions to improve the overall effectiveness of our internalcontrols over financial reporting during the quarter ended March 31, 2010,there were no changes to our internal controls over financial reporting thathave materially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting. Furthermore, the design or operating effectiveness of any changes ininternal control over financial reporting have not yet been evaluated throughour remediation process.

 

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# **PART II —OTHER INFORMATION**

# ** **

## **ITEM 1.          LEGAL PROCEEDINGS**

## ** **

Otherthan those stated in “Part 1- Item 1- Note 4. Commitments andContingencies — Legal Proceedings,” there have been no new, materialdevelopments to or terminations of legal proceedings, other than ordinaryroutine litigation incidental to the business, to which the Company or any ofits subsidiaries is a party or of which any of their property is the subjectduring the period covered by this Quarterly Report.

 

## **ITEM 1A.       RISK FACTORS**

## ** **

Therehave been no material changes in our risk factors since we last reported under Part I,Item 1A, in our Annual Report on Form 10-K for the year ended December 31,2009.

 

## **ITEM 2           UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS**

 

(a)           In connection with the Merger Agreement, we enteredinto a Securities Purchase Agreement and Investor Rights Agreement(collectively, the “Investment Agreements”). Pursuant to the Investment Agreements, Parent purchased 2,700,000 sharesof our common stock (the “Purchased Stock”) at a price of $6.00 per share, foran aggregate purchase price of $16.2 million and we incurred related specificincremental transactional costs of $0.1 million.  As permitted under the terms of theInvestment Agreements, the Company applied the proceeds derived from the saleof the Purchased Stock to reduce our revolving line of credit, the borrowings ofwhich are used for capital expenditures and working capital purposes.  The Investment Agreements entitle Parent toappoint a designee to serve on our board of directors (which right Parent hasnot exercised to date), and also to certain registration rights with respect tothe Purchased Stock in the event of the termination of the MergerAgreement.  The Investment Agreementsrestrict Parent’s ability to sell or otherwise transfer the Purchased Stockprior to the earlier of the consummation or termination of the MergerAgreement.  Except as contemplated by theMerger Agreement, Parent and Merger Sub are also prohibited from acquiring anyadditional shares of our common stock until the termination of the MergerAgreement.

 

 

(b)          Not applicable

 

(c)           Not applicable

 

 

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

 

 

## **ITEM 6.          EXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                                                             |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                           |
|        |       |                                                                                                                                                                                                                                                                                   |
| 3.1         |       | Certificate of Amendment  to Restated Certificate of Incorporation of SouthWest Water Company  (incorporated by reference to Exhibit 3.1 included in the Company’s Form 8  K filed with the Commission on May 22, 2008)                                            |
| 3.1.1       |       | Certificate of Amendment  to Certificate of Incorporation of SouthWest Water Company (incorporated by  reference to Exhibit 3.1 included in the Company’s Form 8-K filed  on May 22, 2008                                                                          |
| 3.2         |       | Amended and Restated  Bylaws of SouthWest Water Company dated August 20, 2009 (incorporated by  reference to Exhibit 3.2 included in the Company’s Form 10-Q filed  with the Commission on September 18, 2009)                                                |
| 10.17.6     | *          | Amendment No. 6 to  Amended and Restated Credit Agreement dated as of March 2, 2010                                                                                                                                                                                          |
| 10.18       |       | Agreement and Plan of  Merger, dated March 2, 2010, by and among SouthWest Water Company, SW  Merger Corp. and SW Merger Sub Corp. (incorporated by reference to Exhibit 2.1  included on the Company’s Form 8-K filed with the Commission on March 3,  2010. |
| 10.18.1     |       | Securities Purchase  Agreement, dated March 16, 2010, by and between SouthWest Water Company  and SW Merger Acquisition Corp (incorporated by reference to Exhibit 10.1  included on the Company’s Form 8-K filed with the Commission on March 16,  2010.     |
| 10.18.2     |       | Investor Rights  Agreement, dated March 16, 2010, by and between SouthWest Water Company  and SW Merger Acquisition Corp (incorporated by reference to Exhibit 10.2  included on the Company’s Form 8-K filed with the Commission on March 16,  2010.         |
| 31.1        | *          | Certification of  Principal Executive Officer Pursuant to Section 302 of the Sarbanes  Oxley Act of 2002                                                                                                                                                                          |
| 31.2        | *          | Certification of  Principal Financial Officer Pursuant to Section 302 of the Sarbanes  Oxley Act of 2002                                                                                                                                                                          |
| 32.1        | *          | Certification of Chief Executive  Officer pursuant to Section 906 of the Sarbanes Oxley Act of 2002                                                                                                                                                                               |
| 32.2        | *          | Certification of Chief  Financial Officer pursuant to Section 906 of the Sarbanes Oxley Act of  2002                                                                                                                                                                              |

 

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*                  Filed herewith

 

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# **SIGNATURES**

# ** **

Pursuantto the requirements of the Securities Exchange Act of 1934, the Registrant hasduly caused this report to be signed on its behalf by the undersigned, theretoduly authorized.

 

 
|                          | SOUTHWEST WATER COMPANY  (REGISTRANT**)**               |
|-------------------------------|---------------------------------------------------------|
|                          |                                                    |
|                          |                                                    |
| Dated:  May 7, 2010 | /s/  BEN SMITH                                     |   |
|                          | Ben Smith                                               |
|                          | Chief Financial Officer

(Principal Financial  Officer) |

 

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