**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C.  20549**

**FORM 10-Q**
| **(Mark One)** |       |                                                                                                                                                                                                                            |
|----------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **     |       |                                                                                                                                                                                                                            |
| **x**          | ** ** | **Quarterly Report pursuant to Section 13 or 15(d)  of the Securities Exchange Act of 1934**                                                                                                                                    |
| ** **     | ** ** | ** **                                                                                                                                                                                                                      |
|           |       | **For the quarterly period ended June 30, 2007**                                                                                                                                                                                |
|           |       |                                                                                                                                                                                                                            |
|           |       | **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 of registrant as specified in its charter)

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

 

**One Wilshire Building**

**624 South Grand Avenue, Suite2900**

**Los Angeles, California90017-3782**

(Address of principal executive offices, including zip code)

**(213) 929-1800**

(Registrant’s telephone, including area code)

**None**

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

Indicate by checkmark whether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days.  Yes **x**   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 |
|---------------------------|---------------------|-------------------------|

 

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

Indicate thenumber of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.
| Class                                  | ** ** | **Outstanding as of August 3, 2007** |
|----------------------------------------|------------|--------------------------------------|
| Common Stock, $.01 par value per share |       | 24,174,120  shares                   |

 

 

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**TABLE OF CONTENTS**
| **Part I**     | ** ** | **Financial Information**                                                                                         | ** ** | ** ** |
|----------------|------------|-------------------------------------------------------------------------------------------------------------------|------------|------------|
| ** **     | ** ** | ** **                                                                                                        | ** ** | ** ** |
| Item 1.        |       | Financial Statements  (Unaudited)                                                                                 |       |       |
|           |       | Report of  Independent Registered Public Accounting Firm                                                          |       |       |
|           |       | Condensed  Consolidated Balance Sheets as of June 30, 2007 and December 31, 2006                                  |       |       |
|           |       | Condensed  Consolidated Statements of Income for the three months and six months ended  June 30, 2007 and 2006    |       |       |
|           |       | Condensed  Consolidated Statement of Changes in Stockholders’ Equity for the six months  ended June 30, 2007 |       |       |
|           |       | Condensed  Consolidated Statements of Cash Flows for the six months ended June 30, 2007  and 2006                 |       |       |
|           |       | Condensed  Notes to Consolidated Financial Statements                                                             |       |       |
| Item 2.        |       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                       |       |       |
| Item 3.        |       | Quantitative  and Qualitative Disclosures About Market Risk                                                       |       |       |
| Item 4.        |       | Controls and  Procedures                                                                                          |       |       |
|           |       |                                                                                                              |       |       |
| **Part II**    | ** ** | **Other Information**                                                                                             | ** ** | ** ** |
| Item 1.        |       | Legal Proceedings                                                                                                 |       |       |
| Item 4.        |       | Submission of  Matters to a Vote of Security Holders                                                              |       |       |
| Item  6.       |       | Exhibits                                                                                                          |       |       |
|           |       |                                                                                                              |       |       |
| **Signatures** |       |                                                                                                              |

 

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# **PART I —FINANCIAL INFORMATION**

## **ITEM 1.  FINANCIALSTATEMENTS**

### **REPORT OF INDEPENDENT REGISTERED PUBLICACCOUNTING FIRM**

The Board of Directorsand StockholdersSouthwest Water Company:

We have reviewed theaccompanying condensed consolidated balance sheet of Southwest Water Companyand subsidiaries (“the Company”) as of June 30, 2007, the relatedcondensed consolidated statements of income for the three-month and six-monthperiods ended June 30, 2007 and 2006, the related condensed consolidatedstatement of changes in stockholders’ equity for the six-month period endedJune 30, 2007, and the related condensed consolidated statements of cashflows for the six-month periods ended June 30, 2007 and 2006.  These condensed consolidated financialstatements are the responsibility of the Company’s management.

We conducted our reviewsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  A review ofinterim financial information consists principally of applying analytical proceduresand making inquiries of persons responsible for financial and accountingmatters.  It is substantially less inscope than an audit conducted in accordance with the standards of the PublicCompany Accounting Oversight Board (United States), the objective of which isthe expression of an opinion regarding the financial statements taken as awhole.  Accordingly, we do not expresssuch an opinion.

Based on our reviews, weare not aware of any material modifications that should be made to thecondensed consolidated financial statements referred to above for them to be inconformity with U.S. generally accepted accounting principles.

We have previouslyaudited, in accordance with the standards of the Public Company AccountingOversight Board (United States), the consolidated balance sheet of the Companyas of December 31, 2006, and the related consolidated statements of income,changes in stockholders’ equity, and cash flows for the year then ended (notpresented herein); and in our report dated March 13, 2007, we expressed anunqualified opinion on those consolidated financial statements.  In our opinion, the information set forth inthe accompanying condensed consolidated balance sheet as of December 31, 2006,is fairly stated, in all material respects, in relation to the consolidatedbalance sheet from which it has been derived.
| /s/ KPMG LLP             |   |
|--------------------------|--------|
|                     |
| Los Angeles,  California |
| August 9, 2007           |

 

1

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

### **CONDENSED CONSOLIDATED BALANCE SHEETS (UNAUDITED)**

| ** **                                     | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(In thousands)**                        | ** ** | **2007**          | ** ** | **2006**              | ** ** |
| **ASSETS**                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
|                                           |       |              |       |                  |       |
| Current Assets:                                |       |              |       |                  |       |
| Cash  and cash equivalents                     |       | $                 | 2,892      |                  | $          | 4,294 |   |
| Accounts  receivable, net                      |       | 29,399            |       | 27,512                |       |
| Other  current assets                          |       | 13,512            |       | 16,451                |       |
| Total  current assets                          |       | 45,803            |       | 48,257                |       |
|                                           |       |              |       |                  |       |
| Property, Plant and  Equipment, Net:           |       |              |       |                  |       |
| Regulated  utilities                           |       | 398,245           |       | 378,260               |       |
| Non-regulated  operations                      |       | 13,440            |       | 11,365                |       |
| Total  property, plant and equipment, net      |       | 411,685           |       | 389,625               |       |
|                                           |       |              |       |                  |       |
| Other Assets:                                  |       |              |       |                  |       |
| Goodwill                                       |       | 33,152            |       | 33,152                |       |
| Intangible  assets                             |       | 2,609             |       | 2,844                 |       |
| Other  assets                                  |       | 18,070            |       | 17,815                |       |
|                                           |       | $                 | 511,319    |                  | $          | 491,693 |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** | ** ** | ** **        | ** ** | ** **            | ** ** |
| ** **                                     | ** ** | ** **        | ** ** | ** **            | ** ** |
| Current Liabilities:                           |       |              |       |                  |       |
| Accounts  payable                              |       | $                 | 9,135      |                  | $          | 12,746 |   |
| Current  portion of long-term debt             |       | 1,500             |       | 1,423                 |       |
| Other  current liabilities                     |       | 21,514            |       | 21,661                |       |
| Total  current liabilities                     |       | 32,149            |       | 35,830                |       |
|                                           |       |              |       |                  |       |
| Other Liabilities and  Deferred Credits:       |       |              |       |                  |       |
| Long-term  debt                                |       | 143,629           |       | 128,624               |       |
| Deferred  income taxes                         |       | 27,360            |       | 26,011                |       |
| Advances  for construction                     |       | 8,103             |       | 8,413                 |       |
| Contributions  in aid of construction          |       | 113,708           |       | 110,024               |       |
| Other  liabilities and deferred credits        |       | 15,994            |       | 16,264                |       |
|                                           |       |              |       |                  |       |
| Commitments and  Contingencies                 |       |              |       |                  |       |
|                                           |       |              |       |                  |       |
| Stockholders’ Equity:                     |       |              |       |                  |       |
| Preferred  stock                               |       | 458               |       | 458                   |       |
| Common  stock                                  |       | 241               |       | 238                   |       |
| Additional  paid-in capital                    |       | 142,522           |       | 138,728               |       |
| Retained  earnings                             |       | 27,079            |       | 27,031                |       |
| Accumulated  other comprehensive income        |       | 76                |       | 72                    |       |
| Total  stockholders’ equity               |       | 170,376           |       | 166,527               |       |
|                                           |       | $                 | 511,319    |                  | $          | 491,693 |   |

 

See accompanyingnotes to consolidated financial statements.

2

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

### **CONDENSED CONSOLIDATED STATEMENTS OF INCOME(UNAUDITED)**

| ** **                                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                            | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands, except per share data)**    | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Revenues:                                                             |       |                             |       |                           |       |   |   |   |   |
| Utility Group                                                         |       | $                                | 23,554     |                           | $          | 20,790 |   | $ | 43,588 |   | $ | 38,763 |   |
| Services Group                                                        |       | 31,421                           |       | 33,506                         |       | 59,461 |   | 65,127 |   |
| Total revenues                                                        |       | 54,975                           |       | 54,296                         |       | 103,049 |   | 103,890 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Expenses:                                                             |       |                             |       |                           |       |   |   |   |   |
| Utility Group  operating expenses                                     |       | 12,993                           |       | 10,506                         |       | 24,589 |   | 20,903 |   |
| Services Group  operating expenses                                    |       | 27,123                           |       | 28,954                         |       | 52,125 |   | 56,749 |   |
| Selling, general  and administrative expenses                         |       | 9,312                            |       | 9,208                          |       | 17,845 |   | 17,593 |   |
| Impairment of  goodwill                                               |       | —                           |       | 668                            |       | — |   | 668 |   |
| Total expenses                                                        |       | 49,428                           |       | 49,336                         |       | 94,559 |   | 95,913 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Operating income                                                      |       | 5,547                            |       | 4,960                          |       | 8,490 |   | 7,977 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Other income (expense):                                               |       |                             |       |                           |       |   |   |   |   |
| Interest expense                                                      |       | (2,124                           | )          | (2,121                         | )          | (4,194 | ) | (4,252 | ) |
| Interest income                                                       |       | 76                               |       | 174                            |       | 216 |   | 255 |   |
| Other, net                                                            |       | (12                              | )          | (150                           | )          | (61 | ) | (11 | ) |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Income before income  taxes and change in  accounting  principle |       | 3,487                            |       | 2,863                          |       | 4,451 |   | 3,969 |   |
| Provision for income  taxes                                           |       | 1,264                            |       | 1,047                          |       | 1,614 |   | 1,452 |   |
| Income before change in  accounting principle                         |       | 2,223                            |       | 1,816                          |       | 2,837 |   | 2,517 |   |
| Cumulative effect of  change in accounting principle, net of tax      |       | —                           |       | —                         |       | — |   | 71 |   |
| Net income                                                            |       | 2,223                            |       | 1,816                          |       | 2,837 |   | 2,588 |   |
| Preferred stock  dividends                                            |       | (6                               | )          | (6                             | )          | (12 | ) | (12 | ) |
| Net income applicable  to common stockholders                         |       | $                                | 2,217      |                           | $          | 1,810 |   | $ | 2,825 |   | $ | 2,576 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Earnings per common  share:                                           |       |                             |       |                           |       |   |   |   |   |
| Basic:                                                                |       |                             |       |                           |       |   |   |   |   |
| Income before  change in accounting principle                         |       | $                                | 0.09       |                           | $          | 0.08 |   | $ | 0.12 |   | $ | 0.11 |   |
| Cumulative  effect of change in accounting principle                  |       | —                           |       | —                         |       | — |   | — |   |
| Net income  applicable to common stockholders                         |       | $                                | 0.09       |                           | $          | 0.08 |   | $ | 0.12 |   | $ | 0.11 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Diluted:                                                              |       |                             |       |                           |       |   |   |   |   |
| Income before  change in accounting principle                         |       | $                                | 0.09       |                           | $          | 0.08 |   | $ | 0.12 |   | $ | 0.11 |   |
| Cumulative  effect of change in accounting principle                  |       | —                           |       | —                         |       | — |   | — |   |
| Net income  applicable to common stockholders                         |       | $                                | 0.09       |                           | $          | 0.08 |   | $ | 0.12 |   | $ | 0.11 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Weighted average common  shares outstanding:                          |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                 |       | 24,100                           |       | 22,713                         |       | 23,992 |   | 22,501 |   |
| Diluted                                                               |       | 24,386                           |       | 23,451                         |       | 24,301 |   | 23,338 |   |

 

See accompanyingnotes to consolidated financial statements.

3

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

### **CONDENSED CONSOLIDATED STATEMENT OF CHANGESIN STOCKHOLDERS’ EQUITY (UNAUDITED)**

| ** **                                      | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | **Accumlated** | ** ** | ** **             | ** ** |
|-------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|------------------|------------|--------------|------------|----------------|------------|------------------------|------------|
| ** **                                      | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **       | ** ** | ** **   | ** ** | **Other**      | ** ** | ** **             | ** ** |
| ** **                                      | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | **Compre—** | ** ** | **Total**    | ** ** |
| ** **                                      | ** ** | **Number of**       | ** ** | ** **            | ** ** | **Number of** | ** ** | ** ** | ** ** | **Paid-in**      | ** ** | **Retained** | ** ** | **hensive**    | ** ** | **Stockholders’** | ** ** |
| **(In thousands)**                         | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**         | ** ** | **Amount** | ** ** | **Capital**      | ** ** | **Earnings** | ** ** | **Income**     | ** ** | **Equity**             | ** ** |
| Balance at December 31,  2006                   |       | 9                        |       | $                     | 458        |               | 23,802     |       | $          | 238              |       | $            | 138,728    |           | $          | 27,031                 |       | $ | 72 |   | $ | 166,527 |   |
|                                            |       |                     |       |                  |       |               |       |       |       |             |       |         |       |           |       |                   |       |
| Comprehensive income:                           |       |                     |       |                  |       |               |       |       |       |             |       |         |       |           |       |                   |       |
| Net income                                      |       | —                   |       | —                |       | —             |       | —     |       | —           |       | 2,837        |       | —         |       | 2,837                  |       |
| Other  comprehensive income, net of tax:        |       |                     |       |                  |       |               |       |       |       |             |       |         |       |           |       |                   |       |
| Amortization of  actuarial net gain             |       | —                   |       | —                |       | —             |       | —     |       | —           |       | —       |       | (24            | )          | (24                    | )          |
| Amortization of  prior service costs            |       | —                   |       | —                |       | —             |       | —     |       | —           |       | —       |       | 28             |       | 28                     |       |
| Comprehensive  income                           |       |                     |       |                  |       |               |       |       |       |             |       |         |       |           |       | 2,841                  |       |
|                                            |       |                     |       |                  |       |               |       |       |       |             |       |         |       |           |       |                   |       |
| Dividend reinvestment  and stock purchase plans |       | —                   |       | —                |       | 119                |       | 1          |       | 1,543            |       | —       |       | —         |       | 1,544                  |       |
| Proceeds from stock  options exercised          |       | —                   |       | —                |       | 157                |       | 2          |       | 640              |       | —       |       | —         |       | 642                    |       |
| Tax benefit from stock  options exercised       |       | —                   |       | —                |       | —             |       | —     |       | 394              |       | —       |       | —         |       | 394                    |       |
| Share-based  compensation expense               |       | —                   |       | —                |       | 27                 |       | —     |       | 863              |       | —       |       | —         |       | 863                    |       |
| Debenture conversions                           |       | —                   |       | —                |       | 34                 |       | —     |       | 354              |       | —       |       | —         |       | 354                    |       |
| Cash dividends declared                         |       | —                   |       | —                |       | —             |       | —     |       | —           |       | (2,789       | )          | —         |       | (2,789                 | )          |
|                                            |       |                     |       |                  |       |               |       |       |       |             |       |         |       |           |       |                   |       |
| Balance at June 30, 2007                        |       | 9                        |       | $                     | 458        |               | 24,139     |       | $          | 241              |       | $            | 142,522    |           | $          | 27,079                 |       | $ | 76 |   | $ | 170,376 |   |

 

See accompanyingnotes to consolidated financial statements.

