Table of Contents

 

 

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

 

| **x**  | ** ** | **Quarterly Report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                                                                                                                                                                |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |       | **For the quarterly period ended June 30, 2008**                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |       | **or**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
| **o**  | ** ** | **Transition report pursuant to  Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                                                                                                                                                                                                                                                                                                               |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |
|   |       | **For the transition period  from                                    to                                    ** |
|   |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                  |

**Commission File Number 0-8176**

 

(Exact name of registrant as specified in its charter)

 

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

 

**One Wilshire Building**

**624 South Grand Avenue, Suite 2900**

**Los Angeles, California 90017-3782**

(Address of principal executive offices, including zip code)

 

**(213) 929-1800**

(Registrant’s telephone, including area code)

 

**None**

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

 

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

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See definitions of “large accelerated filer,” “accelerated filer,” and“smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| Large  accelerated filer o | Accelerated  filer x | Non-accelerated  filer o                       | Smaller  reporting company o |
|----------------------------|---------------------------|------------------------------------------------|-----------------------------------|
|                       |                      | (Do not check if a smaller  reporting company) |                              |

 

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

 

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

 
| **Class**                              | ** ** | **Outstanding as of August 1, 2008** | ** ** |
|----------------------------------------|------------|---------------------------------------------------------------|------------|
|                                   |       |                                                          |       |
| Common Stock, $.01 par value per share |       | 24,592,039 shares                                             |       |

 

 

 

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Tableof Contents

 

**TABLE OF CONTENTS**

 
| ** **       | ** **                                                                                                                         | **Page** |
|------------------|------------------------------------------------------------------------------------------------------------------------------------|----------|
|             |                                                                                                                               |     |
| **Part I**  | **Financial Information**                                                                                                          | **1**    |
|             |                                                                                                                               |     |
| Item 1.          | Financial Statements                                                                                                               | 1        |
|             |                                                                                                                               |     |
|             | Report of Independent Registered Public Accounting Firm                                                                            | 1        |
|             |                                                                                                                               |     |
|             | Condensed Consolidated Balance Sheets as of June 30, 2008 and  December 31, 2007 (Unaudited)                             | 2        |
|             |                                                                                                                               |     |
|             | Condensed Consolidated Statements of Income for the three months and  six months ended June 30, 2008 and 2007 (Unaudited)     | 3        |
|             |                                                                                                                               |     |
|             | Condensed Consolidated Statement of Changes  in Stockholders’ Equity for the six months ended June 30, 2008  (Unaudited) | 4        |
|             |                                                                                                                               |     |
|             | Condensed Consolidated Statements of Cash  Flows for the six months ended June 30, 2008 and 2007  (Unaudited)            | 5        |
|             |                                                                                                                               |     |
|             | Notes to Condensed Consolidated Financial  Statements (Unaudited)                                                                  | 6        |
|             |                                                                                                                               |     |
| Item  2.         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                        | 21       |
|             |                                                                                                                               |     |
| Item 3.          | Quantitative and Qualitative Disclosures  About Market Risk                                                                        | 38       |
|             |                                                                                                                               |     |
| Item 4.          | Controls and Procedures                                                                                                            | 38       |
|             |                                                                                                                               |     |
| **Part II** | **Other Information**                                                                                                              | **39**   |
|             |                                                                                                                               |     |
| Item 1.          | Legal Proceedings                                                                                                                  | 39       |
|             |                                                                                                                               |     |
| Item 1A.         | Risk Factors                                                                                                                       | 39       |
|             |                                                                                                                               |     |
| Item 4.          | Submission of Matters to a Vote of Security  Holders                                                                               | 39       |
|             |                                                                                                                               |     |
| Item 6.          | Exhibits                                                                                                                           | 40       |
|             |                                                                                                                               |
| **Signatures**   | **41**                                                                                                                             |

 

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Table of Contents

 

# **PART I –FINANCIAL INFORMATION**

# ** **

## **ITEM 1.  FINANCIAL STATEMENTS**

## ** **

### **REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

###  

The Board of Directors and StockholdersSouthWest Water Company:

 

We have reviewed the accompanying condensedconsolidated balance sheet of SouthWest Water Company and its subsidiaries as ofJune 30, 2008, and the related condensed consolidated statements of incomefor the three-month and six-month periods ended June 30, 2008 and therelated condensed consolidated changes in stockholders’ equity and cash flowsfor the six-month period ended June 30, 2008. This interim financialinformation is the responsibility of the Company’s management.

 

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

 

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

 

/s/  PricewaterhouseCoopers LLP

 

Los Angeles, California

August 11, 2008

 

1

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| *** ***                                  | *** *** | ***June 30,*** | *** *** | ***December 31,*** | *** *** |
|-----------------------------------------------|--------------|---------------------|--------------|-------------------------|--------------|
| ***(In  thousands)***                         | ** **   | **2008**            | ** **   | **2007**                | ** **   |
| **ASSETS**                                    |         |                |         |                    |         |
| ** **                                    |         |                |         |                    |         |
| Current Assets:                               |         |                |         |                    |         |
| Cash and cash equivalents                     |         | $                   | 3,883        |                    | $            | 2,950 |   |
| Accounts receivable, net                      |         | 30,180              |         | 26,005                  |         |
| Assets held for sale                          |         | 13,655              |         | 16,013                  |         |
| Other current assets                          |         | 17,122              |         | 16,617                  |         |
| Total current assets                          |         | 64,840              |         | 61,585                  |         |
|                                          |         |                |         |                    |         |
| Property, Plant and Equipment, Net:           |         |                |         |                    |         |
| Regulated utilities                           |         | 428,091             |         | 399,146                 |         |
| Non-regulated operations                      |         | 21,155              |         | 18,757                  |         |
| Total property, plant and equipment, net      |         | 449,246             |         | 417,903                 |         |
|                                          |         |                |         |                    |         |
| Other Assets:                                 |         |                |         |                    |         |
| Goodwill                                      |         | 17,349              |         | 17,349                  |         |
| Intangible assets                             |         | 2,325               |         | 2,539                   |         |
| Other assets                                  |         | 16,036              |         | 17,033                  |         |
|                                          |         | $                   | 549,796      |                    | $            | 516,409 |   |
|                                          |         |                |         |                    |         |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY** |         |                |         |                    |         |
| ** **                                    |         |                |         |                    |         |
| Current Liabilities:                          |         |                |         |                    |         |
| Accounts payable                              |         | $                   | 8,097        |                    | $            | 14,930 |   |
| Liabilities related to assets held for sale   |         | 4,456               |         | 4,297                   |         |
| Current portion of long-term debt             |         | 1,927               |         | 1,937                   |         |
| Other current liabilities                     |         | 21,125              |         | 25,020                  |         |
| Total current liabilities                     |         | 35,605              |         | 46,184                  |         |
|                                          |         |                |         |                    |         |
| Other Liabilities and Deferred Credits:       |         |                |         |                    |         |
| Long-term debt                                |         | 191,414             |         | 145,353                 |         |
| Deferred income taxes                         |         | 28,331              |         | 28,102                  |         |
| Advances for construction                     |         | 12,824              |         | 9,210                   |         |
| Contributions in aid of construction          |         | 110,700             |         | 115,442                 |         |
| Other liabilities and deferred credits        |         | 13,727              |         | 12,924                  |         |
|                                          |         |                |         |                    |         |
| Commitments and Contingencies                 |         |                |         |                    |         |
|                                          |         |                |         |                    |         |
| Stockholders’ Equity:                    |         |                |         |                    |         |
| Preferred stock                               |         | 458                 |         | 458                     |         |
| Common stock                                  |         | 245                 |         | 243                     |         |
| Additional paid-in capital                    |         | 147,418             |         | 145,072                 |         |
| Retained earnings                             |         | 8,995               |         | 13,336                  |         |
| Accumulated other comprehensive income        |         | 79                  |         | 85                      |         |
| Total stockholders’ equity               |         | 157,195             |         | 159,194                 |         |
|                                          |         | $                   | 549,796      |                    | $            | 516,409 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

2

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands, except per share data)** | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Revenues:                                                          |       |                             |       |                           |       |   |   |   |   |
| Utility Group                                                      |       | $                                | 27,484     |                           | $          | 23,554 |   | $ | 49,825 |   | $ | 43,588 |   |
| Services Group                                                     |       | 29,582                           |       | 31,342                         |       | 58,004 |   | 59,177 |   |
| Total revenues                                                     |       | 57,066                           |       | 54,896                         |       | 107,829 |   | 102,765 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Expenses:                                                          |       |                             |       |                           |       |   |   |   |   |
| Utility Group operating expenses                                   |       | 15,746                           |       | 13,207                         |       | 29,187 |   | 25,016 |   |
| Services Group operating expenses                                  |       | 28,833                           |       | 26,730                         |       | 54,743 |   | 51,172 |   |
| Selling, general and administrative  expenses                      |       | 9,113                            |       | 9,311                          |       | 18,718 |   | 17,841 |   |
| Total expenses                                                     |       | 53,692                           |       | 49,248                         |       | 102,648 |   | 94,029 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Operating income                                                   |       | 3,374                            |       | 5,648                          |       | 5,181 |   | 8,736 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Other income (expense):                                            |       |                             |       |                           |       |   |   |   |   |
| Interest expense                                                   |       | (2,042                           | )          | (1,885                         | )          | (4,403 | ) | (3,739 | ) |
| Interest income                                                    |       | 128                              |       | 50                             |       | 250 |   | 185 |   |
| Other, net                                                         |       | 4                                |       | (12                            | )          | 4 |   | (61 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations before  income taxes             |       | 1,464                            |       | 3,801                          |       | 1,032 |   | 5,121 |   |
| Provision for income taxes                                         |       | 573                              |       | 1,380                          |       | 455 |   | 1,860 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations                                  |       | 891                              |       | 2,421                          |       | 577 |   | 3,261 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Loss from discontinued operations, net of  tax                     |       | (1,678                           | )          | (198                           | )          | (1,965 | ) | (424 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Net income (loss)                                                  |       | (787                             | )          | 2,223                          |       | (1,388 | ) | 2,837 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Preferred stock dividends                                          |       | (6                               | )          | (6                             | )          | (12 | ) | (12 | ) |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Net income (loss) applicable to common  stockholders               |       | $                                | (793       | )                              | $          | 2,217 |   | $ | (1,400 | ) | $ | 2,825 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Earnings (loss) per common share:                                  |       |                             |       |                           |       |   |   |   |   |
| Basic:                                                             |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations                                  |       | $                                | 0.04       |                           | $          | 0.10 |   | $ | 0.02 |   | $ | 0.14 |   |
| Loss from discontinued operations                                  |       | (0.07                            | )          | (0.01                          | )          | (0.08 | ) | (0.02 | ) |
| Net income (loss) applicable to common  stockholders               |       | $                                | (0.03      | )                              | $          | 0.09 |   | $ | (0.06 | ) | $ | 0.12 |   |
| Diluted:                                                           |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations                                  |       | $                                | 0.04       |                           | $          | 0.10 |   | $ | 0.02 |   | $ | 0.13 |   |
| Loss from discontinued operations                                  |       | (0.07                            | )          | (0.01                          | )          | (0.08 | ) | (0.01 | ) |
| Net income (loss) applicable to common  stockholders               |       | $                                | (0.03      | )                              | $          | 0.09 |   | $ | (0.06 | ) | $ | 0.12 |   |
|                                                               |       |                             |       |                           |       |   |   |   |   |
| Weighted average common shares outstanding:                        |       |                             |       |                           |       |   |   |   |   |
| Basic                                                              |       | 24,507                           |       | 24,100                         |       | 24,444 |   | 23,992 |   |
| Diluted                                                            |       | 24,711                           |       | 24,386                         |       | 24,666 |   | 24,301 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| ** **                                                           | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **  | ** ** | ** **   | ** ** | **Accumulated** | ** ** | ** **             | ** ** |
|----------------------------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|-------------|------------|--------------|------------|-----------------|------------|------------------------|------------|
| ** **                                                           | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **  | ** ** | ** **   | ** ** | **Other**       | ** ** | ** **             | ** ** |
| ** **                                                           | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | **Compre-** | ** ** | **Total**    | ** ** |
| ** **                                                           | ** ** | **Number of**       | ** ** | ** **            | ** ** | **Number of** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **hensive**     | ** ** | **Stockholders’** | ** ** |
| **(In thousands, except per share data)**   | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**         | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Income**      | ** ** | **Equity**             | ** ** |
| ** **                                                           | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **  | ** ** | ** **   | ** ** | ** **      | ** ** | ** **             | ** ** |
| Balance at December 31, 2007                                    |       | 9                        |       | $                     | 458        |               | 24,268     |       | $          | 243         |       | $            | 145,072    |            | $          | 13,336                 |       | $ | 85 |   | $ | 159,194 |   |
|                                                                 |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       |                   |       |
| Comprehensive income (loss):                                         |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       |                   |       |
| Net income (loss)                                                    |       | —                   |       | —                |       | —             |       | —     |       | —      |       | (1,388       | )          | —          |       | (1,388                 | )          |
| Other comprehensive income, net of tax:                              |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       |                   |       |
| Amortization of actuarial net gain                                   |       | —                   |       | —                |       | —             |       | —     |       | —      |       | —       |       | (6              | )          | (6                     | )          |
| Comprehensive income (loss)                                          |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       | (1,394                 | )          |
|                                                                 |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       |                   |       |
| Stock issuance under dividend reinvestment  and stock purchase plans |       | —                   |       | —                |       | 127                |       | 1          |       | 1,426       |       | —       |       | —          |       | 1,427                  |       |
| Proceeds from stock options exercised                                |       | —                   |       | —                |       | 48                 |       | —     |       | 335         |       | —       |       | —          |       | 335                    |       |
| Stock options tax benefit adjustment                                 |       | —                   |       | —                |       | —             |       | —     |       | (40         | )          | —       |       | —          |       | (40                    | )          |
| Share-based compensation expense                                     |       | —                   |       | —                |       | 114                |       | 1          |       | 612         |       | —       |       | —          |       | 613                    |       |
| Debenture conversions                                                |       | —                   |       | —                |       | 1                  |       | —     |       | 13          |       | —       |       | —          |       | 13                     |       |
| Cash dividends declared:                                             |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       |                   |       |
| Preferred stock ($1.3125 per share)                                  |       | —                   |       | —                |       | —             |       | —     |       | —      |       | (12          | )          | —          |       | (12                    | )          |
| Common stock ($0.12 per share)                                       |       | —                   |       | —                |       | —             |       | —     |       | —      |       | (2,941       | )          | —          |       | (2,941                 | )          |
|                                                                 |       |                     |       |                  |       |               |       |       |       |        |       |         |       |            |       |                   |       |
| Balance at June 30, 2008                                        |       | 9                        |       | $                     | 458        |               | 24,558     |       | $          | 245         |       | $            | 147,418    |            | $          | 8,995                  |       | $ | 79 |   | $ | 157,195 |   |

 

See accompanying notes to condensed consolidated financial statements.

