**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

 

**FORM 10-****Q**

 

| **(Mark  One)** |
|-----------------|
| ** **      |
| **ý**      | ** ** | **Quarterly  Report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
|            |   |   |
|            |   | **For the quarterly period ended March 31,  2006** |
|            |   |   |
| **or**          |
|            |   |   |
| **o**           | ** ** | **Transition  report pursuant to Section 13 or 15(d) of the Securities Exchange  Act of 1934** |
| ** **      | ** ** | ** ** |
|            |   | **For the transition period from                         to                         ** |

 

**CommissionFile Number 0-8176**

 

|            | **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 Number) |

 

**OneWilshire Building**

**624 SouthGrand Avenue, Suite 2900**

**LosAngeles, California 90017-3782**

(Address of principal executive offices,including zip code)

 

**(213)929-1800**

(Registrant’s telephone, including area code)

 

**No****ne**

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

 

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

 

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

 
| Large accelerated filer o |   | Accelerated filer ý |   | Non-Accelerated filer o |
|---------------------------|--------|--------------------------|--------|-------------------------|

 

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

 

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

 
| **Class**                              | ** ** | **Outstanding as of May 5,  2006** |
|----------------------------------------|------------|-----------------------------------------|
|                                   |       |                                    |
| Common Stock, $.01 par value per share |       | 22,667,379 shares                       |

 

 

----

 

**TABLE OFCONTENTS**

 
| **Part I**  | **Financial Information**                                                                                                | ** ** |
|------------------|--------------------------------------------------------------------------------------------------------------------------|------------|
| ** **       | ** **                                                                                                               | ** ** |
| Item 1.          | Financial Statements (Unaudited)                                                                                         |       |
|             |                                                                                                                     |       |
|             | Condensed Consolidated Balance Sheets as of March 31, 2006 and December 31,  2005                              |       |
|             |                                                                                                                     |       |
|             | Condensed Consolidated Statements of Income for the three months  ended March 31, 2006 and 2005                     |       |
|             |                                                                                                                     |       |
|             | Condensed Consolidated Statement of Changes  in Stockholders’ Equity for the three months ended March 31, 2006 |       |
|             |                                                                                                                     |       |
|             | Condensed Consolidated Statements of Cash Flows for the three months  ended March 31, 2006                          |       |
|             |                                                                                                                     |       |
|             | Condensed Notes to Consolidated Financial Statements                                                                     |       |
|             |                                                                                                                     |       |
| Item  2.         | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                              |       |
|             |                                                                                                                     |       |
| Item 3.          | Quantitative and Qualitative Disclosures  About Market Risk                                                              |       |
|             |                                                                                                                     |       |
| Item 4.          | Controls and Procedures                                                                                                  |       |
|             |                                                                                                                     |       |
| **Part II** | **Other Information**                                                                                                    | ** ** |
| ** **       | ** **                                                                                                               | ** ** |
| Item 1.          | Legal Proceedings                                                                                                        |       |
|             |                                                                                                                     |       |
| Item 1A.         | Risk Factors                                                                                                             |       |
|             |                                                                                                                     |       |
| Item  2.         | Unregistered  Sales of Equity Securities and Use of Proceeds                                                             |       |
|             |                                                                                                                     |       |
| Item 6.          | Exhibits                                                                                                                 |       |
|             |                                                                                                                     |       |
| **Signatures**   | ** **                                                                                                               |

 

i

----

 

**PART I– FINANCIAL INFORMATION**

 

**ITEM 1.**          FINANCIALSTATEMENTS

 

**SOUTHWEST WATER COMPANYAND SUBSIDIARIES**

**Condensed Consolidated Balance Sheets**

**(Unaudited)**

 
| ** **                                     | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(In thousands)**                             | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                     | ** ** | ** **         | ** ** | ** **            | ** ** |
| **ASSETS**                                     | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current  Assets:                               |       |               |       |                  |       |
| Cash and  cash equivalents                     |       | $                  | 2,342      |                  | $          | 2,764 |   |
| Restricted  cash                               |       | 241                |       | 241                   |       |
| Accounts  receivable, net                      |       | 25,832             |       | 26,517                |       |
| Other  current assets                          |       | 16,946             |       | 18,224                |       |
| Total  current assets                          |       | 45,361             |       | 47,746                |       |
|                                           |       |               |       |                  |       |
| Property,  Plant and Equipment, Net:           |       |               |       |                  |       |
| Regulated  utilities                           |       | 339,552            |       | 333,027               |       |
| Non-regulated  operations                      |       | 11,434             |       | 11,794                |       |
| Total  property, plant and equipment, net      |       | 350,986            |       | 344,821               |       |
|                                           |       |               |       |                  |       |
| Other  Assets:                                 |       |               |       |                  |       |
| Goodwill                                       |       | 34,324             |       | 32,977                |       |
| Intangible  assets                             |       | 2,819              |       | 2,965                 |       |
| Other assets                                   |       | 16,155             |       | 16,216                |       |
|                                           |       | $                  | 449,645    |                  | $          | 444,725 |   |
|                                           |       |               |       |                  |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY** | ** ** | ** **         | ** ** | ** **            | ** ** |
| ** **                                     | ** ** | ** **         | ** ** | ** **            | ** ** |
| Current  Liabilities:                          |       |               |       |                  |       |
| Current  portion of long-term debt             |       | $                  | 9,497      |                  | $          | 9,492 |   |
| Accounts  payable                              |       | 6,737              |       | 10,018                |       |
| Other  current liabilities                     |       | 19,522             |       | 21,069                |       |
| Total  current liabilities                     |       | 35,756             |       | 40,579                |       |
|                                           |       |               |       |                  |       |
| Other  Liabilities and Deferred Credits:       |       |               |       |                  |       |
| Long-term  debt                                |       | 122,577            |       | 117,603               |       |
| Deferred  income taxes                         |       | 23,022             |       | 22,609                |       |
| Advances for  construction                     |       | 8,315              |       | 8,478                 |       |
| Contributions  in aid of construction          |       | 95,782             |       | 94,660                |       |
| Other  liabilities and deferred credits        |       | 15,201             |       | 15,543                |       |
|                                           |       |               |       |                  |       |
| Commitments  and Contingencies                 |       |               |       |                  |       |
|                                           |       |               |       |                  |       |
| Stockholders’  Equity:                    |       |               |       |                  |       |
| Preferred  stock                               |       | 461                |       | 461                   |       |
| Common stock                                   |       | 226                |       | 222                   |       |
| Additional  paid-in capital                    |       | 126,517            |       | 122,368               |       |
| Retained  earnings                             |       | 21,788             |       | 22,202                |       |
| Total  stockholders’ equity               |       | 148,992            |       | 145,253               |       |
|                                           |       | $                  | 449,645    |                  | $          | 444,725 |   |

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

1

----

 

**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**Condensed Consolidated Statements of Income**

**(Unaudited)**

** **
| ** **                                                         | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                         | ** ** | **March 31,**               | ** ** |
| **(In thousands, except per share data)** | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                                                         | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Revenues:                                                          |       |                             |       |   |   |
| Utility  Group                                                     |       | $                                | 17,973     |   | $ | 15,459 |   |
| Services  Group                                                    |       | 32,829                           |       | 29,772 |   |
| Total  revenues                                                    |       | 50,802                           |       | 45,231 |   |
|                                                               |       |                             |       |   |   |
| Expenses:                                                          |       |                             |       |   |   |
| Utility  Group operating expenses                                  |       | 10,397                           |       | 9,979 |   |
| Services Group  operating expense                                  |       | 29,003                           |       | 25,908 |   |
| Selling,  general and administrative                               |       | 8,385                            |       | 7,859 |   |
| Total  expenses                                                    |       | 47,785                           |       | 43,746 |   |
|                                                               |       |                             |       |   |   |
| Operating  income                                                  |       | 3,017                            |       | 1,485 |   |
|                                                               |       |                             |       |   |   |
| Other income  (expense):                                           |       |                             |       |   |   |
| Interest  expense                                                  |       | (2,131                           | )          | (1,771 | ) |
| Interest  income                                                   |       | 81                               |       | 107 |   |
| Other, net                                                         |       | 139                              |       | (13 | ) |
|                                                               |       |                             |       |   |   |
| Income  (loss) from continuing operations before income taxes      |       | 1,106                            |       | (192 | ) |
| Provision  for income taxes                                        |       | (405                             | )          | 65 |   |
|                                                               |       |                             |       |   |   |
| Income  (loss) from continuing operations                          |       | 701                              |       | (127 | ) |
|                                                               |       |                             |       |   |   |
| Cumulative  effect of change in accounting principle, net of tax   |       | 71                               |       | — |   |
| Loss from  discontinued operations, net of tax                     |       | —                           |       | (114 | ) |
|                                                               |       |                             |       |   |   |
| Net income  (loss)                                                 |       | 772                              |       | (241 | ) |
|                                                               |       |                             |       |   |   |
| Preferred  stock dividends                                         |       | (6                               | )          | (6 | ) |
| Net income  (loss) applicable to common stockholders               |       | $                                | 766        |   | $ | (247 | ) |
|                                                               |       |                             |       |   |   |
| Earnings per  common share:                                        |       |                             |       |   |   |
| Basic:                                                             |       |                             |       |   |   |
| Income  (loss) from continuing operations                          |       | $                                | 0.03       |   | $ | (0.01 | ) |
| Cumulative  effect of change in accounting principle               |       | —                           |       | — |   |
| Loss from  discontinued operations                                 |       | —                           |       | — |   |
| Net income  (loss) applicable to common stockholders               |       | $                                | 0.03       |   | $ | (0.01 | ) |
|                                                               |       |                             |       |   |   |
| Diluted:                                                           |       |                             |       |   |   |
| Income  (loss) from continuing operations                          |       | $                                | 0.03       |   | $ | (0.01 | ) |
| Cumulative  effect of change in accounting principle               |       | —                           |       | — |   |
| Loss from  discontinued operations                                 |       | —                           |       | — |   |
| Net income  (loss) applicable to common stockholders               |       | $                                | 0.03       |   | $ | (0.01 | ) |
|                                                               |       |                             |       |   |   |
| Weighted  average common shares outstanding:                       |       |                             |       |   |   |
| Basic                                                              |       | 22,293                           |       | 20,382 |   |
| Diluted                                                            |       | 23,307                           |       | 20,382 |   |

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

2

----

 

**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**Condensed Consolidated Statements of Changes inStockholders’ Equity**