4

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

### **CONDENSED CONSOLIDATED STATEMENTS OF CASHFLOWS (UNAUDITED)**

| ** **                                                                         | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                         | ** ** | **June 30,**              | ** ** |
| **(In thousands)**                                                            | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| ** **                                                                         |       |                           |       |   |   |
| **Cash flows from operating  activities:**                                         |       |                           |       |   |   |
| Net income                                                                         |       | $                              | 2,837      |   | $ | 2,588 |   |
| Adjustments to  reconcile net income to net cash provided by operating activities: |       |                           |       |   |   |
| Cumulative  effect of change in accounting principle, net of tax                   |       | —                         |       | (71) |   |
| Depreciation and  amortization                                                     |       | 6,158                          |       | 5,358 |   |
| Deferred income  taxes                                                             |       | 1,596                          |       | 1,694 |   |
| Share-based  compensation expense                                                  |       | 863                            |       | 585 |   |
| Impairment of  goodwill                                                            |       | —                         |       | 668 |   |
| Gain on sales of  land                                                             |       | —                         |       | (407) |   |
| Changes in  assets and liabilities, net of effects of acquisitions:                |       |                           |       |   |   |
| Accounts  receivable                                                               |       | (1,761)                        |       | (2,516) |   |
| Other current  assets                                                              |       | 3,062                          |       | 2,310 |   |
| Other assets                                                                       |       | (385)                          |       | (1,112) |   |
| Accounts payable                                                                   |       | (3,625)                        |       | 826 |   |
| Other current  liabilities                                                         |       | (608)                          |       | (97) |   |
| Other  liabilities                                                                 |       | (707)                          |       | (142) |   |
| Other, net                                                                         |       | (33)                           |       | (37) |   |
| Net cash  provided by operating activities                                         |       | 7,397                          |       | 9,647 |   |
| ** **                                                                         |       |                           |       |   |   |
| **Cash flows from investing  activities:**                                         |       |                           |       |   |   |
| Additions to  property, plant and equipment                                        |       | (18,865)                       |       | (18,245) |   |
| Acquisitions of  businesses, net of cash acquired                                  |       | (6,547)                        |       | (1,247) |   |
| Purchase of  minority interest                                                     |       | —                         |       | (1,012) |   |
| Proceeds from  sales of land                                                       |       | 41                             |       | 427 |   |
| Net cash used in  investing activities                                             |       | (25,371)                       |       | (20,077) |   |
| ** **                                                                         |       |                           |       |   |   |
| **Cash flows from financing  activities:**                                         |       |                           |       |   |   |
| Borrowings under  lines of credit                                                  |       | 16,000                         |       | 8,500 |   |
| Proceeds from  stock option and stock purchase plans                               |       | 2,186                          |       | 3,114 |   |
| Capital  improvement reimbursements                                                |       | 1,628                          |       | 1,346 |   |
| Contributions in  aid of construction                                              |       | 556                            |       | 1,311 |   |
| Excess tax  benefit from stock options exercised                                   |       | 394                            |       | 598 |   |
| Dividends paid                                                                     |       | (2,789)                        |       | (2,389) |   |
| Payments on  long-term debt                                                        |       | (1,042)                        |       | (699) |   |
| Repayment of advances  for construction                                            |       | (356)                          |       | (312) |   |
| Deferred  financing costs                                                          |       | (5)                            |       | (6) |   |
| Net cash  provided by financing activities                                         |       | 16,572                         |       | 11,463 |   |
| Net change in cash and  cash equivalents                                           |       | (1,402)                        |       | 1,033 |   |
| Cash and cash  equivalents at beginning of year                                    |       | 4,294                          |       | 2,764 |   |
| Cash and cash equivalents at end of period                                         |       | $                              | 2,892      |   | $ | 3,797 |   |

 

See accompanyingnotes to consolidated financial statements.

5

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

### **CONDENSED NOTES TO CONSOLIDATED FINANCIALSTATEMENTS (UNAUDITED)**

**Note 1.       Summary of Significant AccountingPolicies**

**Basisof Presentation**

These consolidatedinterim financial statements are unaudited. The Company believes the interim financial statements are presented on abasis consistent with the audited financial statements and include alladjustments necessary for a fair presentation of the financial condition,results of operations and cash flows for such interim periods.  All of these adjustments are normal recurringadjustments.

Preparation of theseconsolidated financial statements in conformity with U.S. generally acceptedaccounting principles (“GAAP”) requires the Company to make estimates andjudgments that affect the reported amounts of assets, liabilities anddisclosure of contingent assets and liabilities at the date of the consolidatedfinancial statements and the reportedamounts of revenues and expenses during the reporting periods.  Actual results could differ from thoseestimates.

Certain information anddisclosures normally included in financial statements prepared in accordancewith GAAP have been omitted in accordance with Securities and ExchangeCommission’s rules and regulations for interim financial reporting.  These interim consolidated financialstatements should be read in conjunction with Management’s Discussion andAnalysis of Financial Condition and Results of Operations and the auditedfinancial statements and related notes included in the Company’s 2006 AnnualReport on Form 10-K.  The Company’sbusinesses are seasonal because they are affected by weather.  As a result, operating results for interimperiods do not necessarily predict the operating results for any other interimperiod or for the full year.

**Changein Presentation**

Effective January 1,2007, the Company elected to allocate a portion of its Services Group’soperating expense overhead between affiliated and unaffiliated customers forsegment reporting purposes (Note 10).  Inprior periods, all operating expense overhead was reflected as operatingexpenses attributable to unaffiliated customers.  This change in allocation methodologyincreased the gross profit from sales to unaffiliated customers and decreasedthe gross profit from sales to affiliated customers by the same amount.  In accordance with SFAS No. 131, *Disclosures about Segments of an Enterprise and Related Information*,prior year amounts have been reclassified to conform to the 2007 presentation.

In accordance with SFASNo. 71, *Accounting for the Effects of Certain Types ofRegulation* (“SFAS 71”), the Company does not eliminate the intersegmentprofit recognized on sales to affiliated customers because the Company believesthe sales price is reasonable and it is probable that, through the rate makingprocess, future Utility Group revenue approximately equal to the sales pricewill result from the regulated utilities’ use of the services.  The Company does, however, eliminate theServices Group’s revenues from affiliated customers to the extent of itscost.  Consequently, this change resultedin a decrease in the Services Group’s revenues and direct operating expensesreported in 2006 by the same amounts. Consolidated gross profit, operating income and net income areunchanged.

6

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**AccountingGuidance and Pronouncements Adopted During 2007**

***SFAS No. 158***

In September 2006, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans — an amendment of FASB Statements No. 87, 88, 106, and132(R)*(“SFAS 158”).  Thisstatement requires balance sheet recognition of the funded status of pensionand postretirement benefit plans.  UnderSFAS 158, actuarial gains and losses, prior service costs or credits, and anyremaining transition assets or obligations that have not been recognized underprevious accounting standards must be recognized in accumulated othercomprehensive income (loss), net of tax effects, until they are amortized as acomponent of net periodic benefit cost. The balance sheet recognition provisions of SFAS 158 were effectivefor the Company’s fiscal year ended December 31, 2006 and, as a result, theCompany began recognizing the unamortized portion of actuarial gains and priorservice costs in accumulated other comprehensive income.  The adoption of SFAS 158 did not have amaterial effect on the consolidated financial statements.

***FIN No. 48***

On January 1, 2007, theCompany adopted the provisions of FASB Interpretation No. 48, *Accounting for Uncertainty in Income Taxes* (“FIN 48”).  This interpretation clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes*(“SFAS 109”). FIN 48 requires companies to recognize the financial statementbenefit of a tax position only after determining the relevant tax authoritywould “more likely than not” sustain the position following an examination bytaxing authorities.  For tax positionsmeeting the more-likely-than-not threshold, the amount recognized in thefinancial statements is the largest benefit that has a greater than 50%likelihood of being realized upon settlement with the relevant taxingauthority.

The Company adopted theprovisions of FIN No. 48 on January 1, 2007. On December 31, 2006 and June 30, 2007, the Company’s liabilities foruncertain tax positions are not significant. The Company’s policy is to recognize interest and penalties related toliabilities for uncertain tax benefits in the income tax expense line-item ofthe consolidated statements of income. Net interest and penalties incurred during the three months and sixmonths ended June 30, 2007 and 2006 were insignificant.

The Company is subject tofederal and various state and local income taxes.  Tax regulations within each jurisdiction aresubject to the interpretation of related tax laws and regulations and requiresignificant judgment to apply.  TheCompany is no longer subject to federal, state and local income tax returnexaminations by taxing authorities for years before 2002.  The Company’s federal income tax returns forthe 2002 through 2004 tax years were recently examined by the Internal RevenueService.  The examination was concludedin February 2007 and resulted in no net change for the tax years examined.  State and local income tax returns from 2002to the present and federal income tax returns from 2005 to the present arestill subject to examinations by taxing authorities.

7

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**RecentAccounting Pronouncements**

***SFAS No. 157***

In September 2006, theFASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”).  This statement establishesa single authoritative definition of fair value, sets out framework forestablishing fair value, and requires additional disclosures about fair valuemeasurements.  This statement appliesonly to fair value measurements that are already required or permitted by otheraccounting standards and is expected to increase the consistency of thosemeasurements.  Adoption of SFAS 157 isrequired for the Company’s fiscal year beginning January 1, 2008, and will beapplied prospectively under most circumstances. While the Company is still evaluating the impact this statement willhave on its consolidated financial statements, management currently believesthe impact will not be material.

***SFAS No. 159***

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities — Including an amendment of FASBStatement No. 115* (“SFAS 159”). This statement permits companies to choose to measure many financialinstruments and other specified items at fair value.  This statement is effective for the Company’sfiscal year beginning January 1, 2008 and will be applied prospectively.  While the Company is still evaluating theimpact this statement will have on its consolidated financial statements,management currently believes the impact will not be material.

**Note 2.       Acquisitions**

During the six monthsended June 30, 2007, the Company acquired:

·                  substantiallyall of the assets of a small water and wastewater collection utility in a highgrowth area of northern Mississippi, just south of Memphis, Tennessee, inFebruary 2007; and

·                  allof the common stock of two water utilities in a high population growth areanorthwest of San Antonio, Texas in May 2007.

The aggregate purchaseprice for these acquisitions was $6.5 million in cash plus $0.8 million ofliabilities assumed.  The assets acquiredand liabilities assumed have been recorded at their estimated fair values basedupon preliminary valuations.  The consolidatedfinancial statements include the operations of the utilities subsequent totheir respective acquisition dates.  Theacquisitions are not material, either individually or in the aggregate, to theCompany’s consolidated financial statements. The Company expects to finalize the purchase price allocations during2007.

On March 20, 2006, the10% minority interest stockholder in Operations Technology, Inc. (“OpTech”), aGeorgia-based non-regulated business in the Company’s Services Group, exercisedits right to require the Company to purchase the remaining 10% of OpTech stockthat it did not already own for $1.0 million in cash (Note 4).  In connection with this acquisition, theCompany allocated $0.5 million of the purchase price to finite-lived intangibleassets and the remaining $0.5 million to goodwill.  The intangible assets, principally customerrelationships and tradenames, are being amortized on a straight-line basis overa weighted-average amortization period of 8.1 years.

The acquisitions werefunded with borrowings under the Company’s revolving line of credit.

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**Note 3.       Long-Term Debt**

Long-term debt consistsof the following as of June 30, 2007 and December 31, 2006:
| ** **                                            | ** ** | **June 30,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|-------------------|------------|-----------------------|------------|
| **(In thousands)**                               | ** ** | **2007**          | ** ** | **2006**              | ** ** |
|                                                  |       |              |       |                  |       |
| $100 million revolving  credit facility               |       | $                 | 52,000     |                  | $          | 36,000 |   |
|                                                  |       |              |       |                  |       |
| 6.85% convertible  subordinated debentures due 2021   |       | 12,237            |       | 12,610                |       |
|                                                  |       |              |       |                  |       |
| Term Loans:                                           |       |              |       |                  |       |
| Monarch  Utilities, Inc.:                             |       |              |       |                  |       |
| 7.37% fixed rate  term loan due 2022                  |       | 11,422            |       | 11,807                |       |
| 5.77% fixed rate  term loan due 2022                  |       | 785               |       | 811                   |       |
| 6.10% fixed rate  term loan due 2031                  |       | 20,000            |       | 20,000                |       |
|                                                  |       |              |       |                  |       |
| First Mortgage Bonds:                                 |       |              |       |                  |       |
| Suburban Water  Systems:                              |       |              |       |                  |       |
| 9.09% series B  first mortgage bond due 2022          |       | 8,000             |       | 8,000                 |       |
| 5.64% series D  first mortgage bond due 2024          |       | 15,000            |       | 15,000                |       |
| 6.30% series E  first mortgage bond due 2026          |       | 10,000            |       | 10,000                |       |
| New Mexico Utilities,  Inc.:                          |       |              |       |                  |       |
| 6.10% series C  first mortgage bond due 2024          |       | 12,000            |       | 12,000                |       |
|                                                  |       |              |       |                  |       |
| Economic Development  Revenue Bonds:                  |       |              |       |                  |       |
| ECO Resources,  Inc.:                                 |       |              |       |                  |       |
| 5.5% series  1998A due 2008                           |       | 220               |       | 220                   |       |
| 6.0% series  1998A due 2018                           |       | 1,810             |       | 1,810                 |       |
|                                                  |       |              |       |                  |       |
| Acquisition-related  indebtedness and other           |       | 834               |       | 904                   |       |
| Total long-term  debt payment obligations             |       | 144,308           |       | 129,162               |       |
| Unamortized  Monarch term loan fair value adjustments |       | 821               |       | 885                   |       |
| Total long-term  debt                                 |       | 145,129           |       | 130,047               |       |
| Less current  portion of long-term debt               |       | (1,500)           |       | (1,423)               |       |
| Long-term debt, less  current portion                 |       | $                 | 143,629    |                  | $          | 128,624 |   |

 

The $100 millionrevolving line of credit commitment ends on April 1, 2010 (if not renewed orextended), at which time all borrowings must be repaid.  Borrowings under the credit facility bearinterest, at the Company’s option, based on a margin either: a) over the LIBORrate; or b) under the prime rate.  Themargins vary depending upon the Company’s consolidated debt to equityratio.  Currently, the applicable marginsare 0.875% over the LIBOR rate or 0.25% under the prime rate.  The weighted-average interest rates on allcredit facility borrowings outstanding were 6.23% as of June 30, 2007 and 6.23%as of December 31, 2006.

The Company hadirrevocable standby letters of credit in the amount of $0.7 million issued andoutstanding under its revolving credit facility as of June 30, 2007, reducingavailable borrowings under the credit facility to $47.3 million as of thatdate.

