Table ofContents

** **

 

 

** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

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

 

**Commission File Number 0-8176**

 

 

(Exact nameof registrant as specified in its charter)

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

** **

**One Wilshire Building**

**624 South Grand Avenue, Suite 2900**

**Los Angeles, California 90017-3782**

(Address ofprincipal executive offices, including zip code)

 

**(213) 929-1800**

(Registrant’stelephone, including area code)

 

**None**

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

 

Indicate by checkmark whether the registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 duringthe preceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes x   No o

 

Indicate by check mark whether theregistrant has submitted electronically and posted on its corporate website, ifany, every Interactive Data File required to be submitted and posted pursuantto Rule 405 of Regulation S-T (**§**232.405of this chapter) during the preceding 12 months (or for such shorter periodthat the registrant was required to submit and post suchfiles).    Yes  o    No  o

 

Indicate by check mark whether theregistrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. (Check one):

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

 

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

 

Indicate the number of sharesoutstanding of each of the issuer’s classes of common stock, as of the latestpracticable date.

 
|                                    | Class  |               |   |   | Outstanding  as of May 31, 2009 |   |
|-----------------------------------------|--------|--------------------|--------|--------|--------------------------------------|--------|
|                                    |   |               |
| Common  Stock, $.01 par value per share |   | 24,888,745  shares |

 

 

 

 

Table ofContents

 

**TABLE OF CONTENTS**

 
|             |                                                                                                                                                            |       | **Page** |
|------------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|
|             |                                                                                                                                                            |       |     |
| **Part I**  | **Financial Information**                                                                                                                                       | ** ** | **2**    |
|             |                                                                                                                                                            |       |     |
| Item 1.          | Financial Statements                                                                                                                                            |       | 2        |
|             |                                                                                                                                                            |       |     |
|             | Condensed Consolidated  Balance Sheets (Unaudited) as of September 30, 2008 and  December 31, 2007 (As Restated)                                      |       | 2        |
|             |                                                                                                                                                            |       |     |
|             | Condensed Consolidated Statements  of Operations (Unaudited) for the three months and nine months ended  September 30, 2008 and 2007 (As Restated)         |       | 3        |
|             |                                                                                                                                                            |       |     |
|             | Condensed Consolidated Statement of Changes in  Stockholders’ Equity and Comprehensive Loss for the nine months ended  September 30, 2008 (Unaudited) |       | 4        |
|             |                                                                                                                                                            |       |     |
|             | Condensed Consolidated Statements of Cash Flows  (Unaudited) for the nine months ended September 30, 2008 and 2007 (As  Restated)                          |       | 5        |
|             |                                                                                                                                                            |       |     |
|             | Notes to Condensed Consolidated Financial Statements  (Unaudited)                                                                                               |       | 6        |
|             |                                                                                                                                                            |       |     |
| Item 2.          | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                                                     |       | 25       |
|             |                                                                                                                                                            |       |     |
| Item 3.          | Quantitative  and Qualitative Disclosures About Market Risk                                                                                                     |       | 36       |
|             |                                                                                                                                                            |       |     |
| Item 4.          | Controls and  Procedures                                                                                                                                        |       | 37       |
|             |                                                                                                                                                            |       |     |
|             |                                                                                                                                                            |       |     |
| **Part II** | **Other Information**                                                                                                                                           | ** ** | **41**   |
|             |                                                                                                                                                            |       |     |
| Item 1.          | Legal Proceedings                                                                                                                                               |       | 41       |
|             |                                                                                                                                                            |       |     |
| Item 1A.         | Risk Factors                                                                                                                                                    |       | 41       |
|             |                                                                                                                                                            |       |     |
| Item 6.          | Exhibits                                                                                                                                                        |       | 45       |
|             |                                                                                                                                                            |       |     |
|             |                                                                                                                                                            |       |     |
| **Signatures**   |                                                                                                                                                            |       | **46**   |

Tableof Contents

 

**EXPLANATORY NOTE REGARDING RESTATEMENTS**

 

TheCompany, on July 9, 2009, filed its 2008 Annual Report on Form 10-Kand the disclosures contained therein may, for certain events, provide moreinformation than contained within this Quarterly Report.

 

SouthWestWater Company and its subsidiaries’ (“SouthWest Water” or the “Company”)condensed consolidated financial statements at December 31, 2007 and forthe three- and nine-month periods ended September 30, 2007 and relatedfinancial information have been restated to correct for certain accountingerrors. For further details on the nature of the corrections and the relatedeffects on the Company’s previously issued consolidated financial statements,see Note 2, “Restatement of Condensed Consolidated Financial Statements.”Restated balances have been identified with the notation “As Restated” whereappropriate. Throughout the financial statements, the term “as previouslyreported” will be used to refer to balances from the 2007 consolidatedfinancial statements as reported prior to restatement for the errors.

 

TheCompany also found material weaknesses in internal control over financialreporting for such periods and previously advised that management’s report oninternal control over financial reporting for the fiscal year ended December 31,2007 contained in our public reports should not be relied upon.

 

Wehave not filed amendments to any previously filed Quarterly Report on Form 10-Qfor the periods affected by the restatement. The financial information that hasbeen previously filed or otherwise reported for these periods is superseded bythe information in this Quarterly Report on Form 10-Q, and the financialstatements and related financial information contained in previously filedreports should no longer be relied upon.

 

 

1

# **Table of Contents**

 

# **PART I — FINANCIAL INFORMATION**

# ** **

## **ITEM 1.          FINANCIALSTATEMENTS**

**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

 

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

 
| ***(In thousands)***                             |   | **September 30,  2008** |    | **December 31,  2007  As Restated** |   |
|--------------------------------------------------|--------|------------------------------|---------|------------------------------------------|--------|
| ** **                                       |   |                         |    |                                     |   |
| **ASSETS**                                       |   |                         |    |                                     |   |
| Current Assets:                                  |   |                         |    |                                     |   |
| Cash and cash equivalents                        |   | $                            | 3,253   |                                     | $      | 2,950 |   |
| Accounts receivable, net                         |   | 33,416                       |    | 28,434                                   |   |
| Prepaid expenses and other current  assets       |   | 18,797                       |    | 17,971                                   |   |
| Total current assets                             |   | 55,466                       |    | 49,355                                   |   |
|                                             |   |                         |    |                                     |   |
| Property, Plant and Equipment, net               |   | 429,387                      |    | 388,415                                  |   |
|                                             |   |                         |    |                                     |   |
| Other Assets:                                    |   |                         |    |                                     |   |
| Goodwill                                         |   | 43,275                       |    | 43,275                                   |   |
| Intangible assets                                |   | 1,767                        |    | 2,297                                    |   |
| Other assets                                     |   | 20,622                       |    | 20,782                                   |   |
|                                             |   |                         |    |                                     |   |
| Total assets                                     |   | $                            | 550,517 |                                     | $      | 504,124 |   |
|                                             |   |                         |    |                                     |   |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**   |   |                         |    |                                     |   |
|                                             |   |                         |    |                                     |   |
| Current Liabilities:                             |   |                         |    |                                     |   |
| Accounts payable                                 |   | $                            | 12,681  |                                     | $      | 15,969 |   |
| Current portion of long-term debt                |   | 2,226                        |    | 2,236                                    |   |
| Other current liabilities                        |   | 25,972                       |    | 26,635                                   |   |
| Total current liabilities                        |   | 40,879                       |    | 44,840                                   |   |
|                                             |   |                         |    |                                     |   |
| Other Liabilities and Deferred  Credits:         |   |                         |    |                                     |   |
| Long-term debt, less current  portion            |   | 193,221                      |    | 145,684                                  |   |
| Deferred income taxes                            |   | 20,731                       |    | 20,945                                   |   |
| Advances for construction                        |   | 9,522                        |    | 9,210                                    |   |
| Contributions in aid of  construction            |   | 113,464                      |    | 109,297                                  |   |
| Other liabilities and deferred  credits          |   | 28,849                       |    | 27,394                                   |   |
|                                             |   |                         |    |                                     |   |
| Commitments and Contingencies                    |   |                         |    |                                     |   |
|                                             |   |                         |    |                                     |   |
| Stockholders’ Equity:                       |   |                         |    |                                     |   |
| Preferred stock                                  |   | 458                          |    | 458                                      |   |
| Common stock                                     |   | 247                          |    | 243                                      |   |
| Additional paid-in capital                       |   | 147,288                      |    | 143,778                                  |   |
| Retained earnings (accumulated  deficit)         |   | (4,217                       | )       | 2,190                                    |   |
| Accumulated other comprehensive  income          |   | 75                           |    | 85                                       |   |
| Total stockholders’ equity                  |   | 143,851                      |    | 146,754                                  |   |
|                                             |   |                         |    |                                     |   |
| Total liabilities and stockholders’  equity |   | $                            | 550,517 |                                     | $      | 504,124 |   |
|                                                  |        |                              |         |                                          |        |  |  |  |  |  |

 

 

See accompanying notes to condensedconsolidated financial statements.

 

 

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

 

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

 
|                                                          |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|---------------------------------------------------------------|--------|--------------------------------------------|--------|-------------------------------------------|--------|
| ***(In thousands, except per share data)***                   |   | **2008**                                   |   | **2007********As Restated**               |   | **2008** |   | **2007********As Restated** |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Operating revenue                                             |   | $                                          | 60,360 |                                      | $      | 57,553 |   | $ | 166,901 |   | $ | 159,608 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Expenses:                                                     |   |                                       |   |                                      |   |   |   |   |   |
| Operating expenses                                            |   | 55,347                                     |   | 49,584                                    |   | 150,165 |   | 138,010 |   |
| Depreciation and amortization                                 |   | 3,699                                      |   | 2,938                                     |   | 11,254 |   | 8,818 |   |
| Impairment of goodwill and other  long-lived assets           |   | —                                     |   | —                                    |   | 210 |   | — |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Total operating expenses                                      |   | 59,046                                     |   | 52,522                                    |   | 161,629 |   | 146,828 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Operating income                                              |   | 1,314                                      |   | 5,031                                     |   | 5,272 |   | 12,780 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Other income (expense):                                       |   |                                       |   |                                      |   |   |   |   |   |
| Interest expense                                              |   | (2,340                                     | )      | (2,162                                    | )      | (6,932 | ) | (6,247 | ) |
| Interest income                                               |   | 343                                        |   | 284                                       |   | 436 |   | 490 |   |
| Other, net                                                    |   | —                                     |   | (41                                       | )      | 4 |   | (102 | ) |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) from continuing  operations before income taxes |   | (683                                       | )      | 3,112                                     |   | (1,220 | ) | 6,921 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Provision for (benefit from) income  taxes                    |   | (239                                       | )      | 1,055                                     |   | (428 | ) | 2,346 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) from continuing  operations                     |   | (444                                       | )      | 2,057                                     |   | (792 | ) | 4,575 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Loss from discontinued operations,  net of tax                |   | (532                                       | )      | (69                                       | )      | (1,177 | ) | (406 | ) |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Net income (loss)                                             |   | (976                                       | )      | 1,988                                     |   | (1,969 | ) | 4,169 |   |
| Preferred stock dividends                                     |   | (6                                         | )      | (6                                        | )      | (18 | ) | (18 | ) |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Net income (loss) applicable to  common stockholders          |   | $                                          | (982   | )                                         | $      | 1,982 |   | $ | (1,987 | ) | $ | 4,151 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Earning per common share:                                     |   |                                       |   |                                      |   |   |   |   |   |
| Basic:                                                        |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) from continuing  operations                     |   | $                                          | (0.02  | )                                         | $      | 0.09 |   | $ | (0.03 | ) | $ | 0.19 |   |
| Loss from discontinued operations                             |   | (0.02                                      | )      | —                                    |   | (0.05 | ) | (0.02 | ) |
| Net income (loss) applicable to  common stockholders          |   | $                                          | (0.04  | )                                         | $      | 0.09 |   | $ | (0.08 | ) | $ | 0.17 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Diluted:                                                      |   |                                       |   |                                      |   |   |   |   |   |
| Income (loss) from continuing  operations                     |   | $                                          | (0.02  | )                                         | $      | 0.08 |   | $ | (0.03 | ) | $ | 0.19 |   |
| Loss from discontinued operations                             |   | (0.02                                      | )      | —                                    |   | (0.05 | ) | (0.02 | ) |
| Net income (loss) applicable to  common stockholders          |   | $                                          | (0.04  | )                                         | $      | 0.08 |   | $ | (0.08 | ) | $ | 0.17 |   |
|                                                          |   |                                       |   |                                      |   |   |   |   |   |
| Weighted average common shares outstanding:                   |   |                                       |   |                                      |   |   |   |   |   |
| Basic                                                         |   | 24,607                                     |   | 24,178                                    |   | 24,498 |   | 24,054 |   |
| Diluted                                                       |   | 24,607                                     |   | 24,541                                    |   | 24,498 |   | 24,425 |   |
|                                                               |        |                                            |        |                                           |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

 

See accompanying notes to condensedconsolidated financial statements.