**(Unaudited)**

** **
| ** **                                       | ** ** | **Preferred Stock** | ** ** | **Common Stock** | ** ** | **Additional**     | ** ** | ** ** | ** ** | **Total**   | ** ** |
|--------------------------------------------------|------------|--------------------------|------------|-----------------------|------------|--------------------|------------|------------|------------|-------------|------------|
| ** **                                       | ** ** | **Number of**       | ** ** | ** **            | ** ** | **Number of** | ** ** | ** ** | ** ** | **Paid-in** | ** ** | **Retained** | ** ** | **Stockholders’** | ** ** |
| **(In thousands)**                          | ** ** | **Shares**               | ** ** | **Amount**            | ** ** | **Shares**         | ** ** | **Amount** | ** ** | **Capital** | ** ** | **Earnings** | ** ** | **Equity** | ** ** |
| ** **                                       | ** ** | ** **               | ** ** | ** **            | ** ** | ** **         | ** ** | ** ** | ** ** | ** **  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance at December 31, 2005                |       | 9                        |       | $                     | 461        |               | 22,185     |       | $          | 222         |       | $ | 122,368 |   | $ | 22,202 |   | $ | 145,253 |   |
| Dividend  reinvestment and stock purchase plans  |       | —                   |       | —                |       | 43                 |       | —     |       | 667         |       | — |   | 667 |   |
| Proceeds  from stock options exercised           |       | —                   |       | —                |       | 191                |       | 2          |       | 1,345       |       | — |   | 1,347 |   |
| Excess tax  benefit from stock options exercised |       | —                   |       | —                |       | —             |       | —     |       | 362         |       | — |   | 362 |   |
| Stock-based  compensation                        |       | —                   |       | —                |       | —             |       | —     |       | 275         |       | — |   | 275 |   |
| Cumulative  effect of change in principle        |       | —                   |       | —                |       | —             |       | —     |       | (110        | )          | — |   | (110 | ) |
| Debenture  conversions                           |       | —                   |       | —                |       | 153                |       | 2          |       | 1,610       |       | — |   | 1,612 |   |
| Net income                                       |       | —                   |       | —                |       | —             |       | —     |       | —      |       | 772 |   | 772 |   |
| Cash  dividends declared                         |       | —                   |       | —                |       | —             |       | —     |       | —      |       | (1,186 | ) | (1,186 | ) |
| Balance at March 31,  2006                  |       | 9                        |       | $                     | 461        |               | 22,572     |       | $          | 226         |       | $ | 126,517 |   | $ | 21,788 |   | $ | 148,992 |   |

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

3

----

 

**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**Condensed Consolidated Statements of Cash Flows**

**(Unaudited)**

** **
| ** **                                                                                | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                | ** ** | **March 31,**               | ** ** |
| **(In thousands)**                                                                   | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                                                                                | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Cash  flows from operating activities of continuing operations:**                       | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Net income  (loss)                                                                        |       | $                                | 772        |   | $ | (241 | ) |
| Adjustments  to reconcile net income (loss) to net cash provided by operating activities: |       |                             |       |   |   |
| Cumulative  effect of change in accounting principle, net of tax                          |       | (71                              | )          | — |   |
| Loss from  discontinued operations, net of tax                                            |       | —                           |       | 114 |   |
| Depreciation  and amortization                                                            |       | 2,685                            |       | 2,411 |   |
| Deferred  income taxes                                                                    |       | 778                              |       | 830 |   |
| Stock-based  compensation expense                                                         |       | 275                              |       | 252 |   |
| Gain on  sales of land                                                                    |       | (407                             | )          | — |   |
| Changes in  assets and liabilities, net of effects of acquisitions:                       |       |                             |       |   |   |
| Restricted  cash                                                                          |       | —                           |       | 190 |   |
| Accounts  receivable                                                                      |       | 698                              |       | (912 | ) |
| Other  current assets                                                                     |       | 1,279                            |       | 3,040 |   |
| Other assets                                                                              |       | (130                             | )          | (1,254 | ) |
| Accounts  payable                                                                         |       | (3,274                           | )          | (2,059 | ) |
| Other  current liabilities                                                                |       | (1,940                           | )          | (747 | ) |
| Other  liabilities                                                                        |       | (447                             | )          | (153 | ) |
| Other, net                                                                                |       | (39                              | )          | 257 |   |
| Net cash  provided by operating activities                                                |       | 179                              |       | 1,728 |   |
|                                                                                      |       |                             |       |   |   |
| **Cash  flows from investing activities of continuing operations:**                       | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Additions to  property, plant and equipment                                               |       | (7,426                           | )          | (6,932 | ) |
| Acquisition  of businesses, net of cash acquired                                          |       | (1,231                           | )          | (2,008 | ) |
| Purchase of  minority interest                                                            |       | (1,010                           | )          | — |   |
| Proceeds  from sales of land                                                              |       | 427                              |       | — |   |
| Net cash  used in investing activities                                                    |       | (9,240                           | )          | (8,940 | ) |
|                                                                                      |       |                             |       |   |   |
| **Cash  flows from financing activities of continuing operations:**                       | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Borrowings  under lines of credit                                                         |       | 7,000                            |       | 11,774 |   |
| Proceeds  from stock option and stock purchase plans                                      |       | 2,014                            |       | 202 |   |
| Excess tax  benefit from stock options exercised                                          |       | 362                              |       | — |   |
| Contributions  in aid of construction                                                     |       | 702                              |       | 263 |   |
| Capital  improvement reimbursements                                                       |       | 220                              |       | — |   |
| Dividends  paid                                                                           |       | (1,186                           | )          | (977 | ) |
| Payments on  long-term debt                                                               |       | (303                             | )          | (364 | ) |
| Repayment of  advances for construction                                                   |       | (164                             | )          | (83 | ) |
| Deferred  financing costs                                                                 |       | (6                               | )          | — |   |
| Net cash  provided by financing activities                                                |       | 8,639                            |       | 10,815 |   |
|                                                                                      |       |                             |       |   |   |
| **Cash  flows from discontinued operations:**                                             | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Operating  activities                                                                     |       | —                           |       | (269 | ) |
| Investing  activities                                                                     |       | —                           |       | (9 | ) |
| Financing  activities                                                                     |       | —                           |       | (186 | ) |
| Net cash  used in discontinued operations                                                 |       | —                           |       | (464 | ) |
|                                                                                      |       |                             |       |   |   |
| Net increase  (decrease) in cash and cash equivalents                                     |       | (422                             | )          | 3,139 |   |
| Cash and  cash equivalents at beginning of year                                           |       | 2,764                            |       | 1,388 |   |
| Cash and  cash equivalents at end of year                                                 |       | $                                | 2,342      |   | $ | 4,527 |   |

 

The accompanying notes are an integral part ofthe consolidated financial statements.

 

4

----

** **
| ** **                                                                                                      | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                                                      | ** ** | **March 31,**               | ** ** |
| **(In thousands)**                                                                                         | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                                                                                                      | ** ** | ** **                       | ** ** | ** ** | ** ** |
| **Supplemental  cash flow information:**                                                                        | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Cash paid  during the year for:                                                                                 |       |                             |       |   |   |
| Interest                                                                                                        |       | $                                | 2,208      |   | $ | 1,521 |   |
| Income taxes  paid (refunded), net                                                                              |       | (1,852                           | )          | (1,419 | ) |
|                                                                                                            |       |                             |       |   |   |
| Components  of cash paid for acquisitions:                                                                      |       |                             |       |   |   |
| Fair value  of assets acquired                                                                                  |       | $                                | 1,234      |   | $ | 3,214 |   |
| Liabilities  assumed                                                                                            |       | (3                               | )          | (1,206 | ) |
| Cash paid  for acquisitions                                                                                     |       | $                                | 1,231      |   | $ | 2,008 |   |
|                                                                                                            |       |                             |       |   |   |
| Non-cash  investing and financing activities:                                                                   |       |                             |       |   |   |
| Non-cash  contributions in aid of construction and advances for construction conveyed  to Company by developers |       | $                                | 1,059      |   | $ | 346 |   |
| Debentures  converted into common stock                                                                         |       | 1,687                            |       | 15 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

5

----

 

**SOUTHWEST WATER COMPANYAND SUBSIDIARIES**

**Condensed Notes toConsolidated Financial Statements**

**(Unaudited)**

** **

**Note 1.**   Summaryof Significant Accounting Policies

** **

**Basisof Presentation**

** **

These consolidated interim financialstatements are unaudited. The Company believes the interim financial statementsare presented on a basis consistent with the audited financial statements andinclude all adjustments necessary for a fair presentation of the financialcondition, results of operations and cash flows for such interim periods. Allof these adjustments are normal recurring adjustments.

 

Preparation of these consolidated financialstatements in conformity with accounting principles generally accepted in theUnited States of America (“GAAP”) requires the Company to make estimates andjudgments that affect the reported amounts of assets, liabilities anddisclosure of contingent assets and liabilities at the date of the consolidatedfinancial statements and the reported amounts of revenues and expenses duringthe reporting periods. Actual results could differ from those estimates.

 

Some information and disclosures normallyincluded in financial statements prepared in accordance with GAAP have beenomitted accordance with Securities and Exchange Commission’s rules andregulations for interim financial reporting. These interim consolidatedfinancial statements should be read in conjunction with Management’s Discussionand Analysis of Financial Condition and Results of Operations and the auditedfinancial statements and related notes included in the Company’s 2005 AnnualReport on Form 10-K. Reclassifications have been made to the financialstatements for prior periods to conform to the current year presentation,principally to reflect the sale of a subsidiary during 2005 as a discontinuedoperation (Note 2).

 

The Company’s businesses are seasonal becausethey are affected by weather. As a result, operating results for interimperiods do not necessarily predict the operating results for any other interimperiod or for the full year.

 

**Gainon Sale of Land**

** **

During the three months ended March 31,2006, the Company recorded a $0.4 million gain on the sale of land that was nolonger needed to support our California utility’s operations. The gain isreflected as a reduction of Utility Group operating expenses in theconsolidated financial statements.

 

**Changein Accounting Principle**

** **

Effective January 1, 2006, the Companyadopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R),“*Share-Based Payment*” using the modifiedprospective method. Generally, SFAS No. 123(R) is similar in approach toSFAS No. 123, which the Company adopted in 2002, and requires thatcompensation cost relating to share-based payments be recognized in thefinancial statements based on the fair value of the equity or liabilityinstruments issued. The adoption of SFAS No. 123(R) required the Companyto change from recognizing the effect of forfeitures as they occur toestimating the number of outstanding instruments for which the requisiteservice is not expected to be rendered. As a result, the Company recorded abenefit of $0.1 million ($0.07 million, net of tax) on January 1, 2006,which is reported as a cumulative effect of a change in accounting principle. SeeNote 7 for additional information.

 

6

----

 

**Note 2.**   Acquisitionsand Dispositions

** **

**Acquisitions**

** **

During the three months ended March 31,2006, the Company’s acquired a small water utility and the rights to providewater and wastewater utility service in another area, both located near Austin,Texas. The aggregate purchase price for these acquisitions was $1.3 million incash; liabilities assumed in connection with the acquisitions were negligible. Theassets acquired and liabilities assumed have been recorded at their estimatedfair values based upon preliminary valuations, including $0.3 million ofgoodwill. The consolidated financial statements reflect the acquired utilitiessubsequent to their respective acquisition dates. The acquisitions are notmaterial, either individually or in the aggregate, to the Company’sconsolidated results of operations.

 

On March 21, 2006, the 10% minorityinterest stockholder in Operations Technology, Inc. (“OpTech”), a Georgia-basednon-regulated business in the Company’s Services Group, exercised its right torequire the Company to purchase the remaining 10% of OpTech stock that it didnot already own for $1.0 million in cash. In connection with this acquisition,the Company has preliminarily allocated the entire purchase price to goodwill.