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

| *** ***                                                                                        | *** *** | ***Six Months Ended*** | *** *** |
|-----------------------------------------------------------------------------------------------------|--------------|----------------------------------|--------------|
| *** ***                                                                                        | *** *** | ***June 30,***              |
| ***(In thousands)***                                                                           | ** **   | **2008**                         | ** **   | **2007** | ** ** |
| ** **                                                                                          |         |                             |         |   |   |
| **Cash flows from operating activities of  continuing operations:**                                 |         |                             |         |   |   |
| Net income (loss)                                                                                   |         | $                                | (1,388       | ) | $ | 2,837 |   |
| Adjustments to reconcile net income (loss)  to net cash provided by (used in) operating activities: |         |                             |         |   |   |
| Loss from discontinued operations, net of  tax                                                      |         | 1,965                            |         | 424 |   |
| Depreciation and amortization                                                                       |         | 7,201                            |         | 5,906 |   |
| Deferred income taxes                                                                               |         | 234                              |         | 1,596 |   |
| Share-based compensation expense                                                                    |         | 613                              |         | 863 |   |
| Changes in assets and liabilities, net of  effects of acquisitions:                                 |         |                             |         |   |   |
| Accounts receivable                                                                                 |         | (4,176                           | )            | (1,831 | ) |
| Other current assets                                                                                |         | 782                              |         | 3,044 |   |
| Other assets                                                                                        |         | (2,443                           | )            | (387 | ) |
| Accounts payable                                                                                    |         | (7,055                           | )            | (3,576 | ) |
| Other current liabilities                                                                           |         | (1,276                           | )            | 59 |   |
| Other liabilities                                                                                   |         | 46                               |         | (1,120 | ) |
| Other, net                                                                                          |         | (278                             | )            | (26 | ) |
| Net cash provided by (used in) operating  activities                                                |         | (5,775                           | )            | 7,789 |   |
|                                                                                                |         |                             |         |   |   |
| **Cash flows from investing activities of  continuing operations:**                                 |         |                             |         |   |   |
| Acquisitions of businesses, net of cash  acquired                                                   |         | (23,330                          | )            | (6,547 | ) |
| Additions to property, plant and equipment                                                          |         | (16,129                          | )            | (18,548 | ) |
| Proceeds from sales of equipment                                                                    |         | 179                              |         | 41 |   |
| Net cash used in investing activities                                                               |         | (39,280                          | )            | (25,054 | ) |
|                                                                                                |         |                             |         |   |   |
| **Cash flows from financing activities of  continuing operations:**                                 |         |                             |         |   |   |
| Revolving lines of credit:                                                                          |         |                             |         |   |   |
| Borrowings                                                                                          |         | 131,500                          |         | 16,000 |   |
| Repayment of $100 million revolving line of  credit                                                 |         | (84,500                          | )            | — |   |
| Capital improvement reimbursements                                                                  |         | 1,854                            |         | 1,628 |   |
| Proceeds from stock option and stock  purchase plans                                                |         | 1,762                            |         | 2,186 |   |
| Contributions in aid of construction                                                                |         | 363                              |         | 556 |   |
| Dividends paid                                                                                      |         | (2,953                           | )            | (2,789 | ) |
| Repayment of advances for construction                                                              |         | (1,140                           | )            | (356 | ) |
| Payments on long-term debt                                                                          |         | (873                             | )            | (1,042 | ) |
| Deferred financing costs                                                                            |         | (532                             | )            | (5 | ) |
| Stock option tax benefit adjustment                                                                 |         | (40                              | )            | 394 |   |
| Net cash provided by financing activities                                                           |         | 45,441                           |         | 16,572 |   |
|                                                                                                |         |                             |         |   |   |
| **Cash flows from discontinued operations:**                                                        |         |                             |         |   |   |
| Operating activities                                                                                |         | 575                              |         | (392 | ) |
| Investing activities                                                                                |         | (28                              | )            | (317 | ) |
| Financing activities                                                                                |         | —                           |         | — |   |
| Net cash provided by (used in) discontinued  operations                                             |         | 547                              |         | (709 | ) |
|                                                                                                |         |                             |         |   |   |
| Net change in cash and cash equivalents                                                             |         | 933                              |         | (1,402 | ) |
| Cash and cash equivalents at beginning of  year                                                     |         | 2,950                            |         | 4,294 |   |
| Cash and cash equivalents at end of period                                                          |         | $                                | 3,883        |   | $ | 2,892 |   |

 

Seeaccompanying notes to condensed consolidated financial statements.

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

 

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

###  

**Note 1.       Summary of Significant AccountingPolicies**

** **

**Basis of Presentation**

** **

These condensed consolidated interimfinancial statements are unaudited. SouthWest Water Company (the “Company”)believes the interim financial statements are presented on a basis consistentwith the audited financial statements for the year ended December 31, 2007and include all adjustments necessary for a fair presentation of the financialcondition, results of operations and cash flows for such interim periods. Allof these adjustments are normal recurring adjustments.

 

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

 

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

 

The condensed consolidated financialstatements as of June 30, 2008 and for the three-month and six-monthperiods ended June 30, 2008 have been reviewed by PricewaterhouseCoopersLLP, an independent registered public accounting firm. Their report (dated August 11,2008) is included on page 1 on this report. The report of PricewaterhouseCoopersLLP states that they did not audit and they do not express an opinion on thatunaudited financial information. Accordingly, the degree of reliance on theirreport on such information should be restricted in light of the limited natureof the review procedures applied. PricewaterhouseCoopers LLP is not subject tothe liability provisions of Section 11 of the Securities Act of 1933 fortheir report on the unaudited financial information because that report is nota “report” or a “part” of the registration statement prepared or certified byPricewaterhouseCoopers LLP within the meaning of Sections 7 and 11 of the Act.

 

**Change in Presentation**

** **

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

 

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

 

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**Note 1.       Summary ofSignificant Accounting Policies (Continued)**

** **

**Accounting Pronouncement Adopted During 2008**

** **

*SFAS No. 157*

* *

In September 2006, the FinancialAccounting Standards Board (“FASB”) issued SFAS No. 157, *Fair Value Measurements*(“SFAS 157”). This statement definesfair value, establishes a framework for using fair value to measure assets andliabilities, and expands disclosures about fair value measurements. Thestatement applies when other statements require or permit the fair valuemeasurement of assets and liabilities. This statement does not expand the useof fair value measurement. In February 2008, the FASB issued FASB StaffPosition No. 157-2, *Effective Date of FASBStatement No. 157* (“FSP 157-2”). FSP 157-2 delays theeffective date of SFAS No. 157 for certain non-financial assets andliabilities to fiscal years beginning after November 15, 2008.

 

The Company adopted SFAS No. 157 asrequired on January 1, 2008 for all financial assets and liabilities, andthe adoption did not have a material impact on the Company’s consolidatedresults of operations or financial position. The Company is currently assessingthe potential effect of SFAS No. 157 on all non-financial assets andliabilities.

 

*SFAS No. 159*

* *

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

 

*EITF 06-11*

* *

The Company adopted EITF Issue No. 06-11,*Accounting for the Income Tax Benefits of Dividendson Share-Based Payment Awards* (EITF 06-11) effective January 1,2008. EITF 06-11 provides that tax benefits associated with dividends onshare-based payment awards be recorded as a component of additional paid-incapital. Adoption of this standard did not have a material impact on theCompany’s consolidated financial position and results of operations.

 

**Recent Accounting Pronouncements**

** **

*SFAS No. 141(R)*

* *

In December 2007, the FASB issuedStatement No. 141 (revised 2007), *Business Combinations*(“SFAS 141(R)”). SFAS No. 141(R) provides revised guidance on howacquirers recognize and measure the consideration transferred, identifiableassets acquired, liabilities assumed, contingencies, noncontrolling interestsand goodwill acquired in a business combination. SFAS No. 141(R) alsorequires that transaction costs be expensed as incurred. SFAS No. 141(R) alsoexpands required disclosures surrounding the nature and financial effects ofbusiness combinations. SFAS No. 141(R) is effective, on a prospectivebasis, for the Company’s fiscal year beginning January 1, 2009. Uponadoption, this standard will not have a material impact on our consolidatedfinancial position and results of operations. However, if the Companyconsummates any business combinations after the adoption of SFAS No. 141(R),the transaction may significantly impact the Company’s consolidated financialposition and results of operations as compared to the Company’s recentacquisitions, accounted for under existing GAAP requirements, due to thechanges described above.

 

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**Note 1.       Summary ofSignificant Accounting Policies (Continued)**

** **

*SFAS No. 160*

* *

In December 2007, the FASB issued SFAS No. 160,*Noncontrolling Interests in Consolidated FinancialStatements, an amendment of ARB No. 51* (“SFAS 160”). SFAS 160introduces significant changes in the accounting and reporting for businessacquisitions and noncontrolling interest in a subsidiary. SFAS 160 also changesthe accounting for and reporting for the deconsolidation of a subsidiary. TheCompany is required to adopt the new standard for its fiscal year beginning January 1,2009. The Company is evaluating the impact of this standard and currently doesnot expect it to have a significant impact on its consolidated financialposition or results of operations.

 

*SFAS No. 161*

* *

In March 2008, the FASB issued SFAS No. 161,*Disclosures about Derivative Instruments andHedging Activities—an amendment of FASB Statement No. 133* (“SFAS161”). This statement amends SFAS No. 133 by requiring enhanceddisclosures about a company’s derivative instruments and hedging activities, butdoes not change the scope of, or accounting under, SFAS No. 133. SFAS No. 161requires increased qualitative, quantitative and credit-risk disclosures aboutthe entity’s derivative instruments and hedging activities. SFAS 161 iseffective for the Company’s fiscal year beginning January 1, 2009.Adoption of this statement will not have a material impact on the Company’sconsolidated financial position or results of operations.

 

*SFAS No. 162*

* *

In May 2008, the FASB issued SFAS No. 162,*The Hierarchy of Generally Accepted AccountingPrinciples* (“SFAS No. 162”). SFAS No. 162 identifiesthe sources of accounting principles and the framework for selecting theprinciples used in the preparation of financial statements. SFAS No. 162is effective 60 days following the SEC’s approval of the Public CompanyAccounting Oversight Board amendments to AU Section 411, *The Meaning of Present Fairly in Conformity with Generally AcceptedAccounting Pr*inciples. Adoption of this standard will not have amaterial impact on the Company’s consolidated financial position and results ofoperations.

 

*FSP No. 142-3*

* *

In April 2008, the FASB issued FSP No. 142-3,*Determination of the Useful Life of IntangibleAssets* (“FSP 142-3”). FSP 142-3 amends the factors that shouldbe considered in developing renewal or extension assumptions used to determinethe useful life of a recognized intangible asset under SFAS No. 142, *Goodwill and Other Intangible Assets*. FSP 142-3 is effectivefor the Company’s fiscal years beginning January 1, 2009. The Company iscurrently assessing the impact of FSP 142-3 on its consolidated financialposition and results of operations.

 

*FSP No. EITF 03-6-1*

* *

In June 2008, the FASB issued FSP No. EITF03-6-1, *Determining Whether Instruments Granted inShare-Based Payment Transactions Are Participating Securities* (“FSPEITF 03-6-1”). FSP EITF 03-6-1 clarified that all outstanding unvestedshare-based payment awards that contain rights to nonforfeitable dividendsparticipate in undistributed earnings with common shareholders. Awards of thisnature are considered participating securities and the two-class method ofcomputing basic and diluted earnings per share must be applied. FSP EITF 03-6-1is effective for the Company’s fiscal year beginning January 1, 2009. Allprior period earnings per share data must be adjusted retrospectively toconform to the provisions of FSP EITF 03-6-1. The Company is currentlyassessing the impact of FSP EITF 03-6-1 on its computation of earnings pershare however; it currently believes the impact will not be material.

 

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**Note 1.       Summary of Significant AccountingPolicies (Continued)**

** **

*EITF 07-5*

* *

In June 2008, the FASB ratified EITFIssue No. 07-5, *Determining Whether anInstrument (or an Embedded Feature) Is Indexed to an Entity’s Own Stock*(“EITF07-5”). EITF 07-5 provides that an entity should use a two step approach toevaluate whether an equity-linked financial instrument (or embedded feature) isindexed to its own stock, including evaluating the instrument’s contingentexercise and settlement provisions. It also clarifies on the impact of foreigncurrency denominated strike prices and market-based employee stock optionvaluation instruments on the evaluation. EITF 07-5 is effective for the Company’sfiscal year beginning January 1, 2009. The Company is currently assessingthe impact of EITF 07-5 on its consolidated financial position and results ofoperations.

 

*EITF 08-3*

* *

In June 2008, the FASB ratified EITFIssue No. 08-3, *Accounting for Lessees forMaintenance Deposits Under Lease Arrangements* (“EITF 08-3”). EITF08-3 provides guidance for accounting for nonrefundable maintenance deposits.It also provides revenue recognition accounting guidance for the lessor. EITF08-3 is effective for the Company’s fiscal year beginning January 1, 2009.The Company is currently assessing the impact of EITF 08-3 on its consolidatedfinancial position and results of operations.

 

**Note 2.       Acquisition**

** **

On January 31, 2008, the Companyacquired substantially all of the assets of a wastewater collection system andrelated treatment plant in Birmingham, Alabama. The purchase price was $23.3million in cash which the Company borrowed under its revolving line of credit.The acquisition was accounted for as a purchase and the assets acquired havebeen recorded at their estimated fair values, consisting of $20.8 million ofutility plant and $2.5 million of land, based upon preliminary valuations. TheCompany expects to finalize the valuations and purchase price allocation during2008.

 

The consolidated financial statements reflectthe financial position and results of operations of the acquired utilitysubsequent to its acquisition date. Unaudited pro forma consolidated results ofoperations are presented in the table below for the three months and six monthsended June 30, 2008 and 2007 as if the acquisition had occurred as of thebeginning of each period presented.

 
| ** **                                                           | ** ** | **Unaudited Pro Forma for the** | ** ** |
|----------------------------------------------------------------------|------------|-----------------------------------------------------|------------|
| ** **                                                           | ** ** | **Three Months Ended**                    | ** ** | **Six Months Ended** | ** ** |
| ** **                                                           | ** ** | **June 30,**                                   | ** ** | **June 30,** | ** ** |
| **(In thousands, except per share data)**   | ** ** | **2008**                                            | ** ** | **2007** | ** ** | **2008** | ** ** | **2007** | ** ** |
| Total revenues                                                       |       | $                                                   | 57,066     |   | $ | 56,269 |   | $ | 108,236 |   | $ | 105,340 |   |
| Income from continuing operations                                    |       | 891                                                 |       | 2,597 |   | 628 |   | 3,541 |   |
| Income from continuing operations  applicable to common stockholders |       | 885                                                 |       | 2,591 |   | 616 |   | 3,529 |   |
| Net income (loss) applicable to common  stockholders                 |       | (793                                                | )          | 2,393 |   | (1,349 | ) | 3,105 |   |
| Earnings (loss) per common share:                                    |       |                                                |       |   |   |   |   |   |   |
| From continuing operations applicable to  common stockholders:       |       |                                                |       |   |   |   |   |   |   |
| Basic                                                                |       | $                                                   | 0.04       |   | $ | 0.11 |   | $ | 0.03 |   | $ | 0.15 |   |
| Diluted                                                              |       | 0.04                                                |       | 0.11 |   | 0.02 |   | 0.15 |   |
| Net income (loss) applicable to common  stockholders:                |       |                                                |       |   |   |   |   |   |   |
| Basic                                                                |       | (0.03                                               | )          | 0.10 |   | (0.06 | ) | 0.13 |   |
| Diluted                                                              |       | (0.03                                               | )          | 0.10 |   | (0.05 | ) | 0.13 |   |

 

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**Note 2.       Acquisition (Continued)**

** **

The pro forma results of operations are notnecessarily indicative of the results that would have been achieved had theacquisition occurred as of the dates indicated or the results of operations forany future periods. The above information reflects adjustments for historicalrevenues and expenses prior to the acquisition, as well as incrementaloperating, general and administrative, depreciation, interest and income taxexpense based on the estimated fair value of assets acquired and additionalindebtedness in connection with the acquisition.