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**Note 4.       Commitmentsand Contingencies**

**Legal Proceedings**

New MexicoUtilities, Inc. (“NMUI”), one of the Company’s wholly-owned regulatedutilities, has an agreement with the Albuquerque Bernalillo County WaterUtility Authority, a political subdivision of the State of New Mexico (the“Water Authority”), whereby the Water Authority treats the effluent from NMUI’swastewater collection system for a fee. The treated effluent is returned to the Rio Grande Underground Basin,creating return flow credits.  Returnflow credits supplement NMUI’s existing water rights, enabling it to pumpadditional water from the basin.

In August 2004,the Water Authority increased the fee charged to NMUI, using a differentformula than had been used in prior years. The Company believes the increase violates the terms of the agreement.  Subsequently, the Water Authority alsoclaimed ownership of the return flow credits. The Company filed a Complaint for Declaratory Judgment in the SecondJudicial District Court, County of Bernalillo, State of New Mexico, requestingthat the Court settle these disputes.  Ina letter ruling dated May 2, 2007, the Court ruled that the Water Authoritycould use a new formula to set fees for NMUI. The Company has filed a motion for reconsideration and that motion isscheduled to be presented on October 2, 2007. The Company believes that either the Court will reconsider the ruling orthe ruling will ultimately be reversed by the Court of Appeals.  The Court has not ruled on whether the newrate was appropriate; has made no determination as to any amount NMUI may oweto the Water Authority, or ruled on the ownership of the return flowcredits.  Although the Company cannotgive any assurances as to the ultimate resolution of this matter, the Companydoes not believe that it is probable it will be required to pay the disputedfees and related late payment penalties, which totaled $3.9 million as of June30, 2007, and has not recognized a reserve for any potential liabilities in theaccompanying consolidated financial statements. The Company is unable to predict the impact the resolution of the returnflow credits ownership dispute will have on its consolidated financialstatements.

In addition, onJanuary 19, 2007, the Water Authority and the City of Rio Rancho, a home-rulemunicipal corporation, as Petitioners, filed a Petition for Condemnationagainst NMUI and others, as Defendants, in the Second Judicial District Court,County of Bernalillo, State of New Mexico (the “Petition”).  The Petition seeks to acquire, by condemnation,all of the assets of NMUI, including all real property, through the statedpower of eminent domain.  The Petitionalso alleges that the Petitioners need to acquire the NMUI assets for thepublic purposes of providing water and wastewater services to NMUI customersand that the acquisition of NMUI is necessary, appropriate and in the publicinterest.  The Company believes it hasdefenses to the Petition which it intends to vigorously assert.  If the Company does not prevail, thePetitioners must pay fair market value as determined by the court, based onappraisals.  NMUI and the Petitioners donot agree on the value of the assets which the Petitioners seek tocondemn.  While it is too early topredict the outcome of this matter, the Company believes that the fair marketvalue of its NMUI utility exceeds its recorded net book value as of June 30,2007.

10

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Southwest Water and a subsidiary were named as defendants in severallawsuits alleging various injuries as a result of water contamination in theSan Gabriel Valley Main Basin.  TheCalifornia Supreme Court ruled in February 2002 that the plaintiffs could notchallenge the adequacy of the water quality standards established by CaliforniaDepartment of Health Services.  In August2004, the case against Southwest Water and its subsidiary was dismissed;however, the plaintiffs appealed the dismissal to the Court of Appeals for theState of California, First Appellate District (1DCA Civil No.  B178283). Oral arguments for the appeal were presented on June 20, 2007 and theCompany expects to receive a ruling within 60 to 90 days from that date.  To date, liability insurance carriers haveabsorbed the costs of defense of the lawsuits. Based upon information available at this time, the Company does notexpect that this action will have a material adverse effect on its consolidatedfinancial position, results of operations or cash flows.

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

**EPA Investigations**

On May 5, 2005,one of the Company’s operating subsidiaries received a subpoena to providerecords to a grand jury.  The requestedrecords relate to the operations of the San Simeon wastewater treatment plantin California for the period January 2002 to the date of the subpoena.  The subsidiary has operated this facilitysince September 2004.  The facility wasalso served with search warrants executed by the EPA.  The Company is cooperating fully with theinvestigation and has provided the records requested.  There have been no further significantdevelopments since May 5, 2005.

On May 18, 2005,the EPA executed a search warrant at the Company’s Texas-based testinglaboratory and on July 20, 2006 the laboratory received a subpoena toprovide additional records and information to a grand jury.  The Company is cooperating fully with theinvestigation and has provided the records requested.  There have been no further significantdevelopments since July 20, 2006.

11

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**Commitments UnderLong-Term Service Contracts**

In 2002, theCompany was retained to facilitate the engineering and construction of a $23.0million reverse osmosis water treatment plant in the city of San JuanCapistrano, California for the Capistrano Valley Water District (“CVWD”).  In 2003, the Company obtained a $3.4 millionstandby letter of credit as collateral to insure its performance during thedesign and construction of the water treatment plant.  Construction was completed during 2005 andthe $3.4 million standby letter of credit was released on May 3, 2007.  The Company obtained final acceptance of thecompleted project from the CVWD in July 2007 and payment of the final $2.3million of the total contract price, which is included in accounts receivable,was released to the Company from the construction financing escrow account.

The Company nowoperates the completed plant under a twenty-year operating agreement.  The CVWD service contract contains threeguarantees related to the performance of the Company and its subsidiary duringthe term of the operating agreement.  Theagreement provides for the Company to pay liquidated damages in the event itfails to perform for reasons other than those caused by “uncontrollablecircumstances,” as such term is defined in the agreement.

During the term ofthe operating agreement, the Company may be liable for liquidated damagesrelating to any lost payments from a financial assistance agreement CVWD haswith a state water agency, up to a maximum of $1.4 million per contractyear.  The Company has also madeguarantees to CVWD with respect to the quantity of finished water produced bythe facility.  In the event the actualnumber of acre feet of finished water delivered is less than the water deliveryguarantee, the Company is required to pay liquidated damages of approximately$600 per acre foot of shortfall, up to a maximum of 15.8 acre feet perday.  Finally, the Company has madeguarantees with respect to seven measurable finished water qualitystandards.  Liquidated damages forfailure to meet these quality standards range from $100 to $400 per day perfailed quality standard (up to a maximum of $2,800 per day), depending on thenumber of violations per contract year. The CVWD has not asserted any claims for liquidated damages pursuant tothese guarantees through the date of this report.

As part of thefinancing for this project, the CVWD sold insured municipal bonds.  The Company entered into an agreement withthe bond insurer to guarantee the Company’s performance under the servicecontract, subject to certain liability caps to the bond insurer in the event ofa default.  During the twenty-yearoperation of the facility, such liability caps will not exceed an amount equalto $4.0 million plus an amount no greater than the replacement cost of theactual reverse osmosis filtration unit within the facility, estimated to beapproximately $1.5 million.

**Water SupplyCommitments**

One of the Company’sregulated utilities has a water supply contract providing for the purchase ofwater to supplement its own water supply. The agreement requires the Company to purchase minimum quantities ofwater annually at a specified price.  Theprice is subject to annual adjustment for production cost increases incurred bythe seller.  The minimum quantity is alsosubject to adjustment based on average actual water purchases over a movingtwo-year period, but the minimum will not be reduced below a specifiedthreshold.  As of June 30, 2007, theminimum annual purchase commitment is $0.5 million through 2024.

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**Minority Interest Put and Call Rights**

Prior to March 20,2006, the Company owned 90% of the outstanding common stock of OperationsTechnologies, Inc. (“OpTech”).  Theminority stockholder had the right to require the Company to purchase theremaining 10% of OpTech for the greater of $1.0 million or a formula-determinedamount based on the profitability of OpTech. The Company had the right to purchase the remaining 10% of OpTechbeginning in August 2006 at the same terms. On March 20, 2006, the minority stockholder elected to exercise itsright and the Company acquired the shares based on the formula determinedamount which was slightly more than the $1.0 million minimum amount (Note 2).

**Note 5.       EarningsPer Share**

The followingtable is a reconciliation of the numerators (income) and denominators (shares)used in both the basic and diluted earnings per share calculations.
| ** **                                                                      | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **(In thousands)**                                                         | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| *** ***                                                                    | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Numerators—Net  income applicable to common stockholders:                  |       |                                            |       |                                          |       |   |   |   |   |
| Income before change in accounting principle                                    |       | $                                               | 2,223      |                                          | $          | 1,816 |   | $ | 2,837 |   | $ | 2,517 |   |
| Less preferred stock dividends                                                  |       | (6                                              | )          | (6                                            | )          | (12 | ) | (12 | ) |
| Income before change in accounting principle  applicable to common stockholders |       | 2,217                                           |       | 1,810                                         |       | 2,825 |   | 2,505 |   |
| Cumulative effect of change in accounting principle                             |       | —                                          |       | —                                        |       | — |   | 71 |   |
| Net income applicable to common stockholders                                    |       | $                                               | 2,217      |                                          | $          | 1,810 |   | $ | 2,825 |   | $ | 2,576 |   |
| Denominators—Weighted  average common shares outstanding:                  |       |                                            |       |                                          |       |   |   |   |   |
| Basic weighted average common shares outstanding                                |       | 24,100                                          |       | 22,713                                        |       | 23,992 |   | 22,501 |   |
| Plus shares issued on assumed exercise of stock  options and warrants           |       | 286                                             |       | 738                                           |       | 309 |   | 837 |   |
| Diluted weighted  average common shares outstanding                             |       | 24,386                                          |       | 23,451                                        |       | 24,301 |   | 23,338 |   |

As described inNote 3, the Company has $12.2 million of 6.85% fixed-rate convertiblesubordinate debentures outstanding as of June 30, 2007.  The debentures are convertible into commonstock at any time prior to maturity, unless previously redeemed, at aconversion price of $11.018 per share which totals 1.1 million shares as ofJune 30, 2007.  At such time as theassumed conversion of the debentures has a dilutive effect on earnings pershare, the debentures will be included in the calculation of diluted earningsper share after adjusting net income for the after-tax effect of the debentureinterest expense.

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**Note 6.       ConsolidatedStatements of Cash Flows**

The followinginformation supplements the Company’s consolidated statements of cash flows.
| ** **                                                                                                     | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                     | ** ** | **June 30,**              | ** ** |
| **(In thousands)**                                                                                        | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| ** **                                                                                                     | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Cash paid during  the period for:                                                                              |       |                           |       |   |   |
| Interest                                                                                                       |       | $                              | 4,179      |   | $ | 4,081 |   |
| Income taxes paid (refunded), net                                                                              |       | (725                           | )          | (1,956 | ) |
|                                                                                                           |       |                           |       |   |   |
| Components of  cash paid for acquisitions:                                                                     |       |                           |       |   |   |
| Fair value of assets acquired                                                                                  |       | $                              | 7,386      |   | $ | 1,250 |   |
| Liabilities assumed                                                                                            |       | 839                            |       | (3 | ) |
| Cash paid for acquisitions                                                                                     |       | $                              | 6,547      |   | $ | 1,247 |   |
|                                                                                                           |       |                           |       |   |   |
| Non-cash  investing and financing activities:                                                                  |       |                           |       |   |   |
| Non-cash contributions in aid of construction and  advances for construction conveyed to Company by developers |       | $                              | 3,153      |   | $ | 4,113 |   |
| Debentures  converted into common stock                                                                        |       | 373                            |       | 2,929 |   |

 

**Note 7.       Share-BasedCompensation Plans**

The Company hastwo share-based compensation plans: an Equity Incentive Plan and an EmployeeStock Purchase Plan.

As more fullydescribed in Note 13 to the Company’s consolidated financial statementsincluded in its 2006 Annual Report on Form 10-K, effective January 1,2006, the Company adopted the provisions of SFAS No. 123(R), “*Share-Based Payment*” (“SFAS 123(R)”).  The adoption of SFAS 123(R) required theCompany to change from recognizing the effect of forfeitures as they occur toestimating the number of options for which the requisite service is notexpected to be rendered and reducing the periodic compensation cost recordedaccordingly.  As a result, the Companyrecorded a benefit of $0.1 million ($0.07 million, net of tax) on January 1,2006, which is reported as the cumulative effect of a change in accountingprinciple.

**Equity Incentive Plan**

The stockholder-approvedEquity Incentive Plan (“EIP”) authorizes the Company to award up to 5.4 millionshares of its common stock.  As of June30, 2007, 0.980 million shares were available for granting future awards underthe plan which may be granted until May 16, 2016.  The Company has reserved 2.786 million sharesof its authorized common shares for issuance upon exercise of awardsoutstanding and future awards available for granting under the plan.  Under the EIP, the Company may award, eitherqualified or non-qualified stock options, stock appreciation rights, restrictedstock, restricted stock units and other stock-based awards to officers,employees and non-employee directors.

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The following table summarizes thecompensation expense and related income tax benefit related to share-basedcompensation expense recognized during the periods:
| ** **                                    | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **(In thousands)**                       | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| *** ***                                  | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Stock options                                 |       | $                                               | 403        |                                          | $          | 310 |   | $ | 801 |   | $ | 585 |   |
| Restricted stock  awards                      |       | 52                                              |       | —                                        |       | 62 |   | — |   |
| Share-based compensation expense              |       | 455                                             |       | 310                                           |       | 863 |   | 585 |   |
| Income tax benefit                            |       | (165                                            | )          | (113                                          | )          | (313 | ) | (214 | ) |
| Share-based  compensation expense, net of tax |       | $                                               | 290        |                                          | $          | 197 |   | $ | 550 |   | $ | 371 |   |

 

***StockOptions***

The followingtable summarizes all stock option activity during the six months ended June 30,2007:
| **(In thousands, except weighted average exercise prices)** | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Exercise  Price** | ** ** |
|-------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                | ** ** | ** **             | ** ** | ** **                              | ** ** |
| Outstanding at  December 31, 2006                                                         |       | 1,788                  |       | $                                       | 10.29      |   |
| Granted                                                                                   |       | 333                    |       | 12.78                                   |       |
| Exercised                                                                                 |       | (213                   | )          | 6.82                                    |       |
| Forfeited                                                                                 |       | (118                   | )          | 13.65                                   |       |
| Expired                                                                                   |       | (10                    | )          | 6.17                                    |       |
| Outstanding at  June 30, 2007                                                             |       | 1,780                  |       | 10.97                                   |       |
|                                                                                      |       |                   |       |                                    |       |
| Exercisable at June 30,  2007                                                             |       | 976                    |       | 9.01                                    |       |
|                                                                                           |            |                        |            |                                         |            |  |

The fair value ofeach option grant is estimated on the date of grant using the Black-Scholesoption pricing model with the following weighted average assumptions used forgrants in 2007 and 2006:
| ** **               | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30,**              | ** ** |
| ** **               | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| Dividend yield           |       | 1.7                            | %          | 1.4 | % |
| Expected  volatility     |       | 34.4                           | %          | 33.5 | % |
| Risk-free  interest rate |       | 4.6                            | %          | 4.8 | % |
| Expected life in years   |       | 4.5                            |       | 4.6 |   |

 

The weighted averagegrant date fair value of options granted using these assumptions was $3.96 and$4.84 per share for the three months ended June 30, 2007 and 2006,respectively, and $3.90 and $4.99 per share for the six months endedJune 30, 2007 and 2006, respectively.