 

The acquisitions were funded with borrowingsunder the Company’s revolving line of credit. The Company expects to finalizethe purchase price allocations during 2006.

 

**Dispositionof Master Tek**

** **

During the second quarter of 2005, theCompany sold Master Tek International, Inc., a subsidiary in its ServicesGroup that provided utility submetering and billing and collection services formulti-family residential properties. The Company sold Master Tek for $12.2million and received $11.1 million in cash at closing and $1.1 million of thesales price was placed into an escrow account which was to be released to theCompany in April 2006 at the end of a specified representation andwarranty period covering customary matters.

 

On March 29, 2006, the Company receiveda letter from the buyer claiming that the Company violated certain standardrepresentations and warranties and that it was seeking $1.65 million. TheCompany has reviewed the claims and in accordance with the agreement has agreedto release $0.3 million of the escrow balance to the buyer, but denies theremainder of the claims. The $0.3 million released from escrow was offsetagainst an accrual made at closing for certain retained liabilities andestimated post-closing obligations.

 

At March 31, 2006, the remaining $0.8million escrow account balance is included in other current assets in theaccompanying consolidated balance sheets.

 

As a result of the sale, Master Tek ispresented as a discontinued operation in the accompanying consolidatedfinancial statements and the results of operations and cash flows for 2005 havebeen reclassified to segregate Master Tek’s results for that period.

 

7

----

 

The following tables summarize the results ofoperations of Master Tek included in the consolidated financial statements.

 
| ** **                           | ** ** | **Three Months** | ** ** |
|--------------------------------------|------------|-----------------------|------------|
| ** **                           | ** ** | **Ended**             | ** ** |
| ** **                           | ** ** | **March 31,**    | ** ** |
| **(In thousands)**              | ** ** | **2005**              | ** ** |
| ** **                           | ** ** | ** **            | ** ** |
| Services  Group revenues             |       | $                     | 1,635      |   |
|                                 |       |                  |       |
| Expenses:                            |       |                  |       |
| Services  Group operating expense    |       | 1,188                 |       |
| Selling,  general and administrative |       | 453                   |       |
| Total  expenses                      |       | 1,641                 |       |
|                                 |       |                  |       |
| Operating  loss                      |       | (6                    | )          |
|                                 |       |                  |       |
| Interest  expense                    |       | (178                  | )          |
|                                 |       |                  |       |
| Loss before  income taxes            |       | (184                  | )          |
| Income tax  benefit                  |       | 70                    |       |
|                                 |       |                  |       |
| Loss from  discontinued operations   |       | $                     | (114       | ) |

 

**Note 3.**   AccountsReceivable

** **

The Company’s Services Group providescontract operations and maintenance services to clients in Mississippi andTexas, among other states. Hurricanes Katrina and Rita caused significantdamage in the Gulf Coast region of the United States during the third quarterof 2005. The water and wastewater infrastructures for five clients inMississippi were disabled by Hurricane Katrina. The contracts with theseclients provide that the Company can incur and bill additional expenses duringan emergency situation to restore water supply and wastewater treatmentservices to customers. In addition, the clients requested our assistance withthe removal of debris to enable access for emergency vehicles and residents. TheCompany incurred $0.7 million of overtime labor costs and emergencyout-of-pocket operating expenses in 2005 and $0.1 million in 2006, related tothese recovery efforts for these clients, which are reflected as operatingexpenses during those periods. The Company has billed its clients $0.9 millionfor these emergency services and we are assisting our clients in requestingreimbursement from the Federal Emergency Management Agency (“FEMA”) pursuant toguidelines established in FEMA’s Applicant Handbook with respect to these costs.We recognized revenues of $0.8 million during 2005 and $0.1 million during thethree months ended March 31, 2006 based on the revenue recognition criteriaset forth in Staff Accounting Bulletin No. 104, *RevenueRecognition*. As of March 31, 2006, we have collected $0.4million of the $0.9 million billed to date and the remaining $0.5 million isreflected in accounts receivable as of March 31, 2006.

 

8

----

 

**Note 4.**   Long-TermDebt

** **

Long-term debt consists of the following asof March 31, 2006 and December 31, 2005:

 
| ** **                                            | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------------------------------------|------------|--------------------|------------|-----------------------|------------|
| **(In thousands)**                               | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **                                            | ** ** | ** **         | ** ** | ** **            | ** ** |
| $100 million  revolving credit facility               |       | $                  | 37,000     |                  | $          | 30,000 |   |
|                                                  |       |               |       |                  |       |
| 6.85%  convertible subordinated debentures due 2021   |       | 14,421             |       | 16,108                |       |
|                                                  |       |               |       |                  |       |
| Term Loans:                                           |       |               |       |                  |       |
| Monarch  Utilities, Inc.:                        |       |               |       |                  |       |
| 7.37% fixed  rate term loan due 2022                  |       | 12,384             |       | 12,577                |       |
| 5.77% fixed  rate term loan due 2022                  |       | 851                |       | 864                   |       |
| 6.10% fixed  rate term loan due 2031                  |       | 20,000             |       | 20,000                |       |
|                                                  |       |               |       |                  |       |
| First  Mortgage Bonds:                                |       |               |       |                  |       |
| Suburban  Water Company:                              |       |               |       |                  |       |
| 9.09% series B  first mortgage bond due 2022     |       | 8,000              |       | 8,000                 |       |
| 7.61% series C  first mortgage bond due 2006     |       | 8,000              |       | 8,000                 |       |
| 5.64% series D  first mortgage bond due 2024     |       | 15,000             |       | 15,000                |       |
| New Mexico  Utilities, Inc.:                     |       |               |       |                  |       |
| 6.10% series C  first mortgage bond due 2024     |       | 12,000             |       | 12,000                |       |
|                                                  |       |               |       |                  |       |
| Economic  Development Revenue Bonds:                  |       |               |       |                  |       |
| ECO  Resources, Inc.:                            |       |               |       |                  |       |
| 6.0% series 1998A  due 2018                      |       | 1,810              |       | 1,810                 |       |
| 5.5% series 1998A  due 2008                      |       | 320                |       | 320                   |       |
|                                                  |       |               |       |                  |       |
| Acquisition-related  indebtedness                     |       | 1,298              |       | 1,395                 |       |
| Total  long-term debt payment obligations             |       | 131,084            |       | 126,074               |       |
| Unamortized  Monarch term loan fair value adjustments |       | 990                |       | 1,021                 |       |
| Total  long-term debt                                 |       | 132,074            |       | 127,095               |       |
| Less current  portion of long-term debt               |       | (9,497             | )          | (9,492                | )          |
| Long-term  debt, less current portion                 |       | $                  | 122,577    |                  | $          | 117,603 |   |

 

The Company had irrevocable standby lettersof credit in the amount of $4.1 million issued and outstanding under itsrevolving credit facility as of March 31, 2006, reducing availableborrowings under the credit facility to $58.9 million as of that date.

 

9

----

 

**Note 5.**   Commitmentsand Contingencies

** **

**CommitmentsUnder Long-Term Service Contracts**

** **

In 2002, the Company was retained tofacilitate the engineering and construction of a $23.0 million reverse osmosiswater treatment plant in the city of San Juan Capistrano, California for theCapistrano Valley Water District (“CVWD”). In 2003, the Company obtained a $3.4million standby letter of credit as collateral to insure its performance duringthe design and construction of the water treatment plant. Construction was completedduring 2005 and upon final acceptance of the completed project by the CVWD,which is expected in 2006, the standby letter of credit will be terminated.

 

The Company now operates the completed plantunder a twenty-year operating agreement. The CVWD service contract containscertain guarantees related to the performance of the Company and a subsidiary,including certain liquidated damages in the event of failure on the part ofthe Company to perform not caused by uncontrollable circumstances asdefined in the service contract. Also, the Company has made other guarantees toCVWD, including guarantees with respect to the quality and quantity of thefinished water and the production efficiency of the facility.

 

As part of the financing for thisproject, the CVWD sold insured municipal bonds. The Company entered into anagreement with the bond insurer to guarantee the Company’s performance underthe service contract, subject to certain liability caps to the bond insurer inthe event of a default. During the twenty-year operation of the facility, suchliability caps will not exceed an amount equal to $4.0 million plus an amountno greater than the replacement cost of the actual reverse osmosis filtrationunit within the facility, estimated to be approximately $1.5 million.

 

**LegalProceedings**

** **

Southwest Water and a subsidiary were namedas defendants in several lawsuits alleging various injuries as a result ofwater contamination in the San Gabriel Valley Main Basin. The CaliforniaSupreme Court ruled in February 2002 that the plaintiffs could notchallenge the adequacy of the water quality standards established by CaliforniaDepartment of Health Services. In August 2004, the case against SouthwestWater and its subsidiary was dismissed; however, the plaintiffs appealed thedismissal to the Court of Appeals for the State of California, Second AppellateDistrict. A court date has not been set and, to date, liability insurancecarriers have absorbed the costs of defense of the lawsuits. Based uponinformation available at this time, the Company does not expect that thisaction will have a material adverse effect on its consolidated financialposition, results of operations or cash flows.

 

The Company and its subsidiaries are alsoinvolved in other routine legal and administrative proceedings incident to thenormal conduct of business. The Company believes the ultimate disposition ofsuch matters will not have a material adverse effect on its business,consolidated financial position, results of operations or cash flows.

 

10

----

 

**MinorityInterest Put and Call Rights**

** **

Prior to March 31, 2006, the Company owned90% of the outstanding common stock of Operations Technologies, Inc. (“OpTech”).The minority stockholder had the right to require the Company to purchase theremaining 10% of OpTech for the greater of $1.0 million or a formula-determinedamount based on the profitability of OpTech. The Company had the right topurchase the remaining 10% of OpTech beginning in August 2006 at the sameterms. In March 2006, the minority stockholder elected to exercise itsright and the Company acquired the shares based on the formula determinedamount which was slightly more than the $1.0 million minimum amount (Note 2).

 

Prior to December 2005, the Company hadan 80% interest in Windermere Utility Company. The stockholders rightsagreement provided that the Company had the right to acquire the remaining 20%of Windermere at any point in time for $6.0 million payable with common stockof the Company provided certain market value thresholds were attained. Theminority stockholder of Windermere had the right to require the Company topurchase the shares beginning in October 2005 at essentially the sameterms, depending on the prevailing market value of the common stock. In December 2005,the minority stockholder elected to exercise its right and the Company issued450,644 shares of its common stock in exchange for the remaining Windermereshares.

 

**EPAInvestigations**

** **

On May 5, 2005, one of the Company’soperating subsidiaries received a subpoena to provide records to a grand jury. Therequested records relate to the operations of the San Simeon wastewatertreatment plant in California for the period January 2002 to present. Thefacility was also served with search warrants executed by the EPA. Thesubsidiary has operated this facility since September 2004. The Company iscooperating fully with the investigation. 

 

On May 18, 2005, the EPA executed asearch warrant at one of the Company’s operating subsidiaries in Texas. Thesearch warrant sought information relating to the subsidiary’s laboratoryoperations. The Company is cooperating fully with the investigation. 

 

11

----

 

**Note 6.**   EarningsPer Share

** **

The following table is a reconciliation ofthe numerators (income or loss) and denominators (shares) used in both thebasic and diluted earnings per share calculations.