 

**Note 3.       Assets Held for Sale**

** **

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

 
| *** ***                                  | *** *** | ***June 30,*** | *** *** | ***December 31,*** | *** *** |
|-----------------------------------------------|--------------|---------------------|--------------|-------------------------|--------------|
| ***(In thousands)***                     | ** **   | **2008**            | ** **   | **2007**                | ** **   |
| Assets held for sale:                         |         |                |         |                    |         |
| Accounts receivable                           |         | $                   | 205          |                    | $            | 81 |   |
| Other current assets                          |         | 168                 |         | 167                     |         |
| Property, plant and equipment, net            |         | 12,354              |         | 14,833                  |         |
| Other assets                                  |         | 928                 |         | 932                     |         |
| Assets held for sale                          |         | 13,655              |         | 16,013                  |         |
|                                          |         |                |         |                    |         |
| Liabilities related to assets held for  sale: |         |                |         |                    |         |
| Accounts payable                              |         | 91                  |         | 31                      |         |
| Deferred revenue                              |         | 4,365               |         | 4,266                   |         |
| Liabilities related to assets held for sale   |         | 4,456               |         | 4,297                   |         |
| Net assets held for sale                      |         | $                   | 9,199        |                    | $            | 11,716 |   |

 
| ** **                        | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                        | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands)**           | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Revenues                          |       | $                                | 174        |                           | $          | 79 |   | $ | 364 |   | $ | 284 |   |
| Expenses:                         |       |                             |       |                           |       |   |   |   |   |
| Operating expenses                |       | 34                               |       | 180                            |       | 326 |   | 530 |   |
| Impairment of long-lived assets   |       | 2,507                            |       | —                         |       | 2,507 |   | — |   |
| Total expenses                    |       | 2,541                            |       | 180                            |       | 2,833 |   | 530 |   |
|                              |       |                             |       |                           |       |   |   |   |   |
| Operating loss                    |       | (2,367                           | )          | (101                           | )          | (2,469 | ) | (246 | ) |
|                              |       |                             |       |                           |       |   |   |   |   |
| Other income (expense):           |       |                             |       |                           |       |   |   |   |   |
| Interest expense                  |       | (303                             | )          | (239                           | )          | (602 | ) | (455 | ) |
| Interest income                   |       | 5                                |       | 26                             |       | 11 |   | 31 |   |
|                              |       |                             |       |                           |       |   |   |   |   |
| Pretax loss                       |       | (2,665                           | )          | (314                           | )          | (3,060 | ) | (670 | ) |
| Income tax benefit                |       | 987                              |       | 116                            |       | 1,095 |   | 246 |   |
|                              |       |                             |       |                           |       |   |   |   |   |
| Loss from discontinued operations |       | $                                | (1,678     | )                              | $          | (198 | ) | $ | (1,965 | ) | $ | (424 | ) |

 

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**Note 3.       Assets Held for Sale (Continued)**

** **

In accordance with SFAS No. 144, *Accounting for the Impairment or Disposal of Long-Lived Assets*,intangible and other long-lived assets are assessed for recoverability wheneverevents or changes in circumstances indicate that their carrying value may notbe recoverable. In 2007, the Company determined that the carrying value of theassets may not be recoverable through the sales process and, as a result,recorded impairment charges aggregating $3.4 million to reduce the carryingvalue of the long-lived assets to expected realizable value. As negotiationswith prospective buyers have progressed, the Company determined during thesecond quarter of 2008 that an additional $2.5 million impairment charge wasnecessary to further reduce the carrying value of the long-lived assets to expectedrealizable value. Included in the additional charge is $0.6 million ($0.4million net of tax) pertaining to an error made when the initial writedown was calculatedin the fourth quarter of 2007. We have evaluated the error in accordance withthe guidance provided in SEC Staff Accounting Bulletin No. 99, *Materiality*, and have determined the error is not materialto any period.

 

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

 

**Note 4.       Long-Term Debt**

** **

Long-term debt consists of the following asof June 30, 2008 and December 31, 2007:

 
| *** ***                                          | *** *** | ***June 30,*** | *** *** | ***December 31,*** | *** *** |
|-------------------------------------------------------|--------------|---------------------|--------------|-------------------------|--------------|
| ***(In thousands)***                             | ** **   | **2008**            | ** **   | **2007**                | ** **   |
|                                                  |         |                |         |                    |         |
| Revolving credit facility                             |         | $                   | 98,000       |                    | $            | 51,000 |   |
|                                                  |         |                |         |                    |         |
| 6.85% convertible subordinated debentures  due 2021   |         | 12,034              |         | 12,053                  |         |
|                                                  |         |                |         |                    |         |
| $30 million capital lease facility                    |         | 4,168               |         | 4,582                   |         |
|                                                  |         |                |         |                    |         |
| Term Loans:                                           |         |                |         |                    |         |
| Monarch Utilities, Inc.:                         |         |                |         |                    |         |
| 7.37% fixed rate term loan due 2022                   |         | 10,652              |         | 11,037                  |         |
| 5.77% fixed rate term loan due 2022                   |         | 732                 |         | 759                     |         |
| 6.10% fixed rate term loan due 2031                   |         | 20,000              |         | 20,000                  |         |
|                                                  |         |                |         |                    |         |
| First Mortgage Bonds:                                 |         |                |         |                    |         |
| Suburban Water Systems:                               |         |                |         |                    |         |
| 9.09% series B first mortgage bond due 2022           |         | 8,000               |         | 8,000                   |         |
| 5.64% series D first mortgage bond due 2024           |         | 15,000              |         | 15,000                  |         |
| 6.30% series E first mortgage bond due 2026           |         | 10,000              |         | 10,000                  |         |
| New Mexico Utilities, Inc.:                      |         |                |         |                    |         |
| 6.10% series C first mortgage bond due 2024           |         | 12,000              |         | 12,000                  |         |
|                                                  |         |                |         |                    |         |
| Economic Development Revenue Bonds:                   |         |                |         |                    |         |
| ECO Resources, Inc.:                             |         |                |         |                    |         |
| 5.5% series 1998A due 2008                            |         | 115                 |         | 115                     |         |
| 6.0% series 1998A due 2018                            |         | 1,810               |         | 1,810                   |         |
|                                                  |         |                |         |                    |         |
| Acquisition-related indebtedness and other            |         | 134                 |         | 176                     |         |
| Total long-term debt payment obligations              |         | 192,645             |         | 146,532                 |         |
| Unamortized Monarch term loan fair value  adjustments |         | 696                 |         | 758                     |         |
| Total long-term debt                                  |         | 193,341             |         | 147,290                 |         |
| Less current portion of long-term debt                |         | (1,927              | )            | (1,937                  | )            |
| Long-term debt, less current portion                  |         | $                   | 191,414      |                    | $            | 145,353 |   |

 

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**Note 4.       Long-Term Debt (Continued)**

** **

On February 15, 2008, the Companyentered into a credit agreement with several lenders including Bank of America,as lender and Administrative Agent, KeyBank, CoBank, U.S. Bank, JPMorgan ChaseBank, Comerica Bank, Bank of the West, Citibank and Union Bank of California.The credit agreement provides for a $150.0 million revolving credit facility.The Company may elect to increase the amount of the credit facility by anamount not to exceed $75.0 million during the term of the agreement providedcertain conditions are met. The Company is subject to commitment fees under thefacility as well as the maintenance of customary financial ratios, cash flowresults and other restrictive covenants. Proceeds from the initial $84.5million borrowing under the credit agreement were used to repay borrowingsunder the Company’s prior $100.0 million revolving line of credit. The prioragreement was terminated upon repayment at which time $0.3 million ofunamortized deferred financing costs were written off.

 

The revolving line of credit commitment endson February 15, 2013 (if not renewed or extended), at which time allborrowings must be repaid. Borrowings under the credit facility bear interest,at the Company’s option, based on a margin either over the LIBOR rate or underthe prime rate. The margins vary depending upon the Company’s consolidated debtto equity ratio. Currently, the applicable margins are 0.750% over the LIBORrate or 0.25% under the prime rate. The weighted-average annual interest rateson all credit facility borrowings outstanding were 3.34% as of June 30,2008 and 5.74% as of December 31, 2007.

 

The Company had irrevocable standby lettersof credit in the amount of $2.0 million issued and outstanding under itsrevolving credit facility as of June 30, 2008, reducing availableborrowings under the credit facility to $50.0 million as of that date.

 

**Note 5.       Commitments and Contingencies**

** **

**Legal Proceedings**

** **

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

 

New Mexico Utilities, Inc. (“NMUI”), oneof the Company’s wholly-owned regulated utilities, has an agreement with theAlbuquerque Bernalillo County Water Utility Authority, a political subdivisionof the State of New Mexico (the “ABCWUA”), whereby the ABCWUA treats theeffluent from NMUI’s wastewater collection system for a fee. The treatedeffluent is returned to the Rio Grande Underground Basin, creating return flowcredits. Return flow credits supplement NMUI’s existing water rights, enablingit to pump additional water from the basin.

 

In August 2004, the ABCWUA increased thefee charged to NMUI, using a different formula than had been used to calculatefee increases in prior years. The Company believes the increase violates theterms of a written agreement between the parties. Subsequently, the ABCWUA alsoclaimed ownership of the return flow credits. The Company filed a Complaint forDeclaratory Judgment in the Second Judicial District Court, County ofBernalillo, State of New Mexico (the “Court”), requesting that the Court settlethese disputes. In a letter ruling dated May 2, 2007, the Court ruled thatthe ABCWUA could use a new formula to set fees for NMUI. The Company filed amotion for reconsideration and that motion was denied on October 2, 2007.The matter has now been set for trial in the fall of 2008. The Court has notruled on whether the new rate was appropriate; has made no determination as toany amount NMUI may owe to the ABCWUA, or ruled on the ownership of the returnflow credits.

 

In September 2007, NMUI received a $0.7million retroactive billing adjustment from the ABCWUA covering the period fromAugust 2003 through April 2006 for the volume of wastewater itbelieves NMUI discharged into the treatment system versus the amount reportedby NMUI. The amounts reported by NMUI were based on a calculation methodologythat had been agreed to by both parties and used for approximately 30 years.NMUI is contesting the billing adjustment.

 

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**Note 5.       Commitments and Contingencies (Continued)**

** **

Although the Company cannot give anyassurances as to the ultimate resolution of these matters, the Company does notbelieve that it is probable it will be required to pay the disputed fees andrelated late payment penalties, which totaled $6.8 million as of June 30,2008, and has not recognized a reserve for any potential liabilities in the accompanyingconsolidated financial statements. In addition, should the Court rule againstNMUI, the New Mexico Public Regulation Commission (the “NMPRC”) has issued anopinion that NMUI be permitted to establish a regulatory asset for any amountspaid, including legal fees and late payment penalties, and recover that assetprospectively through a rate surcharge to its customers. The NMPRC ruled thatthe Company may commence billing its customers for a portion of the sewer feeincrease and hold the collected amounts in escrow, pending a final courtdecision. The Company is unable to predict the impact the resolution of thereturn flow credits ownership dispute will have on its consolidated financialstatements.

 

On February 26, 2008, the Company wasmade aware of a “Claim of Lien” filed by the ABCWUA against NMUI in the sum of$5.8 million, allegedly for the amount of delinquent sewer charges at the timeof filing. This lien is related to the above described matters currently beinglitigated in New Mexico State Court.

 

*New Mexico Utilities, Inc.—CondemnationProceedings*

 

In addition, on January 19, 2007, theABCWUA and the City of Rio Rancho, a home-rule municipal corporation, asPetitioners, filed a Petition for Condemnation against NMUI and others, asDefendants, in the Court (the “Petition”). The Petition seeks to acquire, bycondemnation, all of the assets of NMUI, including all real property, throughthe stated power of eminent domain. The Petition also alleges that thePetitioners need to acquire the NMUI assets for the public purposes ofproviding water and wastewater services to NMUI customers and that theacquisition of NMUI is necessary, appropriate and in the public interest. TheCompany is contesting the Petition and the matter is scheduled for trial in April 2009.If the Company does not prevail, the Petitioners must pay fair market value forthe utility as determined by the Court, based on appraisals. NMUI and thePetitioners do not agree on the value of the assets which the Petitioners seekto condemn. While it is too early to predict the outcome of this matter, theCompany believes that if the Court were to determine the fair market value ofNMUI, it would exceed its recorded net book value as of June 30, 2008.

 

*Other Matters*

 

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

 

**Investigations**

** **

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

 

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

 

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**Note 5.       Commitments and Contingencies (Continued)**

** **

The Company received a letter dated January 28,2008 from the California State Water Resources Control Board Office ofEnforcement (the “Board”). The letter indicates that the Board has conducted aninvestigation of the operations of a subsidiary of the Company with respect tovarious California wastewater treatment facilities which are operated, but notowned, by the subsidiary. The Board alleges that the subsidiary has violatedcertain provisions of the California Water Code and may be subject to civiladministrative liability in excess of $15.0 million, and possibleadministrative action against the subsidiary’s status as a contract operator inCalifornia.

 

The Company undertook its own internal reviewand audit of the allegations made by the Board and met with the Board duringthe second quarter of 2008 to discuss its findings from that audit as well asthe corrective compliance actions already taken by the Company prior toreceiving the January 28, 2008 letter. The Board has indicated that itwould be willing to consider settling the matter based on obtaining certainevidence indicating agreed upon improvements in the Company’s complianceefforts in California have been made.

 

While, at this time, the Company believesthat many of the summary allegations cannot be substantiated, or are subject tosignificant mitigation, and has indicted as much to the Board in a presentationin July, the Company is working cooperatively with the Board in an effort tofavorably resolve this issue. The Company cannot currently predict what, ifany, actions may be taken by the Board or the effect those actions may have onits financial position, results of operations or cash flows.

 

**Settlement Agreement Liability**

** **

In 2006, the Company negotiated a settlementagreement with the municipality of Rio Vista relating to possible fines andpenalties for specified violations occurring during the time the Companyoperated the municipality’s wastewater system. The Company’s maximum paymentobligation was capped at $0.7 million under the agreement provided that totalfines and penalties levied do not exceed a specified amount. The Regional WaterQuality Control Board had levied fines and penalties exceeding the amountcontemplated by the settlement agreement. The Company believed there wereconvincing arguments for negotiating a reduction in the amounts levied but itelected to accrue the $0.7 million maximum amount contemplated by thesettlement agreement.

 

In July 2008, the Company, themunicipality and the Regional Water Quality Control Board reached a finalsettlement in this matter resulting in no fines or penalties being leviedagainst the municipality or the Company. As a result, the $0.7 million accrualwas reversed into income as of June 30, 2008.

 

**Commitments Under Long-Term Service Contracts**

** **

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

 

14

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**Note 5.       Commitments and Contingencies (Continued)**

** **

During the term of the agreement, the Companymay be liable for liquidated damages relating to any lost payments from afinancial assistance agreement CVWD has with a state water agency, up to amaximum of $1.4 million per contract year. The Company has also made guaranteesto CVWD with respect to the quantity of finished water produced by thefacility. In the event the actual number of acre feet of finished waterdelivered is less than the water delivery guarantee, the Company is required topay liquidated damages of approximately $600 per acre foot of shortfall, up toa maximum of 15.8 acre feet per day. Finally, the Company has made guaranteeswith respect to seven measurable finished water quality standards. Liquidateddamages for failure to meet these quality standards range from $100 to $400 perday per failed quality standard (up to a maximum of $2,800 per day), dependingon the number of violations per contract year. The CVWD has not asserted anyclaims for liquidated damages pursuant to these guarantees through the date ofthis report.

 

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

 

**Water Supply Commitment**

** **

One of the Company’s regulated utilities hasa water supply contract providing for the purchase of water to supplement itsown water supply. The agreement requires the Company to purchase minimumquantities of water annually at a specified price. The price is subject toannual adjustment for production cost increases incurred by the seller. Theminimum quantity is also subject to adjustment based on average actual waterpurchases over a moving two-year period, but the minimum will not be reducedbelow a specified threshold. As of June 30, 2008, the minimum annualpurchase commitment is $0.5 million through 2024.

