**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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**(Mark One)**
| **ý**                         |   | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE  SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                                                                           |
|------------------------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                               |   |                                                                                                                                                                                                                                                                                                                                                                                                   |
|                               |   | **For  the quarterly period ended September 30, 2003**                                                                                                                                                                                                                                                                                                                                                 |
|                               |   |                                                                                                                                                                                                                                                                                                                                                                                                   |
| **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** |

 

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

 

| **Delaware**                                                                                 |   | **95-1840947**                        |
|----------------------------------------------------------------------------------------------|--------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                              |   | (I.R.S. Employer  Identification No.) |
|                                                                                         |   |                                  |
| **One Wilshire Building****624  South Grand Avenue, Suite 2900****Los  Angeles, California** |   | **90017-3782**                        |
| (Address of principal executive offices)                                                     |   | (Zip Code)                            |
|                                                                                         |   |                                  |
| **(213) 929-1800**                                                                           |
| (Registrant’s telephone number, including area code)                                    |

 

Indicateby check mark whether the Registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filing requirementsfor the past 90 days. Yes ýNo o

 

Indicateby check mark whether the Registrant is an accelerated filer (as defined inRule 12b-2 of the Act). Yes ýNo o

 

Indicatethe number of shares outstanding of each of the issuer’s classes of commonstock, as of the latest practicable date. On November 12, 2003, there were10,996,121 common shares outstanding.

 

 

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

 

**INDEX**

 
| **Part I.**    | **Financial Information:** |
|----------------|----------------------------|
|           |                       |   |
|           | Item 1.                    | Financial Statements: |
|           |                       |   |
|           |                       | Condensed  Consolidated Statements of Income (unaudited) –   Three and Nine Months Ended September 30, 2003 and 2002 |
|           |                       |   |
|           |                       | Condensed Consolidated  Balance Sheets (unaudited) –   September 30, 2003 and December 31, 2002 |
|           |                       |   |
|           |                       | Condensed  Consolidated Statements of Cash Flows (unaudited) –   Nine Months Ended September 30, 2003 and 2002 |
|           |                       |   |
|           |                       | Notes  to Condensed Consolidated Financial Statements (unaudited) |
|           |                       |   |
|           | Item 2.                    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |
|           |                       |   |
|           | Item 3.                    | Quantitative and Qualitative Disclosures About  Market Risk |
|           |                       |   |
|           | Item 4.                    | Controls and Procedures |
|           |                       |   |
| **Part II.**   | **Other Information:**     |
|           |                       |   |
|           | Item 1.                    | Legal  Proceedings |
|           |                       |   |
|           | Item 6.                    | Exhibits and Reports on Form 8-K |
|           |                       |   |
| **Signatures** |

 

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**PART I – FINANCIAL INFORMATION**

 

***Item 1. FinancialStatements***

 

***Southwest WaterCompany and Subsidiaries******CONDENSED CONSOLIDATED STATEMENTS OF INCOME*****(unaudited)**

 
|                                            |   | **Three Months Ended  September 30,**    |       | **Nine Months Ended  September 30,** |   |
|-------------------------------------------------|--------|------------------------------------------|------------|--------------------------------------|--------|
|                                            |   | **2003**                                 |       | **2002**                             |   | **2003** |   | **2002** |   |
|                                            |   | **(in thousands except per share data)** |       |
| **Revenues:**                                   |   |                                     |       |                                 |   |   |   |   |   |
| Service operations                              |   | **$**                                    | **33,361** | ** **                           | $      | 19,243 |   | **$** | **86,251** | ** ** | $ | 55,609 |   |
| Utility operations                              |   | **18,051**                               | ** ** | 15,331                               |   | **42,739** | ** ** | 39,879 |   |
|                                            |   | **51,412**                               |       | 34,574                               |   | **128,990** | ** ** | 95,488 |   |
| **Expenses:**                                   |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| Operating expenses –  services             |   | **28,324**                               | ** ** | 16,306                               |   | **74,653** | ** ** | 47,299 |   |
| Operating expenses –  utilities            |   | **9,901**                                | ** ** | 10,628                               |   | **25,547** | ** ** | 26,271 |   |
| Selling, general and  administrative expenses   |   | **6,584**                                | ** ** | 3,977                                |   | **17,769** | ** ** | 14,419 |   |
|                                            |   | **44,809**                               |       | 30,911                               |   | **117,969** | ** ** | 87,989 |   |
|                                            |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Operating Income**                            |   | **6,603**                                | ** ** | 3,663                                |   | **11,021** | ** ** | 7,499 |   |
|                                            |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Non-Operating Income (Expense):**             |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| Interest expense                                |   | **(963**                                 | **)**      | (1,058                               | )      | **(3,260** | **)** | (3,277 | ) |
| Interest income                                 |   | **—**                               | ** ** | 163                                  |   | **49** | ** ** | 195 |   |
| Gains on sales of land                          |   | **—**                               | ** ** | —                               |   | **720** | ** ** | 119 |   |
| Other                                           |   | **(198**                                 | **)**      | (128                                 | )      | **(326** | **)** | 2,512 |   |
|                                            |   | **(1,161**                               | **)**      | (1,023                               | )      | **(2,817** | **)** | (451 | ) |
| **Income Before Income Taxes**                  |   | **5,442**                                | ** ** | 2,640                                |   | **8,204** | ** ** | 7,048 |   |
| **Income Tax Provision**                        |   | **2,013**                                | ** ** | 920                                  |   | **3,035** | ** ** | 2,456 |   |
|                                            |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Net Income**                                  |   | **3,429**                                | ** ** | 1,720                                |   | **5,169** | ** ** | 4,592 |   |
| **Dividends on Preferred Shares**               |   | **6**                                    | ** ** | 6                                    |   | **20** | ** ** | 20 |   |
| **Net Income Available for Common  Shares**     |   | **$**                                    | **3,423**  | ** **                           | $      | 1,714 |   | **$** | **5,149** | ** ** | $ | 4,572 |   |
|                                            |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Earnings per Common Share**                   |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Basic**                                       |   | **$**                                    | **0.31**   | ** **                           | $      | 0.18 |   | **$** | **0.50** | ** ** | $ | 0.47 |   |
| **Diluted**                                     |   | **$**                                    | **0.30**   | ** **                           | $      | 0.17 |   | **$** | **0.48** | ** ** | $ | 0.45 |   |
|                                            |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Weighted Average Outstanding Common  Shares** |   |                                     | ** ** |                                 |   |   | ** ** |   |   |
| **Basic**                                       |   | **10,984**                               | ** ** | 9,736                                |   | **10,302** | ** ** | 9,707 |   |
| **Diluted**                                     |   | **11,486**                               | ** ** | 10,286                               |   | **10,772** | ** ** | 10,257 |   |

 

*See accompanying notes to unauditedcondensed consolidated financial statements.*

 

1

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***Southwest Water Company and Subsidiaries***

***CONDENSEDCONSOLIDATED BALANCE SHEETS******(unaudited)***

 
|                                                                                                             |   | **September 30,  2003** |        | **December 31,  2002** |   |
|------------------------------------------------------------------------------------------------------------------|--------|-------------------------|-------------|------------------------|--------|
|                                                                                                             |   | **(in thousands)**      |        |
| **ASSETS**                                                                                                       |   |                    | ** **  |                   |   |
| **Current Assets:**                                                                                              |   |                    | ** **  |                   |   |
| Cash and cash  equivalents                                                                                       |   | **$**                   | **3,515**   | ** **             | $      | 1,606 |   |
| Restricted cash                                                                                                  |   | **2,434**               | ** **  | —                 |   |
| Trade accounts  receivable, net                                                                                  |   | **21,697**              | ** **  | 16,657                 |   |
| Other current assets                                                                                             |   | **11,909**              | ** **  | 11,573                 |   |
|                                                                                                             |   | **39,555**              | ** **  | 29,836                 |   |
| **Property, Plant and Equipment:**                                                                               |   |                    | ** **  |                   |   |
| Utility group property,  plant and equipment – at cost                                                      |   | **263,339**             | ** **  | 245,134                |   |
| Services group  property, plant and equipment – at cost                                                     |   | **24,665**              | ** **  | 20,753                 |   |
|                                                                                                             |   | **288,004**             | ** **  | 265,887                |   |
| Less accumulated  depreciation and amortization                                                                  |   | **67,683**              | ** **  | 61,954                 |   |
|                                                                                                             |   | **220,321**             | ** **  | 203,933                |   |
| **Other Assets:**                                                                                                |   |                    | ** **  |                   |   |
| Goodwill                                                                                                         |   | **20,242**              | ** **  | 20,151                 |   |
| Intangible assets, net                                                                                           |   | **2,174**               | ** **  | 2,497                  |   |
| Other assets                                                                                                     |   | **12,134**              | ** **  | 12,327                 |   |
|                                                                                                             |   | **34,550**              | ** **  | 34,975                 |   |
|                                                                                                             |   | **$**                   | **294,426** | ** **             | $      | 268,744 |   |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                   |   |                    | ** **  |                   |   |
| **Current Liabilities:**                                                                                         |   |                    | ** **  |                   |   |
| Current portion of  long-term debt                                                                               |   | **$**                   | **2,629**   | ** **             | $      | 1,969 |   |
| Accounts payable                                                                                                 |   | **11,684**              | ** **  | 11,390                 |   |
| Other current  liabilities                                                                                       |   | **21,097**              | ** **  | 18,264                 |   |
|                                                                                                             |   | **35,410**              | ** **  | 31,623                 |   |
| **Long-Term Liabilities and Deferred  Credits:**                                                                 |   |                    | ** **  |                   |   |
| Long-term debt                                                                                                   |   | **59,595**              | ** **  | 60,827                 |   |
| Bank lines of credit                                                                                             |   | **15,785**              | ** **  | 20,158                 |   |
| Advances for  construction                                                                                       |   | **7,229**               | ** **  | 7,352                  |   |
| Contributions in aid of  construction                                                                            |   | **80,109**              | ** **  | 70,658                 |   |
| Deferred income taxes                                                                                            |   | **10,356**              | ** **  | 8,411                  |   |
| Other liabilities and  deferred credits                                                                          |   | **8,194**               | ** **  | 7,878                  |   |
| **Total Liabilities and Deferred  Credits**                                                                      |   | **216,678**             | ** **  | 206,907                |   |
|                                                                                                             |   |                    | ** **  |                   |   |
| **Stockholders’ Equity:**                                                                                   |   |                    | ** **  |                   |   |
| Preferred stock, par  value of $0.01 per share (aggregate  liquidation preference of $507 at September 30, 2003) |   | **507**                 | ** **  | 513                    |   |
| Common stock, par value  $0.01 per share (10.984 million shares issued)                                          |   | **110**                 | ** **  | 98                     |   |
| Paid-in capital                                                                                                  |   | **55,401**              | ** **  | 42,787                 |   |
| Retained earnings                                                                                                |   | **21,730**              | ** **  | 18,439                 |   |
| **Total Stockholders’ Equity**                                                                              |   | **77,748**              | ** **  | 61,837                 |   |
|                                                                                                             |   | **$**                   | **294,426** | ** **             | $      | 268,744 |   |

 

*See accompanying notes to unauditedcondensed consolidated financial statements.*

 

2

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***Southwest Water Company and Subsidiaries***

***CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS******(unaudited)***

 
|                                                                                                |   | **Nine Months Ended  September 30,** |       |
|-----------------------------------------------------------------------------------------------------|--------|--------------------------------------|------------|
|                                                                                                |   | **2003**                             |       | **2002** |   |
|                                                                                                |   | **(in thousands)**                   |       |
| **Cash Flows from Operating  Activities**:                                                          |   |                                 | ** ** |   |   |
| Net income                                                                                          |   | **$**                                | **5,169**  | ** ** | $ | 4,592 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities         |   |                                 | ** ** |   |   |
| Depreciation and  amortization                                                                      |   | **5,823**                            | ** ** | 5,279 |   |
| Stock-based  compensation expense                                                                   |   | **696**                              | ** ** | 710 |   |
| Deferred income taxes                                                                               |   | **1,945**                            | ** ** | 278 |   |
| Gains on sales of land                                                                              |   | **(720**                             | **)**      | (45 | ) |
| Changes in assets and  liabilities, net of the effects of acquisitions:                             |   |                                 | ** ** |   |   |
| Restricted cash                                                                                     |   | **(2,434**                           | **)**      | — |   |
| Trade accounts  receivable                                                                          |   | **(5,040**                           | **)**      | 4,265 |   |
| Other current assets                                                                                |   | **(557**                             | **)**      | (2,086 | ) |
| Other assets                                                                                        |   | **425**                              | ** ** | (2,142 | ) |
| Accounts payable                                                                                    |   | **294**                              | ** ** | (672 | ) |
| Other current  liabilities                                                                          |   | **3,200**                            | ** ** | 3,449 |   |
| Other liabilities                                                                                   |   | **(1,366**                           | **)**      | (2,853 | ) |
| Other                                                                                               |   | **(383**                             | **)**      | (557 | ) |
| Net cash provided by  operating activities                                                          |   | **7,052**                            | ** ** | 10,218 |   |
|                                                                                                |   |                                 | ** ** |   |   |
| **Cash Flows from Investing  Activities:**                                                          |   |                                 | ** ** |   |   |
| Additions to property,  plant and equipment                                                         |   | **(17,132**                          | **)**      | (13,119 | ) |
| Proceeds from sale of  land                                                                         |   | **741**                              | ** ** | 165 |   |
| Other investments, net                                                                              |   | **(40**                              | **)**      | (2,461 | ) |
| Net cash used in  investing activities                                                              |   | **(16,341**                          | **)**      | (15,415 | ) |
|                                                                                                |   |                                 | ** ** |   |   |
| **Cash Flows from Financing  Activities:**                                                          |   |                                 | ** ** |   |   |
| Proceeds from issuance  of long-term debt                                                           |   | **—**                           | ** ** | 10,000 |   |
| Net proceeds from  private issuance of common stock                                                 |   | **10,925**                           | ** ** | — |   |
| Net repayment on bank  lines of credit                                                              |   | **(4,373**                           | **)**      | (10,747 | ) |
| Capital improvement  reimbursements                                                                 |   | **2,360**                            | ** ** | 2,577 |   |
| Contributions in aid of  construction and advances for construction                                 |   | **2,643**                            | ** ** | 7,527 |   |
| Net proceeds from  dividend reinvestment plan, employee stock purchase plan and stock option  plans |   | **1,023**                            | ** ** | 725 |   |
| Proceeds from  sale/leaseback of assets                                                             |   | **1,102**                            | ** ** | — |   |
| Dividends paid                                                                                      |   | **(1,790**                           | **)**      | (1,575 | ) |
| Repayment of long-term  debt                                                                        |   | **(412**                             | **)**      | (2,209 | ) |
| Repayments on advance  contracts, net of additions                                                  |   | **(190**                             | **)**      | (175 | ) |
| Net cash provided by  financing activities                                                          |   | **11,288**                           | ** ** | 6,123 |   |
|                                                                                                |   |                                 | ** ** |   |   |
| **Net increase (decrease) in cash and  cash equivalents**                                           |   | **1,909**                            | ** ** | 926 |   |
| Cash and cash  equivalents at beginning of period                                                   |   | **1,606**                            | ** ** | 789 |   |
| **Cash and cash equivalents at end of  period**                                                     |   | **$**                                | **3,515**  | ** ** | $ | 1,715 |   |
|                                                                                                |   |                                 | ** ** |   |   |
| **Supplemental Disclosure of Cash  Flow Information:**                                              |   |                                 | ** ** |   |   |
| **Cash paid during the period for:**                                                                |   |                                 | ** ** |   |   |
| Interest                                                                                            |   | **$**                                | **3,257**  | ** ** | $ | 3,559 |   |
| Income taxes                                                                                        |   | **$**                                | **1,185**  | ** ** | $ | 1,160 |   |
| **Non-cash contribution in aid of  construction**                                                   |   | **$**                                | **7,446**  | ** ** | $ | 5,693 |   |

 

*See accompanying notes to unauditedcondensed consolidated financial statements.*

 

3

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#### **SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

 

**NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS(unaudited)**

 

***Note 1. – Basis of Presentation***

 

Southwest Water Companywas incorporated in California in 1954 and reincorporated in Delaware in 1988.Southwest Water Company and our subsidiaries (collectively referred to in thisreport as Southwest Water, the Company, “we”, “us” or “our” except where thecontext otherwise requires) provide a broad range of services including waterproduction and distribution, wastewater collection and treatment, public worksservices, water and wastewater infrastructure development, customer billing andservice, and utility submetering. The accompanying unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (USGAAP) for interim financial information and with the instructions to Form 10-Qand Rule 10-01 of Regulation S-X; accordingly, they do not include allinformation and notes required by US GAAP for complete financial statements.Except as disclosed herein, there have been no material changes in theinformation disclosed in the notes to the consolidated financial statementscontained in our Annual Report on Form 10-K for the year ended December 31,2002 (the 2002 Annual Report). The unaudited condensed consolidated financialstatements reflect all adjustments which, in our opinion, are necessary topresent fairly the financial position of Southwest Water as of September 30,2003, our results of operations for the three and nine months ended September30, 2003 and 2002 and our cash flows for the nine months ended September 30,2003 and 2002. These adjustments are of a normal recurring nature.

 

Certain amounts in ourprior period financial statements have been reclassified to conform to thecurrent period presentation. In 2002, we retroactively adopted the fair valuebased method of accounting for stock options as outlined in Statement ofFinancial Accounting Standards (SFAS) No. 123, *Accounting for Stock-Based Compensation*.Accordingly, all prior periods presented have been restated to reflectcompensation costs that would have been recognized under the fair value basedaccounting method for all options granted, modified or settled in fiscal yearsbeginning after December 15, 1994. See Note 5 for detailed information.

 

***Note 2. – Operating Segments***

 

Our operating structureincludes two segments: our Services Group and our Utility Group. We have notchanged the basis of segmentation or measurement of segment profit or loss fromthat reported in our 2002 Annual Report.

 

In our Services Group, weoperate and maintain water supply and wastewater facilities owned by cities,public agencies, municipal utility districts and private entities in Texas,Mississippi, California, Georgia, New Mexico, Colorado and South Dakota. Whilestate and federal agencies issue regulations regarding standards of waterquality, safety, environmental and other matters which affect these operations,the pricing of our services by the Services Group is not subject to regulation.

 

In our Utility Group, weown and operate rate-regulated public water and wastewater utilities inCalifornia, New Mexico and Texas. State and federal agencies issue regulationsregarding standards of water quality, safety, environmental and other matterswhich affect these operations, as well as establish the rates that we cancharge for our water and wastewater services.

 

4

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Information about ouroperations for each operating segment for the three months ended September 30,2003 and 2002 is as follows:

 
|                                   |   | **Services  Group** |   | **Utility  Group (2)** |   | **Total  Segments** |   | **Other  (3)** |   | **Total  Consolidated** |   |
|----------------------------------------|--------|---------------------|--------|------------------------|--------|---------------------|--------|----------------|--------|-------------------------|--------|
|                                   |   | **(in thousands)**  |   |
| Three  months ended September 30, 2003 |   |                |   |                   |   |                |   |           |   |                    |   |
| Total  revenues (1)                    |   | $                   | 33,361 |                   | $      | 18,051              |   | $              | 51,412 |                    | $      | — |   | $ | 51,412 |   |
|                                   |   |                |   |                   |   |                |   |           |   |                    |   |
| Segment  operating income              |   | 1,704               |   | 5,909                  |   | 7,613               |   | (1,010         | )      | 6,603                   |   |
| Interest  income                       |   | —              |   | —                 |   | —              |   | —         |   | —                  |   |
| Interest  expense                      |   | 54                  |   | (612                   | )      | (558                | )      | (405           | )      | (963                    | )      |
| Gain  on sales of land                 |   | —              |   | —                 |   | —              |   | —         |   | —                  |   |
| Other  income (expense)                |   | (500                | )      | 62                     |   | (438                | )      | 240            |   | (198                    | )      |
| Income  before income taxes            |   | 1,258               |   | 5,359                  |   | 6,617               |   | (1,175         | )      | 5,442                   |   |
|                                   |   |                |   |                   |   |                |   |           |   |                    |   |
| Segment  assets                        |   | 70,706              |   | 215,837                |   | 286,543             |   | 7,883          |   | 294,426                 |   |
|                                   |   |                |   |                   |   |                |   |           |   |                    |   |
|                                   |   | **Services  Group** |   | **Utility  Group (2)** |   | **Total  Segments** |   | **Other  (3)** |   | **Total  Consolidated** |   |
|                                   |   | **(in thousands)**  |   |
| Three  months ended September 30, 2002 |   |                |   |                   |   |                |   |           |   |                    |   |
| Total  revenues (1)                    |   | $                   | 19,243 |                   | $      | 15,331              |   | $              | 34,574 |                    | $      | — |   | $ | 34,574 |   |
|                                   |   |                |   |                   |   |                |   |           |   |                    |   |
| Segment  operating income              |   | 1,487               |   | 3,046                  |   | 4,533               |   | (870           | )      | 3,663                   |   |
| Interest  income                       |   | 59                  |   | 104                    |   | 163                 |   | —         |   | 163                     |   |
| Interest  expense                      |   | (113                | )      | (547                   | )      | (660                | )      | (398           | )      | (1,058                  | )      |
| Gain  on sales of land                 |   | —              |   | —                 |   | —              |   | —         |   | —                  |   |
| Other  income (expense)                |   | (199                | )      | (115                   | )      | (314                | )      | 186            |   | (128                    | )      |
| Income  before income taxes            |   | 1,234               |   | 2,488                  |   | 3,722               |   | (1,082         | )      | 2,640                   |   |
|                                   |   |                |   |                   |   |                |   |           |   |                    |   |
| Segment  assets                        |   | 48,616              |   | 188,735                |   | 237,351             |   | 4,133          |   | 241,464                 |   |
|                                        |        |                     |        |                        |        |                     |        |                |        |                         |        |  |  |  |  |  |  |  |  |

 

1)     Total revenues include both revenues from external customers andintersegment transactions. The portion of intersegment revenues that were noteliminated in accordance with FAS 71 were approximately $1,528,000 and $332,000for the three months ended September 30, 2003 and 2002, respectively.

 

2)     One of the water sources for our Californiawater utility has been affected by the presence of certain groundwatercontaminants.  This contaminationnecessitated the shutdown of a number of our wells, and we purchasedreplacement water at a cost substantially higher than the cost of waterpumped from our own wells.  In May 2002,a settlement agreement was reached between some of the parties responsible forthe contamination and a number of affected water companies, including ourCalifornia water utility.  As a resultof our settlement agreement, we have received payments, and we expect tocontinue to receive payments until completion of remediation, for theincremental cost of purchasing water over the cost that would have beenincurred by us to pump water from our wells had they not been shut down as aresult of contamination.  For the threemonth periods ended September 30,2003 and 2002 the amount of thesereimbursed expenses were $1,362,000 and $1,421,000, respectively.  These reimbursements pertain to oursettlement agreement with the parties responsible for the contamination and, assuch, are recorded as a reduction to “Operating expenses – utilities”, whichconsequently increased our Operating Income. See related disclosure in Note 10, Non-Operating Income (Expense) -Other.

 

3)     “Other” consists of costs that include any corporate functionaldepartments whose costs are not allocated and headquarters expenses.