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                  | ** ** | **March 31,**               | ** ** |
| **(In thousands, except per share data)**          | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                                                                  | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Basic  earnings (loss) per share:                                           |       |                             |       |   |   |
| Income  (loss) from continuing operations                                   |       | $                                | 701        |   | $ | (127 | ) |
| Less  preferred stock dividends                                             |       | (6                               | )          | (6 | ) |
| Income  (loss) from continuing operations applicable to common stockholders |       | 695                              |       | (133 | ) |
| Cumulative  effect of change in accounting principle                        |       | 71                               |       | — |   |
| Loss from  discontinued operations                                          |       | —                           |       | (114 | ) |
| Net income  (loss) applicable to common stockholders                        |       | $                                | 766        |   | $ | (247 | ) |
|                                                                        |       |                             |       |   |   |
| Weighted  average common shares outstanding                                 |       | 22,293                           |       | 20,382 |   |
|                                                                        |       |                             |       |   |   |
| Earning (loss)  per common share applicable to common stockholders:         |       |                             |       |   |   |
| Continuing  operations                                                      |       | $                                | 0.03       |   | $ | (0.01 | ) |
| Cumulative  effect of change in accounting principle                        |       | —                           |       | — |   |
| Discontinued  operations                                                    |       | —                           |       | — |   |
| Net income  (loss) applicable to common stockholders                        |       | $                                | 0.03       |   | $ | (0.01 | ) |
|                                                                        |       |                             |       |   |   |
| Diluted  earnings (loss) per share:                                         |       |                             |       |   |   |
| Income  (loss) from continuing operations applicable to common stockholders |       | $                                | 695        |   | $ | (133 | ) |
| Cumulative  effect of change in accounting principle                        |       | 71                               |       | — |   |
| Loss from  discontinued operations                                          |       | —                           |       | (114 | ) |
| Net income  (loss) applicable to common stockholders                        |       | $                                | 766        |   | $ | (247 | ) |
|                                                                        |       |                             |       |   |   |
| Weighted  average common shares outstanding                                 |       | 22,293                           |       | 20,382 |   |
| Plus shares  issued on assumed exercise of stock options and warrants       |       | 1,014                            |       | — |   |
| Weighted  average common shares outstanding                                 |       | 23,307                           |       | 20,382 |   |
|                                                                        |       |                             |       |   |   |
| Earnings  (loss) per common share applicable to common stockholders:        |       |                             |       |   |   |
| Continuing  operations                                                      |       | $                                | 0.03       |   | $ | (0.01 | ) |
| Cumulative  effect of change in accounting principle                        |       | —                           |       | — |   |
| Discontinued  operations                                                    |       | —                           |       | — |   |
| Net income  (loss) applicable to common stockholders                        |       | $                                | 0.03       |   | $ | (0.01 | ) |

 

The difference between basic and dilutedearnings per share is the effect of stock options that, under the treasuryshare method, give rise to potentially dilutive common shares. The Companyincurred a loss during the three months ended March 31, 2005. As a result,options to purchase 875,000 shares of common stock as of March 31, 2005are considered antidilutive and therefore are not included in the computationof diluted loss per share for this period.

 

As described in Note 4, the Company has $14.4million of 6.85% fixed-rate convertible subordinate debentures outstanding asof March 31, 2006. The debentures are convertible into common stock at anytime prior to maturity, unless previously redeemed, at a conversion price of$11.018 per share which totals 1.3 million shares as of March 31, 2006). Atsuch time as the assumed conversion of the debentures has a dilutive effect onearnings per share, the debentures will be included in the calculation ofdiluted earnings per share after adjusting net income for the after-tax effectof the debenture interest expense.

 

Both basic and diluted earnings per commonshare and the related weighted average common shares outstanding for the threemonths ended March 31, 2005 have been retroactively adjusted to reflect a5% stock dividend declared on January 2, 2006.

 

12

----

 

**Note 7.**   StockBased Incentive Compensation Plans

** **

The Company has three stock-based incentivecompensation plans: the Stock Option Plan, the Director Stock Option Plan, andthe Employee Stock Purchase Plan. The table below summarizes the number ofshares authorized and available for issuance under the three stock-based plansas of March 31, 2006.

 
| ** **                    | ** ** | **Number of Shares** | ** ** |
|-------------------------------|------------|--------------------------------|------------|
| **(In thousands)**       | ** ** | **Authorized**                 | ** ** | **Available** | ** ** |
| ** **                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Stock Option  Plan            |       | 4,676                          |       | 814 |   |
| Director  Stock Option Plan   |       | 758                            |       | 315 |   |
| Employee  Stock Purchase Plan |       | 1,256                          |       | 908 |   |
| Total                         |       | 6,690                          |       | 2,037 |   |

 

Effective January 1, 2006, the Companyadopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R),“*Share-Based Payment*” using the modifiedprospective method. Generally, SFAS No. 123(R) is similar in approach toSFAS No. 123, which the Company adopted in 2002, and requires thatcompensation cost relating to share-based payments be recognized in thefinancial statements based on the fair value of the equity or liabilityinstruments issued. Because the Company has been recognizing compensation costrelated to share-based payments since its 2002 adoption of SFAS No. 123,the adoption of SFAS No. 123(R) did not have a material effect on theconsolidated financial statements.

 

The adoption of SFAS No. 123(R) requiredthe Company to change from recognizing the effect of forfeitures as they occurto estimating the number of options for which the requisite service is notexpected to be rendered and reducing the periodic compensation cost recordedaccordingly. As a result, the Company recorded a benefit of $0.1 million ($0.07million, net of tax) on January 1, 2006, which is reported as thecumulative effect of a change in accounting principle, to reflect the amount ofcompensation cost previously recognized related to outstanding options as of December 31,2005 that are not expected to vest based on an estimate of forfeitures derivedfrom historical data.

 

The following table illustrates the pro formaeffect if the Company had applied the provisions of SFAS No. 123(R)as of January 1, 2005:

 
| ** **                                                         | ** ** | **Three Months** | ** ** |
|--------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                         | ** ** | **Ended**             | ** ** |
| ** **                                                         | ** ** | **March 31,**    | ** ** |
| **(In thousands, except per share data)** | ** ** | **2005**              | ** ** |
| ** **                                                         | ** ** | ** **            | ** ** |
| Compensation  cost:                                                |       |                  |       |
| Recorded in  2005 recognizing forfeitures as they occur            |       | $                     | 252        |   |
| Net change                                                         |       | 2                     |       |
| Pro forma  for 2005 estimating expected forfeitures                |       | $                     | 254        |   |

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------------|------------|
| ** **                                    | ** ** | **March 31, 2005**     | ** ** |
| ** **                                    | ** ** | **As Reported**             | ** ** | **Pro Forma** | ** ** |
| ** **                                    | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Loss from  continuing operations              |       | $                                | (127       | ) | $ | (129 | ) |
| Net loss                                      |       | (241                             | )          | (243 | ) |
| Net loss  applicable to common stockholders   |       | (247                             | )          | (249 | ) |
| Basic and  diluted loss per common share: (1) |       |                             |       |   |   |
| Loss from  continuing operations              |       | (0.01                            | )          | (0.01 | ) |
| Net loss                                      |       | (0.01                            | )          | (0.01 | ) |
|                                               |            |                                  |            |  |  |  |  |

 

----

(1)       Basedon 20.4 million weighted average common shares outstanding during the period.Since the Company incurred a loss for the period, dilutive common stock equivalentsare excluded from the diluted weighted average share computation (Note 6).

 

13

----

 

**StockOption Plans**

** **

The fair value of each option grant isestimated on the date of grant using the Black-Scholes option pricing modelwith the following weighted average assumptions used for grants in 2006 and2005:

 
| ** **               | ** ** | **Three Months Ended** | ** ** |
|--------------------------|------------|----------------------------------|------------|
| ** **               | ** ** | **March 31,**               | ** ** |
| ** **               | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **               | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Dividend  yield          |       | 1.3                              | %          | 1.7 | % |
| Expected  volatility     |       | 32.7                             | %          | 24.3 | % |
| Risk-free  interest rate |       | 4.8                              | %          | 4.1 | % |
| Expected  life in years  |       | 3.8                              |       | 5.7 |   |

 

The weighted average grant date fair value ofoptions granted during the three months ended March 31, 2006 and 2005 was$4.83 and $3.05 per share, respectively. Compensation expense arising fromstock option grants was $0.3 million during the three months ended March 31,2006 and 2005. As of March 31, 2006, aggregate unrecognized compensationcosts, before estimated forfeitures, totals $2.3 million and is expected to berecognized over the next five years (2.7 years on a weighted average basis).

 

The following table summarizes all stockoption plan activity during the three months ended March 31, 2006:

 
| ** **                                                     | ** ** | ** ** | ** ** | **Weighted-** | ** ** |
|----------------------------------------------------------------|------------|------------|------------|---------------|------------|
| ** **                                                     | ** ** | **Number** | ** ** | **Average**   | ** ** |
| ** **                                                     | ** ** | **of**     | ** ** | **Exercise**  | ** ** |
| **(In thousands, except exercise prices)** | ** ** | **Shares** | ** ** | **Price**     | ** ** |
|                                                           |       |       |       |          |       |
| Outstanding  at December 31, 2005                         |       | 2,641      |       | $             | 8.30       |   |
| Granted                                                        |       | 291        |       | 17.68         |       |
| Exercised                                                      |       | (245       | )          | 9.09          |       |
| Forfeited                                                      |       | (70        | )          | 10.06         |       |
| Expired                                                        |       | —     |       | —        |       |
| Outstanding  at March 31, 2006                            |       | 2,617      |       | 9.11          |       |
|                                                                |            |            |            |               |            |  |

 

The total intrinsic value of optionsexercised during the three months ended March 31, 2006 and 2005 was $1.7million and less than $0.1 million, respectively.