 

 

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

 

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

 
|                                                    |       |                |       |       |          |             |       |       |       |           |       | **Retained  Earnings  (Accumulated  Deficit)** |              | **Accumulated Other  Comprehensive  Income  (Loss)** |       |             |       |
|---------------------------------------------------------|------------|---------------------|------------|------------|---------------|------------------|------------|------------|------------|----------------|------------|------------------------------------------------|-------------------|------------------------------------------------------|------------|------------------|------------|
| ** **                                              | ** ** | ** **          | ** ** | ** ** | ** **    | ** **       | ** ** | ** ** | ** ** | ** **     | ** ** | ** **                                     | ** **        | ** **                                           | ** ** |
| ** **                                              | ** ** | **Preferred Stock** | ** ** | ** ** | ** **    | **Common Stock** | ** ** | ** ** | ** ** | **Additional** | ** ** | ** **                                     | ** **        | ** **                                           | ** ** |
| ** **                                              | ** ** | **Number of**       | ** ** | ** ** | ** **    | **Number of**    | ** ** | ** ** | ** ** | **Paid-in**    | ** ** | ** **                                     | ** **        | ** **                                           | ** ** |
| ** **                                              | ** ** | **Shares**          | ** ** | **Amount** | ** **    | **Shares**       | ** ** | **Amount** | ** ** | **Capital**    | ** ** | ** **                                     | ** **        | **Total**                                            | ** ** |
| ***(In thousands)***                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| **Balance  - December 31, 2007- As Restated**      | ** ** | **9**               | ** ** | **$**      | **458**       | ** **       | **24,268** | ** ** | **$**      | **243**        | ** ** | **$**                                          | **143,778**       | ** **                                           | **$**      | **2,190**        | ** ** | **$** | **85** | ** ** | **$** | **146,754** | ** ** |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Comprehensive income (loss):                            |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Net loss                                                |       | —              |       | —     |          | —           |       | —     |       | —         |       | (1,969                                         | )                 | —                                               |       | (1,969           | )          |
| Other comprehensive loss:                               |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Amortization of actuarial net gain                      |       | —              |       | —     |          | —           |       | —     |       | —         |       | —                                         |              | (10                                                  | )          | (10              | )          |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Comprehensive loss                                      |       | —              |       | —     |          | —           |       | —     |       | —         |       | —                                         |              | —                                               |       | (1,979           | )          |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Dividend reinvestment and stock  purchase plans         |       | —              |       | —     |          | 195              |       | 2          |       | 2,174          |       | —                                         |              | —                                               |       | 2,176            |       |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Proceeds from stock options  exercised                  |       | —              |       | —     |          | 82               |       | 1          |       | 611            |       | —                                         |              | —                                               |       | 612              |       |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Post-vest cancellations of  non-qualified stock options |       | —              |       | —     |          | —           |       | —     |       | (79            | )          | —                                         |              | —                                               |       | (79              | )          |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Share-based compensation                                |       | —              |       | —     |          | 114              |       | 1          |       | 761            |       | —                                         |              | —                                               |       | 762              |       |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Debenture conversion                                    |       | —              |       | —     |          | 4                |       | —     |       | 43             |       | —                                         |              | —                                               |       | 43               |       |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Cash dividends declared:                                |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| Preferred stock - $2.00 per share                       |       | —              |       | —     |          | —           |       | —     |       | —         |       | (18                                            | )                 | —                                               |       | (18              | )          |
| Common stock - $0.18 per share                          |       | —              |       | —     |          | —           |       | —     |       | —         |       | (4,420                                         | )                 | —                                               |       | (4,420           | )          |
|                                                    |       |                |       |       |          |             |       |       |       |           |       |                                           |              |                                                 |       |             |       |
| **Balance  - September 30, 2008**                  | ** ** | **9**               | ** ** | **$**      | ** 458** | ** **       | **24,663** | ** ** | **$**      | ** 247**  | ** ** | **$**                                          | ** 147,288** | ** **                                           | **$**      | ** (4,217** | **)**      | **$** | ** 75** | ** ** | **$** | ** 143,851** | ** ** |
|                                                         |            |                     |            |            |               |                  |            |            |            |                |            |                                                |                   |                                                      |            |                  |            |  |  |  |  |  |  |  |

 

 

See accompanying notes to condensedconsolidated financial statements.

 

 

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

 

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

 

 
| ** **                                                                                | ** ** | **Nine Months Ended  September 30,** | ** **   |
|-------------------------------------------------------------------------------------------|------------|-------------------------------------------|--------------|
| ** **                                                                                | ** ** | ** **                                | ** **   | ** ** | ** ** |
| ***(In thousands)***                                                                      | ** ** | **2008**                                  | ** **   | ** ** | **2007  As Restated** | ** ** | ** ** |
|                                                                                      |       |                                      |         |   |   |
| Cash flows from operating  activities of continuing operations:                           |       |                                      |         |   |   |
| Net income (loss)                                                                         |       | $                                         |  (1,969 | ) | $ |  4,169 |   |
| Adjustments to reconcile net income  (loss) to net cash provided by operating activities: |       |                                      |         |   |   |
| Loss from discontinued operations,  net of tax                                            |       | 1,177                                     |         | 406 |   |
| Depreciation and amortization                                                             |       | 11,254                                    |         | 8,818 |   |
| Deferred income taxes                                                                     |       | 1,179                                     |         | 2,236 |   |
| Provision for doubtful accounts                                                           |       | 1,568                                     |         | 249 |   |
| Share-based compensation expense                                                          |       | 762                                       |         | 733 |   |
| Impairment of goodwill and  long-lived assets                                             |       | 210                                       |         | — |   |
| Other, net                                                                                |       | 475                                       |         | 239 |   |
| Changes in assets and liabilities,  net of effects of acquisitions                        |       |                                      |         |   |   |
| Accounts receivable                                                                       |       | (6,369                                    | )            | (729 | ) |
| Other current assets                                                                      |       | 774                                       |         | (1,605 | ) |
| Other assets                                                                              |       | (3,646                                    | )            | (199 | ) |
| Accounts payable                                                                          |       | (4,258                                    | )            | (3,499 | ) |
| Other current liabilities                                                                 |       | (820                                      | )            | 4,260 |   |
| Other liabilities                                                                         |       | 474                                       |         | (1,533 | ) |
| Other, net                                                                                |       | (33                                       | )            | 293 |   |
|                                                                                      |       |                                      |         |   |   |
| Net cash provided by operating  activities                                                |       | 778                                       |         | 13,838 |   |
|                                                                                      |       |                                      |         |   |   |
| Cash flows from investing  activities of continuing operations:                           |       |                                      |         |   |   |
| Additions to property, plant and  equipment                                               |       | (25,883                                   | )            | (25,419 | ) |
| Acquisition of businesses, net of  cash acquired                                          |       | (23,330                                   | )            | (6,547 | ) |
| Proceeds from the sale of a  business                                                     |       | 170                                       |         | — |   |
| Proceeds from sales of equipment                                                          |       | 9                                         |         | 42 |   |
|                                                                                      |       |                                      |         |   |   |
| Net cash used in investing  activities                                                    |       | (49,034                                   | )            | (31,924 | ) |
|                                                                                      |       |                                      |         |   |   |
| Cash flows from financing  activities of continuing operations:                           |       |                                      |         |   |   |
| Borrowings under lines of credit                                                          |       | 147,000                                   |         | 30,000 |   |
| Repayments under lines of credit                                                          |       | (98,000                                   | )            | (14,000 | ) |
| Capital improvement reimbursements                                                        |       | 2,153                                     |         | 3,046 |   |
| Proceeds from share-based equity  incentive plans and stock purchase plans                |       | 2,788                                     |         | 2,835 |   |
| Contributions in aid of  construction                                                     |       | 374                                       |         | 360 |   |
| Excess tax benefit from stock  options exercised                                          |       | —                                    |         | 414 |   |
| Dividends paid                                                                            |       | (4,438                                    | )            | (4,186 | ) |
| Payments on long-term debt                                                                |       | (1,574                                    | )            | (1,609 | ) |
| Repayment of advances for  construction                                                   |       | (942                                      | )            | (509 | ) |
| Deferred financing costs                                                                  |       | (537                                      | )            | — |   |
|                                                                                      |       |                                      |         |   |   |
| Net cash provided by financing  activities                                                |       | 46,824                                    |         | 16,351 |   |
|                                                                                      |       |                                      |         |   |   |
| Cash flows from discontinued  operations:                                                 |       |                                      |         |   |   |
| Operating activities                                                                      |       | 1,738                                     |         | 326 |   |
| Investing activities                                                                      |       | (3                                        | )            | (466 | ) |
| Financing activities                                                                      |       | —                                    |         | — |   |
| Net cash provided by (used in)  discontinued operations                                   |       | 1,735                                     |         | (140 | ) |
|                                                                                      |       |                                      |         |   |   |
| Net increase (decrease) in cash and  cash equivalents                                     |       | 303                                       |         | (1,875 | ) |
|                                                                                      |       |                                      |         |   |   |
| Cash and cash equivalents at  beginning of year                                           |       | 2,950                                     |         | 4,294 |   |
|                                                                                      |       |                                      |         |   |   |
| Cash and cash equivalents at end of  year                                                 |       | $                                         |  3,253  |   | $ |  2,419 |   |
|                                                                                           |            |                                           |              |  |  |  |  |  |  |

 

 

See accompanyingnotes to condensed consolidated financial statements.

 

 

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

 

### **NOTES TOCONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)**

### ** **

**Note 1.       Summary of Significant AccountingPolicies**

** **

**Basis of Presentation**

** **

Thesecondensed consolidated interim financial statements are unaudited. SouthWestWater Company (the “Company”) believes the interim financial statements arepresented on a basis consistent with the audited consolidated financialstatements for the year ended December 31, 2007 (As Restated) and includeall adjustments necessary for a fair presentation of the financial condition,results of operations and cash flows for such interim periods. All of theseadjustments are normal recurring adjustments.

 

TheDecember 31, 2007 condensed balance sheet data were derived from theaudited financial statements (As Restated), but do not include all disclosuresrequired by accounting principles generally accepted in the United States ofAmerica (“GAAP”).

 

Certaininformation and disclosures normally included in financial statements preparedin accordance with GAAP have been omitted in accordance with Securities andExchange Commission’s rules and regulations for interim financialreporting. These condensed consolidated interim financial statements should beread in conjunction with the audited financial statements and related notesincluded in the Company’s 2008 Annual Report on Form 10-K (filed with theSEC on July 9, 2009). The Company’s businesses are seasonal because theyare affected by weather. As a result, operating results for interim periods arenot necessarily predictive of the operating results for any other interimperiod or for the full year.

 

**Recent AccountingPronouncements**

** **

*SFAS No. 157*

* *

InSeptember 2006, the Financial Accounting Standards Board (“FASB”) issuedSFAS No. 157, *Fair Value Measurements*(“SFAS157”). This statement defines fair value, establishes a framework for usingfair value to measure assets and liabilities, and expands disclosures aboutfair value measurements. The statement applies when other statements require orpermit the fair value measurement of assets and liabilities. This statementdoes not expand the use of fair value measurement. In February 2008, theFASB issued FASB Staff Position No. 157-2, *EffectiveDate of FASB Statement No. 157* (“FSP 157-2”). FSP 157-2delays the effective date of SFAS 157 for certain non-financial assets andliabilities to fiscal years beginning after November 15, 2008. Thesenon-financial items include assets and liabilities that are recognized anddisclosed at fair value in the financial statements on a non-recurring basis,such as the Company’s reporting units measured at fair value in a goodwill impairmenttest and asset retirement obligations.

 

Asit applies to its financial instruments, the Company implemented the newstandard effective January 1, 2008.  The partial adoption ofSFAS 157 for financial assets and liabilities did not have any impact onthe Company’s consolidated financial position, results of operations or cashflows. The Company is currently assessing the potential effect of SFAS 157 onall non-financial assets and liabilities.

 

OnOctober 10, 2008, FASB issued FASB Staff Position No. 157-3, *Determining the Fair Value of a Financial Asset When a Market for ThatAsset Is Not Active*(“FSP 157-3”), which clarifies the applicationof SFAS 157 in an inactive market and provides an example to demonstrate howthe fair value of a financial asset is determined when the market for thatfinancial asset is inactive. FSP 157-3 was effective upon issuance, includingprior periods of which financial statements had not been issued. The adoptionof this standard did not have an impact on the Company’s results of operations,financial position or cash flows.