 

5

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Information about ouroperations by operating segment for the nine months ended September 30, 2003and 2002 is as follows:

 
|                                  |   | **Services  Group** |   | **Utility  Group (2)** |   | **Total  Segments** |   | **Other  (3)** |    | **Total  Consolidated** |   |   |
|---------------------------------------|--------|---------------------|--------|------------------------|--------|---------------------|--------|----------------|---------|-------------------------|--------|--------|
|                                  |   | **(in thousands)**  |   |
| Nine  months ended September 30, 2003 |   |                |   |                   |   |                |   |           |    |                    |   |   |
| Total  revenues (1)                   |   | $                   | 86,251 |                   | $      | 42,739              |   | $              | 128,990 |                    | $      | — |   | $ | 128,990 |   |   |
|                                  |   |                |   |                   |   |                |   |           |    |                    |   |   |
| Segment  operating income             |   | 2,646               |   | 11,350                 |   | 13,996              |   | (2,975         | )       | 11,021                  |   |   |
| Interest  income                      |   | 49                  |   | —                 |   | 49                  |   | —         |    | 49                      |   |   |
| Interest  expense                     |   | (285                | )      | (1,865                 | )      | (2,150              | )      | (1,110         | )       | (3,260                  | )      |   |
| Gain  on sales of land                |   | —              |   | 720                    |   | 720                 |   | —         |    | 720                     |   |   |
| Other  income (expense)               |   | (1,133              | )      | 377                    |   | (756                | )      | 430            |    | (326                    | )      |   |
| Income  before income taxes           |   | 1,277               |   | 10,582                 |   | 11,859              |   | (3,655         | )       | 8,204                   |   |   |
|                                  |   |                |   |                   |   |                |   |           |    |                    |   |   |
| Segment  assets                       |   | 70,706              |   | 215,837                |   | 286,543             |   | 7,883          |    | 294,426                 |   |   |
|                                  |   |                |   |                   |   |                |   |           |    |                    |   |   |
|                                  |   | **Services  Group** |   | **Utility  Group (2)** |   | **Total  Segments** |   | **Other  (3)** |    | **Total  Consolidated** |   |   |
|                                  |   | **(in thousands)**  |   |
| Nine  months ended September 30, 2002 |   |                |   |                   |   |                |   |           |    |                    |   |   |
| Total  revenues (1)                   |   | $                   | 55,609 |                   | $      | 39,879              |   | $              | 95,488  |                    | $      | — |   | $ | 95,488 |   |   |
|                                  |   |                |   |                   |   |                |   |           |    |                    |   |   |
| Segment  operating income             |   | 2,458               |   | 8,242                  |   | 10,700              |   | (3,201         | )       | 7,499                   |   |   |
| Interest  income                      |   | 91                  |   | 104                    |   | 195                 |   | —         |    | 195                     |   |   |
| Interest  expense                     |   | (346                | )      | (1,652                 | )      | (1,998              | )      | (1,279         | )       | (3,277                  | )      |   |
| Gain  on sales of land                |   | —              |   | 119                    |   | 119                 |   | —         |    | 119                     |   |   |
| Other  income (expense)               |   | (672                | )      | 1,454                  |   | 782                 |   | 1,730          |    | 2,512                   |   |   |
| Income  before income taxes           |   | 1,531               |   | 8,267                  |   | 9,798               |   | (2,750         | )       | 7,048                   |   |   |
|                                  |   |                |   |                   |   |                |   |           |    |                    |   |   |
| Segment  assets                       |   | 48,616              |   | 188,735                |   | 237,351             |   | 4,113          |    | 241,464                 |   |   |
|                                       |        |                     |        |                        |        |                     |        |                |         |                         |        |        |  |  |  |  |  |  |  |  |

 

1)     Total revenues include both revenues from external customers andintersegment transactions. The portion of intersegment revenues that were noteliminated in accordance with FAS 71 were approximately $2,708,000 and $350,000for the nine months ended September 30, 2003 and 2002, respectively.

 

2)     One of the watersources for our California water utility has been affected by the presence ofcertain groundwater contaminants.  Thiscontamination necessitated the shutdown of a number of our wells, and wepurchased replacement water at a cost substantially higher than the cost ofwater pumped from our own wells.  In May2002, a settlement agreement was reached between some of the partiesresponsible for the contamination and a number of affected water companies,including our California water utility. As a result of our settlement agreement, we have received payments, andwe expect to continue to receive payments until completion of remediation, forthe incremental cost of purchasing water over the cost that would have beenincurred by us to pump water from our wells had they not been shut down as aresult of contamination.  For the ninemonth periods ended September 30,2003 and 2002, the amount of thesereimbursed expenses were $3,294,000 and $2,311,000, respectively.  These reimbursements pertain to oursettlement agreement with the parties responsible for the contamination and, assuch, are recorded as a reduction to “Operating expenses – utilities”, whichconsequently increased our Operating Income. See related disclosure in Note 10, Non-operating income (expense) -other.

 

3)     “Other” consists of costs that include anycorporate functional departments whose costs are not allocated and headquartersexpenses.

 

6

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***Note 3. – Seasonality***

 

Our Services Groupoperations can be affected by weather and rainfall. In general, heavy rainfallor storm conditions may limit our ability to perform certain billable work suchas pipeline maintenance, manhole rehabilitation and other outdoor services.Severe weather conditions may also result in additional labor and materialcosts to us as we meet the terms of our operations and maintenance contracts.Depending on our specific contractual terms, this additional work may bebillable to our various clients.

 

Our Utility Group wateroperations are seasonal as rainfall and weather conditions affect waterconsumption.  In our service areas thesecond and third quarters of each year typically account for the highest volumeof water consumption when weather tends to be hot and dry. The results ofoperations for one quarter do not indicate results to be expected in anotherquarter. Drought conditions may result in lower revenue due to consumerconservation efforts and a shortage of water. Drought conditions may alsoresult in increased water costs to us, which could adversely affect ourprofitability. Conversely, unusually wet conditions may result in decreasedcustomer demand, lower revenues and lower profit in our Utility Groupoperations. Utility Group wastewater operations are generally not affected byseasonality.

 

***Note 4. – New Accounting Pronouncements***

 

In June 2001, theFinancial Accounting Standards Board (FASB) issued SFAS No. 143, *Accountingfor Asset Retirement Obligations.* SFAS No. 143 requires us to recordthe fair value of an asset retirement obligation as a liability in the periodin which we incur a legal obligation associated with the retirement of tangiblelong-lived assets that result from the acquisition, construction, development,and/or normal use of the assets. We also record a corresponding asset that isdepreciated over the life of the asset. Subsequent to the initial measurementof the asset retirement obligation, the obligation will be adjusted at the endof each period to reflect the passage of time and changes in the estimatedfuture cash flows underlying the obligation. We adopted SFAS No. 143 on January1, 2003. The adoption of SFAS No. 143 did not have a material effect on ourconsolidated financial statements.

 

In April 2002, the FASBissued SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64,Amendment of FASB Statement No. 13, and Technical Corrections*. SFASNo. 145 amends existing guidance on reporting gains and loss on the extinguishmentof debt to prohibit the classification of the gain or loss as extraordinary.SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback accounting forcertain lease modifications that have economic effects similar tosale-leaseback transactions. The provisions of SFAS No. 145 related to therescission of Statement No. 4 applied to fiscal years beginning after May 15,2002. The provisions of SFAS No. 145 related to Statement No. 13 were effectivefor transactions occurring after May 15, 2002. The adoption of SFAS No. 145 didnot have a material effect on our consolidated financial statements.

 

In June 2002, the FASBissued SFAS No. 146, *Accounting for Costs Associated with Exit or DisposalActivities*. SFAS No. 146 addresses financial accounting and reportingfor costs associated with exit or disposal activities. The provisions of SFASNo. 146 were effective for exit or disposal activities initiated after December31, 2002. The adoption of SFAS No. 146 did not have a material effect on ourconsolidated financial statements.

 

In November 2002, theFASB issued Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness to Others*,*aninterpretation of FASB Statements No. 5, 57 and 107, and a rescission of FASBInterpretation No. 34*. This interpretation elaborates on thedisclosures to be made by a guarantor in its interim and annual financialstatements about its obligations under guarantees issued. The interpretationalso clarifies that a guarantor is required to recognize, at inception of aguarantee, a liability for the fair value of the obligation undertaken. Theinitial recognition and measurement provisions of the interpretation wereapplicable to guarantees issued or modified after December 31, 2002 and thedisclosure requirements were effective for financial statements of interim andannual periods ending after December 15, 2002. The adoption of InterpretationNo. 45 did not have a material effect on our consolidated financial statements.

 

In November 2002, theEmerging Issues Task Force (EITF) finalized EITF No. 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*. EITF No. 00-21is required to be adopted for all new revenue arrangements entered into infiscal years beginning after June 15, 2003. The EITF also allows application toexisting contracts. We have adopted EITF No. 00-21 and it did not have amaterial effect on our consolidated financial statements.

 

In December 2002, theFASB issued SFAS No. 148, *Accounting forStock-Based Compensation – Transition and Disclosure**,***which amends FASB No. 123, *Accounting for Stock-Based Compensation,*to provide alternative methods of transition for a voluntary change to the fairvalue method of accounting for stock-based compensation. In addition, SFAS No.148 amends the disclosure requirements of Statement No. 123 to requireprominent disclosures in both annual and interim financial statements. In 2002,we adopted the fair value recognition provisions of SFAS No. 123 and therelated provisions of SFAS No. 148 using the retroactive restatement method.See Note 5 for detailed information.

 

7

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In January 2003, the FASBissued Interpretation No. 46, *Consolidation of Variable Interest Entities*,*aninterpretation of Accounting Research Bulletin No. 51*. ThisInterpretation addresses the consolidation by business enterprises of variableinterest entities. The Interpretation applies immediately to variable interestentities created or obtained after January 31, 2003. For all other variableinterest entities the Interpretation applies no later than the end of the firstannual reporting period beginning after June 15, 2003. The Interpretationrequires certain disclosures in financial statements issued after January 31,2003 if it is reasonably possible that an entity will consolidate or discloseinformation about variable interest entities when the Interpretation becomeseffective. The application of this interpretation is not expected to have amaterial effect on our consolidated financial statements.

 

In April 2003, theFASB issued SFAS No. 149, *Amendment ofStatement 133 on Derivative Instruments and Hedging Activities*.  SFAS No. 149 amends and clarifies financialaccounting and reporting for derivative instruments. This statement iseffective for contracts entered into or modified after June 30, 2003.  We adopted this statement in the thirdquarter of 2003 and it did not have a material effect on our consolidatedfinancial statements.

 

In May 2003, the FASBissued SFAS No. 150, *Accounting for Certain Financial Instruments withCharacteristics of Both Liabilities and Equity*. This statementestablishes accounting standards with respect for how a company classifies andmeasures financial instruments that have characteristics of both liabilitiesand equity. This statement is effective for all financial instruments enteredinto or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003. We adoptedthis statement in the third quarter of 2003 and it did not have a materialeffect on our consolidated financial statements.

 

***Note 5. – Adoption of New Accounting Policy – Stock-BasedCompensation***

 

We currently sponsor twostock option plans: a Stock Option Plan (SOP) and a Director Option Plan (DOP).Prior to 2002, we accounted for these plans under the recognition andmeasurement provisions of the Accounting Principles Board (APB) Opinion No. 25,*Accountingfor Stock Issued to Employees, and related Interpretations,*underwhich**nostock-based compensation cost was reflected, as all options granted under thoseplans had an exercise price equal to the market value of the underlying commonstock on the date of grant. In 2002, we adopted the fair value recognitionprovisions of SFAS No. 123, *Accounting for Stock-Based Compensation*.SFAS No. 123 requires that we value stock options issued based upon an optionpricing model and recognize this value as an expense over the period in whichthe options vest. In accordance with the provisions of SFAS No. 148, *Accountingfor Stock-Based Compensation – Transition and Disclosure,* we electedto recognize stock-based compensation using the retroactive restatement method.Under this change in accounting method, we restated our financial statementsfor the prior periods presented in this Report on Form 10-Q for the three andnine months ended September 30, 2003 to reflect stock-based compensationexpense under a fair value based accounting method for all options granted,modified or settled after December 15, 1994.

 

The table below setsforth the effect of our retroactive restatement of the prior periods:

 
|                                   |   | **Periods Ended September 30, 2002  (in thousands except per share amounts)** |   |
|----------------------------------------|--------|-------------------------------------------------------------------------------|--------|
|                                   |   | **Three months**                                                              |   | **Nine months** |   |
| Net Income:                            |   |                                                                          |   |   |   |
| Restated for adoption  of SFAS No. 123 |   | $                                                                             | 1,720  |   | $ | 4,592 |   |
| Previously reported                    |   | $                                                                             | 1,880  |   | $ | 5,044 |   |
| Basic Earnings per  Common Share:      |   |                                                                          |   |   |   |
| Restated for adoption  of SFAS No. 123 |   | $                                                                             | .18    |   | $ | .47 |   |
| Previously reported                    |   | $                                                                             | .20    |   | $ | .54 |   |
| Diluted Earnings per  Common Share:    |   |                                                                          |   |   |   |
| Restated for adoption  of SFAS No. 123 |   | $                                                                             | .17    |   | $ | .45 |   |
| Previously reported                    |   | $                                                                             | .19    |   | $ | .51 |   |

 

We use the Black-Scholesoption valuation model to estimate the fair value of our stock options. This optionvaluation model was developed for use in estimating the fair value of tradedoptions that do not have vesting restrictions and that are fully transferable.Option valuation models require subjective assumptions such as the expectedfuture volatility of the stock price. Because the stock options we grant havecharacteristics that are significantly different from those of traded options,and because changes in the subjective input assumptions can materially affectthe calculated results, in management’s opinion, stock option valuation models,including Black-Scholes, may not necessarily provide a reliable single measureof the fair value of employee stock options.