 

The following tables summarize informationabout stock options outstanding and exercisable as of March 31, 2006.

 
| **(In thousands, except as indicated)**             | ** ** | **Outstanding** | ** ** | **Exercisable** | ** ** |
|-------------------------------------------------------------------------|------------|-----------------|------------|-----------------|------------|
|                                                                    |       |            |       |            |       |
| Number of  shares                                                       |       | 2,617           |       | 1,641           |       |
| Weighted  average remaining contractual life in years                   |       | 4.01            |       | 2.8             |       |
| Weighted  average exercise price per share                              |       | $               | 9.11       |            | $          | 6.82 |   |
| Aggregate  intrinsic value (at closing stock price of $15.94 per share) |       | $               | 18,385     |            | $          | 14,958 |   |

 

14

----

 
| ** **                                                         | ** ** | **Outstanding**    | ** ** | **Exercisable** | ** ** |
|--------------------------------------------------------------------|------------|--------------------|------------|-----------------|------------|
| ** **                                                         | ** ** | **Number**         | ** ** | **Weighted-**   | ** ** | ** ** | ** ** | **Number** | ** ** | ** ** | ** ** |
| ** **                                                         | ** ** | **Outstanding**    | ** ** | **Average**     | ** ** | **Weighted-** | ** ** | **Exercisable** | ** ** | **Weighted-** | ** ** |
| ** **                                                         | ** ** | **as of**     | ** ** | **Remaining**   | ** ** | **Average** | ** ** | **as of** | ** ** | **Average** | ** ** |
| ** **                                                         | ** ** | **March 31,** | ** ** | **Contractual** | ** ** | **Exercise** | ** ** | **March 31,** | ** ** | **Exercise** | ** ** |
| **(In thousands, except per share data)** | ** ** | **2006**           | ** ** | **Life**        | ** ** | **Price** | ** ** | **2006** | ** ** | **Price** | ** ** |
|                                                               |       |               |       |            |       |   |   |   |   |   |   |
| Range of per share exercise prices:                                |       |               |       |            |       |   |   |   |   |   |   |
| $                                                                  | 1.69       | to                 | $          | 3.99            |       |   | 58 |   | 0.92 years |   | $ | 3.23 |   | 58 |   | $ | 3.23 |   |
| $                                                                  | 4.00       | to                 | $          | 7.99            |       |   | 1,052 |   | 2.93 years |   | 5.78 |   | 1,052 |   | 5.78 |   |
| $                                                                  | 8.00       | to                 | $          | 11.99           |       |   | 750 |   | 3.76 years |   | 9.03 |   | 450 |   | 8.80 |   |
| $                                                                  | 12.00      | to                 | $          | 17.75           |       |   | 757 |   | 5.99 years |   | 14.27 |   | 81 |   | 11.99 |   |
| $                                                                  | 1.69       | to                 | $          | 17.75           |       |   | 2,617 |   | 4.01 years |   | 9.11 |   | 1,641 |   | 6.82 |   |
|                                                                    |            |                    |            |                 |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

**EmployeeStock Purchase Plan (“ESPP”)**

** **

The Company has a stockholder-approvedemployee stock purchase plan (“ESPP”) that allows eligible employees topurchase 1.3 million shares of common stock through payroll deductions for upto 10% of their salary, not to exceed $25,000 per year. The purchase price ofthe stock is 90% of the lower of the three-day average share price calculatedat the beginning and end of each three-month offering period. Under the ESPP,the Company issued 4,538 shares to employees during the three months ended March 31,2006. Compensation expense recognized by the Company resulting from employeestock purchases pursuant to this plan was nominal for the three months ended March 31,2006 and 2005. As of March 31, 2006, 0.9 million shares remain availablefor future purchases.

 

**Note 8.**   StockPurchase Plan

** **

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

** **

The Company has a dividend reinvestment andstock purchase plan that gives common stockholders the option of receivingtheir dividends in cash or in common stock at a discount from prevailing marketprices (“DRIP”). The plan also permits existing stockholders to purchaseadditional common stock, up to a maximum of $10,000 per month, at a discount (“DSPP”);new investors may participate in the plan, subject to a $250 minimuminitial investment. The Company may, at its sole discretion, permit purchasesabove the $10,000 stated maximum. The discounts may range from 0% to 5%,as determined from time to time by the Company. The DRIP and DSPP discountoffered by the Company was 3% for the DRIP and 0% for the DSPP during the threemonths ended March 31, 2006. As of March 31, 2006, there are 2.4million shares authorized for issuance under the plan of which 0.3 sharesremain available for issuance. During 2006, an additional 1,200,000 shares ofcommon stock were authorized to be issued and sold under the plan and thoseshares were registered for sale on May 4, 2006.

 

15

----

 

**Note 9.**   EmployeeRetirement Plan

** **

The Company has a non-qualified supplementalexecutive retirement plan (“SERP”) for certain key executive officers for thepurpose of providing supplemental income benefits to plan participants or theirsurvivors upon retirement or death. The following table details the componentsof the net periodic benefit costs:

 
| ** **                 | ** ** | **Three Months Ended** | ** ** |
|----------------------------|------------|----------------------------------|------------|
| ** **                 | ** ** | **March 31,**               | ** ** |
| **(In thousands)**    | ** ** | **2006**                         | ** ** | **2005** | ** ** |
|                       |       |                             |       |   |   |
| Service cost               |       | $                                | 16         |   | $ | 16 |   |
| Interest  cost             |       | 19                               |       | 20 |   |
| Recognized  actuarial loss |       | 13                               |       | 22 |   |
| Total                      |       | $                                | 48         |   | $ | 58 |   |

 

**Note 10.**SegmentInformation

** **

The Company’s businesses are segmented intotwo operating groups: the Utility Group and the Services Group. Each segment isa strategic business unit that offers different services. They are managedseparately since each business requires different operating and growthstrategies. The accounting policies of the segments are described in thesummary of significant accounting policies in Note 1 to the audited financialstatements included in the Company’s 2005 Form 10-K.

 

The Utility Group owns and operates publicwater and wastewater utilities in Alabama, California, New Mexico, Oklahoma andTexas. State and federal agencies issue regulations regarding standards ofwater quality, safety, environmental and other matters which affect theseoperations. In the regulated utility subsidiaries, the rates that we charge forwater and wastewater services are established by state or local authorities. Theservice areas in which the Utility Group operates constitute monopolies withallowable rates determined by state or county regulatory agencies.

 

The Services Group operates and manages waterand wastewater treatment facilities owned by cities, public agencies, municipalutility districts, private entities and investor-owned utilities, includingsome of the companies in the Utility Group. Revenue is also derived throughoperations and maintenance contracts with smaller municipalities. The ServicesGroup also provides construction and construction management services, andcertified water and wastewater laboratory services. The Services Group, whilesubject to certain environmental standards, is not regulated in its pricing,marketing or rates of return.

 

The following table presents informationabout the operations of each segment for the three months ended March 31,2006 and 2005.

 

16

----

 
| ** **                                                    | ** ** | ** **  | ** ** | ** **                  | ** ** | **Total**     | ** ** | **Corporate**      | ** ** | ** **       | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|-----------------------------|------------|---------------|------------|--------------------|------------|------------------|------------|
| ** **                                                    | ** ** | **Utility** | ** ** | **Services**                | ** ** | **Operating** | ** ** | **and**            | ** ** | **Consolidated** | ** ** |
| **(In thousands)**                                       | ** ** | **Group**   | ** ** | **Group (1) (2)** | ** ** | **Segments**  | ** ** | **Other (3)** | ** ** | **Total**        | ** ** |
|                                                          |       |        |       |                        |       |          |       |               |       |             |       |
| Three months  ended March 31, 2006:                      |       |        |       |                        |       |          |       |               |       |             |       |
| Revenues (1)                                                  |       | $           | 17,973     |                        | $          | 32,829        |       | $                  | 50,802     |             | $          | — |   | $ | 50,802 |   |
|                                                          |       |        |       |                        |       |          |       |               |       |             |       |
| Operating  income (loss)                                      |       | $           | 5,330      |                        | $          | 1,064         |       | $                  | 6,394      |             | $          | (3,377 | ) | $ | 3,017 |   |
| Interest  expense                                             |       | (1,514      | )          | (487                        | )          | (2,001        | )          | (130               | )          | (2,131           | )          |
| Interest  income                                              |       | 9           |       | 68                          |       | 77            |       | 4                  |       | 81               |       |
| Other income  (expense)                                       |       | (12         | )          | 139                         |       | 127           |       | 12                 |       | 139              |       |
| Income  (loss) from continuing operations before income taxes |       | $           | 3,813      |                        | $          | 784           |       | $                  | 4,597      |             | $          | (3,491 | ) | $ | 1,106 |   |
|                                                          |       |        |       |                        |       |          |       |               |       |             |       |
| Three months  ended March 31, 2005:                      |       |        |       |                        |       |          |       |               |       |             |       |
| Revenues (1)                                                  |       | $           | 15,459     |                        | $          | 29,772        |       | $                  | 45,231     |             | $          | — |   | $ | 45,231 |   |
|                                                          |       |        |       |                        |       |          |       |               |       |             |       |
| Operating  income (loss)                                      |       | $           | 3,812      |                        | $          | 1,416         |       | $                  | 5,228      |             | $          | (3,743 | ) | $ | 1,485 |   |
| Interest  expense                                             |       | (1,195      | )          | (511                        | )          | (1,706        | )          | (65                | )          | (1,771           | )          |
| Interest  income                                              |       | 12          |       | 93                          |       | 105           |       | 2                  |       | 107              |       |
| Other income  (expense)                                       |       | (20         | )          | 21                          |       | 1             |       | (14                | )          | (13              | )          |
| Income  (loss) from continuing operations before income taxes |       | $           | 2,609      |                        | $          | 1,019         |       | $                  | 3,628      |             | $          | (3,820 | ) | $ | (192 | ) |

 

----

(1)       Inaddition to services provided to external customers, some companies in theServices Group provide construction, operations and maintenance services tocompanies in the Utility Group. In accordance with SFAS No. 71, theCompany does not eliminate the intersegment profit on sales to affiliatedutilities when the sales price is reasonable and it is probable that, throughthe rate making process, future revenue approximately equal to the sales pricewill result from the regulated affiliate’s use of the services. Intersegmentprofit was $2.4 million and $2.1 million for three months ended March 31,2006 and 2005, respectively.

 

(2)       Segmentinformation for the three months ended March 31, 2005 has been revised toreflect the sale of a subsidiary in the Services Group during the secondquarter of fiscal 2005 as a discontinued operation.

 

(3)       Consistsof costs that include headquarters expenses and any corporate functionaldepartments whose costs are not allocated to our reportable segments. Corporateand other assets reflect corporate headquarters assets, excluding investmentsin and receivables from subsidiaries.

 

The following table presents informationabout identifiable assets by segment as of March 31, 2006 and December 31,2005.

 
| ** **              | ** ** | **March 31,** | ** ** | **December 31,** | ** ** |
|-------------------------|------------|--------------------|------------|-----------------------|------------|
| **(In thousands)** | ** ** | **2006**           | ** ** | **2005**              | ** ** |
| ** **              | ** ** | ** **         | ** ** | ** **            | ** ** |
| Utility  Group          |       | $                  | 375,591    |                  | $          | 371,714 |   |
| Services  Group         |       | 67,670             |       | 68,546                |       |
| Corporate  and Other    |       | 6,384              |       | 4,465                 |       |
| Total assets            |       | $                  | 449,645    |                  | $          | 444,725 |   |

 

**Note 11.       SubsequentEvents**

 

In April 2006,the California Public Utilities Commission (the “CPUC”) issued a decision whicheliminates a required earnings test that had prevented some utilities fromrecovering balancing account under-collections, or receivables, fromcustomers.  Because of the uncertaintiesthat this earnings test had created, the Company’s California utility, SuburbanWater Systems, had established a practice of not recording balancing accountunder-collections but instead recording these costs as expenses until the timethat the CPUC actually authorized their recovery.  This decision eliminates thatuncertainty.  The Company estimates theamount of balancing account under-collections that are now reasonably assuredof recovery from customers for the prior and current year will be approximately$1.0 to $1.5 million and anticipates recording this amount into earnings in thesecond quarter 2006.

 

As reported ina Form 8-K filed on April 18, 2006, the Company entered into an employmentagreement with a new Chief Executive Officer. The terms of the agreement include relocation and transition assistancepayable upon the occurrence of certain specified events.  The Company expects to record chargestotaling up to $0.9 million during 2006 associated with these payments.