 

 

6

*Table of Contents*

* *

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

* *

*SFAS No. 159*

* *

TheCompany adopted SFAS No. 159, *The Fair Value Option forFinancial Assets and Financial Liabilities* (“SFAS 159”)effective January 1, 2008. The Company did not elect the fair value optionfor any of its existing financial assets and liabilities.

 

*SFAS No. 141(R)*

 

InDecember 2007, the FASB issued SFAS No. 141 (revised 2007), *Business Combinations* (“SFAS 141(R)”). SFAS 141(R) providesrevised guidance on how acquirers recognize and measure the considerationtransferred, identifiable assets acquired, liabilities assumed, contingencies,noncontrolling interests and goodwill acquired in a business combination. SFAS141(R) also requires that transaction costs be expensed as incurred. SFAS141(R) also expands required disclosures surrounding the nature andfinancial effects of business combinations. SFAS 141(R) is effective, on aprospective basis, for the Company’s fiscal year beginning January 1,2009. Upon adoption, this standard will not have a material impact on theCompany’s consolidated financial position and results of operations. However,if the Company consummates any business combinations after the adoption of SFAS141(R), the transaction may significantly impact the Company’s consolidatedfinancial position and results of operations as compared to the Company’srecent acquisitions, accounted for under previous GAAP requirements, due to thechanges described above.

 

*SFAS No. 160*

 

InDecember 2007, the FASB issued SFAS No. 160, *NoncontrollingInterests in Consolidated Financial Statements, an amendment of ARB No. 51*(“SFAS 160”). SFAS 160 introduces significant changes in theaccounting and reporting for business acquisitions and noncontrolling interestsin a subsidiary. SFAS 160 also changes the accounting for and reporting for thedeconsolidation of a subsidiary. The Company is required to adopt the newstandard for its fiscal year beginning January 1, 2009. The Company isevaluating the impact of this standard and currently does not expect it to havea significant impact on its consolidated financial position or results ofoperations.

 

*SFAS No. 161*

 

InMarch 2008, the FASB issued SFAS No. 161, *Disclosuresabout Derivative Instruments and Hedging Activities—an amendment of FASBStatement No. 133* (“SFAS 161”). This statement amends SFAS 133by requiring enhanced disclosures about a Company’s derivative instruments andhedging activities, but does not change the scope of, or accounting under, SFAS133.  SFAS 161 requires increasedqualitative, quantitative and credit-risk disclosures about the entity’sderivative instruments and hedging activities. SFAS 161 is effective for theCompany’s fiscal year beginning January 1, 2009. Adoption of thisstatement will not have a material impact on the Company’s consolidatedfinancial position or results of operations.

 

*FSP FAS No. 142-3*

 

InApril 2008, the FASB issued FSP FAS No. 142-3, *Determinationof the Useful Life of Intangible Assets* (“FSP 142-3”).FSP 142-3 amends the factors that should be considered in developingrenewal or extension assumptions used to determine the useful life of arecognized intangible asset under SFAS 142, Goodwill and Other IntangibleAssets. FSP 142-3 is effective for the Company’s fiscal years beginning January 1,2009. The Company is currently assessing the impact of FSP 142-3 on itsconsolidated financial position and results of operations.

 

*FSP FAS No. 132(R)-1*

 

InDecember 2008, the FASB issued FSP FAS No. 132(R)-1, *Employers’ Disclosures about Postretirement Benefit Plan Assets*(“FAS132(R)-1”), which requires additional disclosures for employers’ pension andother postretirement benefit plan assets. As pension and other postretirementbenefit plan assets were not included within the scope of SFAS 157, FSP No. FAS132(R)-1 requires employers to disclose information about fair valuemeasurements of plan assets similar to the disclosures required under SFAS 157,the investment policies and strategies for the major categories of plan assets,and significant concentrations of risk within plan assets. FSP No. FAS132(R)-1 will be effective for the Company at December 31, 2009. As FSP No. FAS132(R)-1 provides only disclosure requirements,

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

theadoption of this standard will not have an impact on the Company’s results ofoperations, financial position or cash flows.

 

*SFAS No. 168*

 

InJune 2009, the FASB issued SFAS No. 168, *The FASB Accounting Standards Codification and the Hierarchy ofGenerally Accepted Accounting Principles* (“SFAS 168”). SFAS 168replaces FASB Statement No. 162, *TheHierarchy of Generally Accepted Accounting Principles*, andestablishes the FASB Accounting Standards Codification TM (the “Codification”) as the source ofauthoritative accounting principles recognized by the FASB to be applied bynongovernmental entities in the preparation of financial statements inconformity with generally accepted accounting principles (GAAP). SFAS 168 iseffective for interim and annual periods ending after September 15, 2009.The Company will begin to use the new Codification when referring to GAAP inits annual report on Form 10-K for the fiscal year ending December 31,2009. This will not have an impact on the consolidated results of the Company.

 

**Note 2.       Restatement of Condensed ConsolidatedFinancial Statements.**

** **

TheCompany has restated its condensed consolidated balance sheet at December 31,2007, its condensed consolidated statements of operations for the three- andnine-month periods ended September 30, 2007 and its statement of cashflows for the nine-month period ended September 30, 2007, including thecumulative impact of corrected errors for periods prior to January 1,2007.

 

Descriptionsof the significant restatement adjustments recorded are as follows:

 

***Application of SFAS 71***

 

Managementdetermined that three of the Company’s utilities previously applying SFAS 71 inthe Texas Utilities segment and one utility in the Utilities segment do notmeet the criteria for application of SFAS 71 because their cost structures havenot allowed for full recovery of their cost of service. The Company willcontinue to report these entities as utilities within the Texas Utilities andUtilities operating segments, respectively. The error impacts capitalizedinter-company profit margin, retired assets and certain costs associated withrate filings.

 

Managementdetermined that the remaining utilities in the Texas Utilities segment meet thecriteria for application of SFAS 71, however, management also determined thatinter-company profit was not eliminated, in error, as it is not probable that theCompany would recover this cost in future rates, as required by SFAS 71.

 

Managementalso determined that two of the Company’s Alabama wastewater utilities in theUtilities segment and a wholesale water and wastewater business within theTexas Utilities segment do not meet the criteria for application of SFAS 71because the rates charged by these entities are not established, or subject toapproval, by an independent third-party regulator. Accordingly, capitalizedinter-company profit margin included in certain fixed assets has been writtenoff.

 

Aggregatenet charges to income (loss) from continuing operations before income taxesrelated to SFAS 71 issues, including the inappropriate capitalization ofinter-company profit, of $0.5 million and $1.6 million were recorded for thethree- and nine-month periods ended September 30, 2007, respectively.  Additionally, the carrying value of Property,Plant and Equipment has been reduced by $26.6 million and $0.7 million ofregulatory assets were written off at December 31, 2007.

 

***Accounting for Acquisitions***

 

TheCompany determined that principles related to the accounting for certainbusiness combinations were misapplied and errors were made in establishing therate of depreciation of assets acquired and in allocating the initialallocation of the purchase price to assets and liabilities acquired.

 

Atthe time of those acquisitions, the Company applied a rate of depreciation thatdid not consider the length of time the assets were in service prior to beingacquired. As a result, depreciation expense was understated.

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

Additionally,management identified errors in the allocation of purchase prices and theaccounting for these business combinations was revised to correct theallocation of purchase prices to acquired property plant and equipment,identifiable intangible assets, and goodwill.

 

Basedon the corrected useful lives of acquired assets and the revised purchase priceallocations, depreciation and amortization expense increased $0.1 million and$0.3 million during the three- and nine-month periods ended September 30,2007, respectively. Additionally, based on the revision of the fair valueallocation for certain transactions, operating expenses during the three- andnine-month periods ended September 30, 2007 decreased by $0.03 million and$0.1 million, respectively.  Netproperty, plant and equipment balances decreased by $15.8 million and goodwilland intangible asset balances increased by $9.9 million at December 31,2007.

 

***Goodwill Impairment, Valuation and AccountingEstimates***

 

Priorto the restatement, the Company reported a $0.9 million goodwill impairmentrelated to its O&M Services business at December 31, 2006 and a $17.2million goodwill impairment related to its Texas Utilities business at December 31,2007. The Company has determined the impairment of goodwill for O&MServices was in error as the testing was not performed at the appropriatebusiness level, the reporting unit. Additionally, the Company has determined it impaired the goodwill at theTexas Utilities in error. The Texas Utilities segment passed the annualgoodwill impairment test on October 31, 2007. However, during the firstquarter of 2008, the Company identified a potential triggering event andperformed a goodwill impairment test as of December 31, 2007.  As a result of this test, the Companyerroneously recorded a goodwill impairment as of December 31, 2007. TheCompany re-performed its annual impairment tests for all periods presented andthe correction of the errors resulted in an increase to goodwill of $16.0million at December 31, 2007.

 

Asa part of its restatement and in conjunction with the related re-audit of 2007,the Company identified errors in the following valuation and accountingestimates:

 

·                   Stock-basedcompensation — Management identified errors in its accounting forstock-based compensation primarily related to the acceleration of vesting upontermination and in the valuation of options granted related to appropriateassumptions used in the Black-Scholes option pricing model. The correction ofthese errors resulted in a decrease of stock compensation expense for thethree- and nine-month periods ended September 30, 2007 of $0.1 million and$0.6 million, respectively.

 

·                   Self-insurancereserves — The Company self-insures its risks for workers’compensation, employee health benefits and vehicle liabilities and records anaccrual for insurance liabilities which have been incurred but not yet reported(IBNR).  Management identified errors inits accrual calculation to value the related liability with the third-partyinsurance firms which process claims.

 

·                   Inoperativefixed assets — In June 2005 the Company purchased leaserights to extract ground water in Texas in order to develop a new watersource.  Engineering studies and test well drilling were completed by July 2006;however, the Company continued to pursue obtaining all of the necessaryeasements to bring the well into commercial production.  During the fourth quarter of 2007 managementdetermined that obtaining such permits was not probable and abandoned theproject.  However, such capitalized costswere not expensed at that time.

 

·                   Unrecordedliabilities — Management identified certain liabilities forservices and capital equipment that were not properly accrued at the end ofreported financial periods.

 

Inthe aggregate, the adjustments described above resulted in increases of $0.3million and $1.1 million to income from continuing operations before incometaxes for the three- and nine-month periods ended September 30, 2007,respectively.

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

***Capitalization of Operating Expenses***

 

TheCompany conducted a review of its accounting for the costs associated with theinstallation of water and sewer taps and determined that the Company had beenimproperly capitalizing and depreciating costs associated with installing waterand sewer taps in Texas and Mississippi by recognizing the related tap feerevenue when received, instead of expensing the costs as incurred andrecognizing the related revenue in the period the tap was installed. As a result,previously capitalized tap installation costs were charged to expense whenincurred, the associated revenue was deferred to be recognized uponinstallation and the related depreciation charge was reversed.

 

Aggregatenet charges to income (loss) from continuing operations before income taxesrelated to these issues of $0.1 million and $0.2 million were recorded for thethree- and nine-month periods ended September 30, 2007, respectively.

 

***Other Adjustments***

 

Inthe restatement the Company also adjusted for the impact of other errors thatwere identified in prior periods but were determined to be immaterial to thatperiod’s financial statements and therefore corrected in the subsequent period.As part of the restatement of the consolidated financial statements, theCompany reversed these related entries and reflected the correction of theerror in the appropriate periods. These errors primarily relate to period endrevenue and expense accruals, billing adjustments, the calculation of assetimpairment charges and income taxes.

 

Forboth the three- and nine-month periods ended September 30, 2007 presentedin the “Restatement Adjustments” columns in the tables below, total operatingexpenses increased by $0.4 million.