 

8

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The fair value of eachoption grant is estimated on the date of grant using the Black-Scholes optionpricing model with the following weighted average assumptions used for grantsin 2003 and 2002:

 
|                    |   | **2003** |       | **2002** |   |
|-------------------------|--------|----------|------------|----------|--------|
| Dividend yield          |   | **1.8**  | **%**      | 1.8      | %      |
| Expected volatility     |   | **26.6** | **%**      | 27.3     | %      |
| Risk-free interest rate |   | **2.7**  | **%**      | 4.6      | %      |
| Expected life in years  |   | **5.5**  | ** ** | 5.6      |   |

 

Compensation expensearising from stock option grants as determined using the Black-Scholes fairvalue option model was approximately $229,000 and $251,000 for the three monthsended September 30, 2003 and 2002, respectively, and $696,000 and $710,000 forthe nine months ended September 30, 2003 and 2002, respectively.

 

***Stock Option Plan:***In 1988, thestockholders approved the SOP, and in 2000 approved an amendment to the SOPwhich increased the number of authorized and available shares for issuance by937,500, provided for a 150,000 share annual award limit to any one individual,modified the eligibility requirements to include certain consultants to theCompany and also extended the future grant date to May 23, 2010. In May 2003,the stockholders approved a further amendment to the SOP to increase the numberof authorized and available shares for issuance by 750,000. As of September 30,2003, excluding the issuance of these 750,000 shares, there were 2,430,880shares (adjusted for stock splits and stock dividends) authorized for issuanceunder the SOP and 268,914 shares were available for issuance.  As of October 2003, our registration ofthese shares became effective increasing our shares available for issuance to1,018,914.

 

Under the SOP, we maygrant non-qualified stock options to officers, employees and certainconsultants at an exercise price not less than the fair value of the stock onthe last trading date preceding the date of grant. We also grantednon-qualified options to certain non-employee directors of the Company. Optionsgranted subsequent to December 31, 1999 vest equally over a period of fiveyears and expire seven years and one day from the date of grant. Optionsgranted prior to January 1, 2000 expire 10 years and one day from the date ofgrant.

 

Options issued under theSOP may be exercised in accordance with the provisions of the Internal RevenueCode concerning stock attestation. Shares attested for purposes of stockoptions exercised are cancelled. Options are forfeited when they expire or inthe event a SOP participant terminates employment with the Company prior to theoptions vesting.

 

A summary of the statusof the SOP and changes during the nine months ended September 30, 2003 and 2002is presented below:

 
|                                            |   | **Nine months ended September 30,** |       |
|-------------------------------------------------|--------|-------------------------------------|------------|
|                                            |   | **2003**                            |       | **2002** |   |
| **Fixed  Options**                              |   | **Shares**                          |       | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at  beginning of period             |   | **1,492,373**                       | ** ** | **$** | **8.65** | ** ** | 1,196,394 |   | $ | 7.25 |   |
| Granted                                         |   | **232,000**                         | ** ** | **$** | **12.40** | ** ** | 247,903 |   | $ | 13.12 |   |
| Exercised                                       |   | **(76,271**                         | **)**      | **$** | **7.26** | ** ** | (56,759 | ) | $ | 6.62 |   |
| Forfeited                                       |   | **(3,752**                          | **)**      | **$** | **12.04** | ** ** | — |   | — |   |
| Outstanding options                             |   | **1,644,350**                       | ** ** | **$** | **9.23** | ** ** | 1,387,538 |   | $ | 8.32 |   |
| Options exercisable                             |   | **850,991**                         | ** ** | **$** | **7.05** | ** ** | 621,682 |   | $ | 9.18 |   |
| Weighted average fair  value of options granted |   | **$**                               | **2.96**   | ** ** |   | ** ** | $ | 3.88 |   |   |   |
|                                                 |        |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

9

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The following tablesummarizes information about fixed stock options outstanding at September 30,2003:

 
| **Options Outstanding**       |   | **Options Exercisable**                        |   |
|-------------------------------|--------|------------------------------------------------|--------|
| **Range of  Exercise Prices** |   | **Number  Outstanding at  September 30, 2003** |   | **Weighted  Average  Remaining  Contractual  Life in Years** |   | **Weighted  Average  Exercise Price** |   | **Number  Exercisable at  September 30,  2003** |   | **Weighted  Average  Exercise Price** |   |
| $                             | 2.00   | to                                             | $      | 5.00 |   | 257,691 |   | 1.8 |   | $ | 3.64 |   | 257,691 |   | $ | 3.64 |   |
| 5.00                          | to     | 10.00                                          |   | 424,303 |   | 4.6 |   | 6.96 |   | 348,553 |   | 6.81 |   |
| 10.00                         | to     | 15.00                                          |   | 957,106 |   | 5.3 |   | 11.71 |   | 243,697 |   | 10.96 |   |
| 15.00                         | to     | 20.00                                          |   | 5,250 |   | 5.8 |   | 16.26 |   | 1,050 |   | 16.26 |   |
| $                             | 2.00   | to                                             | $      | 20.00 |   | 1,644,350 |   | 4.7 |   | 9.23 |   | 850,991 |   | 7.05 |   |
|                               |        |                                                |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

***Director Option Plan:***In 1996, thestockholders approved the DOP for non-employee directors, and in 2000, approvedan amendment to the DOP, which provided for an increase of 165,375 sharesreserved for issuance. As of September 30, 2003, there were 328,166 shares(adjusted for stock splits and stock dividends) authorized for issuance underthe DOP and 129,343 shares were available for issuance.

 

The DOP provides for anautomatic grant of options to purchase 5,000 shares of our common stock toeligible non-employee directors of the Company on the date of our AnnualMeeting of Stockholders through 2006 at the fair market value of our commonstock. New directors are granted an initial option to purchase 5,000 shares ofour common stock upon appointment to the Board of Directors. DOP optionsgranted subsequent to December 31, 1999 vest equally over two years and expireseven years and one day after the date of grant. Options granted prior toJanuary 1, 2000 expire 10 years and one day from the date of grant.

 

A summary of the statusof the DOP and changes during the nine months ended September 30, 2003 and 2002is presented below:

 
|                                            |   | **Nine months ended September 30,** |       |
|-------------------------------------------------|--------|-------------------------------------|------------|
|                                            |   | **2003**                            |       | **2002** |   |
| **Fixed  Options**                              |   | **Shares**                          |       | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at  beginning of period             |   | **117,632**                         | ** ** | **$** | **11.20** | ** ** | 105,054 |   | $ | 8.76 |   |
| Granted                                         |   | **30,000**                          | ** ** | **$** | **12.12** | ** ** | 36,750 |   | $ | 15.20 |   |
| Exercised                                       |   | **—**                          | ** ** | **—** | ** ** | — |   | — |   |
| Cancelled                                       |   | **—**                          | ** ** | **—** | ** ** | — |   | — |   |
| Outstanding options                             |   | **147,632**                         | ** ** | **$** | **11.39** | ** ** | 141,804 |   | $ | 10.43 |   |
| Options Exercisable                             |   | **57,177**                          | ** ** | **$** | **9.40** | ** ** | 33,650 |   | $ | 8.14 |   |
| Weighted average fair  value of options granted |   | **$**                               | **2.89**   | ** ** |   | ** ** | $ | 4.50 |   |   |   |
|                                                 |        |                                     |            |  |  |  |  |  |  |  |  |  |  |

 

The following tablesummarizes information about the director stock options outstanding as ofSeptember 30, 2003:

 
| **Options Outstanding**       |   | **Options Exercisable**                        |   |
|-------------------------------|--------|------------------------------------------------|--------|
| **Range of  Exercise Prices** |   | **Number  Outstanding at  September 30, 2003** |   | **Weighted  Average  Remaining  Contractual  Life in Years** |   | **Weighted  Average  Exercise Price** |   | **Number  Exercisable at  September 30, 2003** |   | **Weighted  Average  Exercise Price** |   |
| $                             | 6.00   | to                                             | $      | 9.00 |   | 26,024 |   | 5.4 |   | $ | 6.75 |   | 23,422 |   | $ | 6.69 |   |
| 9.00                          | to     | 15.00                                          |   | 90,108 |   | 5.3 |   | 11.27 |   | 27,455 |   | 10.30 |   |
| 15.00                         | to     | 20.00                                          |   | 31,500 |   | 5.9 |   | 15.56 |   | 6,300 |   | 15.56 |   |
| $                             | 6.00   | to                                             | $      | 20.00 |   | 147,632 |   | 5.5 |   | 11.39 |   | 57,177 |   | 9.40 |   |
|                               |        |                                                |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

10

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12,038 shares and 8,504shares to employees during the nine month periods ended September 30, 2003 and2002, respectively. At September 30, 2003, 854,649 shares (after adjustment forstock splits and stock dividends) were reserved for issuance under the ESPP and680,539 shares were available for issuance.

 

***Note 6. – Earnings Per Share, Stock Options and StockDividends***

 

We record earnings pershare (EPS) by computing “basic EPS” and “diluted EPS” in accordance with USGAAP. Basic EPS measures our performance over the reporting period by dividingnet income available to common stockholders by the weighted average number ofcommon shares outstanding during the period. Diluted EPS measures ourperformance over the reporting period after giving effect to all potentiallydilutive common shares that would have been outstanding if the dilutive commonshares had been issued. Stock options, convertible debentures and warrants giverise to potentially dilutive common shares. In 2002, our Board of Directorsdeclared a five percent stock dividend to stockholders of record on January 1,2003. All per share amounts and numbers of shares outstanding reflect thisdividend.

 

The following table is areconciliation of the numerators (income) and denominators (shares) used inboth basic and diluted EPS calculations:

 
|                                           |   | **Net  Income**                             |       | **Dividends  on  preferred  shares** |       | **Basic  EPS** |       | **Effect of  Dilutive  Options** |       | **Diluted  EPS** |       |
|------------------------------------------------|--------|---------------------------------------------|------------|--------------------------------------|------------|----------------|------------|----------------------------------|------------|------------------|------------|
|                                           |   | **(in thousands except per share amounts)** |       |
| **For three months ended September  30, 2003** |   |                                        |       |                                 |       |           |       |                             |       |             |       |
| **Income (numerator)**                         |   | **$**                                       | **3,429**  | ** **                           | **$**      | **(6**         | **)**      | **$**                            | **3,423**  | ** **       |       | ** ** | **$** | **3,423** | ** ** |
| **Shares (denominator)**                       |   |                                        | ** ** |                                 | ** ** | **10,984**     | ** ** | **502**                          | ** ** | **11,486**       | ** ** |
| **Per share amount**                           |   |                                        | ** ** |                                 | ** ** | **$**          | **.31**    | ** **                       |       | ** **       | **$**      | **.30** | ** ** |
| For three months  ended September 30, 2002     |   |                                        | ** ** |                                 | ** ** |           |       |                             |       |             |       |
| Income (numerator)                             |   | $                                           | 1,720      |                                 | $          | (6             | )          | $                                | 1,714      |             |       |   | $ | 1,714 |   |
| Shares (denominator)                           |   |                                        |       |                                 |       | 9,736          |       | 550                              |       | 10,286           |       |
| Per share amount                               |   |                                        |       |                                 |       | $              | 0.18       |                             |       |             | $          | 0.17 |   |

 
|                                          |   | **Net****Income**                           | ** ** | **Dividends on****preferred  shares** | ** ** | **Basic  EPS** | ** ** | **Effect of  Dilutive  Options** |       | **Diluted  EPS** |       |
|-----------------------------------------------|--------|---------------------------------------------|------------|---------------------------------------|------------|----------------|------------|----------------------------------|------------|------------------|------------|
|                                          |   | **(in thousands except per share amounts)** |       |
| **For nine months ended September 30,  2003** |   |                                        |       |                                  |       |           |       |                             |       |             |       |
| **Income (numerator)**                        |   | **$**                                       | **5,169**  | ** **                            | **$**      | **(20**        | **)**      | **$**                            | **5,149**  | ** **       |       | ** ** | **$** | **5,149** | ** ** |
| **Shares (denominator)**                      |   |                                        | ** ** |                                  | ** ** | **10,302**     | ** ** | **470**                          | ** ** | **10,772**       | ** ** |
| **Per share amount**                          |   |                                        | ** ** |                                  | ** ** | **$**          | **.50**    | ** **                       |       | ** **       | **$**      | **.48** | ** ** |
| For nine months  ended September 30, 2002     |   |                                        |       |                                  |       |           |       |                             |       |             |       |
| Income (numerator)                            |   | $                                           | 4,592      |                                  | $          | (20            | )          | $                                | 4,572      |             |       |   | $ | 4,572 |   |
| Shares (denominator)                          |   |                                        |       |                                  |       | 9,707          |       | 550                              |       | 10,257           |       |
| Per share amount                              |   |                                        |       |                                  |       | $              | 0.47       |                             |       |             | $          | 0.45 |   |

 

***Note 7. – Balancing Account***

 

Our California waterutility has recorded a balancing account receivable in the amount ofapproximately $2,300,000, representing the difference between actual waterproduction costs incurred and California Public Utilities Commission(CPUC)–adopted water production costs. Historically, the CPUC allowed suchbalancing accounts in the income statements of water utilities, with acorresponding liability or asset on the balance sheet. However, the CPUCchanged this policy by eliminating the use of balancing accounts as of November29, 2001. In December 2002, the CPUC issued a decision that we believe willallow our water utility in California to recover the $2,300,000 that was in thebalancing account as of November 29, 2001. Beginning in December 2001, ourwater utility has recognized all water costs as incurred. Currently thedifferences between actual and CPUC-adopted water production costs are expensedas incurred. These expenses are also tracked in a memorandum account.