 

17

----

 

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

 

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

### ** **

Certain statements in Management’s Discussionand Analysis of Financial Condition and Results of Operations (the “MD&A”),other than purely historical information, including estimates, projections,statements relating to our business plans, objectives, and expected operatingresults, and the assumptions upon which those statements are based, are “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933 and Section 21E ofthe Securities Exchange Act of 1934. These forward-looking statements generallyare identified by the words “believes,” “project,” “expects,” “anticipates,” “estimates,”“intends, “strategy,” “plan,” “may,” “will,” “would,” “will be,” “willcontinue,” “will likely result,” and similar expressions. Forward-lookingstatements are based on current expectations and assumptions that are subjectto risks and uncertainties which may cause actual results to differmaterially from the forward-looking statements. We undertake no obligation toupdate or revise publicly any forward-looking statements, whether as a resultof new information, future events or otherwise.

 

The following discussions should be read inconjunction with the consolidated financial statements and accompanying notesincluded in this quarterly report and in our 2005 annual report on Form 10-K.

 

### **OVERVIEW**

### ** **

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

 

#### **Acquisitions and Dispositions**

#### ** **

Our consolidated financial position, resultsof operations and cash flows have been affected by our history of acquisitionsand, in 2005, a disposition. Our most recent significant acquisitions, whichaffect the comparability of the historical financial condition and results ofoperations described in the MD&A, are:

 

*Utility Group*

 

•      anAlabama-based wastewater collection and treatment system, which we operate asSouthwest Water Alabama, in September 2005;

 

*Services Group*

 

•      NovusUtilities, an Alabama based contract operations company, acquired in March 2005.

 

In June 2005 we sold Master TekInternational, Inc., our submetering business that provided multi-familyresidential utility metering, billing and collection services for residentialproperties. The sale of this business, which was part of our ServicesGroup, is not expected to affect the operations of our remaining businesses inthe Services Group or our Utility Group. As a result of the sale, the businesswe sold is reflected as a discontinued operation in our consolidated financialstatements and the discussion below is focused on continuing operations for allperiods.

 

18

----

 

### **RESULTS OF OPERATIONS**

### ** **

#### **Three Months Ended March 31, 2006 and 2005**

#### ** **

**Revenues.**Revenuesincreased $5.6 million, or 12.3%, to $50.8 million for the three months ended March 31,2006 from $45.2 million for the same period during for prior year. By segment,revenues increased as follows:

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                        | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|-----------------------------------|------------|------------|------------|
| ** **                                                     | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues** | ** ** |
| **(In thousands, except percentage data)** | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)**                    | ** ** | **2006**   | ** ** | **2005** | ** ** |
|                                                           |       |                             |       |         |       |                              |       |       |       |   |   |
| Utility  Group                                                 |       | $                                | 17,973     |         | $          | 15,459                            |       | $          | 2,514      |   | 35.4 | % | 34.2 | % |
| Services  Group                                                |       | 32,829                           |       | 29,772       |       | 3,057                             |       | 64.6       |       | 65.8 |   |
| Total                                                          |       | $                                | 50,802     |         | $          | 45,231                            |       | $          | 5,571      |   | 100.0 | % | 100.0 | % |

 

***Utility Group.***Revenuesincreased $2.5 million, or 16.3%, to $18.0 million for the three months ended March 31,2006, from $15.5 million for the same period during the prior year. Theincrease was primarily due to the following:

 

•      a $1.0 millionincrease from our New Mexico and Texas utilities primarily resulting from anincrease in the number of connections, a fourth quarter 2005 rate increase atour Texas utilities and, to a lesser extent, increased consumption;

 

•      a $0.9 millionincrease from our California utility due to increased consumption as a resultof warmer temperatures and lower rainfall versus the prior year; and

 

•      a $0.6 millionincrease related to our acquisition of a wastewater treatment facility inAlabama at the end of the third quarter of 2005.

 

***Services Group.***Revenuesincreased $3.1 million, or 10.3%, to $32.8 million for the three months ended March 31,2006 from $29.8 million for the same period during the prior year. The increasein revenues was primarily due to the following:

 

•      a $1.4 millionincrease resulting from the acquisition of an Alabama-based contract operationscompany in March 2005;

 

•      a $1.1 millionincrease associated with contract operations and maintenance work mainlyassociated with our new Burbank, California contract, as well as increasedconstruction work, primarily work performed for our Utility Group; and

 

•      a $0.6 millionincrease related to an increase in billable service orders at our Mississippioperations for new business and work related to Hurricane Katrina.

 

Our Services Group provides contractoperations and maintenance services to clients in Mississippi and Texas, amongother states. Hurricanes Katrina and Rita caused significant damage in the GulfCoast region of the United States during the third quarter of 2005. The waterand wastewater infrastructures for five clients we service in Mississippi weredisabled by Hurricane Katrina. The contracts with our clients provide that wecan incur and bill additional expenses during an emergency situation to restorewater supply and wastewater treatment services to customers. In addition, ourclients requested our assistance with the removal of debris to enable accessfor emergency vehicles and residents. We incurred $0.7 million of overtimelabor costs and emergency out-of-pocket operating expenses in 2005 and $0.1million in 2006, related to these recovery efforts for our clients, which arereflected as operating expenses during those periods. We have billed ourclients $0.9 million for these emergency services and we are assisting ourclients in requesting reimbursement from the Federal Emergency ManagementAgency (“FEMA”) pursuant to guidelines established in FEMA’s Applicant Handbookwith respect to these costs. We recognized revenues of $0.8 million during 2005and $0.1 million during the three months ended March 31, 2006 based on therevenue recognition criteria set forth in Staff Accounting Bulletin No. 104,Revenue Recognition. As of March 31, 2006, we have collected $0.4 millionof the $0.9 million billed to date and the remaining $0.5 million is reflectedin accounts receivable as of March 31, 2006.

 

19

----

 

**Expenses.**Expensesincreased $4.0 million, or 9.0%, to $47.8 million for the three months ended March 31,2006 from $43.7 million for the same period during the prior year as follows:

 
| ** **                                                     | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** | ** **                               | ** ** | ** ** | ** ** |
|----------------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|------------------------------------------|------------|------------|------------|
| ** **                                                     | ** ** | **March 31,**               | ** ** | **Increase** | ** ** | **Percent of Revenues *** | ** ** |
| **(In thousands, except percentage data)** | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)**                           | ** ** | **2006**   | ** ** | **2005** | ** ** |
|                                                           |       |                             |       |         |       |                                     |       |       |       |   |   |
| Utility  Group operating expenses                              |       | $                                | 10,397     |         | $          | 9,979                                    |       | $          | 418        |   | 57.8 | % | 64.6 | % |
| Services  Group operating expenses                             |       | 29,003                           |       | 25,908       |       | 3,095                                    |       | 88.3       |       | 87.0 |   |
| Selling,  general and administrative expenses                  |       | 8,385                            |       | 7,859        |       | 526                                      |       | 16.5       |       | 17.4 |   |
| Total                                                          |       | $                                | 47,785     |         | $          | 43,746                                   |       | $          | 4,039      |   | 94.1 |   | 96.7 |   |

 

----

*      Utility Group and Services Group operatingexpenses are computed as a percent of their respective revenues. Sellinggeneral and administrative expenses and total expenses are computed as apercent of total revenues.

 

***Utility Group OperatingExpenses.***Operating expenses increased $0.4million, or 4.2%, to $10.4 million for the three months ended March 31,2006, from $10.0 million for the same period during the prior year. Theincrease in operating expenses was primarily due to the following:

 

•      a $0.4 millionincrease in operating expenses at our California utility resulting from higherwater production in response to higher consumption; and

 

•      a $0.4 millionincrease related to our acquisition of a wastewater treatment facility inAlabama at the end of the third quarter of 2005; offset by

 

•      a $0.4 millionreduction in expenses at our California utility resulting from the gain on saleof land.

 

Operating expenses were 57.8% and 64.6% ofrelated revenues for the three months ended March 31, 2006 and 2005,respectively. The decrease is caused primarily by a gain on the sale of landthat is no longer needed to support our California utility’s operations.Operating expenses as a percent of revenues for 2006 were 60.1% excluding thegain on sale of land.

 

***Services Group OperatingExpenses.***Operating expenses increased $3.1million, or 11.9%, to $29.0 million for the three months ended March 31,2006 from $25.9 million for the same period during the prior year. The increase in operating expenses was dueto the following:

 

•      a $2.1 million increase resulting from higherlevels of contract operations and maintenance work; the increase results fromincreased staffing and fleet expenses; and

 

•      a $1.3 million increase resulting from ouracquisition of Novus in early 2005; offset by

 

•      a $0.3 million decrease in construction workrelated to a reverse osmosis plant, which has been under construction since2003 and was substantially completed as of December 31, 2005.

 

Operating expenses as a percentage of therelated revenues increased to 88.3% for the three months ended March 31,2006 compared to 87.0% for the same period during the prior year. The increasein the operating expense percentage is due primarily to higher fleet costs.

 

***Selling, General andAdministrative Expenses.***Selling, general andadministrative expenses increased $0.5 million, or 6.7%, to $8.4 million forthe three months ended March 31, 2006 compared to $7.9 million for thesame period during the prior year. Selling, general and administrativeexpenses, as a percent of revenue, were 16.5% and 17.4% for the three monthsended March 31, 2006 and 2005, respectively. The increase in selling,general and administrative expenses was primarily due to the following:

 

•      a $0.3 millionincrease in salaries, wages and related benefits resulting from workforceincreases to support our business growth;

 

•      a $0.2 millionincrease attributable to acquisitions which occurred in 2005; and

 

•      a $0.3 millionincrease in legal fees, most of which is attributable to supporting theexpanding business base; offset by

 

•      a$0.3 million decrease in Sarbanes-Oxley compliance-related costs.