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

Thenature of the restatement adjustments and the impact on the Company’spreviously reported condensed consolidated statement of operations for thethree-month period ended September 30, 2007 are shown in the followingtable (in thousands, except per share data):

 
| ** **                                            | ** ** | ** **                  | ** ** | ** **                   | ** ** | **Restatement  Adjustment**  | ** ** | ** **                        | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|------------------------------|------------|-----------------------------------|------------|
| **Three Months Ended September 30,  2007**       | ** ** | **As Previously  Reported** | ** ** | **Reclass-  ifications (1)** | ** ** | **Application  of  SFAS 71** | ** ** | **Accounting  for  Acquisitions** | ** ** | **Goodwill,  Valuation  and  Accounting  Estimates** | ** ** | **Capitalization  of Operating  Costs** | ** ** | **Other** | ** ** | **As Restated** | ** ** |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Operating revenue                                     |       | $                           | 57,358     |                         | $          | —                       |       | $                                 | (483       | ) | $ | — |   | $ | 178 |   | $ | (33 | ) | $ | 533 |   | $ | 57,553 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Expenses:                                             |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Operations and maintenance                            |       | 52,075                      |       | (2,821                       | )          | 255                          |       | (25                               | )          | (107 | ) | 90 |   | 117 |   | 49,584 |   |
| Depreciation and amortization                         |       | —                      |       | 2,821                        |       | (192                         | )          | 98                                |       | 6 |   | (34 | ) | 239 |   | 2,938 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Total expenses                                        |       | 52,075                      |       | —                       |       | 63                           |       | 73                                |       | (101 | ) | 56 |   | 356 |   | 52,522 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Operating income                                      |       | 5,283                       |       | —                       |       | (546                         | )          | (73                               | )          | 279 |   | (89 | ) | 177 |   | 5,031 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Interest expense                                      |       | (2,182                      | )          | —                       |       | 34                           |       | (19                               | )          | — |   | — |   | 5 |   | (2,162 | ) |
| Interest income                                       |       | 291                         |       | —                       |       | —                       |       | —                            |       | — |   | — |   | (7 | ) | 284 |   |
| Other income (expense)                                |       | (41                         | )          | —                       |       | —                       |       | —                            |       | — |   | — |   | — |   | (41 | ) |
| Income from continuing operations before income taxes |       | 3,351                       |       | —                       |       | (512                         | )          | (92                               | )          | 279 |   | (89 | ) | 175 |   | 3,112 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Provision for income taxes **(2)**                    |       | 1,276                       |       | —                       |       | —                       |       | —                            |       | — |   | — |   | (221 | ) | 1,055 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                     |       | 2,075                       |       | —                       |       | (512                         | )          | (92                               | )          | 279 |   | (89 | ) | 396 |   | 2,057 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Loss from discontinued operations, net of tax **(3)** |       | —                      |       | —                       |       | (89                          | )          | —                            |       | — |   | — |   | 20 |   | (69 | ) |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Net income                                            |       | 2,075                       |       | —                       |       | (601                         | )          | (92                               | )          | 279 |   | (89 | ) | 416 |   | 1,988 |   |
| Preferred stock dividends                             |       | (6                          | )          | —                       |       | —                       |       | —                            |       | — |   | — |   | — |   | (6 | ) |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Net income applicable to common Stockholders          |       | $                           | 2,069      |                         | $          | —                       |       | $                                 | (601       | ) | $ | (92 | ) | $ | 279 |   | $ | (89 | ) | $ | 416 |   | $ | 1,982 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Earning per common share:                             |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Basic:                                                |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                     |       | $                           | 0.09       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.09 |   |
| Loss from discontinued operations                     |       | —                      |       |                         |       |                         |       |                              |       |   |   |   |   |   |   | — |   |
| Net income applicable to common stockholders          |       | $                           | 0.09       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.09 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Diluted:                                              |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                     |       | $                           | 0.08       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.08 |   |
| Loss from discontinued operations                     |       | —                      |       |                         |       |                         |       |                              |       |   |   |   |   |   |   | — |   |
| Net income applicable to common stockholders          |       | $                           | 0.08       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.08 |   |

 

 

(1)    Certain reclassifications have been made tothe previously reported amounts to conform to the current presentation.

(2)    The tax provisions related to therestatement adjustments were based on the effective rates of the jurisdictionsaffected.

(3)    See Note 4, “Assets Held for Sale andDispositions.”

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

Thenature of the restatement adjustments and the impact on the Company’spreviously reported condensed consolidated statement of operations for thenine-month period ended September 30, 2007 are shown in the followingtable (in thousands, except per share data):

 
| ** **                                            | ** ** | ** **                  | ** ** | ** **                   | ** ** | **Restatement  Adjustment**  | ** ** | ** **                        | ** ** |
|-------------------------------------------------------|------------|-----------------------------|------------|------------------------------|------------|------------------------------|------------|-----------------------------------|------------|
| **Nine Months Ended September 30, 2007**         | ** ** | **As Previously  Reported** | ** ** | **Reclass-  ifications (1)** | ** ** | **Application  of  SFAS 71** | ** ** | **Accounting  for  Acquisitions** | ** ** | **Goodwill,  Valuation  and  Accounting  Estimates** | ** ** | **Capitalization  of Operating  Costs** | ** ** | **Other** | ** ** | **As Restated** | ** ** |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Operating revenue                                     |       | $                           | 160,407    |                         | $          | —                       |       | $                                 | (1,904     | ) | $ | — |   | $ | 453 |   | $ | 141 |   | $ | 511 |   | $ | 159,608 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Expenses:                                             |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Operations and maintenance                            |       | 146,634                     |       | (8,568                       | )          | 530                          |       | (75                               | )          | (651 | ) | 488 |   | (348 | ) | 138,010 |   |
| Depreciation and amortization                         |       | —                      |       | 8,568                        |       | (666                         | )          | 303                               |       | 19 |   | (124 | ) | 718 |   | 8,818 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Total expenses                                        |       | 146,634                     |       | —                       |       | (136                         | )          | 228                               |       | (632 | ) | 364 |   | 370 |   | 146,828 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Operating income                                      |       | 13,773                      |       | —                       |       | (1,768                       | )          | (228                              | )          | 1,085 |   | (223 | ) | 141 |   | 12,780 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Interest expense                                      |       | (6,376                      | )          | —                       |       | 163                          |       | (56                               | )          | — |   | — |   | 22 |   | (6,247 | ) |
| Interest income                                       |       | 507                         |       | —                       |       | —                       |       | —                            |       | — |   | — |   | (17 | ) | 490 |   |
| Other expense                                         |       | (102                        | )          | —                       |       | —                       |       | —                            |       | — |   | — |   | — |   | (102 | ) |
| Income from continuing operations before income taxes |       | 7,802                       |       | —                       |       | (1,605                       | )          | (284                              | )          | 1,085 |   | (223 | ) | 146 |   | 6,921 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Provision for income taxes **(2)**                    |       | 2,890                       |       | —                       |       | —                       |       | —                            |       | — |   | — |   | (544 | ) | 2,346 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                     |       | 4,912                       |       | —                       |       | (1,605                       | )          | (284                              | )          | 1,085 |   | (223 | ) | 690 |   | 4,575 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Loss from discontinued operations, net of tax **(3)** |       | —                      |       | —                       |       | (263                         | )          | —                            |       | — |   | — |   | (143 | ) | (406 | ) |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Net income                                            |       | 4,912                       |       | —                       |       | (1,868                       | )          | (284                              | )          | 1,085 |   | (223 | ) | 547 |   | 4,169 |   |
| Preferred stock dividends                             |       | (18                         | )          | —                       |       | —                       |       | —                            |       | — |   | — |   | — |   | (18 | ) |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Net income applicable to common Stockholders          |       | $                           | 4,894      |                         | $          | —                       |       | $                                 | (1,868     | ) | $ | (284 | ) | $ | 1,085 |   | $ | (223 | ) | $ | 547 |   | $ | 4,151 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Earning per common share:                             |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Basic:                                                |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                     |       | $                           | 0.20       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.19 |   |
| Loss from discontinued operations                     |       | —                      |       |                         |       |                         |       |                              |       |   |   |   |   |   |   | (0.02 | ) |
| Net income applicable to common stockholders          |       | $                           | 0.20       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.17 |   |
|                                                  |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Diluted:                                              |       |                        |       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                     |       | $                           | 0.20       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.19 |   |
| Loss from discontinued operations                     |       | —                      |       |                         |       |                         |       |                              |       |   |   |   |   |   |   | (0.02 | ) |
| Net income applicable to common stockholders          |       | $                           | 0.20       |                         |       |                         |       |                              |       |   |   |   |   |   |   |   | $ | 0.17 |   |

 

 

(1)    Certain reclassifications have been made tothe previously reported amounts to conform to the current presentation.

(2)    The tax provisions related to therestatement adjustments were based on the effective rates of the jurisdictionsaffected.

(3)    See Note 4, “Assets Held for Sale andDispositions.”

 

 

12

Table of Contents

 

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

Thefollowing table presents the impact of the restatement adjustments on theCompany’s previously reported consolidated balance sheet at December 31,2007. In addition to the income statement adjustments described above, certainbalance sheet classification adjustments were also identified. These include (i) correctingfor the proper accounting related to the purchase accounting explained above, (ii) adjustingvarious balance sheet items related to the revenue recognition and (iii) adjustmentsto properly record balance sheet items for the regulatory accounting issues.These balance sheet corrections in classifications are included in theadjustments columns below (in thousands):

 
| ** **                                       | ** ** | ** **                     | ** ** | **Restatement  Adjustment** | ** ** | ** **                        | ** ** | ** **                                           | ** ** | ** **                              | ** ** | ** ** | ** ** | ** ** |
|--------------------------------------------------|------------|--------------------------------|------------|-----------------------------|------------|-----------------------------------|------------|------------------------------------------------------|------------|-----------------------------------------|------------|------------|------------|------------|
| **As  of December 31, 2007**                | ** ** | **As****Previously  Reported** | ** ** | **Application of  SFAS 71** | ** ** | **Accounting  for  Acquisitions** | ** ** | **Goodwill,  Valuation  and  Accounting  Estimates** | ** ** | **Capitalization  of Operating  Costs** | ** ** | **Other**  | ** ** | ** ** | **As Restated** | ** ** | ** ** | **Assets Held  for Sale (1)** | ** ** | ** ** | **As Restated  and  Adjusted  for  Assets Held  for Sale** | ** ** |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| **ASSETS**                                       |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Current Assets:                                  |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents                        |       | $                              | 2,950      |                        | $          | —                            |       | $                                                    | —     |                                    | $          | —     |       | $          | — |   | $ | — |   |   | $ | 2,950 |   |   | $ | — |   |   | $ | 2,950 |   |
| Accounts receivable, net                         |       | 26,005                         |       | —                      |       | —                            |       | 60                                                   |       | 599                                     |       | 1,690      |       |       | 28,354 |   |   | 80 |   |   | 28,434 |   |
| Assets held for sale                             |       | 16,013                         |       | —                      |       | —                            |       | —                                               |       | —                                  |       | —     |       |       | 16,013 |   |   | (16,013 | ) |   | — |   |
| Prepaid expenses and other current  assets       |       | 16,617                         |       | —                      |       | (186                              | )          | 2,535                                                |       | (1,041                                  | )          | (121       | )          |       | 17,804 |   |   | 167 |   |   | 17,971 |   |
| Total current assets                             |       | 61,585                         |       | —                      |       | (186                              | )          | 2,595                                                |       | (442                                    | )          | 1,569      |       |       | 65,121 |   |   | (15,766 | ) |   | 49,355 |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Property, Plant and Equipment, Net               |       | 417,903                        |       | (26,599                     | )          | (15,774                           | )          | (64                                                  | )          | (1,638                                  | )          | (247       | )          |       | 373,581 |   |   | 14,834 |   |   | 388,415 |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Other Assets:                                    |       | —                         |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Goodwill                                         |       | 17,349                         |       | —                      |       | 9,891                             |       | 16,027                                               |       | —                                  |       | 8          |       |       | 43,275 |   |   | — |   |   | 43,275 |   |
| Intangible assets                                |       | 2,539                          |       | —                      |       | 35                                |       | —                                               |       | (276                                    | )          | —     |       |       | 2,298 |   |   | (1 | ) |   | 2,297 |   |
| Other assets                                     |       | 17,033                         |       | (706                        | )          | 218                               |       | 1,951                                                |       | (72                                     | )          | 1,425      |       |       | 19,849 |   |   | 933 |   |   | 20,782 |   |
| Total assets                                     |       | $                              | 516,409    |                        | $          | (27,305                           | )          | $                                                    | (5,816     | )                                       | $          | 20,509     |       | $          | (2,428 | ) | $ | 2,755 |   |   | $ | 504,124 |   |   | $ | — |   |   | $ | 504,124 |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**    |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Current Liabilities:                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Accounts payable                                 |       | $                              | 14,930     |                        | $          | —                            |       | $                                                    | —     |                                    | $          | 804        |       | $          | — |   | $ | 204 |   |   | $ | 15,938 |   |   | $ | 31 |   |   | $ | 15,969 |   |
| Liabilities related to assets held  for sale     |       | 4,297                          |       | —                      |       | —                            |       | —                                               |       | —                                  |       | —     |       |       | 4,297 |   |   | (4,297 | ) |   | — |   |
| Current portion of long-term debt                |       | 1,937                          |       | —                      |       | —                            |       | —                                               |       | —                                  |       | 299        |       |       | 2,236 |   |   | — |   |   | 2,236 |   |
| Other current liabilities                        |       | 25,020                         |       | —                      |       | 4                                 |       | 2,554                                                |       | 65                                      |       | (1,007     | )          |       | 26,636 |   |   | (1 | ) |   | 26,635 |   |
| Total current liabilities                        |       | 46,184                         |       | —                      |       | 4                                 |       | 3,358                                                |       | 65                                      |       | (504       | )          |       | 49,107 |   |   | (4,267 | ) |   | 44,840 |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Other Liabilities and Deferred  Credits:         |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Long-term debt                                   |       | 145,353                        |       | —                      |       | —                            |       | —                                               |       | —                                  |       | 331        |       |       | 145,684 |   |   | — |   |   | 145,684 |   |
| Deferred income taxes                            |       | 28,102                         |       | —                      |       | (535                              | )          | (949                                                 | )          | —                                  |       | (5,673     | )          |       | 20,945 |   |   | — |   |   | 20,945 |   |
| Advances for construction                        |       | 9,210                          |       | —                      |       | —                            |       | —                                               |       | —                                  |       | —     |       |       | 9,210 |   |   | — |   |   | 9,210 |   |
| Contributions in aid of  construction            |       | 115,442                        |       | (2,549                      | )          | (1,248                            | )          | —                                               |       | —                                  |       | (2,348     | )          |       | 109,297 |   |   | — |   |   | 109,297 |   |
| Other liabilities and deferred  credits          |       | 12,924                         |       | 1,391                       |       | 912                               |       | 3,326                                                |       | —                                  |       | 4,574      |       |       | 23,127 |   |   | 4,267 |   |   | 27,394 |   |
|                                             |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Stockholders’ Equity:                       |       |                           |       |                        |       |                              |       |                                                 |       |                                    |       |       |       |       |   |   |   |   |   |   |   |   |
| Preferred stock                                  |       | 458                            |       | —                      |       | —                            |       | —                                               |       | —                                  |       | —     |       |       | 458 |   |   | — |   |   | 458 |   |
| Common stock                                     |       | 243                            |       | —                      |       | —                            |       | —                                               |       | —                                  |       | —     |       |       | 243 |   |   | — |   |   | 243 |   |
| Additional paid-in capital                       |       | 145,072                        |       | —                      |       | (2,108                            | )          | 1,200                                                |       | —                                  |       | (386       | )          |       | 143,778 |   |   | — |   |   | 143,778 |   |
| Retained earnings                                |       | 13,336                         |       | (26,147                     | )          | (2,841                            | )          | 13,574                                               |       | (2,493                                  | )          | 6,761      |       |       | 2,190 |   |   | — |   |   | 2,190 |   |
| Accumulated other comprehensive  income          |       | 85                             |       | —                      |       | —                            |       | —                                               |       | —                                  |       | —     |       |       | 85 |   |   | — |   |   | 85 |   |
| Total stockholders’ equity                  |       | 159,194                        |       | (26,147                     | )          | (4,949                            | )          | 14,774                                               |       | (2,493                                  | )          | 6,375      |       |       | 146,754 |   |   | — |   |   | 146,754 |   |
| Total liabilities and stockholders’  equity |       | $                              | 516,409    |                        | $          | (27,305                           | )          | $                                                    | (5,816     | )                                       | $          | 20,509     |       | $          | (2,428 | ) | $ | 2,755 |   |   | $ | 504,124 |   |   | $ | — |   |   | $ | 504,124 |   |