 

**Note 6.       Earnings Per Share**

** **

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

 
| ** **                                                            | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                            | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands)**                                               | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Numerators—Net income applicable to common  stockholders:        |       |                             |       |                           |       |   |   |   |   |
| Income from continuing operations                                     |       | $                                | 891        |                           | $          | 2,421 |   | $ | 577 |   | $ | 3,261 |   |
| Less preferred stock dividends                                        |       | (6                               | )          | (6                             | )          | (12 | ) | (12 | ) |
| Income from continuing operations  applicable to common stockholders  |       | 885                              |       | 2,415                          |       | 565 |   | 3,249 |   |
| Loss from discontinued operations                                     |       | (1,678                           | )          | (198                           | )          | (1,965 | ) | (424 | ) |
| Net income (loss) applicable to common  stockholders                  |       | $                                | (793       | )                              | $          | 2,217 |   | $ | (1,400 | ) | $ | 2,825 |   |
|                                                                  |       |                             |       |                           |       |   |   |   |   |
| Denominators—Weighted average common shares  outstanding:        |       |                             |       |                           |       |   |   |   |   |
| Basic weighted average common shares  outstanding                     |       | 24,507                           |       | 24,100                         |       | 24,444 |   | 23,992 |   |
| Plus shares issued on assumed exercise of stock  options and warrants |       | 204                              |       | 286                            |       | 222 |   | 309 |   |
| Diluted weighted average common shares  outstanding                   |       | 24,711                           |       | 24,386                         |       | 24,666 |   | 24,301 |   |

 

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**Note 6.       Earnings Per Share (Continued)**

** **

As described in Note 4, the Company has $12.0million of 6.85% fixed-rate convertible subordinate debentures outstanding asof June 30, 2008. The debentures are convertible into common stock at anytime prior to maturity, unless previously redeemed, at a conversion price of$11.018 per share which totals 1.1 million shares as of June 30, 2008. Atsuch time as the assumed conversion of the debentures has a dilutive effect onearnings per share, the debentures will be included in the calculation ofdiluted earnings per share after adjusting net income for the after-tax effectof the debenture interest expense.

 

**Note 7.       Comprehensive Income (Loss)**

** **

Comprehensive income (loss) includes changesin equity that are excluded from net income (loss) as follows:

 
| ** **                                                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                         | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands)**                                            | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Net income (loss)                                                  |       | $                                | (787       | )                              | $          | 2,223 |   | $ | (1,388 | ) | $ | 2,837 |   |
| Amortization of actuarial net gain on  retirement plan, net of tax |       | (3                               | )          | 2                              |       | (6 | ) | 4 |   |
| Comprehensive income (loss)                                        |       | $                                | (790       | )                              | $          | 2,225 |   | $ | (1,394 | ) | $ | 2,841 |   |

 

**Note 8.       Consolidated Statements of Cash Flows**

** **

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

 
| *** ***                                                                                                   | *** *** | ***Six Months Ended*** | ** ** |
|----------------------------------------------------------------------------------------------------------------|--------------|----------------------------------|------------|
| *** ***                                                                                                   | *** *** | ***June 30,***              | ** ** |
| ***(In thousands)***                                                                                      | ** **   | **2008**                         | ** ** | **2007** | ** ** |
| *** ***                                                                                                   | ** **   | ** **                       | ** ** | ** ** | ** ** |
| Cash paid during the period for:                                                                               |         |                             |       |   |   |
| Interest                                                                                                       |         | $                                | 3,940      |   | $ | 4,179 |   |
| Income taxes paid (refunded), net                                                                              |         | 1,937                            |       | (725 | ) |
| Components of cash paid for acquisitions:                                                                      |         |                             |       |   |   |
| Fair value of assets acquired                                                                                  |         | $                                | 23,330     |   | $ | 7,386 |   |
| Liabilities assumed                                                                                            |         | —                           |       | (839 | ) |
| Cash paid for acquisitions                                                                                     |         | $                                | 23,330     |   | $ | 6,547 |   |
| Non-cash investing and financing  activities:                                                                  |         |                             |       |   |   |
| Non-cash contributions in aid of  construction and advances for construction conveyed to Company by developers |         | $                                | —     |   | $ | 3,153 |   |
| Debentures converted into common stock                                                                         |         | 14                               |       | 373 |   |

 

**Note 9.       Dividend Reinvestment and Direct StockPurchase Plan (“DRIP / DSPP”)**

** **

The Company has a dividend reinvestment andstock purchase plan that gives common stockholders the option of receivingtheir dividends in cash or in common stock at a discount from prevailing marketprices (“DRIP”). The plan also permits existing stockholders to purchaseadditional common stock, up to a maximum of $10,000 per month, at a discount (“DSPP”);new investors may participate in the plan, subject to a $250 minimum initialinvestment. The Company may, at its sole discretion, permit purchases above the$10,000 stated maximum. The discounts may range from 0% to 5%, as determinedfrom time to time by the Company. The DRIP and DSPP discounts offered by theCompany are 5% for the DRIP and 0% for the DSPP as of June 30, 2008. As ofJune 30, 2008, there are 3.7 million shares authorized for issuance underthe plan of which 0.8 million shares remain available for issuance.

 

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**Note 10.     Employee Retirement Plan**

** **

The Company has a non-qualified supplementalexecutive retirement plan (“SERP”) for certain key executive officers for thepurpose of providing supplemental income benefits to plan participants or theirsurvivors upon retirement or death. There is only one participant remaining inthe SERP. That individual has reached retirement age and the plan provides thatno additional benefits accrue upon reaching retirement age. The planmeasurement date is December 31st of each year. The followingtable details the components of the net periodic benefit costs:

 
| ** **                               | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                               | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In thousands)**                  | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                               | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                             |       | $                                | —     |                           | $          | — |   | $ | — |   | $ | — |   |
| Interest cost                            |       | 15                               |       | 16                             |       | 30 |   | 32 |   |
| Amortization of actuarial (gains) losses |       | (5                               | )          | (19                            | )          | (10 | ) | (38 | ) |
| Amortization of prior service costs      |       | —                           |       | 22                             |       | — |   | 44 |   |
| Net periodic benefit costs               |       | $                                | 10         |                           | $          | 19 |   | $ | 20 |   | $ | 38 |   |

 

**Note 11.     Segment Information**

** **

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

 

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

 

The Services Group operates and manages waterand wastewater treatment facilities in ten states, primarily Alabama,California, Colorado, Georgia, Mississippi, New Mexico, South Dakota and Texas,owned by cities, public agencies, municipal utility districts, private entitiesand investor-owned utilities, including some of the companies in the UtilityGroup. The Services Group also provides construction and constructionmanagement services, certified water and wastewater laboratory testingservices, and public works services. The Services Group, while subject tocertain environmental standards, is not regulated in its pricing, marketing orrates of return.

 

The following tables present informationabout the operations of each segment for the three months and six months ended June 30, 2008and 2007.

 

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**Note 11.     Segment Information (Continued)**

** **
| ** **                                                          | ** ** | **Utility** | ** **  | **Services**           | ** ** | ** **                 | ** ** | ** **                    | ** **   | ** **       | ** ** |
|---------------------------------------------------------------------|------------|-------------|-------------|------------------------|------------|----------------------------|------------|-------------------------------|--------------|------------------|------------|
| **(In thousands)**                                             | ** ** | **Group**   | ** **  | **Group (1****)** | ** ** | **Corporate (2****)** | ** ** | **Eliminations (3****)** | ** **   | **Consolidated** | ** ** |
| ** **                                                          | ** ** | ** **  | ** **  | ** **             | ** ** | ** **                 | ** ** | ** **                    | ** **   | ** **       | ** ** |
| **Three months ended June 30, 2008:**                          |       |        |        |                   |       |                       |       |                          |         |             |       |
| Revenues:                                                           |       |        |        |                   |       |                       |       |                          |         |             |       |
| Unaffiliated customers                                              |       | $           | 27,484      |                   | $          | 28,884                     |       | $                             | —       |             | $          | — |   | $ | 56,368 |   |
| Intersegment (1) (3)                                           |       | —      |        | 6,362                  |       | —                     |       | (5,664                        | )            | 698              |       |
| Total revenues                                                      |       | 27,484      |        | 35,246                 |       | —                     |       | (5,664                        | )            | 57,066           |       |
|                                                                |       |        |        |                   |       |                       |       |                          |         |             |       |
| Expenses:                                                           |       |        |        |                   |       |                       |       |                          |         |             |       |
| Operating expenses–unaffiliated customers                      |       | 15,746      |        | 28,833                 |       | —                     |       | —                        |         | 44,579           |       |
| Operating expenses–intersegment (3)                            |       | —      |        | 5,664                  |       | —                     |       | (5,664                        | )            | —           |       |
| Selling, general and administrative                                 |       | 2,537       |        | 1,672                  |       | 4,904                      |       | —                        |         | 9,113            |       |
| Total expenses                                                      |       | 18,283      |        | 36,169                 |       | 4,904                      |       | (5,664                        | )            | 53,692           |       |
|                                                                |       |        |        |                   |       |                       |       |                          |         |             |       |
| Operating income (loss)                                             |       | 9,201       |        | (923                   | )          | (4,904                     | )          | —                        |         | 3,374            |       |
|                                                                |       |        |        |                   |       |                       |       |                          |         |             |       |
| Interest expense                                                    |       | (1,599      | )           | (79                    | )          | (364                       | )          | —                        |         | (2,042           | )          |
| Interest income                                                     |       | 83          |        | 41                     |       | 4                          |       | —                        |         | 128              |       |
| Other income (expense)                                              |       | 4           |        | —                 |       | —                     |       | —                        |         | 4                |       |
| Income (loss) from continuing operations before  income taxes  |       | $           | 7,689  |                   | $          | (961                  | )     | $                             | (5,264  | )           | $          | —  |   | $ | 1,464  |   |
| ** **                                                          |       |        |        |                   |       |                       |       |                          |         |             |       |
| **Three months ended June 30, 2007:**                          |       |        |        |                   |       |                       |       |                          |         |             |       |
| Revenues:                                                           |       |        |        |                   |       |                       |       |                          |         |             |       |
| Unaffiliated customers                                         |       | $           | 23,554      |                   | $          | 30,456                     |       | $                             | —       |             | $          | — |   | $ | 54,010 |   |
| Intersegment (1) (3)                                           |       | —      |        | 7,047                  |       | —                     |       | (6,161                        | )            | 886              |       |
| Total revenues                                                      |       | 23,554      |        | 37,503                 |       | —                     |       | (6,161                        | )            | 54,896           |       |
| Expenses:                                                           |       |        |        |                   |       |                       |       |                          |         |             |       |
| Operating expenses–unaffiliated customers                      |       | 13,207      |        | 26,730                 |       | —                     |       | —                        |         | 39,937           |       |
| Operating expenses–intersegment (3)                            |       | —      |        | 6,161                  |       | —                     |       | (6,161                        | )            | —           |       |
| Selling, general and administrative                                 |       | 1,928       |        | 3,553                  |       | 3,830                      |       | —                        |         | 9,311            |       |
| Total expenses                                                      |       | 15,135      |        | 36,444                 |       | 3,830                      |       | (6,161                        | )            | 49,248           |       |
|                                                                |       |        |        |                   |       |                       |       |                          |         |             |       |
| Operating income (loss)                                             |       | 8,419       |        | 1,059                  |       | (3,830                     | )          | —                        |         | 5,648            |       |
|                                                                |       |        |        |                   |       |                       |       |                          |         |             |       |
| Interest expense                                                    |       | (1,356      | )           | (265                   | )          | (264                       | )          | —                        |         | (1,885           | )          |
| Interest income                                                     |       | 6           |        | 36                     |       | 8                          |       | —                        |         | 50               |       |
| Other income (expense)                                              |       | (39         | )           | —                 |       | 27                         |       | —                        |         | (12              | )          |
| Income (loss) from continuing operations before  income taxes       |       | $           | 7,030       |                   | $          | 830                        |       | $                             | (4,059       | )                | $          | — |   | $ | 3,801 |   |

 

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

 

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| ** **                                                    | ** ** | **Utility** | ** ** | **Services**           | ** ** | ** **                 | ** ** | ** **                    | ** ** | ** **       | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|------------------------|------------|----------------------------|------------|-------------------------------|------------|------------------|------------|
| **(In thousands)**                                       | ** ** | **Group**   | ** ** | **Group (1****)** | ** ** | **Corporate (2****)** | ** ** | **Eliminations (3****)** | ** ** | **Consolidated** | ** ** |
| ** **                                                    | ** ** | ** **  | ** ** | ** **             | ** ** | ** **                 | ** ** | ** **                    | ** ** | ** **       | ** ** |
| **Six months ended June 30, 2008:**                      |       |        |       |                   |       |                       |       |                          |       |             |       |
| Revenues:                                                     |       |        |       |                   |       |                       |       |                          |       |             |       |
| Unaffiliated customers                                        |       | $           | 49,825     |                   | $          | 56,183                     |       | $                             | —     |             | $          | — |   | $ | 106,008 |   |
| Intersegment (1) (3)                                     |       | —      |       | 12,701                 |       | —                     |       | (10,880                       | )          | 1,821            |       |
| Total revenues                                                |       | 49,825      |       | 68,884                 |       | —                     |       | (10,880                       | )          | 107,829          |       |
| Expenses:                                                     |       |        |       |                   |       |                       |       |                          |       |             |       |
| Operating expenses–unaffiliated customers                |       | 29,187      |       | 54,743                 |       | —                     |       | —                        |       | 83,930           |       |
| Operating expenses–intersegment (3)                      |       | —      |       | 10,880                 |       | —                     |       | (10,880                       | )          | —           |       |
| Selling, general and administrative                           |       | 5,058       |       | 3,324                  |       | 10,336                     |       | —                        |       | 18,718           |       |
| Total expenses                                                |       | 34,245      |       | 68,947                 |       | 10,336                     |       | (10,880                       | )          | 102,648          |       |
|                                                          |       |        |       |                   |       |                       |       |                          |       |             |       |
| Operating income (loss)                                       |       | 15,580      |       | (63                    | )          | (10,336                    | )          | —                        |       | 5,181            |       |
|                                                          |       |        |       |                   |       |                       |       |                          |       |             |       |
| Interest expense                                              |       | (3,315      | )          | (30                    | )          | (1,058                     | )          | —                        |       | (4,403           | )          |
| Interest income                                               |       | 181         |       | 63                     |       | 6                          |       | —                        |       | 250              |       |
| Other income (expense)                                        |       | 4           |       | —                 |       | —                     |       | —                        |       | 4                |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 12,450     |                   | $          | (30                        | )          | $                             | (11,388    | )                | $          | — |   | $ | 1,032 |   |
|                                                          |       |        |       |                   |       |                       |       |                          |       |             |       |
| **Six months ended June 30, 2007:**                      |       |        |       |                   |       |                       |       |                          |       |             |       |
| Revenues:                                                     |       |        |       |                   |       |                       |       |                          |       |             |       |
| Unaffiliated customers                                        |       | $           | 43,588     |                   | $          | 56,772                     |       | $                             | —     |             | $          | — |   | $ | 100,360 |   |
| Intersegment (1) (3)                                     |       | —      |       | 14,267                 |       | —                     |       | (11,862                       | )          | 2,405            |       |
| Total revenues                                                |       | 43,588      |       | 71,039                 |       | —                     |       | (11,862                       | )          | 102,765          |       |
| Expenses:                                                     |       |        |       |                   |       |                       |       |                          |       |             |       |
| Operating expenses–unaffiliated customers                |       | 25,016      |       | 51,172                 |       | —                     |       | —                        |       | 76,188           |       |
| Operating expenses–intersegment (3)                      |       | —      |       | 11,862                 |       | —                     |       | (11,862                       | )          | —           |       |
| Selling, general and administrative                           |       | 4,389       |       | 6,245                  |       | 7,207                      |       | —                        |       | 17,841           |       |
| Total expenses                                                |       | 29,405      |       | 69,279                 |       | 7,207                      |       | (11,862                       | )          | 94,029           |       |
|                                                          |       |        |       |                   |       |                       |       |                          |       |             |       |
| Operating income (loss)                                       |       | 14,183      |       | 1,760                  |       | (7,207                     | )          | —                        |       | 8,736            |       |
|                                                          |       |        |       |                   |       |                       |       |                          |       |             |       |
| Interest expense                                              |       | (2,634      | )          | (615                   | )          | (490                       | )          | —                        |       | (3,739           | )          |
| Interest income                                               |       | 10          |       | 146                    |       | 29                         |       | —                        |       | 185              |       |
| Other income (expense)                                        |       | (103        | )          | —                 |       | 42                         |       | —                        |       | (61              | )          |
| Income (loss) from continuing operations before  income taxes |       | $           | 11,456     |                   | $          | 1,291                      |       | $                             | (7,626     | )                | $          | — |   | $ | 5,121 |   |

 

*See accompanying notes to the segmentinformation 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 withSFAS 71, the Company does not eliminate the intersegment profit recognizedon these services because the Company believes the sales price is reasonableand it is probable that, through the rate making process, future Utility Grouprevenue approximately equal to the sales price will result from the regulatedutilities’ use of the services. The Company does, however, eliminate theServices Group’s revenues from affiliated customers to the extent of its cost.Consequently, Services Group revenues reflected in the condensed consolidatedstatements of income include intersegment gross profits as follows:

 
| ** **                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                  | ** ** | **June 30,**                | ** ** | **June 30,**              | ** ** |
| **(In  thousands)**         | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                  | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Services Group revenues:    |       |                             |       |                           |       |   |   |   |   |
| From unaffiliated customers |       | $                                | 28,884     |                           | $          | 30,456 |   | $ | 56,183 |   | $ | 56,772 |   |
| Intersegment profits        |       | 698                              |       | 886                            |       | 1,821 |   | 2,405 |   |
| Total revenues              |       | $                                | 29,582     |                           | $          | 31,342 |   | $ | 58,004 |   | $ | 59,177 |   |

 

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(2)          Consists of costs that include headquartersexpenses and any corporate functional departments whose costs are not allocatedto the 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 describedin (1) above.