 

20

----

 

**Other Income (Expense).**Otherexpense increased $0.2 million, or 14.0%, to $1.9 million for the three monthsended March 31, 2006 from $1.7 million for the same period during theprior year as follows:

 
| ** **              | ** ** | **Three Months Ended** | ** ** | ** ** | ** ** |
|-------------------------|------------|----------------------------------|------------|------------|------------|
| ** **              | ** ** | **March 31,**               | ** ** | ** ** | ** ** |
| **(In thousands)** | ** ** | **2006**                         | ** ** | **2005**   | ** ** | **Change** | ** ** |
| * *                | * *   | * *                         | * *   | * *   | * *   | * * | * * |
| Interest  expense       |       | $                                | (2,131     | )          | $          | (1,771 | ) | $ | (360 | ) |
| Interest  income        |       | 81                               |       | 107        |       | (26 | ) |
| Other                   |       | 139                              |       | (13        | )          | 152 |   |
| Total                   |       | $                                | (1,911     | )          | $          | (1,677 | ) | $ | (234 | ) |

 

***Interest Expense.***Interestexpense increased $0.4 million, or 20.3%, during the three months ended March 31,2006 compared to the same period for the prior year. The major components ofinterest expense are as follows:

 
| ** **                           | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** |
|--------------------------------------|------------|----------------------------------|------------|--------------|------------|
| ** **                           | ** ** | **March 31,**               | ** ** | **Increase** | ** ** |
| **(In thousands)**                   | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| * *                             | * *   | * *                         | * *   | * *     | * *   | * * | * * |
| Interest  expense:                   |       |                             |       |         |       |   |   |
| Revolving  lines of credit           |       | $                                | 522        |         | $          | 302 |   | $ | 220 |   |
| Mortgage  bonds and bank term loans  |       | 1,218                            |       | 1,114        |       | 104 |   |
| Convertible  subordinated debentures |       | 278                              |       | 296          |       | (18 | ) |
| Other  indebtedness                  |       | 204                              |       | 129          |       | 75 |   |
| Total  interest incurred             |       | 2,222                            |       | 1,841        |       | 381 |   |
| Less  capitalized interest           |       | (91                              | )          | (70          | )          | (21 | ) |
| Total  interest expense              |       | $                                | 2,131      |         | $          | 1,771 |   | $ | 360 |   |

 

The increase in total interest incurred isprimarily due to an increase in borrowings levels and interest rates related toour revolving line of credit. Average borrowings increased to $33.5 million forthe three months ended March 31, 2006 from $28.9 million for the sameperiod during the prior year. The weighted average interest rate on thoseborrowings increased to 6.15% for the three months ended March 31, 2006from 4.22% for the same period during the prior year. Interest related to ourmortgage bonds and bank term loans increased as a result of a net increase inaverage borrowings between the periods. Our average balances of interestbearing debt outstanding were approximately $128.6 million and $126.0 millionfor the three months ended March 31, 2006 and 2005, respectively. Oureffective weighted average interest rate increased to 6.4% for the three monthsended March 31, 2006 from 5.9% for the same period during the prior year.

 

**Provision for Income Taxes.**Oureffective consolidated income tax rates on combined continuing and discontinuedoperations was 36.5% for the three months ended March 31, 2006 which iscomparable to 35.9% for the same period during the prior year.

 

**Cumulative Effect of Change in AccountingPrinciple.**Effective January 1, 2006, we adoptedthe provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R),“*Share-Based Payment*”. The adoption ofSFAS No. 123(R) required us to change from recognizing the effect offorfeitures as they occur to estimating the number of outstanding instrumentsfor which the requisite service is not expected to be rendered. As required bySFAS No. 123(R) we recorded a $0.07 million net of tax benefit on January 1,2006 to reflect the reduction in compensation expense that would have resultedhad we been estimating the effect of forfeitures in prior periods.

 

**Loss from Discontinued Operations.**Lossfrom discontinued operations was $0.1 million for the three months ended March 31,2005. The loss pertains to the operating loss from our submetering businesswhich we sold during the second quarter of 2005.

 

21

----

 

### **LIQUIDITY AND CAPITAL RESOURCES**

### ** **

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

 

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

 

•      utilize ourcredit facility for major capital improvements and to manage seasonal cashneeds;

 

•      obtain externalfinancing for major acquisitions; and

 

•      maintain approximatelyequal levels of debt and equity consistent with the investor-owned waterutility industry.

 

Our statements of cash flows are summarizedas follows:

 
| ** **                                        | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** |
|---------------------------------------------------|------------|----------------------------------|------------|--------------|------------|
| ** **                                        | ** ** | **March 31,**               | ** ** | **Increase** | ** ** |
| **(In thousands)**                           | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| * *                                          | * *   | * *                         | * *   | * *     | * *   | * * | * * |
| Net cash  provided by (used in):                  |       |                             |       |         |       |   |   |
| Continuing  operations:                           |       |                             |       |         |       |   |   |
| Operating  activities                             |       | $                                | 179        |         | $          | 1,728 |   | $ | (1,549 | ) |
| Investing  activities                             |       | (9,240                           | )          | (8,940       | )          | (300 | ) |
| Financing  activities                             |       | 8,639                            |       | 10,815       |       | (2,176 | ) |
| Total  continuing operations                      |       | (422                             | )          | 3,603        |       | (4,025 | ) |
|                                              |       |                             |       |         |       |   |   |
| Discontinued  operations:                         |       |                             |       |         |       |   |   |
| Operating  activities                             |       | —                           |       | (269         | )          | 269 |   |
| Investing  activities                             |       | —                           |       | (9           | )          | 9 |   |
| Financing  activities                             |       | —                           |       | (186         | )          | 186 |   |
| Total  discontinued operations                    |       | —                           |       | (464         | )          | 464 |   |
| Increase  (decrease) in cash and cash equivalents |       | $                                | (422       | )            | $          | 3,139 |   | $ | (3,561 | ) |

 

**Cash Flows From Operating Activities.**Netcash provided by operating activities decreased by $1.5 million during thethree months ended March 31, 2006 compared to the same period during theprior year. Operational aspects of our businesses that affected working capitalin 2006 versus 2005 are highlighted below:

 

•      increased level of vendorpayments in 2006 for goods and services used during the fourth quarter of 2005;offset by

 

•      increased revenues generatedby our Utility Group, resulting from customer connection growth at our NewMexico and Texas utilities;

 

•      the benefit from increasedwater rates at our California utility;

 

•      favorable weather conditionsfor both our Utility and Services Group.

 

**Cash Flows From Investing Activities.**Cashused in investing activities totaled $9.2 million for the three months ended March 31,2006 compared to $8.9 million for the same period during 2005 as follows:

 
| ** **                                              | ** ** | **Three Months Ended** | ** ** | ** **   | ** ** |
|---------------------------------------------------------|------------|----------------------------------|------------|--------------|------------|
| ** **                                              | ** ** | **March 31,**               | ** ** | **Increase** | ** ** |
| **(In thousands)**                                 | ** ** | **2006**                         | ** ** | **2005**     | ** ** | **(Decrease)** | ** ** |
| * *                                                | * *   | * *                         | * *   | * *     | * *   | * * | * * |
| Cash flows  used in (provided by) investing activities: |       |                             |       |         |       |   |   |
| Additions to  property, plant and equipment             |       | $                                | 7,426      |         | $          | 6,932 |   | $ | 494 |   |
| Acquisition  of businesses, net of cash acquired        |       | 1,231                            |       | 2,008        |       | (777 | ) |
| Purchase of  minority interest                          |       | 1,010                            |       | —       |       | 1,010 |   |
| Proceeds  from sales of land                            |       | (427                             | )          | —       |       | (427 | ) |
| Net cash  used for investing activities                 |       | $                                | 9,240      |         | $          | 8,940 |   | $ | 300 |   |

 

22

----

 

The following table summarizes additions toproperty, plant and equipment additions for 2006 and 2005.

 
| ** **                                             | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                             | ** ** | **March 31,**               | ** ** |
| **(In thousands)**                                | ** ** | **2006**                         | ** ** | **2005** | ** ** |
| ** **                                             | ** ** | ** **                       | ** ** | ** ** | ** ** |
| Company-financed  additions                            |       | $                                | 6,504      |   | $ | 6,669 |   |
| Capital  improvement reimbursements                    |       | 220                              |       | — |   |
| Cash  contributions received in aid of construction    |       | 702                              |       | 263 |   |
| Total cash  additions to property, plant and equipment |       | 7,426                            |       | 6,932 |   |
| Non-cash  contributions in aid of construction         |       | 1,059                            |       | 346 |   |
| Total  additions to property, plant and equipment      |       | $                                | 8,485      |   | $ | 7,278 |   |

 

Capital projects primarily relate to theexpansion, replacement and renovation of our water and wastewater systems,particularly at our Texas and New Mexico utilities. Contributions in Aid ofConstruction (“CIAC”) represent contributions in the form of cash,services or property received from developers, governmental agencies,municipalities or individuals for the purpose of constructing utility plant andis not refundable. In 2006, we expect to spend approximately $31.0 million oncompany-financed additions, principally within our Utility Group, and expect toreceive $11.0 million of CIAC resulting in total expected additions toproperty, plant and equipment of about $42.0 million.

 

In March 2006 we acquired the remaining10% interest in Operations Technology, Inc. (“OpTech”) that we did notalready own for $1.0 million in cash. We also made substantial investments inacquisitions during 2006 and 2005 and expect we will continue to do so in thefuture.

 

**Cash Flows From Financing Activities.**During2006, we financed our growth through a broad range of capital initiatives:

 

•      borrowed $7.0million under our revolving line of credit;

 

•      received $2.0million of proceeds from our direct stock purchase plan, our employee stockpurchase and option plans and our director option plan; and

 

•      received $0.9million of capital improvement reimbursements and contributions in aid ofconstruction.

 

Aggregate borrowings under our revolving lineof credit increased by a net $7.0 million during the three months ended March 31,2006 and were primarily used to fund our investing activities. Additionalborrowing availability under our revolving credit facility was $58.9 million asof March 31, 2006.

 

During the three months ended March 31,2006, we have paid dividends totaling $1.2 million and our quarterly dividendrate is currently $0.0524 per common share.

 

23

----

 

### **CONTRACTUAL OBLIGATIONS**

### ** **

The following table summarizes our knowncontractual obligations to make future cash payments as of March 31, 2006,as well as an estimate of the periods during which these payments are expectedto be made.

 
| ** **                                   | ** ** | ** ** | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------|------------|------------|------------|---------------------------------------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | **Remainder**                               | ** ** | **2007** | ** ** | **2009** | ** ** | **2011** | ** ** |
| ** **                                   | ** ** | ** ** | ** ** | **of**                                      | ** ** | **and** | ** ** | **and** | ** ** | **and** | ** ** |
| **(In thousands)**                      | ** ** | **Total**  | ** ** | **2006**                                    | ** ** | **2008** | ** ** | **2010** | ** ** | **Beyond** | ** ** |
|                                         |       |       |       |                                        |       |   |   |   |   |   |   |
| Long-term  debt (1):                         |       |       |       |                                        |       |   |   |   |   |   |   |
| Bank line of  credit (2)                     |       | $          | 37,000     |                                        | $          | — |   | $ | — |   | $ | 37,000 |   | $ | — |   |
| Mortgage  bonds (3)                          |       | 43,000     |       | 8,000                                       |       | — |   | — |   | 35,000 |   |
| Bank term  loans (4)                         |       | 33,235     |       | 617                                         |       | 1,645 |   | 1,646 |   | 29,327 |   |
| Convertible  subordinated debentures (5)     |       | 14,421     |       | —                                      |       | — |   | — |   | 14,421 |   |
| Economic  development revenue bonds (6)      |       | 2,130      |       | 100                                         |       | 220 |   | 245 |   | 1,565 |   |
| Notes  payable (7)                           |       | 1,298      |       | 472                                         |       | 826 |   | — |   | — |   |
| Total  long-term debt                        |       | 131,084    |       | 9,189                                       |       | 2,691 |   | 38,891 |   | 80,313 |   |
|                                         |       |       |       |                                        |       |   |   |   |   |   |   |
| Repayment of  advances for construction (8)  |       | 9,367      |       | 841                                         |       | 1,196 |   | 720 |   | 6,610 |   |
| Lease  assignment obligations (9)            |       | 2,641      |       | 202                                         |       | 2,439 |   | — |   | — |   |
| Operating  lease obligations                 |       | 34,892     |       | 5,041                                       |       | 10,569 |   | 5,729 |   | 13,553 |   |
| Total  obligations as of March 31, 2006 |       | $          | 177,984    |                                        | $          | 15,273 |   | $ | 16,895 |   | $ | 45,340 |   | $ | 100,476 |   |

 

----

(1)       Excludesinterest payment obligations, which are described in the following notes. Theterms of the long-term debt are more fully described in the notes to theconsolidated financial statements included in this report.