 

11

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***Note 8. – Acquisitions***

 

*AquaServices, LP (Aqua Services)*

 

In November 2002, weacquired 100% ownership of certain contract operations primarily in Texas andColorado of AquaSource, Inc., a provider of contract water and wastewaterservices. The purchase price consisted of approximately $10,317,000 in cash.Upon closing of the transaction, we began operating a part of this businessunder the name Aqua Services, while the remaining part was incorporated intoone of our existing subsidiaries.

 

*OperationsTechnologies, Inc. (OpTech)*

 

In August 2001, wepurchased 90% of the outstanding stock of OpTech, a provider of contract waterand wastewater and public works services in the southeastern United States, fora purchase price of approximately $8,248,000. The purchase price consisted ofcash payments of $3,948,000, promissory notes of $3,000,000 and 96,580 sharesof our common stock with a fair market value of approximately $1,300,000 at thedate of acquisition. Under the terms of the purchase agreement, we have theright to acquire the remaining 10% of OpTech after August 31, 2006 using aformula based upon the profitability of OpTech. After August 31, 2003, theminority owner of OpTech has the option to sell the remaining 10% of OpTech tous for the greater of $1,000,000 or an amount based on Optech’s profitability.

 

*MasterTek International, Inc. (Master Tek)*

 

In April 2000, wepurchased 80% of the outstanding stock of Master Tek, a provider of submeteringequipment and services for approximately $4,000,000, consisting of $2,000,000in cash and a $2,000,000 promissory note. Under the terms of our purchaseagreement, the minority owner of Master Tek may require us to purchase hisremaining 20% minority interest in five percent increments at a price not toexceed $1,000,000 per year over four years. In April 2002, we paid $1,000,000 tothe minority owner to increase our ownership interest to 85%. In the firstquarter of 2003, the minority owner of Master Tek exercised his option to sellto us an additional five percent ownership interest. In April 2003, we paid$1,000,000 into an escrow account as discussed in Note 12.

 

*Intangibles*

 

At September 30, 2003,the gross carrying amount of acquired intangible assets was approximately$3,535,000 and accumulated amortization of these assets was approximately$1,361,000. Amortization expense for intangible assets for the three and ninemonths ended September 30, 2003 was approximately $163,000 and  $412,000, respectively.

 

The changes in thecarrying amount of goodwill from acquisitions for the nine months endedSeptember 30, 2003 are as follows:

 
|                              |   | **Services Group** |   | **Utility Group** |   | **Totals** |   |
|-----------------------------------|--------|--------------------|--------|-------------------|--------|------------|--------|
|                              |   | **(in thousands)** |   |
|                              |   |               |   |              |   |       |   |
| Balance as of December  31, 2002  |   | $                  | 20,151 |              | $      | —     |   | $ | 20,151 |   |
| Goodwill acquired                 |   | 91                 |   | —            |   | 91         |   |
| Impairment losses                 |   | —             |   | —            |   | —     |   |
| Balance as of September  30, 2003 |   | $                  | 20,242 |              | $      | —     |   | $ | 20,242 |   |

 

***Note 9. – Sale of Equity***

 

In May 2003 we completeda private placement of 1,108,033 shares of newly issued common stock to certaininstitutional investors. Gross proceeds from the private placement were$12,000,000 from which commissions and fees of approximately $1,100,000 werepaid. We filed a registration statement with the Securities and ExchangeCommission to register these shares for resale.  The registration statement became effective on October 9, 2003.

 

***Note 10. – Non-Operating Income (Expense) - Other***

 

*GroundwaterSettlement*

 

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

 

12

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Theincremental and unreimbursed costs of purchasing replacement water and relatedenergy costs in 1999, 2000 and 2001 related to this contamination were $84,000,$756,000 and  $809,000, respectively.  Prior to May 2002, we accounted for thepossible recovery of these damages we incurred as a gain contingency inaccordance with SFAS No. 5, and accordingly these costs were recorded asOperating expenses – utilities in our income statement and consequently reducedour operating income.

 

InMay 2002, a settlement agreement was reached between some of the partiesresponsible for the contamination and a number of affected water companies,including our California water utility. As a result of this settlementagreement, we recorded income of approximately $1,649,000, which coveredcertain water and energy costs, incurred in 1999, 2000 and 2001 by us arisingfrom the contamination that were prior to the commencement of monthly paymentsto us by the responsible parties.  Thissettlement was an unusual event and we recorded the $1,649,000 in Other income(expense), in accordance with the provisions of APB No. 30, *Reporting the Results of Operations.*

 

Southwest’sgroundwater contamination related costs incurred prior to the settlement agreementwere absorbed by our water utility and not passed to the ratepayers.Accordingly, the reimbursement offset costs that our utility had previouslyincurred, resulting in no effect on ratepayers.

 

Asa result of this contamination, we have received payments, and we expect tocontinue to receive payments until completion of remediation.  These payments represent the incrementalcost of purchasing water over the cost that would have been incurred by us topump water from our wells had they not been shut down as a result ofcontamination and excluded costs covered in the $1,649,000 settlement. Thissettlement agreement with the responsible parties provided for ongoingreimbursement of our excess water costs and as such we bill and collect thisreimbursement monthly.  These monthlyreimbursements are recorded as a reduction to Operating expenses – utilities,which consequently increase our Operating Income.  In 2001, and 2002 and for the three and nine months endedSeptember 30, 2003 these reimbursements were $1,115,000, $4,338,000, $1,362,000and $3,294,000, respectively.

 

Thesettlement agreement also provides for contributions by the responsible partiesto construct new wells and to develop additional interconnections with nearbywater sources. Funds from the settlement agreement will also be used to developlong-term solutions that will potentially enable us to use our own less costlygroundwater supplies in the future. Commencing in 2002, these contributions for the year ended 2002 were$3,205,000 and for the three and nine months ended September 30, 2003 were$178,000 and  $2,360,000,respectively.  These contributions wererecorded as Contributions in Aid of Construction.

 

*PensionPlan Termination*

 

As of December 30, 1999***,***ournon-contributory defined benefit pension plan was terminated. In January 2002,the net assets of the pension plan were distributed to plan participants aspermitted by the Employee Retirement Income Security Act (ERISA) and itsrelated regulations. Following distribution of the plan assets of approximately$14,400,000 to meet the benefit liabilities of the pension plan, and settlementof expenses paid by the pension plan in accordance with ERISA and its relatedregulations, the pension plan had excess assets of approximately $1,150,000.

 

In February 2002, ourBoard of Directors approved the transfer of excess assets to a qualifiedreplacement plan. The funds were transferred to the Trustee of the qualifiedreplacement plan in March 2002. We recognized a net termination gain of approximately$980,000 as income in the first quarter of 2002.

 

***Note 11. – Commitment, Contingencies and Restrictions***

 

## **Oneof our wholly owned subsidiaries, ECO Capistrano Valley, Inc., is a party tocontracts with a city in California for the construction and long termoperation of a reverse osmosis facility. The assets and liabilities of this subsidiary are included in ourconsolidated financial statements and at September 30, 2003 consist primarilyof restricted cash of $2,434,000, accounts receivable of $1,239,000, deferredpre-contract costs of $840,000 and accounts payable of $3,948,000.  The formation documents for this subsidiaryprevent distributing funds or paying dividends to the parent company or anyother affiliate in excess of an agreed upon formula under the agreements.  To date, there have been no dividends ordistributions made to Southwest Water Company.**

 

## **Oneof our wholly owned subsidiaries, Suburban Water Systems, is limited by itsmortgage bond agreement in distributing funds to Southwest Water Company.  The limitation prevents paying dividendsthat exceed aggregate undistributed net income subsequent to December 31,1995.  Dividend distributions haveaveraged approximately $2,000,000 per year and are less than the dividendrestriction threshold as of September 30, 2003 by approximately $21,000,000.**

 

***Note 12. – Legal Proceeding and Subsequent Events***

 

As previously discussedin out quarterly report on Form 10-Q for the period ended June 30,2003, inApril 2003, Southwest Water filed a lawsuit in the United States District Courtfor the District of Colorado against the minority owner of Master Tek forcertain issues

 

13

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associated with both ourinitial acquisition of 80% of the stock of Master Tek and subsequent costs weincurred.  As allowed in the originalacquisition documents, we purchased an additional five percent interest inMaster Tek for $1,000,000 in April 2003. This payment and other certain other payments were paid into an escrowaccount. In October 2003, we reached a tentative settlement regarding thislawsuit.  In this settlement the Companywill make a final net payment of approximately $2.6 million in exchange for allthe remaining minority interest of MasterTek, satisfaction of all outstandingobligations, and certain continuing guarantees and indemnifications.  The Company believes that this settlementwill not have an adverse affect on the results of operations.

 

Southwest Water and itssubsidiaries are the subjects of certain litigation arising in the ordinarycourse of their operations. We believe the ultimate resolution of such matterswill not materially affect our financial position, results of operations orcash flows.

 

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***Item 2******: Management’s Discussion andAnalysis of Financial Condition and Results of Operations***

 

*The information in thisdiscussion contains forward-looking statements within the meaning of Section27A of the Securities Act of 1933, as amended and Section 21E of the SecuritiesExchange Act of 1934, as amended (the”34 Act”). Such statements are based uponcurrent expectations that involve risks and uncertainties including those set forth under “RiskFactors” in this report**.  Any statements contained herein that are notstatements of historical facts may be deemed to be forward-looking statements.For example, words such as “may”, “will”, “should”, “estimates”, “predicts”,“potential”, “continue”, “strategy”, “believes”, “expects”, “anticipates”,“plans”, “intends”, and similar expressions are intended to identifyforward-looking statements. Our actual results and the timing of certain eventsmay differ significantly from the results discussed in the forward-lookingstatements.*

 

The following discussion should be read inconjunction with the accompanying unaudited condensed Consolidated FinancialStatements and related Notes thereto and the Consolidated Financial Statementsand the Notes thereto contained in our Annual Report on Form 10-K for the yearended December 31, 2002.

 

**Overview**

 

Southwest Water Companyand Subsidiaries (*“Southwest”*, “*We*” or the *“Company”*), provide a broadrange of services including water production and distribution, wastewatercollection and treatment, public works services, customer billing and service,and utility submetering. We provide services to more than two million people in31 states. Our business is segmented into two operating groups, our ServicesGroup and our Utility Group.

 

Our Services Groupoperates our contract service businesses in which we operate and maintain watersupply and wastewater facilities owned by cities, public agencies, municipalutility districts and private entities primarily in Texas, New Mexico,California, Colorado, Mississippi and Georgia. While state and federal agenciesissue regulations regarding standards of water quality, safety, environmentaland other matters which affect these operations, our Services Group prices arenot subject to regulation. We also provide utility submetering and billing andcollection services in numerous states.