 

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| **ITEM 2.** | **MANAGEMENT’S  DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS** |
|-------------|-------------------------------------------------------------------------------------------------|

 

### **SPECIAL NOTE ABOUTFORWARD-LOOKING STATEMENTS**

 

Management’s Discussion and Analysis ofFinancial Condition and Results of Operations (“MD&A”) is intended to helpthe reader understand the results of operations and financial condition ofSouthWest Water Company. This MD&A also contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. All statements containedherein that are not clearly historical in nature are forward-looking, and thewords “anticipate,” “believe,” “belief,” “expect,” “estimate,” “project,” “plan,”“intend,” “continue,” “predict,” “may,” “will,” “should,” “strategy,” “willlikely result,” “will likely continue,” and similar expressions are generallyintended to identify forward-looking statements. Forward-looking statements aresubject to risks and uncertainties that could cause actual results to differmaterially from our historical experience and our present expectations or projections.A detailed discussion of these and other risks and uncertainties that couldcause actual results and events to differ materially from such forward-lookingstatements is included in the section entitled “Item 1A. Risk Factors” in our2007 Annual Report on Form 10-K. Caution should be taken not to placeundue reliance on any such forward-looking statements since such statementsspeak only as of the date when made. Other than as required by applicable law,we undertake no obligation to publicly update or revise forward-lookingstatements whether as a result of new information, future events, or otherwise.

 

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

 

### **OVERVIEW**

 

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

 

#### **Utility Group**

 

Our Utility Group owns public water andwastewater utilities in Alabama, California, Mississippi, New Mexico, Oklahomaand Texas. Except for our California utility, our utilities are operated bycompanies in our Services Group, which we describe below. State and federalagencies issue regulations regarding standards of water quality, safety,environmental and other matters which affect these operations. The rates thatour regulated utility subsidiaries charge for water and wastewater usage areestablished by state or local authorities.

 

Utility Group revenues reflect fees earned forthe production and distribution of water and the collection and treatment ofsewage for residential, business, industrial and public authority use. Thegroup’s operating expenses reflect the costs associated with purchasing,producing and distributing water, collecting and treating wastewater, salaries,wages and employee benefits, facilities costs, supplies and equipment, repairsand maintenance, professional fees and other costs.

 

#### **Services Group**

 

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

 

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

 

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

 

Some companies in our Services Group provideconstruction, operations and maintenance services to our Utility Group andrecognize a profit on those services. In accordance with SFAS No. 71,*Accounting for the Effects of Certain Types ofRegulation* (“SFAS 71”), we do not eliminate the Services Group’sprofit because management believes the sales price is reasonable and it isprobable that, through the rate making process, future Utility Group revenueapproximately equal to the sales price will result from the regulated utilities’use of the services. We do, however, eliminate revenues to the extent of therelated costs in the consolidated financial statements in accordance with theguidance provided in SFAS 71. In 2008, we eliminated the capital projectwork management services offered by our Service Division in Texas. Capitalproject management is a critical component of our Texas utility strategy andtherefore will be managed directly by the Utility Group going forward.  We are also currently considering making thischange in Alabama, Mississippi and New Mexico.

 

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

 

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

 

#### **Effects ofInflation**

 

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

 

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

 

Our financial position, results of operations and cash flows have beenaffected by our history of acquisitions. Our most recent significantacquisitions, which affect the comparability of the historical financialcondition and results of operations described in the MD&A, are:

 

Utility Group:

 

·                  anorthern Mississippi-based water and wastewater utility serving approximately275 water connections and servicing approximately 355 wastewater connectionsthrough four collection systems in February 2007;

 

·                  twoTexas-based water utilities near San Antonio serving approximately 2,600connections in May 2007;

 

·                  aMadison County, Alabama-based wastewater collection and treatment systemservicing approximately 120 connections in November 2007;

 

·                  aBirmingham, Alabama-based wastewater collection and treatment system servicingapproximately 4,100 residential and commercial connections in January 2008.

 

During 2007, we committed to a plan to sell awholesale water and wastewater operation in Texas and believe the sale can beconsummated during 2008. As a result of this decision, the operation isclassified as a discontinued 

 

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operation in our consolidated financial statementsand the discussion below reflects only continuing operations for all periods.

 

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

 

In 2007, the Albuquerque Bernalillo CountyWater Utility Authority and the City of Rio Rancho, New Mexico, filed a Petitionfor Condemnation (the “Petition”) against our New Mexico regulated utility, NewMexico 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. The Petition also alleges that thePetitioners need to acquire the utility assets for the public purposes ofproviding water and wastewater services to customers and that the acquisition of NMUI is necessary, appropriate andin the public interest. We believe we have defenses to the Action which weintend to vigorously assert. If we do not prevail, the Petitioners must payfair market value as determined by the court, based on appraisals. NMUI and thePetitioners do not agree on the value of the assets which the Petitioners seekto condemn. While it is too early to predict the outcome of this matter, webelieve that if the Court were to determine the fair market value of NMUI, itwould exceed its recorded net book value as of June 30, 2008. Foradditional information on this matter, see Note 5 to the condensed consolidatedfinancial statements included in this report.

 

### **BUSINESS OUTLOOK**

 

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

 

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

 

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

 

The Services Group growth strategy focuses onexpanding our client base, making strategic acquisitions and providingperipheral services such as construction of infrastructure, billing andcollection services, customer care/call centers, meter replacement and laboratoryanalysis of water and wastewater samples. By pursuing new operations andmaintenance contracts with cities, municipalities and private owners of waterand wastewater utilities within our geographic footprint, we expand ourpresence in a region and gain economies of scale. We look to expand the scopeof our contracts with current clients by adding additional services such asbilling and collections and providing capital improvement project managementservices. We also continue to pursue acquisitions of small, strategic servicecompanies that expand our geographic presence and give us knowledge of theregion’s water and wastewater needs. This local knowledge positions us forgrowth both in the service as well as the utility side of the business as municipalitieslook to form public/private partnerships or to sell their utility assets. Thiswas demonstrated in March 2005 by our acquisition of Novus Utilities, acontract operations business in Alabama which gave us local knowledge andrelationships in the region. This positioning in turn led to the acquisition ofthree wastewater utilities, one in September 2005, a second in November 2007and the third in January 2008.

 

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### **RESULTS OFOPERATIONS**

 

#### **Change inPresentation**

 

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

 

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

 

#### **Three monthsended June 30, 2008 Compared to 2007**

 

**Revenues.**Revenuesincreased $2.2 million, or 4.0%, to $57.1 million for the quarter ended June 30,2008 from $54.9 million for the 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)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                    |       |                             |       |         |       |                              |       |   |   |   |   |
| Utility Group                           |       | $                                | 27,484     |         | $          | 23,554                            |       | $ | 3,930 |   | 48.2 | % | 42.9 | % |
| Services Group                          |       | 29,582                           |       | 31,342       |       | (1,760                            | )          | 51.8 | % | 57.1 | % |
| Total                                   |       | $                                | 57,066     |         | $          | 54,896                            |       | $ | 2,170 |   | 100.0 | % | 100.0 | % |

 

***UtilityGroup.***Revenues increased $3.9 million, or 16.7%,to $27.5 million for the quarter ended June 30, 2008, from $23.6 millionfor the same period during the prior year. The increase was primarily due tothe following:

 

·                  a$2.0 million increase at  our Texasutilities primarily resulting from a fourth quarter 2007 interim rate increaseat our Monarch utility;

 

·                  a$1.5 million increase at our Alabama utilities primarily resulting from theacquisition of a wastewater treatment plant in the Birmingham, Alabama area atthe end of January 2008;

 

·                  a$0.4 million increase resulting from utility acquisitions near San Antonio,Texas and in northern Alabama; and

 

·                  a$0.4 million increase in rates associated with our California utility stepincrease put in place in July 2007; offset by

 

·                  $0.4million in lower revenues due to decreased consumption at our Californiautility from the prior year.

 

***ServicesGroup.***Revenues decreased $1.8 million, or 5.6%,to $29.6 million for the quarter ended June 30, 2008 from $31.3 millionfor the same period during the prior year. The decrease in revenues wasprimarily due to the following:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|-----------------------------------|------------|
| ** **                                            | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                              |       |   |   |   |   |
| Revenues from unaffiliated customers                  |       | $                                | 28,884     |         | $          | 30,456                            |       | $ | (1,572 | ) | 81.9 | % | 81.2 | % |
| Intersegment revenues                                 |       | 6,362                            |       | 7,047        |       | (685                              | )          | 18.1 | % | 18.8 | % |
| Total revenues                                        |       | 35,246                           |       | 37,503       |       | (2,257                            | )          | 100.0 | % | 100.0 | % |
| Intersegment cost eliminations                        |       | (5,664                           | )          | (6,161       | )          | 497                               |       |   |   |   |   |
| Total                                                 |       | $                                | 29,582     |         | $          | 31,342                            |       | $ | (1,760 | ) |   |   |   |   |

 

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Revenues from unaffiliated customersdecreased $1.6 million, or 5.2%, to $28.9 million for the quarter ended June 30,2008 from $30.5 million for the same period during the prior year. The decreasein revenues was primarily due to the following:

 

·                  a$2.1 million decrease primarily related to lost contracts in our Texas MUDbusiness due to increased competition in addition to a decrease in revenuesassociated with the slowdown in new housing construction; and

 

·                  a$0.9 million decrease in revenue related to the shutdown of our electricalcontracting department in Colorado in December 2007; offset by

 

·                  a$1.4 million increase in our California operations primarily as a result ofincreased billable project work related to repairs and maintenance.

 

Intersegment revenues from our Utility Groupdecreased by $0.7 million, or 9.7%, to $6.4 million for the quarter ended June 30,2008 from $7.0 million for the same period during the prior year. The decreasein revenues was primarily due to the following:

 

·                  a$2.1 million decrease in revenue related to capital project work performed onbehalf of our utilities in New Mexico and Texas. This capital project revenuedecrease is related to our decision to have capital project work directlymanaged by the Utility Group as previously described in the Services GroupOverview; offset by

 

·                  a$0.9 million increase attributable to new revenue related to operations,maintenance and capital project work performed for our Riverview wastewatertreatment plant in Birmingham, Alabama that we acquired in January 2008;

 

·                  a$0.1 million increase in revenue related to operations, maintenance and capitalproject work performed on behalf of our other utilities in Alabama; and

 

·                  a$0.4 million increase in revenue related to repairs and maintenance servicesprovided to our Texas Utilities.

 

**Direct OperatingExpenses.**Direct operating expenses increased $4.6million, or 11.6%, to $44.6 million for the quarter ended June 30, 2008from $39.9 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)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                                | 15,746     |         | $          | 13,207                                     |       | $ | 2,539 |   | 57.3 | % | 56.1 | % |
| Services Group                                        |       | 28,833                           |       | 26,730       |       | 2,103                                      |       | 97.5 | % | 85.3 | % |
| Total                                                 |       | $                                | 44,579     |         | $          | 39,937                                     |       | $ | 4,642 |   | 78.1 | % | 72.8 | % |

 

----

(1)   Utility Groupand Services Group direct operating expenses are computed as a percent of theirrespective revenues. Total direct operating expenses are computed as apercentage of total revenues.

 

***UtilityGroup.***Direct operating expenses increased $2.5million, or 19.2%, to $15.7 million for the quarter ended June 30, 2008,from $13.2 million for the same period during the prior year. The increase indirect operating expenses was primarily due to the following:

 

·                  a$1.1 million increase at our Alabama utilities primarily resulting from theacquisition of a wastewater treatment plant in the Birmingham, Alabama area atthe end of January, 2008;

 

·                  a$0.6 million increase in costs at our California utility principally resultingfrom an increase in production costs associated with higher amounts ofpurchased water in addition to higher salaries associated with filling vacantpositions and annual wage increases;

 

·                  a$0.6 million increase at our Texas utilities primarily in depreciation expense,higher contract operation fees associated with repair and maintenance work andincreased water production costs; and

 

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·                  a$0.2 million increase in expenses resulting from our acquisition near SanAntonio, Texas and in northern Alabama.

 

***ServicesGroup.***Direct operating expenses increased $2.1million, or 7.9%, to $28.8 million for the quarter ended June 30, 2008from $26.7 million for the same period during the prior year. The increase indirect operating expenses was primarily due to the following:

 

·                  a$2.1 million increase related to the change in methodology of capturing directoperating versus selling, general and administrative expenses;

 

·                  a$1.2 million increase in our California operations associated with increasedbillable project work related to repairs and maintenance activities; and

 

·                  a$1.2 million increase related to legal and other expenses associated with theinvestigation by the California State Water Resources Board also described inNote 5 to the condensed consolidated financial statements; offset by

 

·                  a$1.0 million decrease primarily related to lost contracts in our Texas MUDbusiness in addition to a decrease in costs associated with the slowdown in newhousing construction;

 

·                  a$0.7 million decrease in costs related to the reversal of an accrual for finesand penalties for various compliance violations as a result of the favorablesettlement of the matter as described in Note 5 to the condensed consolidatedfinancial statements included in Part I of this report; and

 

·                  a$0.7 million decrease in costs related to the shutdown of our electricalcontracting department in Colorado in December 2007.

 

Direct operating expenses as a percentage ofthe related revenues increased 12.2% to 97.5% for the quarter ended June 30,2008 compared to 85.3% for the same period during the prior year. Without theeffect of the reclassification of the SG&A, direct operating costs wouldhave been 90.4% of revenues for 2008.

 

**Gross Profit.**Grossprofit, which we define as the difference between revenues and the relateddirect operating expenses, which includes depreciation and amortization relatedto direct operating activities, decreased $2.5 million, or 16.5%, to $12.5million for the quarter ended June 30, 2008 from $15.0 million for thesame period during the prior year as follows:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |       |       |   |   |
| Utility Group                                         |       | $                                | 11,738     |         | $          | 10,347                                     |       | $          | 1,391      |   | 42.7 | % | 43.9 | % |
| Services Group                                        |       | 749                              |       | 4,612        |       | (3,863                                     | )          | 2.5        | %          | 14.7 | % |
| Total                                                 |       | $                                | 12,487     |         | $          | 14,959                                     |       | $          | (2,472     | ) | 21.9 | % | 27.2 | % |

 

----

(1)   Utility Groupand Services Group gross profit is computed as a percent of their respectiverevenues after intersegment eliminations. Total gross profit is computed as apercentage of total revenues.