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*Restricted Stock Awards*

Under the EIP, theCompany may award shares of restricted stock to employees that vest and arereleased to the employee as the vesting conditions are met.  The Committee has established a straight-linevesting schedule over a three-year period of continuous service to the Companyfor all awards granted to date. Restricted stock is forfeited in the event a participant terminatesemployment with the Company prior to the award vesting.  The grant date fair value of stock awarded isrecognized as compensation expense over the vesting term.

The followingtable summarizes all restricted stock award activity during the six monthsended June 30, 2007:
| **(In thousands, except weighted average grant date fair value)** | ** ** | **Number  of  Shares** | ** ** | **Weighted-  Average  Grant Date  Fair Value** | ** ** |
|-----------------------------------------------------------------------------------------------------------|------------|------------------------|------------|----------------------------------------------------------|------------|
| *** ***                                                                                              | ** ** | ** **             | ** ** | ** **                                               | ** ** |
| Outstanding at  December 31, 2006                                                                         |       | —                 |       | $                                                        | —     |   |
| Awarded                                                                                                   |       | 27                     |       | 12.76                                                    |       |
| Vested and  released                                                                                      |       | —                 |       | —                                                   |       |
| Forfeited                                                                                                 |       | —                 |       | —                                                   |       |
| Outstanding at  June 30, 2007                                                                        |       | 27                     |       | 12.76                                                    |       |
|                                                                                                           |            |                        |            |                                                          |            |  |

 

**Employee Stock PurchasePlan (“ESPP”)**

The Company has astockholder-approved employee stock purchase plan (“ESPP”) that allows eligibleemployees to purchase 1.005 million shares of common stock through payrolldeductions of up to 10% of their salary, not to exceed $25,000 per year.  The purchase price of the stock is 90% of thelower of the three-day average share price calculated at the beginning and endof each three-month offering period. Under the ESPP, employees purchased 5,184 and 10,511 shares for $61,000and $122,000 during the three months and six months ended June 30, 2007,respectively, and 4,615 and 9,153 shares for $61,000 and $119,000 during thethree months and six months ended June 30, 2006, respectively.

The fair value ofESPP shares purchased is estimated using a Black-Scholes option pricing modelwith the following weighted average assumptions used for 2007 and 2006:
| ** **               | ** ** | **Six Months Ended** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **June 30,**              | ** ** |
| ** **               | ** ** | **2007**                       | ** ** | **2006** | ** ** |
|                     |       |                           |       |   |   |
| Dividend yield           |       | 1.4                            | %          | 1.4 | % |
| Expected  volatility     |       | 33.6                           | %          | 33.6 | % |
| Risk-free  interest rate |       | 4.8                            | %          | 4.8 | % |
| Expected life in years   |       | 0.25                           |       | 0.25 |   |

Compensation expenserecognized by the Company resulting from employee stock purchases pursuant tothis plan was $12,000 and $11,000 for the three months ended June 30, 2007 and2006, respectively, and $23,000 and $22,000 for the six months ended June 30,2007 and 2006, respectively.  As of June30, 2007, 0.630 million shares remain available for future purchases.

16

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

The Company has adividend reinvestment and stock purchase plan that gives common stockholdersthe option of receiving their dividends in cash or in common stock at adiscount from prevailing 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 Companymay, at its sole discretion, permit purchases above the $10,000 statedmaximum.  The discounts may range from 0%to 5%, as determined from time to time by the Company.  The DRIP and DSPP discounts offered by theCompany are 5% for the DRIP and 0% for the DSPP as of June 30, 2007.  As of June 30, 2007, there are 3.696 millionshares authorized for issuance under the plan of which 0.998 million sharesremain available for issuance.

**Note 9.       EmployeeRetirement Plan**

The Company has anon-qualified supplemental executive retirement plan (“SERP”) for certain keyexecutive officers for the purpose of providing supplemental income benefits toplan participants or their survivors upon retirement or death.  The plan measurement date is December 31st ofeach year.  As discussed in Note 1, theCompany adopted the balance sheet recognition requirements of SFAS 158 onDecember 31, 2006 and began recognizing the unamortized portion of actuarialgains and prior service costs in accumulated other comprehensive income.  The following table details the components ofthe net periodic benefit costs:
| ** **                                | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|-------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------|------------|
| **(In thousands)**                   | ** ** | **2007**                                        | ** ** | **2006**                                      | ** ** | **2007** | ** ** | **2006** | ** ** |
| *** ***                              | ** ** | ** **                                      | ** ** | ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                              |       | $                                               | —     |                                          | $          | 15 |   | $ | — |   | $ | 32 |   |
| Interest cost                             |       | 16                                              |       | 19                                            |       | 32 |   | 38 |   |
| Amortization of  actuarial (gains) losses |       | (19                                             | )          | 5                                             |       | (38 | ) | 9 |   |
| Amortization of  prior service costs      |       | 22                                              |       | 9                                             |       | 44 |   | 17 |   |
| Net periodic  benefit costs               |       | $                                               | 19         |                                          | $          | 48 |   | $ | 38 |   | $ | 96 |   |

The sole remainingparticipant in the plan has reached retirement age and the plan provides thatno additional benefits accrue upon reaching retirement age.  Summarized in the table below is informationabout the changes in the projected benefit obligation and the liabilityrecognized in the consolidated balance sheet as of June 30, 2007.
| **(In thousands)**                                        | ** ** | **June 30,  2007** | ** ** |
|----------------------------------------------------------------|------------|-------------------------|------------|
| ** **                                                     | ** ** | ** **              | ** ** |
| Projected  benefit obligation:                                 |       |                    |       |
| Balance at December 31, 2006                                   |       | $                       | 1,224      |   |
| Interest cost                                                  |       | 32                      |       |
| Payment of benefit obligation                                  |       | (174                    | )          |
| Balance at June 30, 2007                                       |       | $                       | 1,082      |   |
|                                                           |       |                    |       |
| Amounts  recognized in accumulated other comprehensive income: |       |                    |       |
| Actuarial gains                                                |       | $                       | (161       | ) |
| Prior service cost                                             |       | 44                      |       |
| Related deferred income taxes                                  |       | 41                      |       |
| Total                                                          |       | $                       | (76        | ) |

 

17

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**Note 10.     SegmentInformation**

The Company’sbusinesses are segmented into two operating groups: the Utility Group and theServices Group.  Each segment is astrategic business unit that offers different services.  They are managed separately since eachbusiness requires different operating and growth strategies.  The accounting policies of the segments aredescribed in the summary of significant accounting policies in Note 1 to theaudited financial statements included in the Company’s 2006 Form 10-K.

The Utility Groupowns and operates public water and wastewater utilities in Alabama, California,New Mexico, Mississippi, Oklahoma and Texas. State and federal agencies issue regulations regarding standards ofwater quality, safety, environmental and other matters which affect theseoperations.  In the regulated utilitysubsidiaries, the rates that they charge for water and wastewater services areestablished by state or local regulatory authorities.  The service areas in which the Utility Groupoperates constitute monopolies with allowable rates determined by state orlocal regulatory agencies.

The Services Groupoperates and manages water and wastewater treatment facilities owned by cities,public agencies, municipal utility districts, private entities andinvestor-owned utilities, including some of the companies in the UtilityGroup.  The Services Group also providesconstruction and construction management services, certified water andwastewater laboratory testing services, and public works services.  The Services Group, while subject to certainenvironmental standards, is not regulated in its pricing, marketing or rates ofreturn.

As more fullydescribed in Note 1, effective January 1, 2007 the Company elected to allocatea portion of its Services Group’s operating expense overhead between affiliatedand unaffiliated customers for segment reporting purposes.  Prior year amounts have been reclassified toconform to the 2007 presentation.

18

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The following tables present informationabout the operations of each segment for the three months and six months endedJune 30, 2007 and 2006.
| **(In thousands)**                                               | ** ** | **Utility  Group** | ** ** | **Services  Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations (3)** | ** ** | **Consolidated** | ** ** |
|-----------------------------------------------------------------------|------------|--------------------|------------|------------------------|------------|------------------------|------------|---------------------------|------------|------------------|------------|
| **Three  months ended June 30, 2007:**                                |       |               |       |                   |       |                   |       |                      |       |             |       |
| Revenues:                                                             |       |               |       |                   |       |                   |       |                      |       |             |       |
| Unaffiliated customers                                                |       | $                  | 23,554     |                   | $          | 30,711                 |       | $                         | —     |             | $          | — |   | $ | 54,265 |   |
| Intersegment (1) (3)                                                  |       | 438                |       | 6,264                  |       | —                 |       | (5,992                    | )          | 710              |       |
| Total revenues                                                        |       | 23,992             |       | 36,975                 |       | —                 |       | (5,992                    | )          | 54,975           |       |
|                                                                  |       |               |       |                   |       |                   |       |                      |       |             |       |
| Expenses:                                                             |       |               |       |                   |       |                   |       |                      |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 12,993             |       | 27,123                 |       | —                 |       | —                    |       | 40,116           |       |
| Operating expenses–intersegment (3)                              |       | 438                |       | 5,554                  |       | —                 |       | (5,992                    | )          | —           |       |
| Selling, general and administrative                                   |       | 1,928              |       | 3,554                  |       | 3,830                  |       | —                    |       | 9,312            |       |
| Total expenses                                                        |       | 15,359             |       | 36,231                 |       | 3,830                  |       | (5,992                    | )          | 49,428           |       |
|                                                                  |       |               |       |                   |       |                   |       |                      |       |             |       |
| Operating income (loss)                                               |       | 8,633              |       | 744                    |       | (3,830                 | )          | —                    |       | 5,547            |       |
|                                                                  |       |               |       |                   |       |                   |       |                      |       |             |       |
| Interest expense                                                      |       | (1,589             | )          | (271                   | )          | (264                   | )          | —                    |       | (2,124           | )          |
| Interest income                                                       |       | 6                  |       | 62                     |       | 8                      |       | —                    |       | 76               |       |
| Other income (expense)                                                |       | (39                | )          | —                 |       | 27                     |       | —                    |       | (12              | )          |
| Income (loss) before income taxes                                     |       | $                  | 7,011      |                   | $          | 535                    |       | $                         | (4,059     | )                | $          | — |   | $ | 3,487 |   |
|                                                                  |       |               |       |                   |       |                   |       |                      |       |             |       |
| **Three  months ended June 30, 2006:**                                |       |               |       |                   |       |                   |       |                      |       |             |       |
| Revenues:                                                             |       |               |       |                   |       |                   |       |                      |       |             |       |
| Unaffiliated customers                                                |       | $                  | 20,790     |                   | $          | 31,647                 |       | $                         | —     |             | $          | — |   | $ | 52,437 |   |
| Intersegment (1) (3)                                                  |       | 384                |       | 9,571                  |       | —                 |       | (8,096                    | )          | 1,859            |       |
| Total revenues                                                        |       | 21,174             |       | 41,218                 |       | —                 |       | (8,096                    | )          | 54,296           |       |
|                                                                  |       |               |       |                   |       |                   |       |                      |       |             |       |
| Expenses:                                                             |       |               |       |                   |       |                   |       |                      |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 10,506             |       | 28,954                 |       | —                 |       | —                    |       | 39,460           |       |
| Operating expenses–intersegment (3)                              |       | 384                |       | 7,712                  |       | —                 |       | (8,096                    | )          | —           |       |
| Selling, general and administrative                                   |       | 1,837              |       | 3,280                  |       | 4,091                  |       | —                    |       | 9,208            |       |
| Impairment of goodwill                                                |       | —             |       | 668                    |       | —                 |       | —                    |       | 668              |       |
| Total expenses                                                        |       | 12,727             |       | 40,614                 |       | 4,091                  |       | (8,096                    | )          | 49,336           |       |
|                                                                  |       |               |       |                   |       |                   |       |                      |       |             |       |
| Operating income (loss)                                               |       | 8,447              |       | 604                    |       | (4,091                 | )          | —                    |       | 4,960            |       |
| Interest expense                                                      |       | (1,559             | )          | (491                   | )          | (71                    | )          | —                    |       | (2,121           | )          |
| Interest income                                                       |       | 20                 |       | 96                     |       | 58                     |       | —                    |       | 174              |       |
| Other income (expense)                                                |       | (13                | )          | (139                   | )          | 2                      |       | —                    |       | (150             | )          |
| Income (loss)  before income taxes and change in accounting principle |       | $             | 6,895      |                   | $     | 70                     |       | $                    | (4,102     | )                | $     | — |   | $  | 2,863 |   |

 

*Seeaccompanying notes to the segment information following these tables.*

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| ** **                                                            | ** ** | **Utility** | ** ** | **Services** | ** ** | ** **             | ** ** | ** **                | ** ** | ** **       | ** ** |
|-----------------------------------------------------------------------|------------|-------------|------------|--------------|------------|------------------------|------------|---------------------------|------------|------------------|------------|
| **(In thousands)**                                               | ** ** | **Group**   | ** ** | **Group(1)** | ** ** | **Corporate (2)** | ** ** | **Eliminations (3)** | ** ** | **Consolidated** | ** ** |
| **Six  months ended June 30, 2007:**                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Revenues:                                                             |       |        |       |         |       |                   |       |                      |       |             |       |
| Unaffiliated customers                                                |       | $           | 43,588     |         | $          | 57,232                 |       | $                         | —     |             | $          | — |   | $ | 100,820 |   |
| Intersegment (1) (3)                                                  |       | 890         |       | 13,484       |       | —                 |       | (12,145                   | )          | 2,229            |       |
| Total revenues                                                        |       | 44,478      |       | 70,716       |       | —                 |       | (12,145                   | )          | 103,049          |       |
|                                                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Expenses:                                                             |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 24,589      |       | 52,125       |       | —                 |       | —                    |       | 76,714           |       |
| Operating expenses–intersegment (3)                              |       | 890         |       | 11,255       |       | —                 |       | (12,145                   | )          | —           |       |
| Selling, general and administrative                                   |       | 4,389       |       | 6,249        |       | 7,207                  |       | —                    |       | 17,845           |       |
| Total expenses                                                        |       | 29,868      |       | 69,629       |       | 7,207                  |       | (12,145                   | )          | 94,559           |       |
|                                                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating income (loss)                                               |       | 14,610      |       | 1,087        |       | (7,207                 | )          | —                    |       | 8,490            |       |
|                                                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Interest expense                                                      |       | (3,100      | )          | (604         | )          | (490                   | )          | —                    |       | (4,194           | )          |
| Interest income                                                       |       | 10          |       | 177          |       | 29                     |       | —                    |       | 216              |       |
| Other income (expense)                                                |       | (103        | )          | —       |       | 42                     |       | —                    |       | (61              | )          |
| Income (loss) before income taxes                                     |       | $           | 11,417     |         | $          | 660                    |       | $                         | (7,626     | )                | $          | — |   | $ | 4,451 |   |
| ** **                                                            |       |        |       |         |       |                   |       |                      |       |             |       |
| **Six  months ended June 30, 2006:**                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Revenues:                                                             |       |        |       |         |       |                   |       |                      |       |             |       |
| Unaffiliated customers                                                |       | $           | 38,763     |         | $          | 62,072                 |       | $                         | —     |             | $          | — |   | $ | 100,835 |   |
| Intersegment (1) (3)                                                  |       | 750         |       | 17,059       |       | —                 |       | (14,754                   | )          | 3,055            |       |
| Total revenues                                                        |       | 39,513      |       | 79,131       |       | —                 |       | (14,754                   | )          | 103,890          |       |
|                                                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Expenses:                                                             |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating expenses–unaffiliated customers                        |       | 20,903      |       | 56,749       |       | —                 |       | —                    |       | 77,652           |       |
| Operating expenses–intersegment (3)                              |       | 750         |       | 14,004       |       | —                 |       | (14,754                   | )          | —           |       |
| Selling, general and administrative                                   |       | 4,083       |       | 6,042        |       | 7,468                  |       | —                    |       | 17,593           |       |
| Impairment of goodwill                                                |       | —      |       | 668          |       | —                 |       | —                    |       | 668              |       |
| Total expenses                                                        |       | 25,736      |       | 77,463       |       | 7,468                  |       | (14,754                   | )          | 95,913           |       |
|                                                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Operating income (loss)                                               |       | 13,777      |       | 1,668        |       | (7,468                 | )          | —                    |       | 7,977            |       |
|                                                                  |       |        |       |         |       |                   |       |                      |       |             |       |
| Interest expense                                                      |       | (3,073      | )          | (978         | )          | (201                   | )          | —                    |       | (4,252           | )          |
| Interest income                                                       |       | 29          |       | 164          |       | 62                     |       | —                    |       | 255              |       |
| Other income (expense)                                                |       | (25         | )          | —       |       | 14                     |       | —                    |       | (11              | )          |
| Income (loss)  before income taxes and change in accounting principle |       | $      | 10,708     |         | $     | 854                    |       | $                    | (7,593     | )                | $     | — |   | $  | 3,969 |   |