 

(1)    See Note 4, “Assets Held for Sale andDispositions.”

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

Thefollowing table presents the impact of the restatement adjustments on theCompany’s previously reported condensed consolidated statements of cash flowsfor the nine months ended September 30, 2007 (in thousands):

 
| ** **                                                                         | ** ** | **Nine months ended  September 30, 2007** | ** ** |
|------------------------------------------------------------------------------------|------------|------------------------------------------------|------------|
| ** **                                                                         | ** ** | **As Previously****Reported**                  | ** ** | **Restatement  Adjustment** | ** ** | **As Restated** | ** ** |
|                                                                               |       |                                           |       |   |   |   |   |
| Cash flows from operating  activities of continuing operations:                    |       |                                           |       |   |   |   |   |
| Net income                                                                         |       | $                                              | 4,912      |   | $ | (743 | ) | $ | 4,169 |   |
| Adjustments to reconcile net income to net cash provided  by operating activities: |       |                                           |       |   |   |   |   |
|                                                                               |       |                                           |       |   |   |   |   |
| Loss from discontinued operations,  net of tax                                     |       | —                                         |       | 406 |   | 406 |   |
| Depreciation and amortization                                                      |       | 9,187                                          |       | (369 | ) | 8,818 |   |
| Deferred income taxes                                                              |       | 2,890                                          |       | (654 | ) | 2,236 |   |
| Provision for doubtful accounts                                                    |       | —                                         |       | 249 |   | 249 |   |
| Share-based compensation expense                                                   |       | 1,311                                          |       | (578 | ) | 733 |   |
| Other, net                                                                         |       | —                                         |       | 239 |   | 239 |   |
| Changes in assets and liabilities, net of effects of  acquisitions:                |       |                                           |       |   |   |   |   |
| Accounts receivable                                                                |       | 261                                            |       | (990 | ) | (729 | ) |
| Other current assets                                                               |       | 3,618                                          |       | (5,223 | ) | (1,605 | ) |
| Other assets                                                                       |       | (1,329                                         | )          | 1,130 |   | (199 | ) |
| Accounts payable                                                                   |       | (3,073                                         | )          | (426 | ) | (3,499 | ) |
| Other current liabilities                                                          |       | 648                                            |       | 3,612 |   | 4,260 |   |
| Other liabilities                                                                  |       | (419                                           | )          | (1,114 | ) | (1,533 | ) |
| Other, net                                                                         |       | (11                                            | )          | 304 |   | 293 |   |
| Net cash provided by operating  activities                                         |       | 17,995                                         |       | (4,157 | ) | 13,838 |   |
|                                                                               |       |                                           |       |   |   |   |   |
| Cash flows from investing activities of continuing  operations:                    |       |                                           |       |   |   |   |   |
| Additions to property, plant and  equipment                                        |       | (29,953                                        | )          | 4,534 |   | (25,419 | ) |
|                                                                               |       |                                           |       |   |   |   |   |
| Acquisition of businesses, net of  cash acquired                                   |       | (6,547                                         | )          | — |   | (6,547 | ) |
| Proceeds from sales of land and  equipment                                         |       | 42                                             |       | — |   | 42 |   |
| Net cash used in investing  activities                                             |       | (36,458                                        | )          | 4,534 |   | (31,924 | ) |
|                                                                               |       |                                           |       |   |   |   |   |
| Cash flows from financing activities of continuing  operations:                    |       |                                           |       |   |   |   |   |
| Borrowings under lines of credit                                                   |       | 16,000                                         |       | 14,000 |   | 30,000 |   |
| Repayments under lines of credit                                                   |       | —                                         |       | (14,000 | ) | (14,000 | ) |
| Capital improvement reimbursements                                                 |       | 3,046                                          |       | — |   | 3,046 |   |
|                                                                               |       |                                           |       |   |   |   |   |
| Proceeds from share-based equity  incentive plans and stock purchase plans         |       | 2,835                                          |       | — |   | 2,835 |   |
| Contributions in aid of construction                                               |       | 360                                            |       | — |   | 360 |   |
| Excess tax benefit from stock  options exercised                                   |       | 414                                            |       | — |   | 414 |   |
| Dividends paid                                                                     |       | (4,186                                         | )          | — |   | (4,186 | ) |
| Payments on long-term debt                                                         |       | (1,372                                         | )          | (237 | ) | (1,609 | ) |
| Repayment of advances for  construction                                            |       | (509                                           | )          | — |   | (509 | ) |
| Net cash provided by financing  activities                                         |       | 16,588                                         |       | (237 | ) | 16,351 |   |
|                                                                               |       |                                           |       |   |   |   |   |
| Cash flows from discontinued  operations:                                          |       |                                           |       |   |   |   |   |
| Operating activities                                                               |       | —                                         |       | 326 |   | 326 |   |
| Investing activities                                                               |       | —                                         |       | (466 | ) | (466 | ) |
| Financing activities                                                               |       | —                                         |       | — |   | — |   |
| Net cash used in discontinued  operations                                          |       | —                                         |       | (140 | ) | (140 | ) |
|                                                                               |       |                                           |       |   |   |   |   |
| Net decrease in cash and cash  equivalents                                         |       | (1,875                                         | )          | — |   | (1,875 | ) |
| Cash and cash equivalents at beginning of the period                               |       | 4,294                                          |       | — |   | 4,294 |   |
| Cash and cash equivalents at end of  the period                                    |       | $                                              | 2,419      |   | $ | — |   | $ | 2,419 |   |

 

 

14

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 

**Note 3.       Acquisition**

** **

OnJanuary 31, 2008, the Company acquired substantially all of the assets ofa wastewater collection system and related treatment plant in Birmingham,Alabama. The purchase price was $23.4 million in cash which the Companyborrowed under its revolving line of credit. The acquisition was accounted foras a purchase and the assets acquired have been recorded at their estimatedfair values, consisting of $20.7 million of utility plant and $2.5 million ofland.

 

Theconsolidated financial statements reflect the financial position and results ofoperations of the acquired utility subsequent to its acquisition date.Unaudited pro forma consolidated results of operations are presented in thetable below for the three-month period ended September 30, 2007 andnine-month periods ended September 30, 2008 and 2007 as if the acquisitionhad occurred as of the beginning of each period presented.

 
|                                                 |       | **Unaudited Pro Forma for the**             |       |
|------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **Three Months  Ended  September 30,** |       | **Nine Months Ended  September 30,** |   |
| ***(In thousands, except per share data)***          | ** ** | **2007**                                    | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                 |       |                                        |       |   |   |   |   |
| Total revenues                                       |       | $                                           | 58,866     |   | $ | 169,308 |   | $ | 163,496 |   |
| Income (loss) from continuing  operations            |       | 2,198                                       |       | (741 | ) | 4,996 |   |
| Net income (loss)                                    |       | 2,129                                       |       | (1,918 | ) | 4,590 |   |
| Net income (loss) applicable to  common stockholders |       | 2,123                                       |       | (1,936 | ) | 4,572 |   |
|                                                 |       |                                        |       |   |   |   |   |
| Earnings  (loss) per common share:                   |       |                                        |       |   |   |   |   |
| From  continuing operations:                         |       |                                        |       |   |   |   |   |
| Basic                                                |       | $                                           | 0.09       |   | $ | (0.03 | ) | $ | 0.21 |   |
| Diluted                                              |       | 0.09                                        |       | (0.03 | ) | 0.20 |   |
| Applicable  to common stockholders:                  |       |                                        |       |   |   |   |   |
| Basic                                                |       | 0.09                                        |       | (0.08 | ) | 0.19 |   |
| Diluted                                              |       | 0.09                                        |       | (0.08 | ) | 0.19 |   |

 

Thepro forma results of operations are not necessarily indicative of the resultsthat would have been achieved had the acquisition occurred as of the datesindicated or the results of operations for any future periods. The aboveinformation reflects adjustments for historical revenues and expenses prior tothe acquisition, as well as incremental operating, general and administrative,depreciation, interest and income tax expense based on the estimated fair valueof assets acquired and additional indebtedness in connection with theacquisition.

 

**Note 4.       Assets Held for Sale and Dispositions**

** **

During2007, the Company committed to a plan to sell its wholesale water andwastewater operations in Texas. As a result, the results of operations and cashflows for these operations are reflected as discontinued operations for allperiods presented. In December 2008, the Company completed the sale of itswholesale wastewater business for net cash proceeds of $2.2 million and areceivable of $0.6 million.  Thewastewater treatment plant sold represents a portion of these assets andliabilities. The Company is uncertain whether it can consummate the sale of theremaining business during 2009, accordingly, the business activity of the watercomponent will be reflected in consolidated continuing operations in 2009.  Net assets held for sale consisted of relatedproperty, plant and equipment aggregating $9.8 million and $10.6 million anddeferred revenue liabilities of $4.4 million and $4.2 million at September 30,2008 and December 31, 2007, respectively. The following tables summarizethe results of operations of these discontinued operations included in theconsolidated financial statements.