 

Our Utility Group ownsand operates rate-regulated public water and wastewater utilities inCalifornia, New Mexico and Texas. State and federal agencies issue regulationsregarding standards of water quality, safety, environmental and other matterswhich affect these operations, as well as establish the rates that we cancharge for our water and wastewater services.

 

Southwest Water Companywas incorporated in California in 1954. We reincorporated in Delaware in 1988.Our principal executive offices are located at One Wilshire Building, 624 SouthGrand Avenue, Los Angeles, California 90017-3872, and our telephone number is(213) 929-1800.

 

The Company is focused onprofitable growth and we apply three principal strategies to expand ourrevenues and profits:

 

 

1.     We work toenhance organic revenue growth in our Services Group through expansion ofbusiness with existing clients and services to new clients and in our UtilityGroup through customer growth and rate case proceedings.

2.     We seek outand develop opportunities for accretive acquisitions that fit our long-termgrowth goals in both the Services and Utility Groups.

3.     We pursueopportunities to improve our margins and gain the benefits of our increasedsize.

 

15

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**Results of Operations**

 

A summary of our consolidated results for the threeand nine months ended September 30, 2003 is as follows:

 
|                                          |   | **Three months ended September 30,** |   | **Nine months ended September 30,** |   |
|-----------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                          |   | **2003**                             |   | **%****of  Revenue**                |   | **2002** |   | **%****of  Revenue** |   | **2003** |   | **%****of  Revenue** |   | **2002** |   | **%****of  Revenue** |   |
|                                          |   | **(Unaudited)(dollars in millions)** |   |
| Revenue:                                      |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Service  operations                           |   | $                                    | 33.3   |                                | 65     |   | $ | 19.2 |   | 55 |   | $ | 86.3 |   | 67 |   | $ | 55.6 |   | 58 |   |
| Utility  operations                           |   | 18.1                                 |   | 35                                  |   | 15.4 |   | 45 |   | 42.7 |   | 33 |   | 39.9 |   | 42 |   |
|                                          |   | 51.4                                 |   | 100                                 |   | 34.6 |   | 100 |   | 129.0 |   | 100 |   | 95.5 |   | 100 |   |
|                                          |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Expenses:                                     |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating  expenses – services           |   | 28.3                                 |   | 55                                  |   | 16.3 |   | 47 |   | 74.7 |   | 58 |   | 47.3 |   | 50 |   |
| Operating  expenses – utilities          |   | 9.9                                  |   | 19                                  |   | 10.6 |   | 31 |   | 25.5 |   | 20 |   | 26.3 |   | 28 |   |
| Selling,  general and administrative expenses |   | 6.6                                  |   | 13                                  |   | 4.0 |   | 12 |   | 17.8 |   | 14 |   | 14.4 |   | 14 |   |
|                                          |   | 44.8                                 |   | 87                                  |   | 30.9 |   | 89 |   | 118.0 |   | 91 |   | 88.0 |   | 92 |   |
|                                          |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating  Income                             |   | 6.6                                  |   | 13                                  |   | 3.7 |   | 11 |   | 11.0 |   | 9 |   | 7.5 |   | 8 |   |
|                                          |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Non-Operating  Income (Expense):              |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest  expense                             |   | (1.0                                 | )      | (2                                  | )      | (1.1 | ) | (3 | ) | (3.3 | ) | (3 | ) | (3.3 | ) | (3 | ) |
| Interest  income                              |   | —                               |   | —                              |   | 0.1 |   | — |   | 0.1 |   | — |   | 0.2 |   | — |   |
| Gain  on sales of land                        |   | —                               |   | —                              |   | — |   | — |   | 0.7 |   | — |   | 0.1 |   | — |   |
| Other                                         |   | (0.2                                 | )      | —                              |   | (0.1 | ) | — |   | (0.3 | ) | — |   | 2.6 |   | 2 |   |
|                                          |   | (1.2                                 | )      | (2                                  | )      | (1.1 | ) | (3 | ) | (2.8 | ) | (3 | ) | (0.4 | ) | (1 | ) |
|                                          |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income  Before Income Taxes                   |   | 5.4                                  |   | 11                                  |   | 2.6 |   | 8 |   | 8.2 |   | 6 |   | 7.1 |   | 7 |   |
|                                          |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Income  Tax Provision                         |   | 2.0                                  |   | 4                                   |   | 0.9 |   | 3 |   | 3.0 |   | 2 |   | 2.5 |   | 3 |   |
|                                          |   |                                 |   |                                |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  Income                                   |   | $                                    | 3.4    |                                | 7      |   | $ | 1.7 |   | 5 |   | $ | 5.2 |   | 4 |   | $ | 4.6 |   | 5 |   |

 

 

**Discussion of Results of Operations for ThreeMonths Ended September 30, 2003 and 2002**

 

**Revenues**

 

**Services operations**

 

Services Group revenuerepresents fees earned for water and wastewater facility operations andmaintenance services, equipment maintenance and repair, sewer pipelinecleaning, billing and collection services, and state-certified water andwastewater laboratory analysis. Our Services Group also facilitates the design,construction, project management, and operating aspects of various water andwastewater projects. Additionally, our Services Group provides utilitysubmetering for multiple family buildings. Revenue for the three months ended September 30, 2003 increasedapproximately $14.1 million, or 73%, to $33.3 million from $19.2 million duringthe same period of the prior year.  Theincrease is due to the following:

 

•      the acquisition of certaincontract operations from AquaSource, Inc. in November 2002,

•      approximately $5.8 millionin revenues from the construction of a reverse osmosis water treatment facilityin California, and

•      increased revenueprincipally driven by real estate development activity in Texas, and

•      the addition of newcontracts.

 

**Utility operations**

 

Utility Group revenuerepresents fees earned by our regulated public water utilities for theproduction and distribution of water and the collection and treatment of sewagefor residential, business, industrial and public authority use.  Revenues in the Utility Group increasedapproximately $2.7 million, or 18%, to $18.1 million during the three monthsended September 30, 2003 from $15.3 million over the same period of the prioryear.  The increase is primarily due tothe favorable effect of rate increases in our California and

 

16

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Texas utilities andincreased customer connections in our New Mexico and Texas utilities.  The effect of increases in rates however waspartially offset by decreases in water consumption due to variations in weatherin communities served by our utilities.

 

**Expenses**

 

**Operating expenses - services**

 

Operating expenses –services represent salaries, wages and employee benefits, facilities costs,supplies and equipment, repairs and maintenance, professional fees and othercosts.  Operating expenses - servicesrepresented approximately 85% of the Services Group revenues for the threemonths ended September 30, 2003 and the same period of 2002. Operating expensesincreased approximately $12.0 million, or 74%, to $28.3 million during thethree months ended September 30, 2003 from $16.3 million during the same periodof 2002.  The increase was due to thefollowing:

 

•      the inclusion of certaincontract operations of AquaSource, Inc., beginning in November 2002, whichrepresented operating costs of approximately $4.4 million during the threemonths ended September 30, 2003,

•      costs related to the constructionof a reverse osmosis water treatment facility in California, amounting toapproximately $5.5 million, and

•      costs attributable toincreased operations and construction in the Service Group’s Texas andMississippi operations.

 

**Operating expenses – utilities**

 

Operating expenses -utilities represent the costs of purchasing and producing water, treatingwastewater, salaries, wages and employee benefits, facilities costs, suppliesand equipment, repairs and maintenance, professional fees and other costs.  Operating expense – utilities representedapproximately 55% and 71% of revenues from utility operations for the threemonths ended September 30, 2003 and 2002, respectively.  Operating expenses for our Utility Groupdecreased $0.7 million or 9% to $9.9 million during the three months endedSeptember 30, 2003, from $10.6 million during the same period of the prioryear.  This decrease in Operatingexpenses as a percentage of Utility Group revenues is driven by both the effectof rate increases in our California utility, and reduced waterconsumption.  This was due to:

 

•      a decrease in consumptiondue to variations in weather in communities served by our utilities,

•      a shift in the source ofwater from external purchases toward less expensive internally produced water,and

•      the benefit of leasingcertain water rights.

 

Operating expenses at ourCalifornia utility decreased $1.8 million due to a reduction in waterconsumption.  Volume related costs atour California utility, net of reimbursements, decreased $1.3 million.

 

Operating expensesincurred by our New Mexico utility increased $0.6 million to $3.3 millionduring the three months ended September 30, 2003 from $2.7 million during thesame period of the prior year.  The Cityof Albuquerque increased sewage treatment rates approximately 9%.  In addition, the New Mexico utility incurredadditional energy costs due to increased water consumption.

 

**Selling, general and administrativeexpenses**

 

Selling expenses consistmainly of personnel, facilities, insurance and professional services costs,which support our sales, marketing, human resources, finance and administrationfunctions.  Selling, general andadministrative costs increased $2.6 million, or 78%, to $6.6 million for thethree months ended September 30, 2003 from $4.0 million during the same periodof the prior year.  Selling, generaland administrative expenses as a percentage of revenue increased two percentagepoints to 13% during the three months ended September 30, 2003 from 11% duringthe same period of the prior year. The increase was due to the following:

 

•      the acquisition of certaincontract operations from AquaSource, Inc. in November 2002,

•      increased costs company-widefor employee health benefits, insurance and compensation expenses, and

•      increased legal andaccounting fees incurred as a result of our increased size.

 

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**Non-operating income (expense)**

 

Interest expense

 

The major components ofinterest expense for three months ended September 30, 2003 and 2002 are asfollows:

 
| **For Three  Months Ended September 30,**                   |   | **2003**          |       | **2002**   |   |
|-------------------------------------------------------------|--------|-------------------|------------|------------|--------|
|                                                        |   | **(in millions)** |       |
| Interest expense –  convertible subordinate debentures |   | **$**             | **.3**     | ** ** | $      | .3 |   |
| Interest expense – bank  lines of credit               |   | **.2**            | ** ** | .1         |   |
| Interest expense –  mortgage bonds and bank term loan  |   | **.6**            | ** ** | .6         |   |
| Interest expense –  other                              |   | **.1**            | ** ** | .1         |   |
| Total interest expense  before capitalized interest         |   | **1.2**           | ** ** | 1.1        |   |
| Capitalized interest                                        |   | **(.2**           | **)**      | —     |   |
| Total interest expense                                      |   | **$**             | **1.0**    | ** ** | $      | 1.1 |   |

 

Total interest expensedecreased 9% to $1.0 million during for the three months ended September 30,2003, compared to $1.1 million for the same period in 2002, due to lowerinterest rates.  Our effective interestrates for the three months ended September 30, 2003 and 2002 were 5.2% and6.1%, respectively.  We also experiencedincreased construction activity in our Utility Group resulting in highercapitalized interest of $0.2 million in 2003. This was offset by higher borrowings on our bank lines of credit.

 

**Income Taxes**

 

Our effective tax ratefor the three months ended September 30, 2003 was 37% compared to approximately35% for 2002. Our effective tax rate for 2002 reflected the benefit of aone-time gain on the termination of a pension plan, which was excluded fromordinary taxable income.

 

**Discussion of the Results of Operations for theNine Months Ended September 30, 2003 and 2002**

 

**Revenues**

 

**Service operations**

 

Services Group revenuesfor the nine months ended September 30, 2003 increased approximately $30.7million, or 55%, to $86.3 million from $55.6 million during the same period ofthe prior year.  The increase is due tothe following:

 

•      approximately $15.0 millionin revenues from the acquisition of certain contract operations fromAquaSource, Inc. in November of 2002,

•      revenues of $9.2 millionfrom the construction of a reverse osmosis water treatment facility inCalifornia during 2003, and

•      increased revenues from ourTexas service operations of $8.7 million to $51.4 million during the ninemonths ended September 30, 2003 from $42.7 million during the same period ofthe prior year.  The revenue increase islargely attributable to increased construction project work and tapping andinspection revenue that is principally driven by real estate developmentactivity in Texas.