 

***UtilityGroup.***Gross profit was 42.7% and 43.9% of relatedrevenues for the quarter ended June 30, 2008 and 2007, respectively. Thedecrease was caused by the higher direct operating expenses described above.

 

***ServicesGroup.***Gross profit for the quarter ended June 30,2008 and 2007 was comprised of the following:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |       |       |   |   |
| Gross profit on sales to:                             |       |                             |       |         |       |                                       |       |       |       |   |   |
| Unaffiliated customers                                |       | $                                | 51         |         | $          | 3,726                                      |       | $          | (3,675     | ) | 0.2 | % | 12.2 | % |
| Affiliated customers (intersegment)                   |       | 698                              |       | 886          |       | (188                                       | )          | 11.0       | %          | 12.6 | % |
| Total                                                 |       | $                                | 749        |         | $          | 4,612                                      |       | $          | (3,863     | ) | 2.1 | % | 12.3 | % |

 

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(1)          Gross profit is computed as a percent of therespective revenues before intersegment eliminations.

 

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Services Group gross profit on revenues fromunaffiliated customers decreased by $3.7 million, or 98.6%, to $0.1 million forthe quarter ended June 30, 2008 from $3.7 million for the same periodduring the prior year. Gross profit as a percent of revenues for 2008 decreasedto 0.2% compared to 12.2% for the same period for the prior year.  The decrease in gross margin was primarilydue to the following:

 

·                  a$1.1 million decrease in margin related to lost contracts and the shutdown ofthe electrical department in Colorado, net of increased margin from ourCalifornia operations;

 

·                  a$0.5 million net decrease in margin resulting from increased legal fees andliability accruals related to various compliance matters, offset by thefavorable resolution other compliance matters; and

 

·                  a$2.1 million increase in direct operating expenses related to our change inmethodology of capturing direct operating versus selling, general andadministrative expenses.

 

Services Group gross profit on revenues fromour Utility Group decreased by $0.2 million, or 21.2% to $0.7 million for thequarter ended June 30, 2008 from $0.9 million for the same period duringthe prior year. The decrease is related to a the elimination of capital projectwork performed on behalf of our Texas utilities offset by increased operations,maintenance and capital project work performed on behalf of our Alabama utilities.

 

The Services Group supports three distinctlydifferent customer bases; Texas Municipal Utility Districts or MUD’s, municipalclients through operations and maintenance contracts, and our own UtilityGroup. We want to accelerate our performance improvements and therefore we haverefocused this Group in 2008 along these business lines to better serve theunique demands of each customer base, to focus our business development effortsfor each market and to eliminate structural redundancies.

 

***Selling,General and Administrative Expenses.***Selling,general and administrative expenses decreased $0.2 million, or 2.1%, to$9.1 million for the quarter ended June 30, 2008 compared to $9.3 millionfor the same period during the prior year as follows:

 
| ** **                                            | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**                | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                         | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                             |       |         |       |                                       |       |       |       |   |   |
| Utility Group                                         |       | $                                | 2,537      |         | $          | 1,928                                      |       | $          | 609        |   | 9.2 | % | 8.2 | % |
| Services Group                                        |       | 1,672                            |       | 3,553        |       | (1,881                                     | )          | 5.7        | %          | 11.3 | % |
| Corporate                                             |       | 4,904                            |       | 3,830        |       | 1,074                                      |       | —     |       | — |   |
| Total                                                 |       | $                                | 9,113      |         | $          | 9,311                                      |       | $          | (198       | ) | 16.0 | % | 17.0 | % |

 

----

(1)   Utility Groupand Services Group expenses are computed as a percent of their respectiverevenues. Total expenses are computed as a percentage of total revenues.

 

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

 

Utility Group expenses increased by $0.6million for the period ended June 30, 2008 compared to the prior yearprimarily due to an increase in information technology expenses associated withsupporting the new infrastructure of our Cornerstone project (described below),which will assist in enhancing customer service.

 

Service Group expenses decreased by $1.9million for the period ended June 30, 2008 compared to the prior yearprimarily related to the following:

 

·                  a$0.2 million increase in costs related to our safety/compliance efforts; offsetby

 

·                  a$2.1 million decrease in selling, general and administrative expenses relatedto management’s change in methodology of capturing direct operating versusselling, general and administrative expense.

 

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Corporate expenses increased $1.1 million to$4.9 million for the period ended June 30, 2008 compared to $3.8 millionfor the same period during the prior year. Our Cornerstone project, whichcommenced during the second quarter of 2007 accounts for $0.9 million of theincrease.

 

The Cornerstone project is a company-wideinitiative to reengineer our business processes and integrate our informationsystems onto a single platform across the entire company utilizingstate-of-the-art systems and technology. Our existing systems are standalonelegacy systems that were in place when we acquired many of our subsidiaries.These individual standalone systems are costly to operate and maintain and makethe consolidation and sharing of data between the various platformslabor-intensive and time-consuming. The financial module of the integratedplatform became operational on January 1, 2008 and is performing asexpected.

 

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

 

**Other Income(Expense).**Other expenses increased $0.1 million, or3.4%, to $1.9 million for the quarter ended June 30, 2008, compared to$1.8 million for the same period during the prior year as follows:

 
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | **(Increase)** | ** ** |
|-------------------------|------------|------------|------------|------------|------------|----------------|------------|
| **(In thousands)** | ** ** | **2008**   | ** ** | **2007**   | ** ** | **Decrease**   | ** ** |
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** |
| Interest expense        |       | $          | (2,042     | )          | $          | (1,885         | )          | $ | (157 | ) |
| Interest income         |       | 128        |       | 50         |       | 78             |       |
| Other, net              |       | 4          |       | (12        | )          | 16             |       |
| Total                   |       | $          | (1,910     | )          | $          | (1,847         | )          | $ | (63 | ) |

 

***InterestExpense.***Interest expense increased by $0.2million, or 8.3%, to $2.0 million for the quarter ended June 30, 2008 from$1.9 million compared to the same period during the prior year. The majorcomponents of interest expense were as follows:

 
| **(In thousands)**                                      | ** ** | **2008**   | ** ** | **2007**   | ** ** | **Change** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Mortgage bonds and bank term loans                           |       | $          | 1,212      |       | $          | 1,193      |       | $ | 19 |   |
| Revolving lines of credit                                    |       | 911        |       | 789        |       | 122        |       |
| Convertible subordinated debentures                          |       | 206        |       | 214        |       | (8         | )          |
| Other indebtedness and deferred financing  cost amortization |       | 161        |       | 151        |       | 10         |       |
| Total interest incurred on indebtedness                      |       | 2,490      |       | 2,347      |       | 143        |       |
| Less capitalized interest                                    |       | (145       | )          | (223       | )          | 78         |       |
| Less interest related to discontinued  operations            |       | (303       | )          | (239       | )          | (64        | )          |
| Total interest expense                                       |       | $          | 2,042      |       | $          | 1,885      |       | $ | 157 |   |

 

The increase in revolving line of creditinterest is caused by higher borrowing levels related to financing capitalspending in 2007 and 2008, including the capital and expense portions of ourCornerstone project, and the first quarter 2008 $23.3 million acquisition ofthe Alabama wastewater treatment facility. This was offset by a lower averageinterest rate on our line of credit. The average balance of interest-bearingdebt outstanding increased to $188.6 million during the quarter ended June 30,2008 compared to $141.2 million for the prior year.

 

The weighted average annual interest rate ontotal borrowings was approximately 5.3% for the quarter ended June 30,2008 and 6.6% for the same period in the prior year.

 

***InterestIncome.***Interest income was constant at $0.1million for the quarters ended June 30, 2008 and 2007.

 

**Provision for IncomeTaxes.**Our effective consolidated income tax rate oncombined continuing and discontinued operations was 34% for the quarter ended June 30,2008 compared to 36% for 2007. The change is principally caused by theinteraction between the newly enacted Texas franchise tax, which does notchange proportionally with 

 

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changes in pre-tax income or loss, andfederal and state income taxes that do change proportionally with to pre-taxincome or losses.

 

**Loss fromDiscontinued Operations.** Loss from discontinued operations, net of tax, which pertains to ourwholesale water and wastewater business we elected to sell, was $1.7 millionfor the quarter ended June 30, 2008, compared to $0.2 million for the sameperiod in 2007. Included in the net loss is a $2.5 million charge ($1.6 millionnet of tax) to further reduce the carrying value of the assets to expected netrealizable value based on the current status of negotiations with prospectivebuyers.

 

#### **Six monthsended June 30, 2008 Compared to 2007**

 

**Revenues.**Revenuesincreased $5.1 million, or 4.9%, to $107.8 million for the six months ended June 30,2008 from $102.8 million for the same period during the prior year. By segment,revenues changed as follows:

 
| ** **                                            | ** ** | **Six months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|--------------|------------|-----------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                       | ** ** | **2007**     | ** ** | **(Decrease)**                    | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                           |       |         |       |                              |       |       |       |   |   |
| Utility Group                                         |       | $                              | 49,825     |         | $          | 43,588                            |       | $          | 6,237      |   | 46.2 | % | 42.4 | % |
| Services Group                                        |       | 58,004                         |       | 59,177       |       | (1,173                            | )          | 53.8       | %          | 57.6 | % |
| Total                                                 |       | $                              | 107,829    |         | $          | 102,765                           |       | $          | 5,064      |   | 100.0 | % | 100.0 | % |

*** ***

***UtilityGroup.***Revenues increased $6.2 million, or 14.3%,to $49.8 million for the six months ended June 30, 2008, from $43.6million for the same period during the prior year. The increase was primarilydue to the following:

 

·                  a$3.9 million increase at our Texas utilities primarily resulting from a fourthquarter 2007 interim rate increase at our Monarch utilities;

 

·                  a$2.5 million increase at our Alabama utilities primarily resulting from theacquisition of a wastewater treatment plant in the Birmingham, Alabama area atthe end of January, 2008;

 

·                  a$0.7 million increase resulting from utility acquisitions near San Antonio,Texas and in northern Alabama in 2007; and

 

·                  a$0.5 million increase in rates associated with our California utility stepincrease put in place in July, 2007; offset by

 

·                  a$1.4 million decrease at our California utility related to lower consumptioncompared to the prior year.

 

***ServicesGroup.***Revenues decreased $1.2 million, or 2.0%,to $58.0 million for the six months ended June 30, 2008 from $59.2 millionfor the same period during the prior year. The decrease in revenues wasprimarily due to the following:

 
| ** **                                            | ** ** | **Six months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|--------------|------------|-----------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                       | ** ** | **2007**     | ** ** | **(Decrease)**                    | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                           |       |         |       |                              |       |       |       |   |   |
| Revenues from unaffiliated customers                  |       | $                              | 56,183     |         | $          | 56,772                            |       | $          | (589       | ) | 81.6 | % | 79.9 | % |
| Intersegment revenues                                 |       | 12,701                         |       | 14,267       |       | (1,566                            | )          | 18.4       | %          | 20.1 | % |
| Total revenues                                        |       | 68,884                         |       | 71,039       |       | (2,155                            | )          | 100.0      | %          | 100.0 | % |
| Intersegment cost eliminations                        |       | (10,880                        | )          | (11,862      | )          | 982                               |       |       |       |   |   |
| Total                                                 |       | $                              | 58,004     |         | $          | 59,177                            |       | $          | (1,173     | ) |   |   |   |   |

 

Revenues from unaffiliated customersdecreased $0.6 million, or 1.0%, to $56.2 million for the six months ended June 30,2008 from $56.8 million for the same period during the prior year. The decreasein revenues was primarily due to the following:

 

·                  a$1.8 million decrease primarily related to lost contracts due to competition inour Texas MUD business in addition to a decrease in revenues associated withthe slowdown in new housing construction, offset by a year to date increase inbillable project revenue related to repairs and maintenance; and

 

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·                  a$0.7 million decrease in revenue related to the shutdown of our electricalcontracting department in Colorado in December 2007; offset by

 

·                  a$1.9 million increase in our California operations primarily as a result ofincreased billable project work related to repairs and maintenance.

 

Intersegment revenues from our Utility Groupdecreased by $1.6 million, or 11.0%, to $12.7 million for the six months ended June 30,2008 from $14.3 million for the same period during the prior year. The decreasein revenues was primarily due to the following:

 

·                  a$5.0 million decrease in revenue related to capital project work performed onbehalf of our utilities in New Mexico and Texas. This capital project revenuedecrease is related to our decision to have capital project work directlymanaged by the Utility Group as previously discussed in the Services GroupOverview; offset by

 

·                  a$1.7 million increase attributable to new revenue related to operations,maintenance and capital project work performed for our Riverview wastewatertreatment plant in Birmingham, Alabama that we acquired in January 2008;

 

·                  a$0.8 million increase in revenue related to operations, maintenance and capitalproject work performed on behalf of our other utilities in Alabama; and

 

·                  a$0.9 million increase in revenue related to repairs and maintenance servicesprovided to our Texas Utilities.

 

**Direct OperatingExpenses.**Direct operating expenses increased $7.7million, or 10.2%, to $83.9 million for the six months ended June 30, 2008from $76.2 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)** | ** ** | **2008**                       | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                           |       |         |       |                                       |       |       |       |   |   |
| Utility Group                                         |       | $                              | 29,187     |         | $          | 25,016                                     |       | $          | 4,171      |   | 58.6 | % | 57.4 | % |
| Services Group                                        |       | 54,743                         |       | 51,172       |       | 3,571                                      |       | 94.4       | %          | 86.5 | % |
| Total                                                 |       | $                              | 83,930     |         | $          | 76,188                                     |       | $          | 7,742      |   | 77.8 | % | 74.1 | % |

 

----

(1)   Utility Groupand Services Group direct operating expenses are computed as a percent of theirrespective revenues. Total direct operating expenses are computed as apercentage of total revenues.

 

***UtilityGroup.***Direct operating expenses increased $4.2million, or 16.7%, to $29.2 million for the six months ended June 30,2008, from $25.0 million for the same period during the prior year. The increasein direct operating expenses was primarily due to the following:

 

·                  a$1.9 million increase at our Alabama utilities primarily resulting from theacquisition of a wastewater treatment plant in the Birmingham, Alabama area atthe end of January, 2008;

 

·                  a$1.6 million increase in costs at our California utility principally resultingfrom an increase in production costs associated with higher amounts ofpurchased water in addition to higher salaries associated with filling vacantpositions and annual wage increases;

 

·                  a$1.5 million increase at our Texas and New Mexico utilities in depreciationexpense, contract operation fees, and sewage treatment expenses as well ascosts associated with improving our information technology support to providebetter customer service; and

 

·                  a$0.4 million increase in expenses resulting from our utility acquisition nearSan Antonio, Texas and in northern Alabama; offset by

 

·                  a$1.2 million decrease in production costs at our California utility associatedwith decreased consumption.

 

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***ServicesGroup.***Direct operating expenses increased $3.6million, or 7.0%, to $54.7 million for the six months ended June 30, 2008from $51.2 million for the same period during the prior year. The increase indirect operating expenses was due to the following:

 

·                  a$0.9 million decrease in costs related to the shutdown of our electricalcontracting department in Colorado in December 2007;

 

·                  a$0.8 million decrease primarily related to lost contracts in our Texas MUDbusiness in addition to a decrease in costs associated with the slowdown in newhousing construction, offset by increased costs associated with increasedbillable revenue for repairs and maintenance; and

 

·                  a$0.7 million decrease in costs related to the favorable settlement of variouscompliance matters described in Note 5 to the condensed consolidated financialstatements; offset by

 

·                  a$3.1 million increase related to the change in methodology of capturing directoperating versus selling, general and administrative expenses;

 

·                  a$1.7 million increase in our California operations associated with increasedbillable project work related to repairs and maintenance activities;

 

·                  a$1.2 million increase related to legal and other expenses associated with theinvestigation by the California State Water Resources Board also described inNote 5.