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**NOTES TO CONDENSED CONSOLIDATED FINANCIALSTATEMENTS (CONTINUED)**

 
| ** **                                     | ** ** | **Three Months Ended  September 30,** |       | **Nine Months Ended  September 30,** |       |
|------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ***(In thousands)***                           | ** ** | **2008**                                   | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                           |       |                                       |       |                                      |       |   |   |   |   |
| Revenues                                       |       | $                                          | 216        |                                      | $          | 184 |   | $ | 498 |   | $ | 469 |   |
|                                           |       |                                       |       |                                      |       |   |   |   |   |
| Expenses:                                      |       |                                       |       |                                      |       |   |   |   |   |
| Operating expenses                             |       | 1,065                                      |       | 278                                       |       | 1,419 |   | 1,000 |   |
| Impairment of long-lived assets                |       | —                                     |       | —                                    |       | 960 |   | — |   |
| Total expenses                                 |       | 1,065                                      |       | 278                                       |       | 2,379 |   | 1,000 |   |
|                                           |       |                                       |       |                                      |       |   |   |   |   |
| Operating loss                                 |       | (849                                       | )          | (94                                       | )          | (1,881 | ) | (531 | ) |
|                                           |       |                                       |       |                                      |       |   |   |   |   |
| Other income (expense):                        |       |                                       |       |                                      |       |   |   |   |   |
| Interest expense                               |       | —                                     |       | 2                                         |       | — |   | — |   |
| Interest income                                |       | (6                                         | )          | (6                                        | )          | (17 | ) | — |   |
|                                           |       |                                       |       |                                      |       |   |   |   |   |
| Pretax loss                                    |       | (843                                       | )          | (90                                       | )          | (1,864 | ) | (531 | ) |
| Income tax benefit                             |       | (311                                       | )          | (21                                       | )          | (687 | ) | (125 | ) |
|                                           |       |                                       |       |                                      |       |   |   |   |   |
| Loss from discontinued operations,  net of tax |       | $                                          | (532       | )                                         | $          | (69 | ) | $ | (1,177 | ) | $ | (406 | ) |

 

Inaccordance with EITF 87-24, *Allocation of Interest toDiscontinued Operation*(“EITF 87-24”), as amended, interestexpense reflects interest on debt that the Company is required to repay as aresult of the sale. In addition, and also in accordance with EITF 87-24,costs and expenses exclude the allocation of general corporate overhead.

 

Inaccordance with SFAS 144**intangible andother long-lived assets are assessed for recoverability**wheneverevents or changes in circumstances indicate that their carrying value may notbe recoverable through the estimated undiscounted future cash flows resultingfrom the use of the assets. The Company has determined that the carrying valueof the assets may not be recoverable through the sales process. As a result,impairment charges aggregating $0.3 million (all related to property, plant andequipment) were recorded in 2008 and $3.7 million ($2.3 million of property,plant and equipment and $1.4 million of goodwill) were recorded in 2007, toreduce the carrying value of the long-lived assets to expected realizablevalue.

 

**The Company entered into an agreement to sell the assets of its SouthwestEnvironmental Laboratories, Inc. subsidiary included in the Texas MUDsegment for $0.5 million in cash paid at close and a contingent considerationconsisting of 25% of the buyer’s quarterly aggregate invoice amounts subsequentto the sale up to an additional $0.75 million of consideration.  The sale closed on April 1, 2009.  Assets held for sale consisted of relatedproperty, plant and equipment aggregating $0.5 million, intangible assets of$0.1 million and goodwill of $1.0 million at September 30, 2008.  The Southwest Environmental Laboratories, Inc.subsidiary was not considered a discontinued operation in the accompanyingconsolidated financial statements.**

** **

** **

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**Note 5.       Long-Term Debt**

** **

Long-termdebt consists of the following as of September 30, 2008 and December 31,2007:

 
| *** ***                                                 | *** *** | ***September 30,*** | *** *** | ***December 31,*** |       |
|--------------------------------------------------------------|--------------|--------------------------|--------------|-------------------------|------------|
| ***(In thousands)***                                         | ** **   | **2008**                 | ** **   | **2007**                | ** ** |
|                                                         |         |                     |         |                    |       |
| Revolving credit facility                                    |         | $                        | 100,000      |                    | $          | 51,000 |   |
|                                                         |         |                     |         |                    |       |
| 6.85% convertible subordinated  debentures due 2021          |         | 12,002                   |         | 12,053                  |       |
|                                                         |         |                     |         |                    |       |
| $30 million capital lease facility  and other capital leases |         | 4,599                    |         | 5,308                   |       |
|                                                         |         |                     |         |                    |       |
| Term Loans:                                                  |         |                     |         |                    |       |
| Monarch Utilities, Inc.:                                |         |                     |         |                    |       |
| 7.37% fixed rate term loan due 2022                          |         | 10,459                   |         | 11,037                  |       |
| 5.77% fixed rate term loan due 2022                          |         | 719                      |         | 759                     |       |
| 6.10% fixed rate term loan due 2031                          |         | 20,000                   |         | 20,000                  |       |
|                                                         |         |                     |         |                    |       |
| First Mortgage Bonds:                                        |         |                     |         |                    |       |
| Suburban Water Systems:                                      |         |                     |         |                    |       |
| 9.09% series B first mortgage bond  due 2022                 |         | 8,000                    |         | 8,000                   |       |
| 5.64% series D first mortgage bond  due 2024                 |         | 15,000                   |         | 15,000                  |       |
| 6.30% series E first mortgage bond  due 2026                 |         | 10,000                   |         | 10,000                  |       |
| New Mexico Utilities, Inc.:                             |         |                     |         |                    |       |
| 6.10% series C first mortgage bond  due 2024                 |         | 12,000                   |         | 12,000                  |       |
|                                                         |         |                     |         |                    |       |
| Economic Development Revenue Bonds:                          |         |                     |         |                    |       |
| ECO Resources, Inc.:                                    |         |                     |         |                    |       |
| 5.5% series 1998A due 2008                                   |         | 115                      |         | 115                     |       |
| 6.0% series 1998A due 2018                                   |         | 1,810                    |         | 1,810                   |       |
|                                                         |         |                     |         |                    |       |
| Acquisition-related indebtedness and  other                  |         | 78                       |         | 80                      |       |
| Total long-term debt payment  obligations                    |         | 194,782                  |         | 147,162                 |       |
| Unamortized Monarch term loan fair  value adjustments        |         | 665                      |         | 758                     |       |
| Total long-term debt                                         |         | 195,447                  |         | 147,920                 |       |
| Less current portion of long-term  debt                      |         | (2,226                   | )            | (2,236                  | )          |
| Long-term debt, less current  portion                        |         | $                        | 193,221      |                    | $          | 145,684 |   |

 

OnFebruary 15, 2008, the Company replaced its existing revolving line ofcredit by entering into a credit agreement with several lenders including Bankof America, as lender and Administrative Agent, KeyBank, CoBank, U.S. Bank,JPMorgan Chase Bank, Comerica Bank, Bank of the West, Citibank and Union Bankof California (the “Bank Group”). The credit agreement provided for a $150.0million revolving credit facility. Proceeds from the initial borrowing underthe credit agreement were used to repay borrowings under the Company’s prior$100.0 million revolving line of credit.

 

TheCompany is subject to commitment fees under the facility as well as themaintenance of customary financial ratios, cash flow results and otherrestrictive covenants. The Company was not in compliance with certainrestrictive covenants due to the failure to timely deliver its September 30,2008 and March 31, 2009 Quarterly Reports on Form 10-Q and its 2008Annual Report on Form 10-K.  Inaddition, the Company was in violation of one of its financial covenants,specifically the debt to capitalization ratio, at December 31, 2008 and atMarch 31, 2009.   However, theCompany received five amendments to the credit agreement from the Bank Groupdated November 19, 2008, May 28, 2009, June 17, 2009, July 8,2009 and July 31, 2009 which waived existing and anticipated defaults,specifically related to additional time with regards to financial filings andwith regards to the debt to capitalization ratio.

 

TheMay 28, 2009 amendment to the agreement reduced the total availableamounts to borrow under the line from $150 million to $110 million.

 

 

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Therevolving line of credit commitment ends on February 15, 2013 (if notrenewed or extended), at which time all borrowings must be repaid. However,there are certain provisions within the revolving credit facility agreementthat could potentially be interpreted as a subjective acceleration clause.Though the Company does not anticipate any changes in its business practicesthat would result in any material adjustments to the revolving credit facility,management cannot be certain how the lender will interpret the subjectiveacceleration clause.

 

Borrowingsunder the credit facility bear interest, at the Company’s option, based on amargin either over the LIBOR rate or under the prime rate. The margins varydepending upon the Company’s consolidated debt to equity ratio. The applicablemargins under the credit agreement were 1.00% over the LIBOR rate or 0.25%under the prime rate. The weighted-average annual interest rates on all creditfacility borrowings outstanding were 3.86% as of September 30, 2008 and5.74% as of December 31, 2007.

 

TheCompany had irrevocable standby letters of credit in the amount of $2.0 millionissued and outstanding under its revolving credit facility as of September 30,2008, reducing available borrowings under the credit facility to $48.0 millionas of that date.

 

**Note 6.       Commitments and Contingencies**

** **

**LegalProceedings**

** **

*New Mexico Utilities, Inc.*

* *

NewMexico Utilities, Inc. (“NMUI”), one of the Company’s wholly-ownedregulated utilities, had an agreement with the Albuquerque Bernalillo CountyWater Utility Authority, a political subdivision of the State of New Mexico(the “ABCWUA”), whereby the ABCWUA treated the effluent from NMUI’s wastewatercollection system for a fee. The treated effluent is returned to the Rio GrandeUnderground Basin, creating return flow credits. Return flow creditssupplemented NMUI’s existing water rights, enabling it to pump additional waterfrom the basin.

 

InAugust 2004, the ABCWUA increased the fee charged to NMUI, using adifferent formula than had been used to calculate fee increases since 1973. TheCompany believed the increase violated the terms of a 1973 written agreementbetween the parties. Subsequently, the ABCWUA also claimed ownership of thereturn flow credits. On September 13, 2004, the Company filed a Complaintfor Declaratory Judgment in the Second Judicial District Court, County ofBernalillo, State of New Mexico (the “Court”), requesting that the Court settlethese disputes. In a letter ruling dated May 2, 2007, the Court ruled thatthe ABCWUA could use a new formula to set fees for NMUI. The Company filed amotion for reconsideration and that motion was denied on October 2, 2007.The Court did not rule on whether the new rate was appropriate; and madeno determination as to any amount NMUI may owe to the ABCWUA, and did not rule onthe ownership of the return flow credits.

 

Additionally,the ABCWUA had asserted that NMUI owed to the ABCWUA an amount of approximately$800,000 related to back payments, penalties and interest arising from analleged underpayment by NMUI for three years for its discharge of effluentthrough an unmetered second connection between NMUI and the ABCWUA. The claimwas contested by NMUI. On October 29, 2008, the matter was settled by aone time payment by NMUI to the ABCWUA of $500,000.

 

TheNew Mexico Public Regulation Commission (the “NMPRC”) ruled that NMUI maycommence billing its customers for a portion of the sewer fee increase and holdthe collected amounts in escrow (“Rate Rider Escrow”), pending a final courtdecision.

 

Inaddition, on January 19, 2007, the ABCWUA and the City of Rio Rancho, ahome-rule municipal corporation, as Petitioners, filed a Petition forCondemnation against NMUI and others, as defendants, in the Court (the “Petition”).The Petition sought to acquire, by condemnation, all of the assets of NMUI,including all real property, through the stated power of eminent domain. ThePetition also alleged that the Petitioners need to acquire the NMUI assets forthe public purposes of providing water and wastewater services to NMUI customersand that the acquisition of NMUI is necessary, appropriate and in the publicinterest. The Company contested the Petition.

 

 

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Inthe fourth quarter of 2008, the Company attempted to settle the sewer rate andreturn flow credit issues with an $8.0 million cash offer. The settlement offerwas not accepted by ABCWUA.

 

OnJanuary 29, 2009, NMUI and the ABCWUA entered into a Settlement,Arbitration Award, and Acquisition Agreement (the “Agreement”) to resolve alloutstanding claims, demands and existing lawsuits between them. The Agreementclosed on May 8, 2009 (the “Closing”). Under the Agreement, the ABCWUA acquired certain of the assets of NMUInecessary for the ABCWUA to own, operate and maintain the water and wastewatersystem of NMUI in settlement of condemnation. In consideration of the assetsacquired, the ABCWUA agreed to pay to NMUI at the Closing as full, final andcomplete consideration the sum of: (i) $60.0 million; (ii) an amountequal to the NMUI accounts receivable at the date of Closing; and (iii) anamount equal to the unbilled services at the date of Closing.