 

*Seeaccompanying notes to the segment information following these tables.*

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----

**Notes**

(1)          Some companies in the Services Group provideconstruction, operations and maintenance services to companies in the UtilityGroup and recognize a profit on those services. In accordance with SFAS 71, the Company does not eliminate theintersegment profit recognized on these services because the Company believesthe sales price is reasonable and it is probable that, through the rate makingprocess, future Utility Group revenue approximately equal to the sales pricewill result from the regulated utilities’ use of the services.  The Company does, however, eliminate theServices Group’s revenues from affiliated customers to the extent of itscost.  Consequently, Services Grouprevenues reflected in the consolidated statements of income includeintersegment gross profits as follows:
|                             | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands)**     | ** ** | **2007**                         | ** ** | **2006**                       | ** ** | **2007** | ** ** | **2006** | ** ** |
| Services Group  revenues:   |       |                             |       |                           |       |   |   |   |   |
| From unaffiliated customers |       | $                                | 30,711     |                           | $          | 31,647 |   | $ | 57,232 |   | $ | 62,072 |   |
| Intersegment profits        |       | 710                              |       | 1,859                          |       | 2,229 |   | 3,055 |   |
| Total revenues              |       | 31,421                           |       | 33,506                         |       | 59,461 |   | 65,127 |   |
|                             |            |                                  |            |                                |            |  |  |  |  |  |  |  |  |

 

(2)   Consistsof costs that include headquarters expenses and any corporate functionaldepartments whose costs are not allocated to our reportable segments.  Corporate and other assets reflect corporateheadquarters assets, excluding investments in and receivables fromsubsidiaries.

(3)          Reflects the elimination of Services Grouprevenues derived from the Utility Group, to the extent of costs as described in(1) above.  In addition, a company in theUtility Group provides services to a company in the Services Group.  Intersegment revenues and expenses, includingall profit, associated with these services are fully eliminated uponconsolidation.

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

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

Management’s Discussionand Analysis of Financial Condition and Results of Operations (“MD&A”) isintended to help the reader understand the results of operations and financialcondition of Southwest Water Company. This MD&A also contains “forward-looking statements” within themeaning of the Private Securities Litigation Reform Act of 1995, Section 27A ofthe Securities Act of 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended.  Allstatements contained herein that are not clearly historical in nature areforward-looking, and the words “anticipate,” “believe,” “belief,” “expect,” “estimate,”“project,” “plan,” “intend,” “continue,” “predict,” “may,” “will,” “should, “strategy,”“will likely result,” “will likely continue,” and similar expressions aregenerally intended to identify forward-looking statements.  Forward-looking statements are subject torisks and uncertainties that could cause actual results to differ materiallyfrom our historical experience and our present expectations orprojections.  A detailed discussion ofthese and other risks and uncertainties that could cause actual results andevents to differ materially from such forward-looking statements is included inthe section entitled “Item 1A.  RiskFactors” in our 2006 Annual Report on Form 10-K.  Caution should be taken not to place unduereliance on any such forward-looking statements since such statements speakonly as of the date when made.  Otherthan as required by applicable law, we undertake no obligation to publiclyupdate or revise forward-looking statements whether as a result of newinformation, future events, or otherwise.

The MD&A is intendedto help the reader understand the results of operations, financial conditionand cash flows of Southwest Water Company and is provided as a supplement to,and should be read in conjunction with, our condensed consolidated financialstatements and the accompanying notes to the financial statements included inthis report.

### **OVERVIEW**

Southwest Water Companyprovides a broad range of services including water production, treatment anddistribution; wastewater collection and treatment; utility billing andcollection; utility infrastructure construction management; and public worksservices.  We own regulated publicutilities and also serve cities, utility districts and private companies undercontract.  Our subsidiaries are segmentedinto two operating groups: our Utility Group and our Services Group.

#### **Utility Group**

Our Utility Group ownspublic water and wastewater utilities in Alabama, California, New Mexico,Oklahoma and Texas and, beginning in February 2007, Mississippi.  Except for our California utility, ourutilities are operated by companies in our Services Group.  State and federal agencies issue regulationsregarding standards of water quality, safety, environmental and other matters whichaffect these operations.  The rates thatour regulated utility subsidiaries charge for water and wastewater usage areestablished by state or local authorities.

Utility Group revenuesreflect fees earned for the production and distribution of water and thecollection and treatment of sewage for residential, business, industrial andpublic authority use.  The group’soperating expenses reflect the costs associated with purchasing, producing anddistributing water, collecting and treating wastewater, salaries, wages andemployee benefits, facilities costs, supplies and equipment, repairs andmaintenance, professional fees and other costs.

We grow our Utility Groupby:

·                  increasingthe number of customers we serve;

·                  increasingthe rate customers pay for our services through rate case filings with stateregulatory commissions;

·                  creatingnew utilities by partnering with the development community in high growthmarkets; and

·                  acquiringutilities from cities, municipalities and private owners in high growthmarkets.

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In our pursuit oflong-term Utility Group growth, during 2006 we acquired two small waterutilities and the rights to provide water and wastewater utility service indeveloping areas located near Austin, Texas, in February 2007, we acquired asmall water and wastewater utility located in northern Mississippi, just southof Memphis, Tennessee and, in May 2007, acquired two water and wastewaterutilities near San Antonio, Texas.  Whilethese acquisitions are insignificant to our financial results, bothindividually and in the aggregate, they are strategically important as theyexpand our utility ownership in areas that are currently experiencingsignificant population growth.

In 2007, the AlbuquerqueBernalillo County Water Utility Authority and the City of Rio Rancho, NewMexico, filed a Petition for Condemnation (the “Petition”) against our NewMexico regulated utility, New Mexico Utilities, Inc. (“NMUI”).  The Petition seeks to acquire, bycondemnation, all of the assets of NMUI, including all real property, throughthe alleged power of eminent domain.  ThePetition also alleges that the Petitioners need to acquire the utility assetsfor the public purposes of providing water and wastewater services to  customers and that the acquisition of NMUI isnecessary, appropriate and in the public interest.  We believe we have defenses to the Actionwhich we intend to vigorously assert.  Ifwe do not prevail, the Petitioners must pay fair market value as determined bythe court, based on appraisals.  NMUI andthe Petitioners do not agree on the value of the assets which the Petitionersseek to condemn.  While it is too earlyto predict the outcome of this matter, we believe that the fair market value ofthe NMUI utility exceeds its recorded net book value as of June 30, 2007.

#### **Services Group**

Our Services Groupoperates our contract service businesses in which we operate and maintain waterand wastewater facilities owned by cities, public agencies, municipal utilitydistricts, private entities and investor-owned utilities, including most of ourown utilities.  Our Services Groupoperates primarily in Alabama, California, Colorado, Georgia, Mississippi, NewMexico and Texas.  While state andfederal agencies issue regulations regarding standards of water quality,safety, environmental and other matters which affect these operations, ourServices Group’s pricing is not subject to regulation.

Services Group revenuesreflect fees earned for water and wastewater facility operations andmaintenance services, equipment maintenance and repair, sewer pipeline cleaning,billing and collection services, public works and state-certified water andwastewater laboratory analysis.  OurServices Group also facilitates the design, construction, project managementand operating aspects of various water and wastewater projects.  The group’s operating expenses reflectsalaries, wages and employee benefits, facilities costs, supplies andequipment, repairs and maintenance, professional fees and other costs.  Most work performed by the Services Group is requiredto be performed by state licensed and certified technicians.

Some companies in ourServices Group provide construction, operations and maintenance services to ourUtility Group and recognize a profit on those services.  In accordance with SFAS No. 71, *Accounting for the Effects of Certain Types of Regulation* (“SFAS71”), we do not eliminate the Services Group’s profit because managementbelieves the sales price is reasonable and it is probable that, through therate making process, future Utility Group revenue approximately equal to thesales price will result from the regulated utilities’ use of the services.  We do, however, eliminate revenues to theextent of the related costs in the consolidated financial statements inaccordance with the guidance provided in SFAS 71.

We grow our ServicesGroup by:

·                  increasingthe number of clients we have contracts with;

·                  increasingthe customer base for our existing contracts;

·                  providingadditional services to clients to enhance the value of our contracts; and

·                  acquiringstrategically located, well-established service contract businesses in highgrowth markets.

The relationships webuild with our service contract clients can position us for additional growthwhen a client decides to sell their utility. Our 2006 acquisitions of small water and wastewater utilities areexamples of this growth strategy, as they were operated by our Services Groupprior to them being sold to us.

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

Selling, general andadministrative expenses consist of costs related to personnel, facilities,insurance, consulting and professional services, which support our sales,marketing, human resources, finance and administration functions for the entirecompany.

### **RESULTS OF OPERATIONS**

#### **Three Months Ended June 30, 2007 Compared to2006**

**Revenues.**  Revenues increased $0.7 million, or 1.3%, to$55.0 million for the three months ended June 30, 2007 from $54.3 million forthe same period during the prior year. By segment, revenues changed as follows:
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|-----------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                        | ** ** | **2006**     | ** ** | **(Decrease)**                    | ** ** | **2007** | ** ** | **2006** | ** ** |
| ** **                                            | ** ** | ** **                                      | ** ** | ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| Utility Group                                         |       | $                                               | 23,554     |         | $          | 20,790                            |       | $ | 2,764 |   | 42.8 | % | 38.3 | % |
| Services Group                                        |       | 31,421                                          |       | 33,506       |       | (2,085                            | )          | 57.2 | % | 61.7 | % |
| Total                                                 |       | $                                               | 54,975     |         | $          | 54,296                            |       | $ | 679 |   | 100.0 | % | 100.0 | % |

 

***Utility Group.***  Revenues increased $2.8 million, or 13.3%, to$23.6 million for the three months ended June 30, 2007, from $20.8 million forthe same period during the prior year. The increase was primarily due to the following:

·                  a$2.4 million increase at our California utility related to increasedconsumption and an increase in rates that went into effect on July 1st of 2006;and

·                  a$0.4 million increase at our Texas utilities primarily resulting from a smallAustin, Texas-area utility acquisition and a fourth quarter 2006 rate increaseat one of our other Texas utilities, partially offset by lower consumption dueto the wet weather in the region during the 2nd quarter of 2007.

***Services Group. ***Revenuesdecreased $2.1 million, or 6.2%, to $31.4 million for the three months endedJune 30, 2007 from $33.5 million for the same period during the prioryear.  The decrease in revenues wasprimarily due to the following:
| ** **                                            | ** ** | **Three Months Ended**June 30, | ** ** | ** ** | ** ** | **Percent of Revenues** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|-----------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                      | ** ** | **2006**   | ** ** | **Change**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
| Revenues from unaffiliated customers                  |       | $                                             | 30,711     |       | $          | 31,647                            |       | $ | (936 | ) | 83.1 | % | 76.8% |   |
| Intersegment revenues                                 |       | 6,264                                         |       | 9,571      |       | (3,307                            | )          | 16.9 | % | 23.2% |   |
| Total revenues                                        |       | 36,975                                        |       | 41,218     |       | (4,243                            | )          | 100.0 | % | 100.0% |   |
| Intersegment cost eliminations                        |       | (5,554                                        | )          | (7,712     | )          | 2,158                             |       |   |   |   |   |
| Total                                                 |       | $                                             | 31,421     |       | $          | 33,506                            |       | $ | (2,085 | ) |   |   |   |   |

 

Revenues fromunaffiliated customers decreased $0.9 million, or 3.0%, to $30.7 million forthe three months ended June 30, 2007 from $31.6 million for the same periodduring the prior year.  The decrease inrevenues was primarily due to the following:

·                  a$2.7 million decrease in contract operations, maintenance, public works andconstruction work in our southeast region due to contracts not renewed orcanceled; offset by

·                  a$1.8 million increase related to increased business activity combined with oursuccessful efforts to review our contracts and increase prices.

Intersegment revenuesreceived from our Utility Group decreased by $3.3 million, or 34.6%, to $6.3million for the three months ended June 30, 2007 from $9.6 million for the sameperiod during the prior year.  Thedecrease in revenues resulted from a decrease in construction projectsperformed for our New Mexico and Texas utilities due to a slow down in housingconstruction as well as a reduction in capital expenditures by our Texasutilities.

24

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**DirectOperating Expenses.**  Direct operating expenses increased$0.7 million, or 1.7%, to $40.1 million for the three months ended June 30, 2007from $39.5 million for the same period during the prior year as follows:
| ** **                                            | ** ** | **Three Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                      | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                          |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                             | 12,993     |         | $          | 10,506                                     |       | $ | 2,487 |   | 55.2% |   | 50.5 | % |
| Services Group                                        |       | 27,123                                        |       | 28,954       |       | (1,831                                     | )          | 86.3% |   | 86.4 | % |
| Total                                                 |       | $                                             | 40,116     |         | $          | 39,460                                     |       | $ | 656 |   | 73.0% |   | 72.7 | % |

 

----

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

***Utility Group.***  Direct operating expenses increased $2.5million, or 23.7%, to $13.0 million for the three months ended June 30, 2007,from $10.5 million for the same period during the prior year.  The increase in direct operating expenses wasprimarily due to the following:

·                  a$1.4 million increase resulting from the recognition of a balancing accountreceivable in 2006 by our California utility pursuant to a California PublicUtilities Commission (“CPUC”) decision which was recognized as a reduction ofoperating expenses;

·                  a$0.8 million net increase in direct operating expenses at our Californiautility principally resulting from higher water usage related to increased consumptionand higher depreciation rates adopted under the rate case that went into effecton July 1, 2006; and

·                  a$0.3 million increase in expenses at our New Mexico and Texas utilitiesresulting from a small Austin, Texas area utility acquisition, an increase indepreciation expense, an increase in contract operation fees, and higher sewagetreatment expenses.