 

Direct operating expenses as a percentage ofthe related revenues increased 7.9% to 94.4% for the six months ended June 30,2008 compared to 86.5% for the same period during the prior year.  Without the effect of the reclassification ofthe SG&A, direct operating costs would have been 89% of revenues for 2008.

 

**Gross Profit.**Grossprofit, which we define as the difference between revenues and the relateddirect operating expenses, which includes depreciation and amortization relatedto direct operating activities, decreased $2.7 million, or 10.1%, to $23.9million for the six months ended June 30, 2008 from $26.6 million for thesame period during the prior year as follows:

 
| ** **                                            | ** ** | **Six months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|--------------|------------|--------------------------------------------|------------|
| ** **                                            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                       | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                  |       |                           |       |         |       |                                       |       |   |   |   |   |
| Utility Group                                         |       | $                              | 20,638     |         | $          | 18,572                                     |       | $ | 2,066 |   | 41.4 | % | 42.6 | % |
| Services Group                                        |       | 3,261                          |       | 8,005        |       | (4,744                                     | )          | 5.6 | % | 13.5 | % |
| Total                                                 |       | $                              | 23,899     |         | $          | 26,577                                     |       | $ | (2,678 | ) | 22.2 | % | 25.9 | % |

 

----

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

 

***UtilityGroup.***Gross profit was 41.4% and 42.6% of relatedrevenues for the six months ended June 30, 2008 and 2007, respectively.

 

***ServicesGroup.***Gross profit for the six months ended June 30,2008 and 2007 was comprised of the following:

 
| ** **                                            | ** ** | **Six months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                       | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                           |       |         |       |                                       |       |       |       |   |   |
| Gross profit on sales to:                             |       |                           |       |         |       |                                       |       |       |       |   |   |
| Unaffiliated customers                                |       | $                              | 1,440      |         | $          | 5,600                                      |       | $          | (4,160     | ) | 2.6 | % | 9.9 | % |
| Affiliated customers (intersegment)                   |       | 1,821                          |       | 2,405        |       | (584                                       | )          | 14.3       | %          | 16.9 | % |
| Total                                                 |       | $                              | 3,261      |         | $          | 8,005                                      |       | $          | (4,744     | ) | 4.7 | % | 11.3 | % |

 

----

(1)          Gross profit is computed as a percent of therespective revenues before intersegment eliminations.

 

Services Group gross profit on revenues fromunaffiliated customers decreased by $4.2 million, or 74.3%, to $1.4 million forthe six months ended June 30, 2008 from $5.6 million for the same periodduring the prior year. Gross profit as a percent of revenues for 2008 decreasedto 2.6% compared to 9.9% for the same period for the prior year. The decreasein gross margin was primarily due to the following:

 

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·                 a$0.6 million decrease in margin related to lost contracts and the shutdown ofthe electrical department in Colorado net of increased margin from ourCalifornia operations; offset by

 

·                 a$3.1 million increase in direct operating expenses related to managementschange in methodology of capturing direct operating versus selling, general andadministrative expense; and

 

·                 a$0.5 million net decrease in margin resulting from increased legal fees andliability accruals related to various compliance matters, offset by thefavorable resolution other compliance matters.

 

Services Group gross profit on revenues fromour Utility Group decreased by $0.6 million, or 24.3% to $1.8 million for thesix months ended June 30, 2008 from $2.4 million for the same periodduring the prior year. The decrease is related to reduced capital project workperformed on behalf of our Texas utilities offset by increased operations,maintenance and capital project work performed on behalf of our Alabamautilities.

 

The Services Group supports three distinctlydifferent customer bases; Texas Municipal Utility Districts or MUD’s, municipalclients through operations and maintenance contracts, and our own UtilityGroup. We want to accelerate our performance improvements and therefore we haverefocused this Group in 2008 along these business lines to better serve theunique demands of each customer base, to focus our business development effortsfor each market and to eliminate structural redundancies that may exist today.

 

***Selling,General and Administrative Expenses.***Selling,general and administrative expenses increased $0.9 million, or 4.9%, to$18.7 million for the six months ended June 30, 2008 compared to $17.8million for the same period during the prior year as follows:

 
| ** **                                            | ** ** | **Six months Ended** | ** ** | ** **   | ** ** | ** **                                 | ** ** | ** ** | ** ** |
|-------------------------------------------------------|------------|--------------------------------|------------|--------------|------------|--------------------------------------------|------------|------------|------------|
| ** **                                            | ** ** | **June 30,**              | ** ** | **Increase** | ** ** | **Percent of Revenues (1)** | ** ** |
| **(In thousands, except percentages)** | ** ** | **2008**                       | ** ** | **2007**     | ** ** | **(Decrease)**                             | ** ** | **2008**   | ** ** | **2007** | ** ** |
|                                                  |       |                           |       |         |       |                                       |       |       |       |   |   |
| Utility Group                                         |       | $                              | 5,058      |         | $          | 4,389                                      |       | $          | 669        |   | 10.2 | % | 10.1 | % |
| Services Group                                        |       | 3,324                          |       | 6,245        |       | (2,921                                     | )          | 5.7        | %          | 10.6 | % |
| Corporate                                             |       | 10,336                         |       | 7,207        |       | 3,129                                      |       | —     |       | — |   |
| Total                                                 |       | $                              | 18,718     |         | $          | 17,841                                     |       | $          | 877        |   | 17.4 | % | 17.4 | % |

 

----

(1)          Utility Group and Services Group expenses arecomputed as a percent of their respective revenues. Total expenses are computedas a percentage of total revenues.

 

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

 

Utility Group expenses increased by $0.7million for the period ended June 30, 2008 compared to the prior yearprimarily due to an increase in information technology expenses associated withsupporting the new infrastructure of the Cornerstone project, (describedbelow), which will assist in enhancing customer service.

 

Service Group expenses decreased by $2.9million for the period ended June 30, 2008 compared to the prior yearprimarily related to the following:

 

·                  a$0.2 million increase in costs related to our safety/compliance efforts; offsetby

 

·                  a$3.1 million decrease increase in selling, general and administrative expensesrelated to managements change in methodology of capturing direct operatingversus selling, general and administrative expenses.

 

Corporate expenses increased $3.1 million to$10.3 million for the period ended June 30, 2008 compared to $7.2 millionfor the same period in the prior year primarily as a result of $1.8 millionincrease in costs incurred related to our Cornerstone project, which commencedduring the second quarter of 2007; $0.7 million increase in professional feesassociated with evaluating a strategic business opportunity that did notmaterialize, in part, because of changes in the market conditions and $0.6million of other temporary increases associated with business processreengineering projects.

 

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The Cornerstone project is a company-wideinitiative to reengineer our business processes and integrate our informationsystems onto a single platform across the entire company utilizingstate-of-the-art systems and technology. Our existing systems are standalonelegacy systems that were in place when we acquired many of our subsidiaries.These individual standalone systems are costly to operate and maintain and makethe consolidation and sharing of data between the various platformslabor-intensive and time-consuming. The financial module of the integratedplatform became operational on January 1, 2008 and is performing asexpected.

 

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

 

**Other Income(Expense).**Other expenses increased $0.5 million, or14.8% to $4.1 million for the six months ended June 30, 2008, compared to$3.6 million for the same period during the prior year as follows:

 
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | **(Increase)** | ** ** |
|-------------------------|------------|------------|------------|------------|------------|----------------|------------|
| **(In thousands)** | ** ** | **2008**   | ** ** | **2007**   | ** ** | **Decrease**   | ** ** |
| ** **              | ** ** | ** ** | ** ** | ** ** | ** ** | ** **     | ** ** |
| Interest expense        |       | $          | (4,403     | )          | $          | (3,739         | )          | $ | (664 | ) |
| Interest income         |       | 250        |       | 185        |       | 65             |       |
| Other, net              |       | 4          |       | (61        | )          | 65             |       |
| Total                   |       | $          | (4,149     | )          | $          | (3,615         | )          | $ | (534 | ) |

 

***InterestExpense.***Interest expense increased by $0.7million, or 17.8% to $4.4 million for the six months ended June 30, 2008from $3.7 million compared to the same period during the prior year. The majorcomponents of interest expense were as follows:

 
| **(In thousands)**                                                  | ** ** | **2008**   | ** ** | **2007**   | ** ** | **Change** | ** ** |
|--------------------------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Mortgage bonds and bank term loans                                       |       | $          | 2,429      |       | $          | 2,383      |       | $ | 46 |   |
| Revolving lines of credit                                                |       | 1,848      |       | 1,449      |       | 399        |       |
| Convertible subordinated debentures                                      |       | 410        |       | 429        |       | (19        | )          |
| Other indebtedness and deferred financing  cost amortization             |       | 323        |       | 348        |       | (25        | )          |
| Total interest incurred on indebtedness                                  |       | 5,010      |       | 4,609      |       | 401        |       |
| Write-off of unamortized financing costs in  connection with refinancing |       | 268        |       | —     |       | 268        |       |
| Less capitalized interest                                                |       | (273       | )          | (415       | )          | 142        |       |
| Less interest related to discontinued  operations                        |       | (602       | )          | (455       | )          | (147       | )          |
| Total interest expense                                                   |       | $          | 4,403      |       | $          | 3,739      |       | $ | 664 |   |

 

The increase in our revolving line of creditinterest is caused by higher borrowing levels related to financing capitalspending in 2007 and 2008, including the capital and expense portions of ourCornerstone project, and the first quarter 2008 $23.3 million acquisition ofthe Alabama wastewater treatment facility. The write-off of unamortizeddeferred financing costs is associated with our $100.0 million revolving creditfacility we refinanced with a new $150.0 million facility in the first quarterof 2008. The average balance of interest-bearing debt outstanding increased to$174.8 million during the six months ended June 30, 2008 compared to$137.5 million for the prior year.

 

The weighted average annual interest rate ontotal borrowings was approximately 5.7% for the six months ended June 30,2008 and 6.7% for the same period in the prior year.

 

***InterestIncome.***Interest income increased by $0.1 million,to $0.3 million, compared to $0.2 million for the six months ended June 30,2008 and 2007. The increase is cause by higher levels of short-term investmentsof excess available cash offset by lower interest rates on such investments.

 

**Provision for IncomeTaxes.**Our effective consolidated income tax rate oncombined continuing and discontinued operations was 32% for the six monthsended June 30, 2008 compared to 36% for 2007. The change is principallycaused by the interaction between the newly enacted Texas franchise tax, whichdoes not change proportionally with

 

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changes in pre-tax income or loss, andfederal and state income taxes that do change proportionally with pre-tax incomeor losses.

 

**Loss fromDiscontinued Operations.** Loss from discontinued operations, net of tax, which pertains to ourwholesale water and wastewater business we elected to sell, was $2.0 millionfor the six months ended June 30, 2008, compared to $0.4 million for thesame period during the prior year. Included in the net loss is a $2.5 millioncharge ($1.6 million net of tax) to further reduce the carrying value of theassets to expected net realizable value based on the current status ofnegotiations with prospective buyers.

 

### **RECENT ACCOUNTINGPRONOUNCEMENTS**

###  

See the discussions under the captions “AccountingPronouncements Adopted During 2008” and “Recent Accounting Pronouncements”contained in Note 1 to the condensed consolidated financial statements includedin Part I, Item 1 of this report.

 

### **LIQUIDITY ANDCAPITAL RESOURCES**

###  

Our overall objectives with respect toliquidity 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 cash flows are summarizedas follows:

 
| ** **                                        | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|------------|------------|
| ** **                                        | ** ** | **June 30,**              | ** ** | ** ** | ** ** |
| **(In thousands)**                           | ** ** | **2008**                       | ** ** | **2007**   | ** ** | **Change** | ** ** |
|                                              |       |                           |       |       |       |   |   |
| Net cash provided by (used in):                   |       |                           |       |       |       |   |   |
| Continuing operations:                            |       |                           |       |       |       |   |   |
| Operating activities                              |       | $                              | (5,775     | )          | $          | 7,789 |   | $ | (13,564 | ) |
| Investing activities                              |       | (39,280                        | )          | (25,054    | )          | (14,226 | ) |
| Financing activities                              |       | 45,441                         |       | 16,572     |       | 28,869 |   |
| Total continuing operations                       |       | 386                            |       | (693       | )          | 1,079 |   |
| Discontinued operations:                          |       |                           |       |       |       |   |   |
| Operating activities                              |       | 575                            |       | (392       | )          | 967 |   |
| Investing activities                              |       | (28                            | )          | (317       | )          | 289 |   |
| Total discontinued operations                     |       | 547                            |       | (709       | )          | 1,256 |   |
| Increase (decrease) in cash and cash  equivalents |       | $                              | 933        |       | $          | (1,402 | ) | $ | 2,335 |   |

 

**Cash Flows From Operating Activities ofContinuing Operations.**Net cash used in operatingactivities was $5.8 million for the six months ended June, 2008 versus $7.8million provided by operating activities for the same period last year.Operational aspects of our businesses that affected working capital in 2008versus 2007 are highlighted below:

 

·                  a$0.8 million increase in receivables resulting from our January 2008acquisition of a wastewater collection system and treatment plant in theBirmingham, Alabama area; the seller retained all receivables as of theacquisition date so the increase relates to the initial, one-time buildup ofreceivables as customers pay the seller for the services rendered prior to theacquisition date;

 

·                  anincrease in receivables because of slower payments by some customers which webelieve may be attributable, in part, to the overall economic downturn; and

 

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·                  increasedlevel of vendor payments in early 2008 for goods and services received duringthe fourth quarter of 2007.

 

**Cash Flows From Investing Activities ofContinuing Operations.**Cash used in investingactivities totaled $39.3 million for the six months ended June 30, 2008compared to $25.1 million for the same period during the prior year as follows:

 
| ** **                                              | ** ** | **Six Months Ended** | ** ** | ** ** | ** ** |
|---------------------------------------------------------|------------|--------------------------------|------------|------------|------------|
| ** **                                              | ** ** | **June 30,**              | ** ** | ** ** | ** ** |
| **(In thousands)**                                 | ** ** | **2008**                       | ** ** | **2007**   | ** ** | **Change** | ** ** |
| ** **                                              | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash flows (used in) provided by investing  activities: |       |                           |       |       |       |   |   |
| Acquisition of businesses, net of cash  acquired        |       | $                              | (23,330    | )          | $          | (6,547 | ) | $ | (16,783 | ) |
| Additions to property, plant and equipment              |       | (16,129                        | )          | (18,548    | )          | 2,419 |   |
| Proceeds from sales of equipment                        |       | 179                            |       | 41         |       | 138 |   |
| Net cash used in investing activities                   |       | $                              | (39,280    | )          | $          | (25,054 | ) | $ | (14,226 | ) |

 

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

 
| *** ***                                           | *** *** | ***Six Months Ended*** | ** ** |
|--------------------------------------------------------|--------------|----------------------------------|------------|
| *** ***                                           | *** *** | ***June 30,***              | ** ** |
| ***(In thousands)***                              | ** **   | **2008**                         | ** ** | **2007** | ** ** |
| ** **                                             | ** **   | ** **                       | ** ** | ** ** | ** ** |
| Company-financed additions                             |         | $                                | 13,912     |   | $ | 16,364 |   |
| Capital improvement reimbursements                     |         | 779                              |       | 1,628 |   |
| Cash contributions received in aid of  construction    |         | 1,438                            |       | 556 |   |
| Total cash additions to property, plant and  equipment |         | 16,129                           |       | 18,548 |   |
| Non-cash contributions in aid of  construction         |         | —                           |       | 3,153 |   |
| Total additions to property, plant and  equipment      |         | $                                | 16,129     |   | $ | 21,701 |   |

 

Capital projects primarily relate to theexpansion, replacement and renovation of our water and wastewater systems,particularly at our California, Texas and New Mexico utilities and, in 2008,include $3.6 million of expenditures related to our Cornerstone project.Contributions in Aid of Construction (“CIAC”) represent contributions in theform of cash, services or property received from developers, governmentalagencies, municipalities or individuals for the purpose of constructing utilityplant and is not refundable.