 

OnMay 8, 2009 NMUI was also refunded an amount equal to 7/8th of the totalRate Rider Escrow Funds deposited from the period from November 27, 2007through January 12, 2009 aggregating $1.3 million. The remaining RateRider Escrow Funds deposited through January 12, 2009 were released toNMUI for transfer to the ABCWUA to fund customer bill credits or refunds.  NMUI also received reimbursement from theRate Rider Escrow Funds for amounts paid to the ABCWUA for the period January 13,2009 through the date of Closing.

 

Inaddition, the settlement resolves all other legal issues between NMUI andABCWUA including the dispute over the sewer fee the ABCWUA charged NMUI for thetreatment of wastewater and the ownership of the return flow credits from thattreated wastewater, as well as all other disputed amounts of the ABCWUA. Aspart of the settlement, NMUI agreed to pay $7.0 million to the ABCWUA at thetime of closing to resolve the sewer fee issue. This amount was accrued at December 31, 2008.

 

Netcash proceeds from settlement were $54.3 million. Substantially all of theutility plant assets of NMUI were pledged as collateral of $12.0 million infirst mortgage bonds with an original maturity of 2024.  The Company repaid in full the outstandingborrowings under the related bonds, and used the remaining cash proceeds of$42.3 million to pay any unassumed liabilities of NMUI and pay down the Company’srevolving credit facility.

 

*Investigations*

* *

OnMay 18, 2005, the Environmental Protection Agency (“EPA”) executed asearch warrant at the Company’s Texas-based testing laboratory and on July 20,2006 the laboratory received a subpoena to provide additional records andinformation to a grand jury. The Company has cooperated fully with the EPA’sinvestigation and has provided the records requested. The Company remains inclose cooperation and coordination with EPA’s counsel in an attempt to resolvethe matter favorably. In April 2009, the Company submitted to the EPA itsformal request that the EPA not pursue criminal sanctions against theCompany.  No amounts have been accruedrelated to the proposed settlement or any potential fines, penalties or otherliabilities.

 

TheCompany received a letter dated January 28, 2008 from the California StateWater Resources Control Board Office of Enforcement (the “Board”). The letterindicates that the Board has conducted an investigation of the operations of asubsidiary of the Company with respect to various California wastewatertreatment facilities which are operated, but not owned, by the subsidiary. TheBoard alleges that the subsidiary has violated certain provisions of theCalifornia Water Code and may be subject to civil administrative liability inexcess of $15.0 million, and possible administrative action against thesubsidiary’s status as a contract operator in California.  Since receipt of the letter, the Company hasconducted an internal investigation and worked in cooperation with the Board toresolve the matter favorably. The Board has made an offer of settlement,assuming that the Company implements an acceptable compliance program thatwould among other things require the Company to pay fines and penalties in thesum of $1.25 million, which is fully accrued at December 31, 2008. TheCompany is still in discussions with the Board to negotiate that offer further.

 

*Class Action Litigation*

* *

*Perrin v. SouthWest Water Company, et al.*, Case No. CV08-07844 (Central District of California) and related, consolidated cases:  On November 26, 2008, an allegedpurchaser of the Company’s stock filed an alleged securities class actionlawsuit in the United States District Court for the Central District ofCalifornia.  The complaint generally 

 

 

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allegesthat from May 10, 2005 through November 9, 2008, the Company madefalse statements or omitted to state facts necessary to make the Company’sdisclosures not misleading.  Fiveadditional and substantially similar cases were filed in the same court.  On January 26, 2009, motions forconsolidation and for the appointment of lead plaintiff and lead counsel werefiled by the plaintiffs.  On February 12,2009, the court granted the motion for consolidation and for the appointment oflead plaintiff and lead counsel. Pursuant to stipulation, the lead plaintiff has up to and including thelater of 60 days after the appointment of lead plaintiff or the filing ofthe restated financial statements to file a consolidated complaint.  The Company will have 60 days to answer ormove to dismiss the consolidated complaint. Given the nature and preliminarystatus of these cases, the Company cannot yet determine the amount or areasonable range of potential loss in these matters, if any.

 

*Derivative Litigation*

* *

*Sherman v. Christie, et al.*, Case No. BC404946 (Los AngelesCounty Superior Court) and related cases): On January 2, 2009, an alleged shareholder of the Company filed ashareholder derivative case on behalf of the Company, alleging breach offiduciary duty arising from the Company’s announcement of its intent to restateits financial statements against certain of its present and former members ofthe Company’s Board of Directors.  Twoadditional, substantially similar cases were filed.  Stipulations were entered extending the timeto respond to the complaints.  On April 23,2009, the court found that the three derivative suits were “complex” andrelated and transferred the cases to a single judge for all purposes andordered an initial status conference for December 3, 2009.  On April 30, 2009, the parties submitteda stipulation for court approval that would consolidate the cases, appoint alead plaintiffs’ counsel, give plaintiffs 60 days from the order consolidatingthe cases to file a consolidated complaint and give the Company and the otherdefendants 60 days to respond to the consolidated complaint. Given the natureand preliminary status of these cases, the Company cannot yet determine theamount or a reasonable range of potential loss in these matters, if any.

 

*Other Matters*

* *

TheCompany and its subsidiaries are also involved in other routine legal andadministrative proceedings arising during the ordinary course of business. TheCompany believes that the ultimate disposition of such matters will not have amaterial adverse effect on the Company’s consolidated financial position,results of operations or cash flows.  Anyrelated legal costs are expensed when incurred.

 

**Note7.       Earnings Per Share**

** **

Thefollowing table is a reconciliation of the numerators (income/(loss)) anddenominators (shares) used in both the basic and diluted earnings per sharecalculations.

 
| ** **                                                                  | ** ** | **Three Months Ended  September 30,** | ** ** | **Nine Months Ended  September 30,** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ***(In thousands)***                                                        | ** ** | **2008**                                   | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Numerators—Net income (loss)  applicable to common stockholders:       |       |                                       |       |                                      |       |   |   |   |   |
| Income (loss) from continuing  operations                                   |       | $                                          | (444       | )                                         | $          | 2,057 |   | $ | (792 | ) | $ | 4,575 |   |
| Less preferred stock dividends                                              |       | (6                                         | )          | (6                                        | )          | (18 | ) | (18 | ) |   |
| Income (loss) from continuing  operations applicable to common stockholders |       | (450                                       | )          | 2,051                                     |       | (810 | ) | 4,557 |   |
| Loss from discontinued operations                                           |       | (532                                       | )          | (69                                       | )          | (1,177 | ) | (406 | ) |   |
| Net income (loss) applicable to  common stockholders                        |       | $                                          | (982       | )                                         | $          | 1,982 |   | $ | (1,987 | ) | $ | 4,151 |   |   |
|                                                                        |       |                                       |       |                                      |       |   |   |   |   |
| Denominators—Weighted average common  shares outstanding:              |       |                                       |       |                                      |       |   |   |   |   |
| Basic weighted average common shares  outstanding                           |       | 24,607                                     |       | 24,178                                    |       | 24,498 |   | 24,054 |   |
| Plus shares issued on assumed  exercise of stock options and warrants       |       | —                                     |       | 363                                       |       | — |   | 371 |   |   |
| Diluted  weighted average common shares outstanding                         |       | 24,607                                     |       | 24,541                                    |       | 24,498 |   | 24,425 |   |   |

 

 

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TheCompany has $12.0 million of 6.85% fixed-rate convertible subordinatedebentures outstanding as of September 30, 2008. The debentures areconvertible into common stock at any time prior to maturity, unless previouslyredeemed, at a conversion price of $11.018 per share which totals 1.1 millionshares as of September 30, 2008. At such time as the assumed conversion ofthe debentures has a dilutive effect on earnings per share, the debentures willbe included in the calculation of diluted earnings per share after adjustingnet income for the after-tax effect of the debenture interest expense.

 

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

** **

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

 
|                                                                                                           |       | ***Nine Months Ended  September 30,*** |       |
|----------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------|------------|
| ***(In thousands)***                                                                                           | ** ** | **2008**                                    | ** ** | **2007** | ** ** |
|                                                                                                           |       |                                        |       |   |   |
| Cash paid during the period for:                                                                               |       |                                        |       |   |   |
| Interest                                                                                                       |       | $                                           | 6,261      |   | $ | 5,853 |   |
| Income taxes paid (refunded), net                                                                              |       | 1,764                                       |       | (666 | ) |
|                                                                                                           |       |                                        |       |   |   |
| Components of cash paid for  acquisitions:                                                                     |       |                                        |       |   |   |
| Fair value of assets acquired                                                                                  |       | $                                           | 23,330     |   | $ | 9,057 |   |
| Liabilities assumed                                                                                            |       | —                                      |       | (2,510 | ) |   |
| Cash paid for acquisitions                                                                                     |       | $                                           | 23,330     |   | $ | 6,547 |   |
|                                                                                                           |       |                                        |       |   |   |
| Non-cash investing and financing  activities:                                                                  |       |                                        |       |   |   |
| Non-cash contributions in aid of  construction and advances for construction conveyed to Company by developers |       | $                                           | 5,953      |   | $ | 5,875 |   |
| Debentures converted into common  stock                                                                        |       | 43                                          |       | 550 |   |

 

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

** **

TheCompany has a dividend reinvestment and stock purchase plan that gives commonstockholders the option of receiving their dividends in cash or in common stockat a discount from prevailing market prices (“DRIP”). The plan also permitsexisting stockholders to purchase additional common stock, up to a maximum of$10,000 per month, at a discount (“DSPP”); new investors may participate in theplan, subject to a $250 minimum initial investment. The Company may, at itssole discretion, permit purchases above the $10,000 stated maximum. Thediscounts may range from 0% to 5%, as determined from time to time by theCompany. The DRIP and DSPP discounts offered by the Company during 2007 were 5%for the DRIP and 0% for the DSPP as of September 30, 2008. As of September 30,2008, there are 3.7 million shares authorized for issuance under the plan ofwhich 0.7 million shares remain available for issuance.  However, in November 2008, the Companydetermined that participation in these plans should be suspended due to theCompany’s ineligibility to use its Registration Statement on Form S-3until 12 months after the Company is current in all SEC filings.

 

**Note 10.     Employee Retirement Plan**

** **

TheCompany has a non-qualified supplemental executive retirement plan (“SERP”) forcertain key executive officers for the purpose of providing supplemental incomebenefits to plan participants or their survivors upon retirement or death.There is only one participant remaining in the SERP. That individual hasreached retirement age and the plan provides that no additional benefits accrueupon reaching retirement age. The plan measurement date is December 31st of each year. The following table details thecomponents of the net periodic benefit costs:

 

 

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| ** **                                | ** ** | **Three Months Ended  September 30,** |       | **Nine Months Ended  September 30,** |       |
|-------------------------------------------|------------|--------------------------------------------|------------|-------------------------------------------|------------|
| ***(In thousands)***                      | ** ** | **2008**                                   | ** ** | **2007**                                  | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                      |       |                                       |       |                                      |       |   |   |   |   |
| Service cost                              |       | $                                          | —     |                                      | $          | — |   | $ | — |   | $ | — |   |
| Interest cost                             |       | 15                                         |       | 16                                        |       | 45 |   | 48 |   |
| Amortization of actuarial (gains)  losses |       | (5                                         | )          | (19                                       | )          | (15 | ) | (57 | ) |
| Amortization of prior service costs       |       | —                                     |       | 22                                        |       | — |   | 66 |   |
| Net periodic benefit costs                |       | $                                          | 10         |                                      | $          | 19 |   | $ | 30 |   | $ | 57 |   |

** **

**Note 11.     Segment Information**

** **

The Company’s principal business activity is to operate andmaintain water and wastewater infrastructure. Through its operating subsidiaries, the Company owns 132 systems andoperates hundreds more under contract to cities, utility districts and privatecompanies. The Company was incorporated in California in 1954 andreincorporated in Delaware in 1988. The Company maintains its corporate officesin Los Angeles, California.

 

In the past ten years, the Company has completed over 19acquisitions of both utility and contract service businesses. Theseacquisitions operated largely independent of each other, resulting in a complexbusiness structure with inconsistent business practices. In 2006, the Board ofDirectors appointed a new Chief Executive Officer to, among other things,review Company operations and plan for future growth. Beginning in 2007,changes were implemented to better integrate the various segments of thebusiness. In 2007 and 2008, the Company made a major change to how itoperates.  The Company consolidated manyof the departments that provide common support functions such as environmentalhealth and safety, financial and accounting services, information technologyand the customer call center. These consolidated departments allocate theircosts to each operating segment. In 2008, operations were divided into fourreportable segments to better focus the distinct strategies of each operatingbusiness. Each operating segment has embedded in it the direct operating costand infrastructure to deliver its plan, relying upon the allocated commonsupport functions discussed above.  Eachoperating segment is led by a Managing Director and a Financial Director.  The Company believes this management structurebrings both direct operational and financial management accountability to eachof the operations.