Direct operating expenseswere 55.2% and 50.5% of related revenues for the three months ended June 30,2007 and 2006, respectively, primarily as a result of the recognition of abalancing account receivable in 2006 as mentioned above.  Excluding the balancing account, directoperating expenses as a percent of revenue were 57.3% for the three monthsended June 30, 2006.

***Services Group.***  Direct operating expenses decreased $1.8million, or 6.3%, to $27.1 million for the three months ended June 30, 2007from $29.0 million for the same period during the prior year.  The decrease in direct operating expenses wasdue to the following:

·      a $2.9 million decrease related tocontracts not renewed or canceled in our southeast region; offset by

·      a $1.1 million increase in direct costsassociated with increased business activity.

Direct operating expensesas a percentage of the related revenues decreased 0.1% to 86.3% for the threemonths ended June 30, 2007 compared to 86.4% for the same period during theprior year.

**GrossProfit.**  Gross profit, which we define as thedifference between revenues and the related direct operating expenses,increased $0.1 million, or 0.2%, to $14.9 million for the three months endedJune 30, 2007 from $14.8 million for the same period during the prior year asfollows:
| ** **                                            | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|-------------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                        | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                            |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                               | 10,561     |         | $          | 10,284                                     |       | $ | 277 |   | 44.8 | % | 49.5 | % |
| Services Group                                        |       | 4,298                                           |       | 4,552        |       | (254                                       | )          | 13.7 | % | 13.6 | % |
| Total                                                 |       | $                                               | 14,859     |         | $          | 14,836                                     |       | $ | 23 |   | 27.0 | % | 27.3 | % |

 

----

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

25

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***Utility Group.***  Gross profit was 44.8% and 49.5% of relatedrevenues for the three months ended June 30, 2007 and 2006, respectively,primarily related to the recognition of a balancing account receivable in 2006as mentioned above.  Excluding thebalancing account, gross profit as a percent of revenue was 42.7% for the threemonths ended June 30, 2006.

***Services Group.**** *Gross profit for the three monthsended June 30, 2007 and 2006 was comprised of the following:
| ** **                                      | ** ** | **Three Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------|------------|-----------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In**thousands, except percentages) | ** ** | **2007**                                      | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                            |       |                                          |       |         |       |                                       |       |   |   |   |   |
| Gross profit on sales to:                       |       |                                          |       |         |       |                                       |       |   |   |   |   |
| Unaffiliated customers                          |       | $                                             | 3,588      |         | $          | 2,693                                      |       | $ | 895 |   | 11.7 | % | 8.5 | % |
| Affiliated customers (intersegment)             |       | 710                                           |       | 1,859        |       | (1,149                                     | )          | 11.3 | % | 19.4 | % |
| Total                                           |       | $                                             | 4,298      |         | $          | 4,552                                      |       | $ | (254 | ) | 11.6 | % | 11.0 | % |

 

----

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

Services Group grossprofit on revenues from unaffiliated customers increased by $0.9 million, or33.2%, to $3.6 million for the three months ended June 30, 2007 from $2.7million for the same period during the prior year.  Gross profit as a percent of revenues for2007 was 11.7%, compared to 8.5% for 2006. The increase in gross margin percent is primarily related to ongoingefforts to increase prices on our existing contracts.

Services Group grossprofit on revenues from our Utility Group decreased by $1.1 million, or 61.8%to $0.7 million for the three months ended June 30, 2007 from $1.9 million forthe same period during the prior year. The decrease is related to a reduction in construction projects for ourTexas and New Mexico utilities.

***Selling, General and Administrative Expenses.***  Selling, general and administrative expensesincreased $0.1 million, or 1.1%, to $9.3 million for the three monthsended June 30, 2007 compared to $9.2 million for the same period during theprior year as follows:
| ** **                                            | ** ** | **Three Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|-----------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                      | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
| Utility Group                                         |       | $                                             | 1,928      |         | $          | 1,837                                      |       | $ | 91 |   | 8.2 | % | 8.8 | % |
| Services Group                                        |       | 3,554                                         |       | 3,280        |       | 274                                        |       | 11.3 | % | 9.8 | % |
| Corporate                                             |       | 3,830                                         |       | 4,091        |       | (261                                       | )          | — |   | — |   |
| Total                                                 |       | $                                             | 9,312      |         | $          | 9,208                                      |       | $ | 104 |   | 16.9 | % | 17.0 | % |

 

----

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

Selling, general andadministrative expenses are relatively fixed in nature and do not fluctuatesignificantly with changes in revenues. The Utility Group increase is primarily caused by legal costs incurredin connection with the condemnation proceedings against our New Mexicoutility.  In accordance with New Mexicostatute, costs incurred during the quarter aggregating $0.2 million ($0.4million incurred to date) are expected to be reimbursed to us by the partiesseeking condemnation should we prevail in the action.  The Services Group expense increase resultedfrom higher salary, wages and related benefits attributable to upgrades inmanagement and staff positions.  TheCorporate decrease is a result of $0.7 million of CEO relocation expensesincurred in 2006, offset by $0.4 million of costs related to our Cornerstoneproject incurred during the second quarter of 2007.

The Cornerstone projectis a company-wide initiative to reengineer our business processes and integrateour information systems onto a single platform across the entire companyutilizing state-of-the-art systems and technology.  Our existing systems are inefficient because,for the most part, they are standalone legacy systems that were in place whenwe acquired many of our companies.  Theseindividual standalone systems are costly to operate and maintain and make theconsolidation and sharing of data between the various platforms labor intensiveand time-consuming.

26

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We are investing in thisnew technology to enable us to gather and disseminate information on a moretimely basis at reduced costs thereby improving customer service and enhancingoperational efficiencies.  Althoughexpenditures related to portions of this initiative will be capitalized,certain costs will be expensed as incurred.

***Impairment of Goodwill.***  During the three months ended June 30, 2006,we recorded impairment charges totaling $0.7 million, primarily related to ourwater and wastewater testing laboratory.

**OtherIncome (Expense).** Other expense was $2.1 million for the three months ended June 30, 2007and for the same period during the prior year as follows:
| ** **              | ** ** | **Three Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|-------------------------|------------|-------------------------------------------------|------------|--------------|------------|
| **(In thousands)** | ** ** | **2007**                                        | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** |
|                    |       |                                            |       |         |       |   |   |
| Interest expense        |       | $                                               | (2,124     | )            | $          | (2,121 | ) | $ | (3 | ) |
| Interest income         |       | 76                                              |       | 174          |       | (98 | ) |
| Other, net              |       | (12                                             | )          | (150         | )          | 138 |   |
| Total                   |       | $                                               | (2,060     | )            | $          | (2,097 | ) | $ | 37 |   |

 

***Interest Expense.***  Interest expense was $2.1 million for thethree months ended June 30, 2007 and 2006. The major components of interest expense were as follows:
| ** **                          | ** ** | **Three Months Ended  June 30,** | ** ** | ** ** | ** ** |
|-------------------------------------|------------|-------------------------------------------------|------------|------------|------------|
| **(In thousands)**             | ** ** | **2007**                                        | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                |       |                                            |       |       |       |   |   |
| Mortgage bonds and bank term loans  |       | $                                               | 1,193      |       | $          | 1,202 |   | $ | (9 | ) |
| Revolving lines of credit           |       | 789                                             |       | 607        |       | 182 |   |
| Convertible subordinated debentures |       | 214                                             |       | 227        |       | (13 | ) |
| Other indebtedness                  |       | 151                                             |       | 216        |       | (65 | ) |
| Total interest incurred             |       | 2,347                                           |       | 2,252      |       | 95 |   |
| Less capitalized interest           |       | (223                                            | )          | (131       | )          | (92 | ) |
| Total interest expense              |       | $                                               | 2,124      |       | $          | 2,121 |   | $ | 3 |   |

 

The change in totalinterest incurred is primarily due to an increase in borrowing levels on ourrevolving line of credit, offset by reduced borrowings related to our otherindebtedness as well as higher levels of capitalized interest.  The average balance of interest bearing debtoutstanding increased to $141.2 million during the three months ended June 30,2007 compared to $132.0 million for the prior year.  The additional borrowings were used to fundcapital expenditures and acquisitions. The weighted average interest rate on total borrowings was approximately6.0% for the three months ended June 30, 2007 and 6.4% for the same period lastyear.

**Provisionfor Income Taxes.**  Oureffective consolidated income tax rate was 36.2% for the three months endedJune 30, 2007 and is comparable to 36.6% for the prior year.

#### **Six Months Ended June 30, 2007 Compared to2006**

**Revenues.**  Revenues decreased $0.9 million, or 0.8%, to$103.0 million for six months ended June 30, 2007 from $103.9 million for thesame period during the prior year.  Bysegment, revenues changed as follows:
| ** **                                      | ** ** | **Six Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
|-------------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|-----------------------------------|------------|
| **(Inthousands, except percentages)** | ** ** | **2007**                                    | ** ** | **2006**     | ** ** | **(Decrease)**                    | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                            |       |                                        |       |         |       |                              |       |   |   |   |   |
| Utility Group                                   |       | $                                           | 43,588     |         | $          | 38,763                            |       | $ | 4,825 |   | 42.3 | % | 37.3 | % |
| Services Group                                  |       | 59,461                                      |       | 65,127       |       | (5,666                            | )          | 57.7 | % | 62.7 | % |
| Total                                           |       | $                                           | 103,049    |         | $          | 103,890                           |       | $ | (841 | ) | 100.0 | % | 100.0 | % |

 

***Utility Group.***  Revenues increased $4.8 million, or 12.4%, to$43.6 million for the six months ended June 30, 2007, from $38.8 million forthe same period during the prior year. The increase was primarily due to the following:

27

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·                  a$4.2 million increase at our California utility related to increasedconsumption and an increase in rates that went into effect on July 1st of 2006;and

·                  a$0.6 million increase at our Texas utilities primarily resulting from a smallAustin, Texas area utility acquisition and a fourth quarter 2006 rate increaseat one of our Texas utilities.

***Services Group. ***Revenuesdecreased $5.7 million, or 8.7%, to $59.5 million for the six months ended June30, 2007 from $65.1 million for the same period during the prior year.  The decrease in revenues was primarily due tothe following:
| ** **                                            | ** ** | **Six Months Ended**June 30, | ** ** | ** ** | ** ** | **Percent of Revenues** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|------------|------------|-----------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                    | ** ** | **2006**   | ** ** | **Change**                        | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                        |       |       |       |                              |       |   |   |   |   |
| Revenues from unaffiliated customers                  |       | $                                           | 57,232     |       | $          | 62,072                            |       | $ | (4,840 | ) | 80.9 | % | 78.4 | % |
| Intersegment revenues                                 |       | 13,484                                      |       | 17,059     |       | (3,575                            | )          | 19.1 | % | 21.6 | % |
| Total revenues                                        |       | 70,716                                      |       | 79,131     |       | (8,415                            | )          | 100.0 | % | 100.0 | % |
| Intersegment cost eliminations                        |       | (11,255                                     | )          | (14,004    | )          | 2,749                             |       |   |   |   |   |
| Total                                                 |       | $                                           | 59,461     |       | $          | 65,127                            |       | $ | (5,666 | ) |   |   |   |   |

 

Revenues fromunaffiliated customers decreased $4.8 million, or 7.8%, to $57.2 million forthe six months ended June 30, 2007 from $62.1 million for the same periodduring the prior year.  The decrease inrevenues was primarily due to the following:

·                  a$5.3 million decrease in contract operations, maintenance, public works andconstruction work in our southeast region due to contracts not renewed orcanceled; and

·                  a$1.3 million decrease related to lower revenues from new housing constructiondue to a slowdown in housing starts as well as inclement weather compared tothe prior year; offset by

·                  a$1.8 million increase related to increased business activity combined with ourongoing efforts to review our contracts and increase prices.

Intersegment revenuesreceived from our Utility Group decreased by $3.6 million, or 21.0%, to $13.5million for the six months ended June 30, 2007 from $17.1 million for the sameperiod during the prior year.  Thedecrease in revenues resulted from a decrease in construction projectsperformed for our New Mexico and Texas utilities due to a slow down in housingconstruction as well as a reduction in capital expenditures by our Texasutilities.

**DirectOperating Expenses.**  Direct operating expenses decreased$0.9 million, or 1.2%, to $76.7 million for the six months ended June 30, 2007from $77.7 million for the same period during the prior year as follows:
| ** **                                            | ** ** | **Six Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                    | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                        |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                           | 24,589     |         | $          | 20,903                                     |       | $ | 3,686 |   | 56.4 | % | 53.9 | % |
| Services Group                                        |       | 52,125                                      |       | 56,749       |       | (4,624                                     | )          | 87.7 | % | 87.1 | % |
| Total                                                 |       | $                                           | 76,714     |         | $          | 77,652                                     |       | $ | (938 | ) | 74.4 | % | 74.7 | % |

 

----

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

***Utility Group.***  Direct operating expenses increased $3.7million, or 17.6%, to $24.6 million for the six months ended June 30, 2007,from $20.9 million for the same period during the prior year.  The increase in direct operating expenses wasprimarily due to the following:

·                  a$1.4 million increase resulting from the recognition of a balancing accountreceivable in 2006 by our California utility pursuant to a CPUC decision whichwas recognized as a reduction of operating expenses; and

·                  a$1.1 million net increase in direct operating expenses at our Californiautility principally resulting from higher water usage related to increasedconsumption and higher depreciation rates adopted under the rate case that wentinto effect on July 1, 2006, and

28

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·                  a$1.2 million increase in expenses at our New Mexico and Texas utilitiesresulting from a small Austin, Texas area utility acquisition, an increase indepreciation expense, an increase in contract operation fees, and higher sewagetreatment expenses.

Direct operating expenseswere 56.4% and 53.9% of related revenues for the six months ended June 30, 2007and 2006, respectively, primarily as a result of the recognition of a balancingaccount receivable in 2006 as mentioned above. Excluding the balancing account, direct operating expenses as a percentof revenue were 57.5% for the six months ended June 30, 2006.

***Services Group.***  Direct operating expenses decreased $4.6million, or 8.1%, to $52.1 million for the six months ended June 30, 2007 from$56.7 million for the same period during the prior year.  The decrease in direct operating expenses wasdue to the following:

·      a $4.9 million decrease related tocontracts not renewed or canceled in our southeast region net of cost increasesto correct past performance issues; and

·      a $0.9 million decrease primarily relatedto lower revenues from new housing construction-related work compared to theprior year due to inclement weather; partially offset by

·      a $1.1 million increase in direct costs associatedwith increased business activity.

Direct operating expensesas a percentage of the related revenues increased 0.6% to 87.7% for the sixmonths ended June 30, 2007 compared to 87.1% for the same period during theprior year.