 

In 2008, we expect to spend approximately$30.0 million on cash additions, principally within our Utility Group, expectto receive $0.4 million of CIAC, and expect to finance up to an additional$14.0 million of Cornerstone-related expenditures with our capital leasefacility resulting in total expected additions to property, plant and equipmentof approximately $44.0 million.

 

**Cash Flows From Financing Activities ofContinuing Operations.**During the six months ended June 30,2008, we financed our growth through a broad range of capital initiatives:

 

·                  borrowed$47.0 million under our revolving line of credit;

 

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

 

·                  received$1.8 million of proceeds from our share-based equity incentive plans and stockpurchase plans.

 

Revolving lines of credit were primarily usedto fund our investing activities and, to a lesser extent, to fund operations.Additional borrowing availability under our revolving credit facility was $50.0million as of June 30, 2008.

 

During the six months ended June 30,2008, we paid dividends totaling $3.0 million and our quarterly dividend rateis currently $0.06 per common share.

 

In February 2008, we entered into a newcredit agreement with several lenders including Bank of America, as lender andAdministrative Agent, KeyBank, CoBank, U.S. Bank, JPMorgan Chase Bank, ComericaBank, Bank of the West, Citibank and Union Bank of California. The creditagreement provides for a $150.0 million revolving credit facility. We

 

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may elect to increase the amount of thecredit facility by an amount not to exceed $75.0 million during the term of theagreement provided certain conditions are met. The new credit agreement is morefully described in Note 4 to the condensed consolidated financial statementsincluded in this report.

 

The new revolving line of credit commitmentends on February 15, 2013 and our $100.0 million credit facility wascancelled upon repayment with an initial borrowing of $84.5 million under the$150.0 million facility.

 

### **CONTRACTUALOBLIGATIONS**

###  

The following table summarizes our knowncontractual obligations to make future cash payments as of June 30, 2008,as well as an estimate of the periods during which these payments are expectedto be made.

 
| ** **                                       | ** ** | **Years Ending December 31,** | ** ** |
|--------------------------------------------------|------------|----------------------------------------------|------------|
| ** **                                       | ** ** | ** **                                   | ** ** | **Remainder** | ** ** | **2009** | ** ** | **2011** | ** ** | **2013** | ** ** |
| ** **                                       | ** ** | ** **                                   | ** ** | **of** | ** ** | **and** | ** ** | **and** | ** ** | **and** | ** ** |
| **(In thousands)**                          | ** ** | **Total**                                    | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** | **Beyond** | ** ** |
|                                             |       |                                         |       |   |   |   |   |   |   |   |   |
| Long-term debt (1):                              |       |                                         |       |   |   |   |   |   |   |   |   |
| Bank line of credit (2)                          |       | $                                            | 98,000     |   | $ | — |   | $ | — |   | $ | — |   | $ | 98,000 |   |
| Mortgage bonds (3)                               |       | 45,000                                       |       | — |   | — |   | — |   | 45,000 |   |
| Bank term loans (4)                              |       | 31,384                                       |       | 411 |   | 1,646 |   | 1,645 |   | 27,682 |   |
| Convertible subordinated debentures (5)          |       | 12,034                                       |       | — |   | — |   | — |   | 12,034 |   |
| Capital lease obligations (6)                    |       | 4,168                                        |       | 424 |   | 1,789 |   | 1,955 |   | — |   |
| Economic development revenue bonds (7)           |       | 1,925                                        |       | 115 |   | 245 |   | 280 |   | 1,285 |   |
| Notes payable and other (8)                      |       | 134                                          |       | 120 |   | 14 |   | — |   | — |   |
| Total long-term debt                             |       | 192,645                                      |       | 1,070 |   | 3,694 |   | 3,880 |   | 184,001 |   |
|                                             |       |                                         |       |   |   |   |   |   |   |   |   |
| Repayment of advances for construction (9)       |       | 13,756                                       |       | 638 |   | 1,366 |   | 864 |   | 10,888 |   |
| Water purchase commitment (10)                   |       | 7,397                                        |       | 230 |   | 920 |   | 920 |   | 5,327 |   |
| Operating lease obligations                      |       | 27,575                                       |       | 3,393 |   | 9,514 |   | 5,207 |   | 9,461 |   |
| Total obligations as of June 30, 2008  (11) |       | $                                            | 241,373    |   | $ | 5,331 |   | $ | 15,494 |   | $ | 10,871 |   | $ | 209,677 |   |

 

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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  to the condensed consolidated financial statements included in this report  and in our 2007 Annual Report on Form 10-K.                                                                                                                                                                  |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (2)    |   | The bank lines of credit bear interest at variable rates and therefore  the amount of future interest payments are uncertain. Borrowings bear  interest, at our option, based on a margin either: a) over the LIBOR rate; or  b) under the prime rate. The margins vary based on our consolidated debt to  equity ratio. The weighted-average annual interest rate on our bank line of  credit borrowings was 3.34% as of June 30, 2008. |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (3)    |   | Interest on the mortgage bonds is fixed at a weighted-average annual  interest rate of 6.52% and is payable semiannually.                                                                                                                                                                                                                                                                                                                     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (4)    |   | Interest on the bank term loans is fixed at a weighted-average annual  interest rate of 6.52% and is payable semiannually.                                                                                                                                                                                                                                                                                                                    |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (5)    |   | Interest on the convertible debentures is fixed at a 6.85% annual rate  and is payable quarterly. The debentures are convertible, at the option of  the holder, into shares of our common stock at any time prior to their  maturity.                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (6)    |   | Interest on the capital lease obligations is imputed at a  weighted-average annual interest rate of 4.43% and is payable monthly.                                                                                                                                                                                                                                                                                                             |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (7)    |   | Interest on the economic development bonds is fixed at a  weighted-average annual interest rate of 5.97% and is payable semiannually.                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (8)    |   | Interest is payable either monthly or quarterly at rates ranging from  5.0% to 8.0% per year.                                                                                                                                                                                                                                                                                                                                                 |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (9)    |   | Advances for construction are non-interest bearing.                                                                                                                                                                                                                                                                                                                                                                                           |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (10)   |   | Reflects the minimum annual contractual commitment to purchase water  through 2024. The amount is subject to increases in future periods for  production costs increases and may also increase, but not decrease, if  average actual usage exceeds a specified amount.                                                                                                                                                                        |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |
| (11)   |   | Excludes preferred stock dividend obligations. Preferred stockholders  are entitled to receive annual dividends of $2.625 per share and there are  9,156 shares of preferred stock currently outstanding. The preferred stock is  redeemable by the Company at any time for $52.00 per share and, from time to  time, we have elected to repurchase shares offered to us by preferred  stockholders at prices less than $52.00 per share.     |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                          |

### **FINANCIAL CONDITIONAND LIQUIDITY**

###  

As of June 30, 2008, we had $29.2 millionof working capital and $3.4 million of operating lease obligations payableduring the remainder of 2008. As of June 30, 2008, we also had $50.0million of additional borrowings available under our line of credit facility,which expires on February 15, 2013. In addition to our line of credit, wealso have $25.4

 

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million of capital available under our $30.0million capital lease facility. Our California and New Mexico mortgage bondindentures also permit the issuance of an additional $92.6 million of firstmortgage bonds as of June 30, 2008. However, the terms of our creditfacility do not permit additional first mortgage bond indebtedness withoutprior consent from the credit facility lenders. The mortgage bond indenturesalso limit the amount of cash and property dividends our California and NewMexico utilities may pay to the parent company to fund its payment obligations.Dividends have averaged $4.2 million to $5.2 million per year and are less thanthe aggregate cumulative dividend restriction threshold by $51.5 million as of June 30,2008. We were in compliance with all loan agreement covenants during the six monthsended June 30, 2008.

 

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

 

We believe that our expected operating cashflows, together with borrowings under our credit facility ($50.0 million ofwhich was available as of June 30, 2008 and expires on February 15,2013) and $25.4 million available under our capital lease facility will besufficient to meet our operating expenses, working capital and capitalexpenditure requirements as well as our debt service and other contractualobligations for the next twelve months. However, our ability to comply withdebt financial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well ascompetitive, legislative, regulatory, business and other factors beyond ourcontrol.

 

### **CERTAIN CONTRACTUALCOMMITMENTS AND INDEMNITIES**

###  

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

 

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

 

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

 

### **OFF-BALANCE SHEETARRANGEMENTS**

###  

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

 

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

 

## **ITEM3.              QUANTITATIVE ANDQUALITATIVE DISCLOSURE ABOUT MARKET RISK**

## ** **

As of June 30, 2008, we had $193.3million of long-term variable and fixed-rate debt. We are exposed to marketrisk based on changes in prevailing interest rates.

 

Market risk related to our variable-rate debtis estimated as the potential decrease in pre-tax earnings resulting from anincrease in interest rates. We have $98.0 million of long-term debt that bearsinterest at variable rates based on either the prime rate or LIBOR rate. Ourvariable-rate debt had a weighted average annual interest rate of 3.34% as of June 30,2008. A hypothetical one percent (100 basis points) increase in the averageannual interest rates charged on our variable-rate debt would reduce ourpre-tax earnings by approximately $1.0 million per year.

 

Our fixed-rate debt, which has a carryingvalue of $95.3 million, has a fair value of $92.1 million as of June 30, 2008.Market risk related to our fixed-rate debt is deemed to be the potentialincrease in fair value resulting from a decrease in prevailing interest rates.Our fixed-rate debt had a weighted average annual interest rate of 6.5% as of June 30,2008. A hypothetical ten percent decrease in annual interest rates, from 6.5%to 5.9%, would increase the fair value of our fixed-rate debt by approximately$5.9 million.

 

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

 

## **ITEM4.              CONTROLS AND PROCEDURES**

## ** **

### **DISCLOSURE CONTROLSAND PROCEDURES**

###  

Under the supervision and with theparticipation of our management, including the Chief Executive Officer andChief Financial Officer, we have evaluated the effectiveness of our disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-15(b) as ofthe end of the period covered by this report. Based on that evaluation, theChief Executive Officer and Chief Financial Officer have concluded that thesedisclosure controls and procedures are effective.

 

### **CHANGES IN INTERNALCONTROL OVER FINANCIAL REPORTING**

###  

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

 

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

 

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# **PART II –OTHER INFORMATION**

# ** **

## **ITEM1.              LEGAL PROCEEDINGS**

## ** **

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

 

## **ITEM1A.           RISK FACTORS**

## ** **

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

 

**Capital Market Transactions**

 

**Because of a late Form 8-K filing, wewill lose our eligibility to use Form S-3 Registration Statements toregister securities for a period of time which, in turn, will adversely affectour ability to access capital markets to finance our capital requirements. Wemay also be required to suspend our Dividend Reinvestment and Direct StockPurchase Plans for a period of time.**

 

We were unable to timely file a CurrentReport on Form 8-K (the “Form 8-K”) related to our January 2008acquisition of the assets of a sewer system and related wastewater treatmentplant (commonly referred to as the “Riverview System”). This failure was due toour inability to provide the audited financial statements for the RiverviewSystem required by the Securities Exchange Act of 1934 (the “Exchange Act”).The independent accountants we retained to perform the audit were unable toexpress an opinion on the historical cost of the assets acquired because theprior owners did not retain sufficient historical transactional records tosupport the recorded values. We contacted the Securities and ExchangeCommission (“SEC”) and filed the required Form 8-K with alternate auditedfinancial information, per our discussions with the SEC, on May 20, 2008.

 

The late filing of the Form 8-K hasadversely affected our eligibility to use Registration Statements on Form S-3for registration of our securities with the SEC. Use of Form S-3 requires,among other things, that the issuer be current and timely in its reports underthe Exchange Act for at least twelve months. Because of our inability to use Form S-3,we will have to meet more demanding requirements to register additionalsecurities, which will make it more difficult for us to effect public offeringtransactions, and our range of available financing alternatives could also benarrowed. It is also likely we will be required to suspend our DividendReinvestment and Direct Stock Purchase Plans after the filing of our 2008 Form 10-Kuntil we regain Form S-3 eligibility on May 20, 2009 (twelve monthsafter the filing of the Form 8-K) because we will not be in a position tofile a registration statement covering those shares prior to regaining Form S-3eligibility.

 

## **ITEM4.              SUBMISSION OF MATTERS TO AVOTE OF SECURITY HOLDERS**

## ** **

The Company’s Annual Meeting of Stockholderswas held on May 20, 2008. The total number of shares of the Company’scommon and preferred stock issued, outstanding and entitled to vote at themeeting was 24,480,993 shares of which 20,606,940 were present at the meetingeither in person or by proxy. The following proposals were submitted tostockholders with the following results:

 

***Proposal 1.***  Approval of the Amendment to the RestatedCertificate of Incorporation to eliminate the classified Board of Directors:

 

·                  Votes“For” – 19,329,464

 

·                  Votes“Against” – 1,123,914

 

·                  Votes“Abstained” – 153,557

 

·                  Broker“Non-Votes” – 5

 

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***Proposal 2.***  Election of Class I Directors until thenext annual meeting of stockholders:

 

·                  ThomasIino—votes “For” – 19,360,018; votes “Against” – 1,186,365: votes “Withheld” –60,552

 

·                  WilliamD. Jones— votes “For” – 19,351,611; votes “Against” – 1,192,331: votes “Withheld”– 62,993

 

·                  MaureenA. Kindel— votes “For” – 19,334,402; votes “Against” – 1,213,472: votes “Withheld”– 59,061

 

In addition to the directors elected above,the following directors’ term of office continued after the meeting until thenext annual meeting of stockholders:

 

·                  H.Frederick Christie

 

·                  LindaGriego

 

·                  DonovanD. Huennekens

 

·                  RichardG. Newman

 

·                  MarkA. Swatek

 

***Proposal 3. ***Ratificationof PricewaterhouseCoopers as the Company’s independent public accountants:

 

·                  Votes“For” – 20,281,762

 

·                  Votes“Against” – 263,800

 

·                  Votes“Abstained” – 61,378

 

·                  Broker“Non-Votes” – 0

 

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

## ** **

## **ITEM6.              EXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                  |
|-------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| **Number**  | ** ** | **Exhibit Description**                                                                                                                                                                                                                |
| 3.1         |       | Certificate of Amendment to Restated Certificate of Incorporation of  SouthWest Water Company (incorporated by reference to Exhibit 3.1  included in the Company’s Form 8 K filed with the Commission on May 22,  2008) |
|        |       |                                                                                                                                                                                                                                        |
| 3.2.5       |       | Amendment No. 5 to the Amended and Restated Bylaws of SouthWest  Water Company (incorporated by reference to Exhibit 3.2 included in the  Company’s Form 8 K filed with the Commission on May 22, 2008)       |
|        |       |                                                                                                                                                                                                                                        |
| 15          | *          | Letter regarding unaudited interim financial information from  Independent Registered Public Accounting Firm                                                                                                                                |
|        |       |                                                                                                                                                                                                                                        |
| 31.1        | *          | Certification of Principal Executive Officer Pursuant to Section 302  of the Sarbanes Oxley Act of 2002                                                                                                                                |
|        |       |                                                                                                                                                                                                                                        |
| 31.2        | *          | Certification of Principal Financial Officer Pursuant to Section 302  of the Sarbanes Oxley Act of 2002                                                                                                                                |
|        |       |                                                                                                                                                                                                                                        |
| 32.1        | *          | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes Oxley Act of 2002                                                                                                                                    |
|        |       |                                                                                                                                                                                                                                        |
| 32.2        | *          | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes Oxley Act of 2002                                                                                                                                    |

 

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*                 Filed herewith

 

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# **SIGNATURES**

# ** **

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

 

 
| ** **                  | **SOUTHWEST WATER COMPANY (REGISTRANT)** |
|-----------------------------|------------------------------------------|
| ** **                  | ** **                               |
|                        |                                     |
| Dated: August 11, 2008 | /s/ CHERYL L. CLARY                      |
|                        | Cheryl L. Clary                          |
|                        | Chief Financial Officer                  |

 

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