 

**Utility operations**

 

Revenues in the UtilityGroup increased approximately $2.8 million, or 7%, to $42.7 million during thenine months ended September 30, 2003 from $39.9 million during the same periodof the prior year.  The increase isprimarily due to the favorable effect of rate increases in our California andTexas utilities and increased customer connections in our New Mexico and Texasutilities.  The effect of increases inrates, however, was partially offset by decreases in water consumption due tovariations in weather in communities served by our utilities, as follows:

 

| Favorable effect  of rate increase in revenues  |   | $    | 3.3    |    | million |   |
|-------------------------------------------------|--------|------|--------|---------|---------|--------|
| Favorable effect  of increase in connections    |   | 1.2  |   | million |    |
| Changes in  volume related to weather and other |   | (1.6 | )      | million |    |
|                                            |   | $    | 2.9    |    | million |   |

 

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**Operating Expenses**

 

**Operating expenses - services**

 

Operating expenses -Services represented approximately 87% and 85% of the Services Group revenuesfor the nine months ended September 30, 2003 and 2002, respectively. Operatingexpenses increased approximately $27.4 million, or 58%, to $74.7 million duringthe nine months ended September 30, 2003 from $47.3 million during the sameperiod of 2002.  The increase was due tothe following:

 

•      the acquisition of certaincontract operations from AquaSource, Inc. in November 2002, which generatedoperating costs of approximately $15.0 million during the nine months endedSeptember 30, 2003, and

•      costs related to theconstruction of the reverse osmosis water treatment facility which accountedfor approximately $9 million of the increase in operating expenses.

 

The remaining increase ofapproximately $3.4 million for the nine months ended September 30, 2003,compared to the prior year, resulted from increased operations and constructionactivity in the Services Group’s operations.

 

**Operating expenses - utilities**

 

Operating expense –utilities represented approximately 60% and 66% of revenues from utilityoperations for the nine months ended September 30, 2003 and 2002, respectively.Operating expenses for our Utility Group decreased $0.8 million, or 3%, to$25.5 million during the nine months ended September 30, 2003, from $26.3million during the same period of the prior year. The decrease in operatingexpenses incurred by our California utility was $0.7 million to $24.9 millionduring the nine months ended September 30, 2003 from $25.6 million during thesame period of the prior year.   TheUtility Group decreases were primarily due to:

 

•      a decrease in consumptiondue to weather variations in our service areas, especially in early 2003,

•      a shift in the source ofwater from external purchases toward less expensive, internally produced water,and

•      the benefit of leasingcertain water rights.

 

Operating expensesincurred by our New Mexico utility increased $152,000, or 13%, during the ninemonths ended September 30, 2003 as compared to the same period of the prioryear.  The City of Albuquerque hasincreased sewage treatment rates approximately 9%.  In addition, our New Mexico utility has incurred additional fuelcosts due to increased volume.

 

**Selling, general and administrativeexpenses**

 

Selling general andadministrative costs increased $3.4 million, or 24%, to $17.8 million for thenine months ended September 30, 2003 from $14.4 million during the same periodof the prior year.  The increase was dueto the inclusion of $1.0 million from certain contract operations acquired fromAquaSource, Inc. in November 2002 and the increased costs company-wide foremployee health benefits, insurance and compensation expenses.  As a percentage of revenues, selling,general and administrative expenses fell one percentage point to 14% for thenine months ended September 30, 2003, from the same period of 2002.

 

**Non-operating income (expense)**

 

**Interest Expense**

 

The major components ofinterest expense for the nine months ended September 30, 2003 and 2002 are asfollows:

 
| **For the  Nine Months Ended September 30,**                |   | **2003**          |       | **2002**   |   |
|-------------------------------------------------------------|--------|-------------------|------------|------------|--------|
|                                                        |   | **(in millions)** |       |
| Interest  expense – convertible subordinate debentures |   | **$**             | **1.0**    | ** ** | $      | 1.1 |   |
| Interest  expense – bank lines of credit               |   | **.6**            | ** ** | .4         |   |
| Interest  expense – mortgage bonds and bank term loan  |   | **1.7**           | ** ** | 1.7        |   |
| Interest  expense – other                              |   | **.4**            | ** ** | .2         |   |
| Total  interest expense before capitalized interest         |   | **3.7**           | ** ** | 3.4        |   |
| Capitalized  interest                                       |   | **(.4**           | **)**      | (.1        | )      |
| Total  interest expense                                     |   | **$**             | **3.3**    | ** ** | $      | 3.3 |   |

 

Total interest expenseremained flat at $3.3 million for the nine months ended September 30, 2003,compared to the same period in 2002. Our benefit from lower interest rates and higher capitalized interestfrom increased construction activity in our Utility

 

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Group was offset byhigher borrowings on our bank lines of credit and increased interest expenserelated to our Texas utility bank term loan. In August 2002, one of our Texas utilities obtained a 10-year, $10.0million secured bank term loan which increased our debt outstanding andconsequently, our interest expense. Our effective interest rates for the ninemonths ended September 30, 2003 and 2002 were 5.2% and 6.1%, respectively.

 

**Gains on Sales of Land and Other**

 

In the second quarter of2003, we recognized a $0.7 million pretax gain on the sale of surplus land, andin the second quarter of 2002 we recognized a $0.1 million pretax gain on thesale of surplus land. In the second quarter of 2002, we recognizedapproximately $1.7 million pretax income from a ground water settlement (seeNote 10 in the accompanying consolidated financial statements). In the firstquarter of 2002, we recorded a one-time pretax gain on the termination of apension plan of approximately $1.0 million (see Note 10 in the accompanyingconsolidated financial statements).

 

**Income Taxes**

 

Our effective tax ratefor the first nine months of 2003 was 37% compared to approximately 35% for2002. Our effective tax rate for 2002 reflected the benefit of a one-time gainon the termination of a pension plan, which was excluded from ordinary taxableincome.

 

**Liquidityand Capital Resources**

 

Our operating activitiesprovided approximately $3.3 million in cash during the nine months endedSeptember 30, 2003 consisting of net income of $5.2 million, adjusted forcertain non-cash items including depreciation and amortization of $5.8 millionand deferred income taxes of $2.0 million.  Operating cash flow wasfurther increased by a net increase in liabilities of $1.7 million.  Operating cash flow was reduced by (i) anincrease in accounts receivable and other assets of $9.0 million and (ii) anincrease in restricted cash of $2.4 million.

 

Our investing activitiesused cash of $12.6 million during the nine months ended September 30,2003.  Capital expenditures of $13.3million were primarily for the acquisition of property plant and equipment forregulated water system assets used by our Utility Group, including new wellsand transmission lines in New Mexico, and the construction of a lift stationand water line in Texas.  The effect ofcapital expenditures on cash was partially offset by proceeds from sales ofland of approximately $0.7 million.

 

The following tablesummarizes our activity for additions to property, plant and equipment duringthe nine months ended September 30, 2003 and 2002:

 
|                                                   |   | **2003**           |       | **2002**   |   |
|--------------------------------------------------------|--------|--------------------|------------|------------|--------|
|                                                   |   | **(in  millions)** |       |
| Company  financed additions                            |   | **$**              | **12.1**   | ** ** | $      | 3.0 |   |
| Capital  improvement reimbursements                    |   | **2.4**            | ** ** | 2.6        |   |
| Contributions  paid for by developers                  |   | **2.6**            | ** ** | 7.5        |   |
| Total  cash additions to property, plant and equipment |   | **17.1**           | ** ** | 13.1       |   |
| Property  contributed by developers                    |   | **7.5**            | ** ** | 5.7        |   |
| Total  additions to property, plant and equipment      |   | **$**              | **24.6**   | ** ** | $      | 18.8 |   |

 

Financing activitiesprovided cash of approximately $11.3 million. Net proceeds from our private placement of equity in May 2003 wereapproximately $10.9 million.  Wecollected an accumulated total of approximately $2.1 million in net proceedsfrom our dividend reinvestment and employee stock purchase plans and from assetsale-leaseback transactions. Reimbursments to our California utility under a settlement agreementwere approximately $2.4 million.  Contributionsin aid of construction and advances for construction were approximately $2.6million, and cash used to reduce debt and to pay dividends was approximately$4.9 million and $1.8 million, respectively.

 

Our liquidity isinfluenced primarily by cash flows from operations and by capital expendituresat our Utility Group for the addition, replacement and renovation of water andwastewater utility facilities. Our capital resources are used for debt serviceon our bonds and debentures and are also influenced by investments in newbusiness opportunities, including the acquisition of companies and acquisitionof contract operations.

 

On September 30, 2003, wehad working capital of approximately $4.1 million with available cash andcash-equivalent balances of approximately $3.5 million (excluding restrictedcash balances), as well as aggregate lines of credit totaling $28.0 millionconsisting of three separate unsecured lines of credit from three commercialbanks. Our total borrowing availability under lines of credit was

 

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approximately $13.7million on September 30, 2003.  InOctober 2003 we renewed one of our lines, resulting in our aggregate lines ofcredit increasing to a total of $30 million. One line of credit expires in March 2005, the other two expire inSeptember 2005.

 

For the three monthsended September 30, 2003 and 2002, we had weighted average borrowing rates onour bank lines of credit of 2.5% and 3.6%, respectively.  For the nine months ended September 30, 2003and 2002, we had weighted average borrowing rates on our bank lines of creditof 2.9% and 3.7%, respectively.

 

In January 2003, weexpanded one of our lines of credit from one of our commercial banks by $3.4million. This facility was utilized to issue a standby letter of credit in thatamount as collateral for performance under a service contract to design andconstruct a reverse osmosis water treatment facility and associated wells. Thisstandby letter of credit is in force for the estimated two-year constructionperiod of the project. Upon acceptance of the completed project, the standbyletter of credit and the related credit facility will be terminated.

 

In addition to our linesof credit, we have excess borrowing capacity under our first mortgage bondindentures of approximately $72.0 million as of September 30, 2003. However,the additional borrowing available under our current commercial lines of creditis limited by financial covenants that restrict additional borrowing to an amountno greater than the remaining unused credit line amount.

 

We expect to maintain ourlines of credit in the normal course of business. Each of the line of creditagreements contains certain financial covenants. During the nine months endedSeptember 30, 2003, we were in compliance with all applicable covenants undereach of the line of credit agreements.

 

We anticipate that ouravailable line of credit borrowing capacity and cash flows generated fromoperations will be sufficient to fund our activities during the next 12 months.If we were unable to renew our existing lines of credit or if we were unable toexecute additional financing alternatives, our capital spending and any futureacquisitions would be reduced, eliminated or delayed.

 

**Critical Accounting Policies**

 

Our consolidated financial statements are prepared inaccordance with accounting principles generally accepted in the United States(GAAP). These accounting principles require us to make certain estimates,judgments and assumptions. We believe that the estimates, judgments andassumptions are reasonable based upon information available to us at the timethat these estimates, judgments and assumptions are made. These estimates,judgments and assumptions can affect the reported amounts of assets andliabilities as of the date of the financial statements, as well as the reportedamounts of revenues and expenses during the periods presented. To the extentthere are material differences between these estimates, judgments orassumptions and actual results, our financial statements will be affected. Thesignificant accounting policies that we believe are important to aid in fullyunderstanding and evaluating our reported financial results include thefollowing:

 

•      revenue recognition,

•      valuation of long-lived andintangible assets,

•      accounting for regulatedbusiness in accordance with SFAS 71, and

•      stock-based compensation.

•      unusual events

 

In many cases, theaccounting treatment of a particular transaction is specifically dictated byGAAP and does not require management’s judgment in its application. There arealso areas in which management’s judgment in selecting among available GAAPalternatives would not produce a materially different result. Our seniormanagement has reviewed these critical accounting policies and relateddisclosures with our Audit Committee.

 

**Revenue recognition**

 

Revenues for contractoperations are billed based on a monthly fee to provide a specific level ofservice as outlined in each individual contract. We generally bill for additionalservices provided beyond the scope of the base contract on a time and materialsbasis as such services are rendered.

 

Revenues for constructionprojects are recorded using the percentage-of-completion method of accounting.The percentage of completion method recognizes revenue and income as workprogresses on a project based on the expected total project costs and theexpected total project revenues. This method is based on an estimate of therevenue and income earned to date, less the revenue and income recognized inearlier periods.  If managementdetermines the Company will ultimately suffer a loss on a construction project,the entire estimated loss will be recorded in the period such a determinationis made.

 

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Revenues for submetering,billing and collection services are recognized and billed at the end of themonth in which services are performed. Revenues for installation of submeteringequipment are accounted for using the percentage-of-completion method.

 

Water utility revenuesare recognized when amounts are billed to customers. An estimated amount forunbilled revenues is accrued for water usage since the previous billing period.