 

(2)       Thebank lines of credit bear interest at variable rates and therefore the amountof future interest payments are uncertain. Borrowings bear interest, at ouroption, based on a margin either: a) over the LIBOR rate; or b) under the primerate. The margins vary based on our consolidated debt to equity ratio. Theweighted-average interest rate on our bank line of credit borrowings was 5.37%as of December 31, 2005.

 

(3)       Intereston the mortgage bonds is fixed at a weighted-average annual interest rate of6.78% and is payable semiannually.

 

(4)       Intereston the bank term loans is fixed at a weighted-average annual interest rate of6.57% and is payable semiannually.

 

(5)       Intereston the convertible debentures is fixed at a 6.85% annual rate and is payablequarterly. The debentures are convertible, at the option of the holder, intoshares of our common stock at any time prior to their maturity.

 

(6)       Intereston the economic development bonds is fixed at a weighted-average annualinterest rate of 5.92% and is payable semiannually.

 

(7)       Interestis payable either monthly or quarterly at rates ranging from 5.0% to 7.5% peryear.

 

(8)       Advancesfor construction are non-interest bearing.

 

(9)       Intereston the lease assignment obligations is fixed at a weighted-average interestrate of 8.39% and is payable monthly.

 

24

----

 

### **FINANCIAL CONDITION AND LIQUIDITY**

### ** **

As of March 31, 2006, we had workingcapital of approximately $9.6 million and $58.9 million of additionalborrowings available under our line of credit facility which expires on April 1,2010. In addition to our line of credit, our California and New Mexico mortgagebond indentures permit the issuance of an additional $72.6 million of firstmortgage bonds as of March 31, 2006. However, the terms of our creditfacility do not permit additional first mortgage bond indebtedness withoutprior consent from the credit facility lenders. The mortgage bond indenturesalso limit the amount of cash and property dividends our California and NewMexico utilities may pay to the parent company to fund its paymentobligations. Dividends have averaged $3.0 to $4.0 million per year and are lessthan the aggregate cumulative dividend restriction threshold by $40.5 millionas of March 31, 2006.

 

We also have on file a registration statementwith the Securities and Exchange Commission, which is effective for theissuance of up to $50.0 million aggregate principal amount of common stock,debt securities and warrants. To date we have issued approximately $44.0million of common stock under the shelf registration, and about $6.0 millionremains available for issuance as of March 31, 2006. We may offer anyof these securities for sale at any time and from time to time.

 

As of March 31, 2006, we havecontractual obligations totaling $178.0 million (excluding interest), $15.3million of which is due during the remainder of 2006. We were in compliancewith all loan agreement covenants during the three months ended March 31,2006. We have $8.0 million of mortgage bonds maturing in the fourth quarter of2006 which we expect we will be able to refinance through the sale of newmortgage bonds or retire with funds borrowed under our credit facility.

 

We believe that our expected operating cashflows, together with borrowings under our revolving credit facility ($58.9million of which was available as of March 31, 2006 and expires on April 1,2010) will be sufficient to meet our operating expenses, working capital andcapital expenditure requirements as well as our debt service obligations forthe next twelve months. However, our ability to comply with debt financialcovenants, pay principal or interest and refinance our debt obligations willdepend on our future operating performance as well as competitive, legislative,regulatory, business and other factors beyond our control.

 

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

### ** **

In 2002, we were retained to facilitate theengineering and construction of a $23.0 million reverse osmosis water treatmentplant in the city of San Juan Capistrano, California for the Capistrano ValleyWater District (“CVWD”). In 2003, we obtained a $3.4 million standby letter ofcredit as collateral to insure our performance during the design andconstruction of the water treatment plant. Construction was completed during2005 and upon final acceptance of the completed project by the CVWD, which isexpected in 2006, the standby letter of credit will be terminated.

 

We now operate the completed plant under atwenty-year operating agreement. The CVWD service contract contains certainguarantees related to our performance, including certain liquidated damages inthe event of failure on our part to perform not caused byuncontrollable circumstances as defined in the service contract. Also, we havemade other guarantees to CVWD, including guarantees with respect to the qualityand quantity of the finished water and the production efficiency of thefacility.

 

As part of the financing for thisproject, the CVWD sold insured municipal bonds. We entered into an agreementwith the bond insurer to guarantee our performance under the service contract,subject to certain liability caps to the bond insurer in the event of a default.During the twenty-year operation of the facility, such liability caps will notexceed an amount equal to $4.0 million plus an amount no greater than thereplacement cost of the actual reverse osmosis filtration unit within thefacility, estimated to be approximately $1.5 million.

 

We had irrevocable standby letters of creditin the amount of $4.1 million issued and outstanding under our credit facility,including the CVWD letter of credit described above as of March 31, 2006.

 

During our normal course of business, we haveentered into agreements containing indemnities pursuant to which we may berequired to make payments in the future. These indemnities are in connectionwith facility leases and liabilities and operations and maintenance andconstruction contracts entered into by our Services Group. The 

 

25

----

 

duration ofthese indemnities, commitments and guarantees varies, and in certain cases, isindefinite. Substantially all of these indemnities provide no limitation on themaximum potential future payments we could be obligated to make and is notquantifiable. We have not recorded any liability for these indemnities.

 

In connection with the sale of Master Tek, weindemnified the buyer with respect to representations and warranties. Ourindemnities with respect to these matters are limited in terms of duration toperiods ranging from one year to the expiration of the applicable statue oflimitations.

 

On March 29, 2006, we received a letterfrom the buyer claiming that we violated some of the representations andwarranties and that it was seeking $1.65 million. We have reviewed the claimsand in accordance with the agreement have agreed to release $0.3 million of theescrow fund balance which was established for this purpose. We deny the remainderof the claims. See Note 2 to the notes accompanying our consolidated financialstatements for additional information.

 

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

### ** **

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

 

**ITEM 3.**          QUANTITATIVEAND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

 

As of March 31, 2006, we had $132.1million of long-term variable and fixed-rate debt. We are exposed to marketrisk based on changes in prevailing interest rates.

 

Market risk related to our variable-rate debtis estimated as the potential decrease in pre-tax earnings resulting from anincrease in interest rates. We have $37.0 million of long-term debt that bearsinterest at variable rates based on either the prime rate or LIBOR. Ourvariable-rate debt had a weighted average interest rate of 5.85% as of March 31,2006. A hypothetical one percent (100 basis points) increase in the averageinterest rates charged on our variable-rate debt would reduce our pre-taxearnings by approximately $0.4 million per year.

 

Our fixed-rate debt, which has a carryingvalue of $95.1 million, has a fair value of $90.4 million as of March 31,2006. Market risk related to our fixed-rate debt is deemed to be the potentialincrease in fair value resulting from a decrease in prevailing interest rates. Ourfixed-rate debt had a weighted average interest rate of 6.7% as of March 31,2006. A hypothetical ten percent decrease in interest rates, from 6.7% to 6.0%,would increase the fair value of our fixed-rate debt by approximately $6.3million.

 

We do not use derivative financialinstruments to manage or reduce these risks although we may elect do so inthe future.

 

**ITEM 4.**          CONTROLSAND PROCEDURES

 

Under the supervision and with theparticipation of our management, including the Chief Executive Officer andChief Financial Officer, we have evaluated the effectiveness of our disclosurecontrols and procedures pursuant to Exchange Act Rule 13a-15(b) as ofthe end of the period covered by this report. Based on that evaluation, theChief Executive Officer and Chief Financial Officer have concluded that thesedisclosure controls and procedures are effective. There were no changes in ourinternal control over financial reporting during the quarter ended March 31,2006 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

26

----

 

**PART II– OTHER INFORMATION**

 

**ITEM 1.**          LEGALPROCEEDINGS

 

See Note 5 to the consolidated financialstatements included in this report.

 

**ITEM 1A.**       RISK FACTORS

 

There have been no material changes to the riskfactor we disclosed in “Item 1A. Risk Factors” in Part I of our 2005Annual Report on Form 10-K.

 

**ITEM 2.**          UNREGISTEREDSALES OF EQUITY SECURITIES AND USE OF PROCEEDS

 

The following table summarizes the Company’srepurchases of its common stock during the quarter ended March 31, 2006.

 
| **Period**                                           | ** ** | **Total Number   of Shares   Purchased (1)** | ** ** | **Average   Price Paid   per Share** | ** ** | **Total Number of   Shares Purchased   as Part of Publicly   Announced Plans   or Programs** | ** ** | **Maximum Number (or   Approximate Dollar Value)   of Shares that May Yet Be   Purchased Under the Plans   or Programs** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------------------------------|------------|----------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                 |       |                                                                  |       |                                                     |       |                                                                                                                                                     |       |                                                                                                                                                                                                          |       |
| January 1,  2006 – January 31, 2006   |       | None                                                                  |       | None                                                     |       | None                                                                                                                                                     |       | None                                                                                                                                                                                                          |       |
| February 1,  2006 – February 28, 2006 |       | None                                                                  |       | None                                                     |       | None                                                                                                                                                     |       | None                                                                                                                                                                                                          |       |
| March 1,  2006 – March 31, 2006       |       | 53,753                                                                |       | $                                                        | 16.31      |                                                                                                                                                     | None       |                                                                                                                                                                                                          | None       |   |
| Total                                                |       | 53,753                                                                |       | $                                                        | 16.31      |                                                                                                                                                     | None       |                                                                                                                                                                                                          | None       |   |

 

----

(1)       Allof the shares purchased during the period were shares attested to the Companyin satisfaction of the exercise price and tax withholding obligations byholders of employee stock options, who exercised options granted pursuant tothe Company’s stock option plan.

 

**ITEMS 3, 4 AND5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.**

 

**ITEM 6.**          EXHIBITS

 
| **Exhibit  Number** | ** ** | ** ** | ** ** | **Exhibit Description**                                                                                      |
|---------------------|------------|------------|------------|-------------------------------------------------------------------------------------------------------------------|
| 31.1                |       | *          |       | Certification of Principal Executive Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |
|                |       |       |       |                                                                                                              |
| 31.2                |       | *          |       | Certification of Principal Financial Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |
|                |       |       |       |                                                                                                              |
| 32.1                |       | *          |       | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002          |
|                |       |       |       |                                                                                                              |
| 32.2                |       | *          |       | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act of 2002          |

 

----

*          Filedherewith

 

27

----

 

**SIGNATURES**

 

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

 

 
|                                 | **SOUTHWEST WATER COMPANY (REGISTRANT)** |
|--------------------------------------|------------------------------------------|
|                                 | ** **                               |
|                                 |                                     |   |
| Date:    May 10, 2006 | BY:                                      | /s/ CHERYL L. CLARY |   |
|                                 |                                     | Cheryl L. Clary |
|                                 |                                     | Chief Financial Officer |

 

28

----