**GrossProfit.**  Gross profit, which we define as thedifference between revenues and the related direct operating expenses,increased $0.1 million, or 0.4%, to $26.3 million for the six months ended June30, 2007 from $26.2 million for the same period during the prior year as follows:
| ** **                                            | ** ** | **Six Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                    | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                        |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                           | 18,999     |         | $          | 17,860                                     |       | $ | 1,139 |   | 43.6 | % | 46.1 | % |
| Services Group                                        |       | 7,336                                       |       | 8,378        |       | (1,042                                     | )          | 12.3 | % | 12.9 | % |
| Total                                                 |       | $                                           | 26,335     |         | $          | 26,238                                     |       | $ | 97 |   | 25.6 | % | 25.3 | % |

 

----

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

***Utility Group.***  Gross profit was 43.6% and 46.1% of relatedrevenues for the six months ended June 30, 2007 and 2006, respectively,primarily related to the recognition of a balancing account receivable in 2006as mentioned above.  Excluding thebalancing account, gross profit as a percent of revenue was 42.5% for the sixmonths ended June 30, 2006.

***Services Group.**** *Gross profit for the six monthsended June 30, 2007 and 2006 was comprised of the following:
| ** **                                            | ** ** | **Six Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                    | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                        |       |         |       |                                       |       |   |   |   |   |
| Gross profit on sales to:                             |       |                                        |       |         |       |                                       |       |   |   |   |   |
| Unaffiliated customers                                |       | $                                           | 5,107      |         | $          | 5,323                                      |       | $ | (216 | ) | 8.9 | % | 8.6 | % |
| Affiliated customers (intersegment)                   |       | 2,229                                       |       | 3,055        |       | (826                                       | )          | 16.5 | % | 17.9 | % |
| Total                                                 |       | $                                           | 7,336      |         | $          | 8,378                                      |       | $ | (1,042 | ) | 10.4 | % | 10.6 | % |

 

----

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

Services Group grossprofit on revenues from unaffiliated customers decreased by $0.2 million, or4.1%, to $5.1 million for the six months ended June 30, 2007 from $5.3 millionfor the same period during the prior year. Gross profit as a percent of revenues for 2007 was 8.9%, compared to8.6% for 2006.  The increase in grossmargin percent is primarily related to our ongoing effort to review contractsand increase prices as allowed under existing contracts or when renewingcontracts.

29

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Services Group grossprofit on revenues from our Utility Group decreased by $0.8 million, or 27.0%to $2.2 million for the six months ended June 30, 2007 from $3.1 million forthe same period during the prior year. The decrease is related to the reduction in construction work for ourTexas and New Mexico utility operations.

***Selling, General and Administrative Expenses.***  Selling, general and administrative expensesincreased $0.2 million, or 1.4%, to $17.8 million for the six months endedJune 30, 2007 compared to $17.6 million for the same period during the prioryear as follows:
| ** **                                            | ** ** | **Six Months Ended**June 30, | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
|-------------------------------------------------------|------------|---------------------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| **(In thousands, except percentages)** | ** ** | **2007**                                    | ** ** | **2006**     | ** ** | **(Decrease)**                             | ** ** | **2007** | ** ** | **2006** | ** ** |
|                                                  |       |                                        |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                           | 4,389      |         | $          | 4,083                                      |       | $ | 306 |   | 10.1 | % | 10.5 | % |
| Services Group                                        |       | 6,249                                       |       | 6,042        |       | 207                                        |       | 10.5 | % | 9.3 | % |
| Corporate                                             |       | 7,207                                       |       | 7,468        |       | (261                                       | )          | — |   | — |   |
| Total                                                 |       | $                                           | 17,845     |         | $          | 17,593                                     |       | $ | 252 |   | 17.3 | % | 16.9 | % |

 

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

Selling, general andadministrative expenses are relatively fixed in nature and do not fluctuatesignificantly with changes in revenues. The Utility Group increase is caused primarily by legal costs incurredin connection with the condemnation proceedings against our New Mexicoutility.  In accordance with New Mexicostatute, costs incurred aggregating $0.4 million through June 30, 2007 areexpected to be reimbursed to us by the parties seeking condemnation should weprevail in the action.  The ServicesGroup expense increase resulted from higher salary, wages and related benefitsattributable to upgrades in management and staff positions.  Corporate expenses decreased as result of$0.7 million of CEO relocation expenses incurred in 2006, offset by $0.4million of costs incurred related to our Cornerstone project which commenced in2007.

The Cornerstone projectis a company-wide initiative to reengineer our business processes and integrateour information systems onto a single platform across the entire companyutilizing state-of-the-art systems and technology.  Our existing systems are inefficient because,for the most part, they are standalone legacy systems that were in place whenwe acquired many of our companies.  Theseindividual standalone systems are costly to operate and maintain and make theconsolidation and sharing of data between the various platforms labor intensiveand time-consuming.

We are investing in thisnew technology to enable us to gather and disseminate information on a moretimely basis at reduced costs thereby improving customer service and enhancingoperational efficiencies.  Althoughexpenditures related to portions of this initiative will be capitalized,certain costs will be expensed as incurred.

***Impairment of Goodwill.***  During the six months ended June 30, 2006, werecorded impairment charges totaling $0.7 million, primarily related to ourwater and wastewater testing laboratory.

**OtherIncome (Expense).** Other expenses were $4.0 million for the six months ended June 30, 2007and 2006 as follows:
| ** **              | ** ** | **Six Months Ended  June 30,** | ** ** | **Increase** | ** ** |
|-------------------------|------------|-----------------------------------------------|------------|--------------|------------|
| **(In thousands)** | ** ** | **2007**                                      | ** ** | **2006**     | ** ** | **(Decrease)** | ** ** |
|                    |       |                                          |       |         |       |   |   |
| Interest expense        |       | $                                             | (4,194     | )            | $          | (4,252 | ) | $ | 58 |   |
| Interest income         |       | 216                                           |       | 255          |       | (39 | ) |
| Other, net              |       | (61                                           | )          | (11          | )          | (50 | ) |
| Total                   |       | $                                             | (4,039     | )            | $          | (4,008 | ) | $ | (31 | ) |

 

***Interest Expense.***  Interest expense decreased $0.1 million, or1.4%, for the six months ended June 30, 2007 compared to the same period duringthe prior year.  The major components ofinterest expense were as follows:

30

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| ** **                           | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** |
|--------------------------------------|------------|-----------------------------------------------|------------|------------|------------|
| **(In thousands)**              | ** ** | **2007**                                      | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                 |       |                                          |       |       |       |   |   |
| Mortgage bonds and bank  term loans  |       | $                                             | 2,383      |       | $          | 2,433 |   | $ | (50 | ) |
| Revolving lines of  credit           |       | 1,449                                         |       | 1,129      |       | 320 |   |
| Convertible  subordinated debentures |       | 428                                           |       | 506        |       | (78 | ) |
| Other indebtedness                   |       | 349                                           |       | 407        |       | (58 | ) |
| Total interest incurred              |       | 4,609                                         |       | 4,475      |       | 134 |   |
| Less capitalized  interest           |       | (415                                          | )          | (223       | )          | (192 | ) |
| Total interest expense               |       | $                                             | 4,194      |       | $          | 4,252 |   | $ | (58 | ) |

 

The increase in totalinterest incurred is primarily due to an increase in borrowing levels on ourrevolving line of credit, offset by a decrease in borrowing levels related toour other indebtedness as well as higher levels of capitalized interest.  The average balance of interest bearing debtoutstanding increased to $137.5 million during the six months ended June 30,2007 compared to $130.4 million for the prior year.  The additional borrowings were used to fundcapital expenditures and acquisitions. The weighted average interest rate on total borrowings was approximately6.1% for the six months ended June 30, 2007 and 6.5% for the same period in theprior year.

**Provisionfor Income Taxes.**  Oureffective consolidated income tax rate was 36.3% for the six months ended June30, 2007 and is comparable to 36.6% for the prior year.

### **NEW ACCOUNTING GUIDANCE AND PRONOUNCEMENTSADOPTED DURING 2007**

#### **SFAS No. 158**

In September 2006, theFinancial Accounting Standards Board (“FASB”) issued SFAS No. 158, *Employers’ Accounting for Defined Benefit Pension and OtherPostretirement Plans – an amendment of FASB Statements No. 87, 88, 106, and132(R)* (“SFAS 158”).  Thisstatement requires balance sheet recognition of the funded status of pensionand postretirement benefit plans.  UnderSFAS 158, actuarial gains and losses, prior service costs or credits, and anyremaining transition assets or obligations that have not been recognized underprevious accounting standards must be recognized in accumulated othercomprehensive income (loss), net of tax effects, until they are amortized as acomponent of net periodic benefit cost. The balance sheet recognition provisions of SFAS 158 were effective forour fiscal year ended December 31, 2006 and, as a result, we began recognizingthe unamortized portion of actuarial gains and prior service costs inaccumulated other comprehensive income. The adoption of SFAS 158 did not have a material effect on ourconsolidated financial statements.

#### **FIN No. 48**

On January 1, 2007, weadopted the provisions of FASB Interpretation No. 48, *Accountingfor Uncertainty in Income Taxes* (“FIN 48”).  This interpretation clarifies the accountingfor uncertainty in income taxes recognized in a company’s financial statementsin accordance with SFAS No. 109, *Accounting for IncomeTaxes*(“SFAS 109”). FIN 48 requires companies to recognize the financial statementbenefit of a tax position only after determining the relevant tax authoritywould “more likely than not” sustain the position following an examination bytaxing authorities.  For tax positionsmeeting the more-likely-than-not threshold, the amount recognized in thefinancial statements is the largest benefit that has a greater than 50%likelihood of being realized upon settlement with the relevant taxingauthority.

We adopted the provisionsof FIN No. 48 on January 1, 2007.  OnDecember 31, 2006 and June 30, 2007, our liabilities for uncertain taxpositions are not significant.  Ourpolicy is to recognize interest and penalties related to liabilities foruncertain tax benefits in the income tax expense line-item of the consolidatedstatements of income.  Net interest andpenalties incurred during the three months and six months ended June 30, 2007and 2006 were insignificant.

We are subject to federaland various state and local income taxes. Tax regulations within each jurisdiction are subject to theinterpretation of related tax laws and regulations and require significantjudgment to apply.  We are no 

31

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longer subject tofederal, state and local income tax return examinations by taxing authoritiesfor years before 2002.  Our federalincome tax returns for the 2002 through 2004 tax years were recently examinedby the Internal Revenue Service.  Theexamination was concluded in February 2007 and resulted in no net change forthe tax years examined.  State and local incometax returns from 2002 to the present and federal income tax returns from 2005to the present are still subject to examinations by taxing authorities.

### **RECENT ACCOUNTING PRONOUNCEMENTS**

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

In September 2006, theFASB issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”).  This statement establishesa single authoritative definition of fair value, sets out framework forestablishing fair value, and requires additional disclosures about fair valuemeasurements.  This statement appliesonly to fair value measurements that are already required or permitted by otheraccounting standards and is expected to increase the consistency of thosemeasurements.  Adoption of SFAS 157 isrequired for our fiscal year beginning January 1, 2008, and will be appliedprospectively under most circumstances. While we are still evaluating the impact this statement will have on ourconsolidated financial statements, we currently believe the impact will not bematerial.

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

In February 2007, theFASB issued SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities – Including an amendment of FASBStatement No. 115* (“SFAS 159”). This statement permits companies to choose to measure many financialinstruments and other specified items at fair value.  This statement is effective for our fiscalyear beginning January 1, 2008 and will be applied prospectively.  While we are still evaluating the impact thisstatement will have on our consolidated financial statements, we currentlybelieve the impact will not be material.

### **LIQUIDITY AND CAPITAL RESOURCES**

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

·                  generatesufficient operating cash flows to service our debt and tax obligations, fundcapital improvements and organic growth, and pay dividends to our stockholders;

·                  utilizeour credit facility for major capital improvements and to manage seasonal cashneeds;

·                  obtainexternal financing for major acquisitions; and

·                  maintainapproximately equal levels of debt and equity consistent with theinvestor-owned water utility industry.

Our statements of cashflows are summarized as follows:
| ** **                            | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** |
|---------------------------------------|------------|-----------------------------------------------|------------|------------|------------|
| **(In thousands)**               | ** ** | **2007**                                      | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                  |       |                                          |       |       |       |   |   |
| Net cash provided by (used in):       |       |                                          |       |       |       |   |   |
| Operating activities                  |       | $                                             | 7,397      |       | $          | 9,647 |   | $ | (2,250 | ) |
| Investing activities                  |       | (25,371                                       | )          | (20,077    | )          | (5,294 | ) |
| Financing activities                  |       | 16,572                                        |       | 11,463     |       | 5,109 |   |
| Decrease in cash and cash equivalents |       | $                                             | (1,402     | )          | $          | 1,033 |   | $ | (2,435 | ) |

 

**CashFlows From Operating Activities.**  Net cash provided by operating activitiesdecreased by $2.3 million during the six months ended June 30, 2007 compared tothe same period during the prior year. Operational aspects of our businesses that affected working capital in2007 versus 2006 are highlighted below:

·                  increasedlevel of vendor payments in 2007 for goods and services used during the fourthquarter of 2006; offset by

·                  increasedrevenues generated by our California and Texas utilities resulting from rateincreases.

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**CashFlows From Investing Activities.**  Cash used in investing activities totaled$25.4 million for the six months ended June 30, 2007 compared to $20.1 millionfor the same period during the prior year as follows:
| ** **                                              | ** ** | **Six Months Ended  June 30,** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|-----------------------------------------------|------------|------------|------------|
| **(In thousands)**                                 | ** ** | **2007**                                      | ** ** | **2006**   | ** ** | **Change** | ** ** |
|                                                    |       |                                          |       |       |       |   |   |
| Cash flows (used in) provided by investing  activities: |       |                                          |       |       |       |   |   |
| Additions to property, plant and equipment              |       | $                                             | (18,865    | )          | $          | (18,245 | ) | $ | (620 | ) |
| Acquisition of businesses, net of cash acquired         |       | (6,547                                        | )          | (1,247     | )          | (5,300 | ) |
| Purchase of minority interest                           |       | —                                        |       | (1,012     | )          | 1,012 |   |
| Proceeds from sales of land                             |       | 41                                            |       | 427        |       | (386 | ) |
| Net cash used in investing activities                   |       | $                                             | (25,371    | )          | $          | (20,077 | ) | $ | (5,294 | ) |

The following tablesummarizes additions to property, plant and equipment additions for 2007 and2006.
| ** **                                             | ** ** | **Six Months Ended  June 30,** | *** *** |
|--------------------------------------------------------|------------|-----------------------------------------------|--------------|
| **(In thousands)**                                | ** ** | **2007**                                      | ** **   | **2006** | ** ** |
|                                                   |       |                                          |         |   |   |
| Company-financed additions                             |       | $                                             | 16,681       |   | $ | 15,588 |   |
| Capital improvement reimbursements                     |       | 1,628                                         |         | 1,346 |   |
| Cash contributions received in aid of construction     |       | 556                                           |         | 1,311 |   |
| Total cash additions to property, plant and  equipment |       | 18,865                                        |         | 18,245 |   |
| Non-cash contributions in aid of construction          |       | 3,153                                         |         | 4,113 |   |
| Total additions to property, plant and equipment       |       | $                                             | 22,018       |   | $ | 22,358 |   |

 

Capital projectsprimarily relate to the expansion, replacement and renovation of our water andwastewater systems, particularly at our California, Texas and New Mexicoutilities and, in 2007, include $2.4 million of expenditures related to theCornerstone project.  Contributions inAid of Construction (“CIAC”) represent contributions in the form of cash,services or property received from developers, governmental agencies,municipalities or individuals for the purpose of constructing utility plant andis not refundable.  In 2007, we expect tospend approximately $29.0 million on cash additions, principally within ourUtility Group, and expect to receive $7.0 million of CIAC resulting in totalexpected additions to property, plant and equipment of approximately $36.0million.