 

**Valuation of long-lived and intangible assets.**

 

Our acquisitions have been accounted forusing the purchase method of accounting. In accordance with SFAS No. 144, *Accountingfor the impairment of Long-Lived Assets and for Long-Lived Assets to beDisposed of,*we assess intangible assets and other long-lived assetsfor recoverability whenever events or changes in circumstances indicate thattheir carrying value may not be recoverable through the estimated undiscountedfuture cash flows resulting from the use of the assets.  If we determine that the carrying value ofintangible assets or other long-lived assets may not be recoverable, we measureimpairment by using the projected discounted cash-flow method in accordancewith Statement No. 144.

 

We have made acquisitionsin the past that resulted in recording goodwill and intangible assets. In June2001, the FASB issued SFAS No. 142*, Goodwill and Other Intangible Assets*.SFAS No. 142 requires that goodwill and intangible assets with indefiniteuseful lives are not amortized, but instead are tested for impairment at leastannually. For intangible assets with definite useful lives, SFAS No. 142requires amortization over their estimated useful lives. SFAS No. 142 becameeffective for fiscal years beginning after December 15, 2001. At September 30,2003, other assets include approximately $20.2 million of goodwill, which wasno longer subject to amortization beginning in 2002. There were no impairmentcharges to goodwill as of September 30, 2003 and no events have occurred thatindicated dimunition in the value of recorded goodwill.

 

Under the provisions ofSFAS No. 141, *Business Combinations*, we identified approximately $0.2million of intangible contract costs in connection with our acquisition of AquaServices and approximately $1.1 million of intangible contract costs inconnection with our acquisition of OpTech. We are amortizing the intangiblecontract costs over a period of four years, which is the average estimated lifeof the contracts.

 

**Accounting for regulated businesses**

 

Our regulated businesses,which include our utilities in California, New Mexico and Texas, are requiredto be accounted for under the provisions of SFAS No. 71, *Accounting for the Effects of CertainTypes of Regulation*, which specifies certain revenue, expense andbalance sheet treatment as required by each state regulatory authority. Eachstate authority establishes rates which are intended to permit each utility torecover its costs and earn a reasonable rate of return. Each utility may fileand process general rate applications on a periodic basis. Since theestablished rates may be in effect for several years, our utilities attempt toanticipate cost increases and apply for rates sufficient to permit recovery ofthose cost increases when incurred.

 

One of our Services Groupsubsidiaries has contracted with our utilities in Texas and New Mexico toperform operating services, maintenance, and construction work, and, inaddition, to manage capital projects. These contracts were establishedutilizing terms and conditions equivalent to prevailing industry rates forsimilar work performed by our Services Group for non-affiliated entities. Inaccordance with SFAS No. 71, our Services Group recognizes profit from workperformed and does not eliminate the intercompany profit when the contractsales price is reasonable and it is probable that the costs and capital will berecoverable by the utility through the rate-making process. Accordingly, theintercompany profit, and the related receivables and payables, on such workhave not been eliminated in the accompanying condensed consolidated financialstatements. However, all revenue in excess of profits has been eliminated inconsolidation, consisting of approximately $3.4 million and $10.0 million forthe three and nine months ended September 30, 2003, respectively.

 

Our California waterutility has recorded a balancing account receivable in the amount ofapproximately $2.3 million, representing the difference between actual waterproduction costs incurred and California Public Utilities Commission(CPUC)-adopted water production costs. Historically, the CPUC allowed suchbalancing accounts in the income statements of water utilities, with acorresponding liability or asset on the balance sheet. However, the CPUCchanged this policy by eliminating the use of balancing accounts as of November29, 2001. In December 2002, the CPUC issued a decision that we believe willallow our water utility in California to recover the $2.3 million that was heldin the balancing account as of November 29, 2001.

 

Beginning in December2001, our water utility has recognized all water costs as incurred. Currentlythe differences between actual and CPUC-adopted water production costs areexpensed as incurred. These differences are tracked in a memorandum account andwe will attempt to recover these expenses in future rate hearings.

 

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**Stock-Based Compensation**

 

In 2002, we adopted thefair value recognition provisions of SFAS No. 123, which requires valuation ofstock options issued based upon an option pricing model and recognition of thisvalue as an expense over the period in which the options vest. In accordancewith the provisions of SFAS No. 148, we elected to recognize stock-basedcompensation using the retroactive restatement method. Under this change inaccounting method, we have restated our accompanying condensed consolidatedfinancial statements for the 2002 periods presented to reflect stock-basedcompensation expense under a fair value based accounting method for all optionsgranted, modified or settled in fiscal years beginning after December 15, 1994.

 

We use the Black-Scholesoption valuation model to estimate the fair value of our stock options. Thisoption valuation model was developed for use in estimating the fair value oftraded options that do not have vesting restrictions and that are fullytransferable. Option valuation models require subjective assumptions such asthe expected future volatility of the stock price. Because the stock options wegrant have characteristics that are significantly different from those oftraded options, and because changes in the subjective input assumptions canmaterially affect the calculated results, in management’s opinion, the stockoption valuation models, including Black-Scholes, may not necessarily provide areliable single measure of the fair value of employee stock options.

 

**Unusual Events**

 

Southwest Water reportsmaterial events that are unusual in nature or occur infrequently, but not both,in Other Income (Expense) rather than in Operating Income, in accordance withthe provisions of APB No. 30 *Reporting theResults of Operations. *APBNo. 30 provides that unusual or infrequent events are separately disclosed andexcluded from Operating Income, and that the nature and financial effects ofeach event or transaction should be disclosed on the face of the IncomeStatement.  Included in Other Income onthe Company’s Consolidated Statements of Income is the effect of a one-time,non-taxable gain in 2002 of approximately $1.0 million resulting from thetermination of the Company’s defined benefit plan as fully disclosed in Note 12to the consolidated financial statements. Also included in Other Income for 2002 is a $1.7 million settlement reachedbetween parties responsible for the contamination and our California utilityregarding water-quality-related expenses incurred in 1999, 2000 and 2001.

 

**RISK FACTORS**

 

The following factors,which are described more fully in our 2002 Annual Report, could cause ouractual results to differ materially from our historical results and/orforward-looking statements (see our 2002 Annual Report and Prospectus filedOctober 9, 2003 for further disclosure related to risks factors) :

 

**RisksRelated to our Common Stock**

 

•      Our outstanding indebtednessmay adversely affect our financial condition and the value of our common stock.

 

•      We are a holding companythat depends on cash flow from our subsidiaries to meet our obligations.

 

•      The market price of ourshares of common stock could be volatile.

 

 

**RisksRelated to Our Business**

 

***Risk factors that affect our Services Groupoperations***

 

•      We operate in a competitivemarket with low operating margins.

 

•      Our revenue growth dependson our ability to enter into new, and maintain our existing, operatingcontracts with cities, agencies and municipal utility districts.

 

•      Our business depends ontrained, qualified employees.

 

•      Risk of events such ashurricanes, tornadoes and floods may affect our results of operations.

 

•      Our Services Group contractshave certain performance risks.

 

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•      Services Group contracts forthe design and construction of water and wastewater projects may expose us tocertain completion and performance risks.

 

•      We use third party equipmentand subcontractors.

 

•      Our Services Group issubject to environmental and water quality risks.

 

•      We operate a large fleet ofvehicles that could expose us to liabilities.

 

•      Our operating costs may risefaster than our revenues.

 

•      Our operating contracts maybe cancelled, reducing our revenues and backlog.

 

***Risk Factors that affect our Utility Groupoperations***

 

•      Weather conditions canaffect the financial results of our Utility Group.

 

•      Changes in the regulatoryenvironment, including restrictions on the rates we are allowed to chargecustomers, may adversely affect our results of operations.

 

•      We own assets in areassubject to natural disasters.

 

•      We are subject to regulatoryand environmental risks and may not be able to provide an adequate supply of waterto our customers.

 

•      We need access to capital tocontinue to invest in our utility assets.

 

 

**Otherrisk factors**

 

•      Our capital resources mayrestrict our ability to operate and expand our business.

 

•      If we continue to grow, wemay fail to effectively manage our growth or we may fail to effectively managethe growth we have experienced.

 

•      Our business may be affectedby the general economic conditions of real estate development in the UnitedStates.

 

•      We are subject to increasingcosts of producing products and services.

 

•      Our operations are subjectto certain risks due to their location.

 

 

***Item 3******. Quantitative and QualitativeDisclosures about Market Risk***

 

We have certainindebtedness that is subject to variable rate interest. As a result, SouthwestWater’s interest expense is affected by changes in the general level ofinterest rates. The interest expense paid on our line of credit borrowings andcertain term loans is determined based upon a rate formula that fluctuates withshort-term LIBOR rates and cannot exceed the banks’ prime rate minusone-quarter percent.

 

We completed a $20.0million, 20-year convertible subordinate debenture offering in July 2001, whichbears a fixed interest rate of 6.85% per annum. The proceeds were used to paydown certain variable rate indebtedness. Our long-term debentures were soldwith a fixed interest rate, and are not subject to market fluctuation ofinterest rates. Our debentures are convertible into Southwest Water commonstock and, at a certain market price, our debentures will become dilutive inour computation of earnings per share.

 

***Item 4******. Controls and Procedures***

 

Our principal executiveofficer and principal financial officer are responsible for establishing andmaintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for Southwest Water, and we have designed suchdisclosure controls and procedures to ensure that material information relatingto Southwest Water, including its consolidated subsidiaries, is

 

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made known to us bymanagement within these entities, particularly during the period in which thisquarterly report is being prepared. In designing and evaluating the disclosurecontrols and procedures, management recognized that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, andmanagement necessarily was required to apply its judgment in evaluating the cost-benefitrelationship of possible controls and procedures. As required by SEC Rule13a-15(b), Southwest Water carried out an evaluation, under the supervision andwith the participation of management, including the Chief Executive Officer andChief Financial Officer, of the effectiveness of our disclosure controls andprocedures as of September 30, 2003, the end of the quarter covered by thisreport. Based upon that evaluation, the Chief Executive Officer and the ChiefFinancial Officer have concluded that the disclosure controls and procedureswere effective at the reasonable assurance level.

 

There has been no changein Southwest Water’s internal controls over financial reporting duringSouthwest Water’s most recent fiscal quarter that has materially affected, oris reasonably likely to materially affect, Southwest Water’s internal controlsover financial reporting.

 

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**PART II****- OTHER INFORMATION**

 

***Legal Proceeding and Subsequent Events***

 

As previously discussedin out quarterly report on Form 10-Q for the period ended June 30,2003, inApril 2003, Southwest Water filed a lawsuit in the United States District Courtfor the District of Colorado against the minority owner of Master Tek forcertain issues associated with both our initial acquisition of 80% of the stockof Master Tek and subsequent costs we incurred.  As allowed in the original acquisition documents, we purchased anadditional 5% interest in Master Tek for $1,000,000 in April 2003.  This payment and other certain otherpayments were paid into an escrow account. In October 2003, we reachedtentative a settlement regarding this lawsuit. In this settlement the Company will make a final net payment ofapproximately $2.6 million in exchange for all the remaining minority interestof MasterTek, satisfaction of all outstanding obligations, and certaincontinuing guarantees and indemnifications. The Company believes that this settlement will not have an adverseaffect on the results of operations.

 

Southwest Water and itssubsidiaries are the subjects of certain litigation arising in the ordinarycourse of their operations. We believe the ultimate resolution of such matterswill not materially affect our financial position, results of operations orcash flows.

 

***Item 6******. Exhibits and Reports on Form 8-K***

 

(a)    Exhibits:

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

 

 

(b)    Reports on Form8-K:

 

On August 12, 2003, theCompany filed a Current Report on Form 8-K furnishing an earnings releaseattached as Item 12 with respect to our financial results for the three and sixmonths ended June 30, 2003.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the Registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 
|                           | SOUTHWEST WATER COMPANY                                                                                        |   |
|--------------------------------|----------------------------------------------------------------------------------------------------------------|--------|
|                           | (Registrant)                                                                                                   |
|                           |                                                                                                           |
|                           |                                                                                                           |
| Dated:  November 12, 2003 | /s/ RICHARD J. SHIELDS                                                                                         |   |
|                           | **Richard J. Shields  Chief Financial Officer****(Principal  Financial Officer and Chief Accounting Officer)** |
|                                |                                                                                                                |        |  |

 

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