In March 2006, weacquired the remaining 10% interest in Operations Technology, Inc. that we didnot already own for $1.0 million in cash. We also made substantial investments in acquisitions during 2007 and2006 and expect we will continue to do so in the future.

**CashFlows From Financing Activities.**  During the first six months of 2007, wefinanced our growth through a broad range of capital initiatives:

·                  borrowed$16.0 million under our revolving line of credit;

·                  received$2.2 million of proceeds from our direct stock purchase plan, our employeestock purchase and option plans and our director option plan; and

·                  received$2.2 million of capital improvement reimbursements and contributions in aid ofconstruction.

Revolving line ofborrowings were primarily used to fund our investing activities and, to alesser extent, to fund operations. Additional borrowing availability under our revolving credit facilitywas $47.3 million as of June 30, 2007.

During the six monthsended June 30, 2007, we paid dividends totaling $2.8 million and our quarterlydividend rate is currently $0.0576 per common share.

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### **CONTRACTUAL OBLIGATIONS**

The following table summarizesour known contractual obligations to make future cash payments as of June 30,2007, as well as an estimate of the periods during which these payments areexpected to be made.
| ** **                                 | ** ** | **Years Ending December 31,** | ** ** |
|--------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                 | ** ** | ** **                                   | ** ** | **Remainder** | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** |
| ** **                                 | ** ** | ** **                                   | ** ** | **of** | ** ** | **and** | ** ** | **and** | ** ** | **and** | ** ** |
| **(In thousands)**                    | ** ** | **Total**                                    | ** ** | **2007** | ** ** | **2009** | ** ** | **2011** | ** ** | **Beyond** | ** ** |
|                                       |       |                                         |       |   |   |   |   |   |   |   |   |
| Long-term debt (1):                        |       |                                         |       |   |   |   |   |   |   |   |   |
| Bank line of credit (2)                    |       | $                                            | 52,000     |   | $ | — |   | $ | — |   | $ | 52,000 |   | $ | — |   |
| Mortgage bonds (3)                         |       | 45,000                                       |       | — |   | — |   | — |   | 45,000 |   |
| Bank term loans (4)                        |       | 32,207                                       |       | 411 |   | 1,645 |   | 1,646 |   | 28,505 |   |
| Convertible subordinated debentures (5)    |       | 12,237                                       |       | — |   | — |   | — |   | 12,237 |   |
| Economic development revenue bonds (6)     |       | 2,030                                        |       | 105 |   | 235 |   | 260 |   | 1,430 |   |
| Notes payable and other (7)                |       | 834                                          |       | 252 |   | 582 |   | — |   | — |   |
| Total long-term debt                       |       | 144,308                                      |       | 768 |   | 2,462 |   | 53,906 |   | 87,172 |   |
| Repayment of advances for construction (8) |       | 9,130                                        |       | 671 |   | 1,540 |   | 928 |   | 5,991 |   |
| Water purchase commitment (9)              |       | 7,857                                        |       | 230 |   | 920 |   | 920 |   | 5,787 |   |
| Lease assignment obligations (10)          |       | 1,131                                        |       | 94 |   | 1,037 |   | — |   | — |   |
| Operating lease obligations                |       | 26,667                                       |       | 3,155 |   | 7,593 |   | 4,692 |   | 11,227 |   |
| Total obligations as of June 30, 2007 (11) |       | $                                            | 189,093    |   | $ | 4,918 |   | $ | 13,552 |   | $ | 60,446 |   | $ | 110,177 |   |

 

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(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 tothe consolidated financial statements included in this report and our 2006Annual Report on Form 10-K.

(2)          The bank lines of credit bearinterest at variable rates and therefore the amount of future interest paymentsare uncertain.  Borrowings bear interest,at our option, based on a margin either: a) over the LIBOR rate; or b) underthe prime rate.  The margins vary basedon our consolidated debt to equity ratio. The weighted-average interest rate on our bank line of credit borrowingswas 6.23% as of June 30, 2007.

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

(4)          Interest on the bank termloans is fixed at a weighted-average annual interest rate of 6.54% and ispayable semiannually.

(5)          Interest on the convertibledebentures is fixed at a 6.85% annual rate and is payable quarterly.  The debentures are convertible, at the optionof the holder, into shares of our common stock at any time prior to theirmaturity.

(6)          Interest on the economicdevelopment bonds is fixed at a weighted-average annual interest rate of 5.95%and is payable semiannually.

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

(8)          Advances for construction arenon-interest bearing.

(9)          Reflects the minimum annualcontractual commitment to purchase water through 2024.  The amount is subject to increases in futureperiods for production costs increases and may also increase, but not decrease,if average actual usage exceeds a specified amount.

(10)    Interest on the leaseassignment obligations is fixed at a weighted-average interest rate of 8.39%and is payable monthly.

(11)    Excludes preferred stockdividend obligations.  Preferredstockholders are entitled to receive annual dividends of $2.625 per share andthere are 9,155 shares of preferred stock outstanding as of June 30, 2007.  The preferred stock is redeemable by theCompany at any time for $52.00 per share and, from time to time, we haveelected to repurchase shares offered to us by preferred stockholders at pricesless than $52.00 per share.

### **FINANCIAL CONDITION AND LIQUIDITY**

As of June 30, 2007, wehad $13.7 million of working capital and $3.4 million of operating lease andwater purchase obligations payable during the remainder of 2007.  As of June 30, 2007, we also had $47.3million of additional borrowings available under our line of credit facility,which expires on April 1, 2010.  Inaddition to our line of credit, our California and New Mexico mortgage bondindentures permit the issuance of an additional $87.5 million of first mortgagebonds as of June 30, 2007.  However,the terms of our credit facility do not permit additional first mortgage bondindebtedness without prior consent from the credit facility lenders.  The mortgage bond indentures also limit theamount of cash and property dividends our California and New Mexico utilitiesmay pay to the parent company to fund its payment obligations.  Dividends have averaged $4.0 to $5.0 millionper year and are less than the aggregate cumulative dividend restrictionthreshold by $47.8 million as of June 30, 2007. We were in compliance with all loan agreement covenants during the sixmonths ended June 30, 2007.

34

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We also have on file aregistration statement with the Securities and Exchange Commission, which iseffective for the issuance of up to $50.0 million aggregate principal amount ofcommon stock, debt securities and warrants. To date we have issued approximately $43.6 million of common stock underthe shelf registration, and about $6.4 million remains available for issuanceas of June 30, 2007.  We may offer any ofthese securities for sale at any time and from time to time.

We believe that ourexpected operating cash flows, together with borrowings under our creditfacility ($47.3 million of which was available as of June 30 2007 and expireson April 1, 2010) will be sufficient to meet our operating expenses, workingcapital and capital expenditure requirements as well as our debt service andother contractual obligations for the next twelve months.  However, our ability to comply with debtfinancial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well ascompetitive, legislative, regulatory, business and other factors beyond ourcontrol.

### **CERTAIN CONTRACTUAL COMMITMENTS ANDINDEMNITIES**

In 2002, we were retainedto facilitate the engineering and construction of a $23.0 million reverseosmosis water treatment plant in the city of San Juan Capistrano, Californiafor the Capistrano Valley Water District (“CVWD”).  In 2003, we obtained a $3.4 million standbyletter of credit as collateral to insure our performance during the design andconstruction of the water treatment plant. Construction was completed during 2005 and the $3.4 million standbyletter of credit was released on May 3, 2007. We obtained final acceptance of the completed project from the CVWD inJuly 2007 and payment of the final $2.3 million of the total contract price,which is included in accounts receivable, was released to us from theconstruction financing escrow account.

We now operate thecompleted plant under a twenty-year operating agreement.  The CVWD service contract contains threeguarantees related to our performance during the term of the operatingagreement.  The agreement provides forliquidated damages in the event we fail to perform for reasons other than thosecaused by “uncontrollable circumstances,” as such term is defined in theagreement.

During the term of theoperating agreement, we may be liable for liquidated damages relating to anylost payments from a financial assistance agreement CVWD has with a state wateragency, up to a maximum of $1.4 million per contract year.  We have also made guarantees to CVWD withrespect to the quantity of finished water produced by the facility.  In the event the actual number of acre feetof finished water delivered is less than the water delivery guarantee, we arerequired to pay liquidated damages of approximately $600 per acre foot ofshortfall, up to a maximum of 15.8 acre feet per day.  Finally, we have made guarantees with respectto seven measurable finished water quality standards.  Liquidated damages for failure to meet thesequality standards range from $100 to $400 per day per failed quality standard(up to a maximum of $2,800 per day), depending on the number of violations percontract year.  The CVWD has not assertedany claims for liquidated damages pursuant to these guarantees through the dateof this report.

As part of the financingfor this project, the CVWD sold insured municipal bonds.  We entered into an agreement with the bondinsurer to guarantee our performance under the service contract, subject tocertain liability caps to the bond insurer in the event of a default.  During the twenty-year operation of thefacility, such liability caps will not exceed an amount equal to $4.0 millionplus an amount no greater than the replacement cost of the actual reverseosmosis filtration unit within the facility, estimated to be approximately $1.5million.

As of June 30 2007, wehad irrevocable standby letters of credit in the amount of $0.7 million issuedand outstanding under our credit facility.

During our normal courseof business, we have entered into agreements containing indemnities pursuant towhich we may be required to make payments in the future.  These indemnities are in connection withfacility leases and liabilities and operations and maintenance and constructioncontracts entered into by our Services Group. The duration of these indemnities, commitments and guarantees varies,and in certain cases, is indefinite. Substantially all of these indemnities provide no limitation on themaximum potential future payments we could be obligated to make and is notquantifiable.  We have not recorded anyliability for these indemnities.

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In connection with thesale of a subsidiary in 2005, we made indemnities to the buyer with respect toa number of customary, and certain other specific, representations andwarranties.  Our indemnities with respectto these matters are limited in terms of duration to periods ranging from oneyear to the expiration of the applicable statue of limitations.

### **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 activities involving non-exchange tradedcontracts.  We are not materially exposedto any financing, liquidity, market or credit risk that could arise if we hadengaged in these relationships.  We donot have relationships or transactions with persons or entities that derivebenefits from their non-independent relationship with our subsidiaries or us.

We lease some of ourequipment and office facilities under operating leases which are deemed to beoff-balance sheet arrangements.  Ourfuture operating lease payment obligations are more fully described under thecaption “–Contractual Obligations” above.

## **ITEM 3.****       QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISK**

As of June 30, 2007, wehad $145.1 million of long-term variable and fixed-rate debt.  We are exposed to market risk based onchanges in prevailing interest rates.

Market risk related toour variable-rate debt is estimated as the potential decrease in pre-taxearnings resulting from an increase in interest rates.  We have $52.0 million of long-term debt thatbears interest at variable rates based on either the prime rate or LIBOR rate.  Our variable-rate debt had a weighted averageinterest rate of 6.23% as of June 30, 2007.  A hypothetical one percent (100 basis points)increase in the average interest rates charged on our variable-rate debt wouldreduce our pre-tax earnings by approximately $0.5 million per year.

Our fixed-rate debt,which has a carrying value of $93.1 million, has a fair value of $88.4 millionas of June 30, 2007.  Market riskrelated to our fixed-rate debt is deemed to be the potential increase in fairvalue resulting from a decrease in prevailing interest rates.  Our fixed-rate debt had a weighted averageinterest rate of 6.5% as of June 30, 2007. A hypothetical ten percent decrease in interest rates, from 6.5% to5.9%, would increase the fair value of our fixed-rate debt by approximately$6.1 million.

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

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

Under the supervision andwith the participation of our management, including the Chief Executive Officerand Chief Financial Officer, we have evaluated the effectiveness of ourdisclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) asof the end of the period covered by this report.  Based on that evaluation, the Chief ExecutiveOfficer and Chief Financial Officer have concluded that these disclosurecontrols and procedures are effective. There were no changes in our internal control over financial reportingduring the quarter ended June 30, 2007 that have materially affected, orare reasonably likely to materially affect, our internal control over financialreporting.

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# **PART II –OTHER INFORMATION**

## **ITEM 1.****      LEGAL PROCEEDINGS**

Information required bythis Item 1 is contained in Note 4 to the consolidated financial statements,Part I, Item 1 of this report, under the captions “Legal Proceedings” and “EPAInvestigations.”  The text under thosecaptions is incorporated by reference into this Item 1.

## **ITEM 4.****      SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

The Company’s AnnualMeeting of Stockholders was held on May 22, 2007.  The total number of shares of the Company’scommon and preferred stocks issued, outstanding and entitled to vote at themeeting was 24,045,588 shares of which 21,147,255 were present at the meetingeither in person or by proxy.  Thefollowing proposals were submitted to stockholders with the following results:

***Proposal1.***  To elect threepersons as Class III Directors each for a three-year term:

·                  H.Frederick Christie–votes “For” – 20,227,902; votes “Withheld” – 919,353

·                  AntonC. Garnier–votes “For” – 20,744,284; votes “Withheld” – 402,971

·                  LindaGriego–votes “For” – 20,295,341; votes “Withheld” – 851,914

In addition to thedirectors elected above, the following directors’ term of office continuedafter the meeting:

Class I Directors (termexpires in 2008)

·                  JamesC. Castle, PhD *

·                  WilliamD. Jones

·                  MaureenA. Kindel

Class II Directors (termexpires in 2009)

·                  DonovanD. Huennekens

·                  RichardG. Newman

·                  MarkA. Swatek

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*                 Asthe Company reported in a Form 8-K dated July 20, 2007, Mr. Castle resigned asa director effective July 1, 2007.  OnJuly 17, 2007, the Board of Directors elected Mr. Thomas Iino as a director tofill the vacancy created by the resignation of Mr. Castle for the unexpiredportion of his term.

***Proposal2. ***To approve theamendment extending the Company’s Employee Stock Purchase Plan:

·                  Votes“For” – 11,147,002

·                  Votes“Against” – 949,664

·                  Votes“Abstained” – 143,141

·                  Broker“Non-Votes” – 8,907,448

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## **ITEM 6.****       EXHIBITS**

| Exhibit    | ** ** | ** **                                                                                                    |
|------------|------------|---------------------------------------------------------------------------------------------------------------|
| **Number** | ** ** | **Exhibit  Description**                                                                                      |
|       |       |                                                                                                          |
| 15         | *          | Letter regarding  unaudited interim financial information from Independent Registered Public  Accounting Firm |
|       |       |                                                                                                          |
| 21.1       | *          | Subsidiaries of  the Registrant                                                                               |
|       |       |                                                                                                          |
| 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

## **ITEMS 1A, 2, 3 AND 5 ARE NOT APPLICABLE ANDHAVE BEEN OMITTED.**

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# **SIGNATURES**

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned, thereto dulyauthorized.
|                       |   | **SOUTHWEST WATER COMPANY (REGISTRANT)** |
|-----------------------|--------|------------------------------------------|
|                  |   |                                     |
|                  |   |                                     |
| Dated: August 9, 2007 |   | /s/ CHERYL L. CLARY                      |
|                  |   | Cheryl L. Clary                          |
|                  |   | Chief Financial  Officer                 |

 

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