 

As a result of this reorganization, the Company now has fourreporting segments. The Company separates its segments first by whether it ownsthe utility or provides contract services to others. Its owned water andwastewater utilities are referred to as its Utilities operations (“Utilities”).In its financial statements the Company reports its Texas Utilities operations(“Texas Utilities”) as a separate segment because of different economiccharacteristics. This is principally due to the fact that Texas Utilities areunder-recovering their current cost of service as the Company has made largeinvestments in these operations that are not yet being recovered through ratesit charges. The Company’s contract operations are segmented by contract typeinto those that are generally larger, stand-alone operations (“O&M Services”)and those that are small, full service contracts operated by a common team ofpersonnel resulting in a model that proportions a fractional cost to eachclient (“Texas MUD Services”).

 

Thefollowing tables present information about the operations of each segment forthe three- and nine-month periods ended September 30, 2008 and2007.  The 2007 amounts have beenadjusted to reflect the change in segments discussed above and to correct theerrors discussed in Note 2.

 

 

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| ***(In thousands)***                                            | ** ** | **Utilities** | ** ** | **Texas****Utilities** | ** ** | **O&M****Services** | ** ** | **MUD****Services** | ** ** | **Corp. (1)** | ** ** | **Consol-  idated** | ** ** |
|-----------------------------------------------------------------|------------|---------------|------------|------------------------|------------|-------------------------|------------|---------------------|------------|---------------|------------|---------------------|------------|
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| **Three  Months Ended September 30, 2008**                 |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating revenue                                               |       | $             | 21,068     |                   | $          | 9,876                   |       | $                   | 10,472     |          | $          | 18,944              |       | $ | — |   | $ | 60,360 |   |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Expenses:                                                       |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating expenses                                              |       | 13,295        |       | 6,063                  |       | 11,249                  |       | 20,697              |       | 4,043         |       | 55,347              |       |
| Depreciation and Amortization                                   |       | 2,101         |       | 1,071                  |       | (131                    | )          | 267                 |       | 391           |       | 3,699               |       |
| Impairment of goodwill                                          |       | —        |       | —                 |       | —                  |       | —              |       | —        |       | —              |       |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Total expenses                                                  |       | 15,396        |       | 7,134                  |       | 11,118                  |       | 20,964              |       | 4,434         |       | 59,046              |       |
| Operating income (loss)                                         |       | 5,672         |       | 2,742                  |       | (646                    | )          | (2,020              | )          | (4,434        | )          | 1,314               |       |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Interest expense                                                |       | (731          | )          | (398                   | )          | (1                      | )          | (33                 | )          | (1,177        | )          | (2,340              | )          |
| Interest income                                                 |       | 4             |       | —                 |       | 3                       |       | 326                 |       | 10            |       | 343                 |       |
| Other income (expense)                                          |       | 115           |       | (1,253                 | )          | (177                    | )          | 280                 |       | 1,035         |       | —              |       |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Income (loss) from continuing  operations before income taxes   |       | $             | 5,060      |                   | $          | 1,091                   |       | $                   | (821       | )             | $          | (1,447              | )          | $ | (4,566 | ) | $ | (683 | ) |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| **Three  Months Ended September 30, 2007   (As Restated)** |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating revenue                                               |       | $             | 19,625     |                   | $          | 6,795                   |       | $                   | 10,734     |          | $          | 20,399              |       | $ | — |   | $ | 57,553 |   |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Expenses:                                                       |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating expenses                                              |       | 10,385        |       | 5,768                  |       | 10,779                  |       | 19,163              |       | 3,489         |       | 49,584              |       |
| Depreciation and Amortization                                   |       | 1,522         |       | 820                    |       | 140                     |       | 341                 |       | 115           |       | 2,938               |       |
| Impairment of goodwill                                          |       | —        |       | —                 |       | —                  |       | —              |       | —        |       | —              |       |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Total expenses                                                  |       | 11,907        |       | 6,588                  |       | 10,919                  |       | 19,504              |       | 3,604         |       | 52,522              |       |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating income (loss)                                         |       | 7,718         |       | 207                    |       | (185                    | )          | 895                 |       | (3,604        | )          | 5,031               |       |
| Interest expense                                                |       | (752          | )          | (250                   | )          | (4                      | )          | (62                 | )          | (1,094        | )          | (2,162              | )          |
| Interest income                                                 |       | —        |       | 3                      |       | 208                     |       | 57                  |       | 16            |       | 284                 |       |
| Other income (expense)                                          |       | 165           |       | (917                   | )          | (143                    | )          | 134                 |       | 720           |       | (41                 | )          |
|                                                            |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Income (loss) from continuing  operations before income taxes   |       | $             | 7,131      |                   | $          | (957                    | )          | $                   | (124       | )             | $          | 1,024               |       | $ | (3,962 | ) | $ | 3,112 |   |

 

 

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

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

 
| ***(In thousands)***                                           | ** ** | **Utilities** | ** ** | **Texas****Utilities** | ** ** | **O&M****Services** | ** ** | **MUD****Services** | ** ** | **Corp. (1)** | ** ** | **Consol-  idated** | ** ** |
|----------------------------------------------------------------|------------|---------------|------------|------------------------|------------|-------------------------|------------|---------------------|------------|---------------|------------|---------------------|------------|
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| **Nine  Months Ended September 30, 2008**                 |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating revenue                                              |       | $             | 54,685     |                   | $          | 26,456                  |       | $                   | 30,559     |          | $          | 55,201              |       | $ | — |   | $ | 166,901 |   |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Expenses:                                                      |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating expenses                                             |       | 31,760        |       | 16,810                 |       | 31,708                  |       | 56,614              |       | 13,273        |       | 150,165             |       |
| Depreciation and Amortization                                  |       | 6,067         |       | 3,038                  |       | (10                     | )          | 884                 |       | 1,275         |       | 11,254              |       |
| Impairment of goodwill and other long-lived assets             |       | —        |       | —                 |       | —                  |       | 210                 |       | —        |       | 210                 |       |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Total expenses                                                 |       | 37,827        |       | 19,848                 |       | 31,698                  |       | 57,708              |       | 14,548        |       | 161,629             |       |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating income (loss)                                        |       | 16,858        |       | 6,608                  |       | (1,139                  | )          | (2,507              | )          | (14,548       | )          | 5,272               |       |
| Interest expense                                               |       | (2,217        | )          | (1,061                 | )          | (2                      | )          | (103                | )          | (3,549        | )          | (6,932              | )          |
| Interest income                                                |       | 28            |       | —                 |       | 16                      |       | 375                 |       | 17            |       | 436                 |       |
| Other income (expense)                                         |       | 378           |       | (3,006                 | )          | (336                    | )          | 434                 |       | 2,534         |       | 4                   |       |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Income (loss) from continuing  operations before income taxes  |       | $             | 15,047     |                   | $          | 2,541                   |       | $                   | (1,461     | )             | $          | (1,801              | )          | $ | (15,546 | ) | $ | (1,220 | ) |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| **Nine  Months Ended September 30, 2007   (As Restated)** |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating revenue                                              |       | $             | 51,623     |                   | $          | 18,918                  |       | $                   | 29,949     |          | $          | 59,118              |       | $ | — |   | $ | 159,608 |   |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |   |   |   |   |   |   |
| Expenses:                                                      |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating expenses                                             |       | 26,797        |       | 14,827                 |       | 30,559                  |       | 55,801              |       | 10,026        |       | 138,010             |       |
| Depreciation and Amortization                                  |       | 4,442         |       | 2,586                  |       | 421                     |       | 1,051               |       | 318           |       | 8,818               |       |
| Impairment of goodwill and other long-lived assets             |       | —        |       | —                 |       | —                  |       | —              |       | —        |       | —              |       |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Total expenses                                                 |       | 31,239        |       | 17,413                 |       | 30,980                  |       | 56,852              |       | 10,344        |       | 146,828             |       |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Operating income (loss)                                        |       | 20,384        |       | 1,505                  |       | (1,031                  | )          | 2,266               |       | (10,344       | )          | 12,780              |       |
| Interest expense                                               |       | (2,257        | )          | (622                   | )          | (24                     | )          | (176                | )          | (3,168        | )          | (6,247              | )          |
| Interest income                                                |       | 1             |       | 12                     |       | 250                     |       | 181                 |       | 46            |       | 490                 |       |
| Other income (expense)                                         |       | 499           |       | (2,449                 | )          | (485                    | )          | (12                 | )          | 2,345         |       | (102                | )          |
|                                                           |       |          |       |                   |       |                    |       |                |       |          |       |                |       |
| Income (loss) from continuing  operations before income taxes  |       | $             | 18,627     |                   | $          | (1,554                  | )          | $                   | (1,290     | )             | $          | 2,259               |       | $ | (11,121 | ) | $ | 6,921 |   |

 

(1)   Reflects corporate headquartersgeneral and administrative expenses and interest expense, net of interestincome charged on intercompany debt. Corporate and other assets reflectcorporate headquarters assets, excluding investments in and receivables fromsubsidiaries.

 

**Note 12.     SubsequentEvents**

** **

***Cornerstone Project***

** **

InOctober of 2008 the Company postponed elements of its Cornerstoneinternal-use software development project. Based on the postponement it was determined that it was not probable thatthe implementation of certain software modules would be completed.  As a result, impairment charges aggregating$1.3 million were recorded in the fourth quarter of 2008 against the costscapitalized in construction work-in-progress.  In May 2009, the Company, based on additional current information,determined that it was not probable that the implementation of the remaininguncompleted software modules would be completed and recorded an additionalcharge of $9.0 million during the quarter ended June 30, 2009.

 

***Goodwill***

 

The Company testsgoodwill annually each year for impairment at the reporting unit level, or whenevents or circumstances indicate the carrying values may not be recoverable. 

 

During annualimpairment testing at October 31, 2008, global market events, including thecredit market crisis, resulted in declines in valuation multiples of comparablewater utilities and a decline in the Company’s stock price. These combinedfactors led to a lower estimated fair market value for all of the Company’ssegments. 

 

Basedon updated projections and the impacts of the market conditions, the Companyimpaired the entire $25.0 million of goodwill associated with the Company’sTexas Utilities and another $0.5 million of goodwill associated with theCompany’s Alabama utilities in the fourth quarter of 2008. 

 

 

24

## **Table of Contents**

 

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

## ** **

### **RESTATEMENT**

### ** **

SouthWestWater Company and its subsidiaries’ (“SouthWest Water” or the “Company”)condensed consolidated financial statements at December 31, 2007 and forthe three- and nine-month periods ended September 30, 2007 and relatedfinancial information have been restated to correct for certain accountingerrors. For further details on the nature of the corrections and the relatedeffects on the Company’s previously issued consolidated financial statements,see Note 2, “Restatement of Condensed Consolidated Financial Statements.”Restated balances have been identified with the notation “As Restated” whereappropriate. Throughout this Quarterly Report, the term “as previously reported”will be used to refer to balances from the 2007 consolidated financialstatements as reported prior to restatement for the errors.

 

Thecorrections to the reports for the affected prior periods are contained in thisreport on Form 10-Q and we are not filing separate corrections to thosereports.

 

### **SPECIALNOTE ABOUT FORWARD-LOOKING STATEMENTS**

### ** **

Management’sDiscussion and Analysis of Financial Condition and Results of Operations (“MD&A”)is intended to help the reader understand the results of operations andfinancial condition of SouthWest Water Company. This MD&A also contains “forward-lookingstatements” within the meaning of the Private Securities Litigation Reform Actof 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. All statements containedherein that are not clearly historical in nature are forward-looking, and thewords “anticipate,” “believe,” “belief,” “expect,” “estimate,” “project,” “plan,”“intend,” “continue,” “predict,” “may,” “will,” “should,” “strategy,” “willlikely result,” “will likely continue,” and similar expressions are generallyintended to identify forward-looking statements. Forward-looking statements aresubject to risks and uncertainties that could cause actual results to differ materiallyfrom our historical experience and our present expectations or projections. Adetailed discussion of these and other risks and uncertainties that could causeactual results and events to differ materially from such forward-lookingstatements is included in the section entitled “Item 1A. Risk Factors” in our2008 Annual Report on Form 10-K. Caution should be taken not to placeundue reliance on any such forward-looking statements since such statementsspeak only as of the date when made. Other than as required by applicable law,we undertake no obligation to publicly update or revise forward-lookingstatements whether as a result of new information, future events, or otherwise.

 

TheMD&A is intended to help the reader understand the results of operations,financial condition and cash flows of SouthWest Water Company and is providedas a supplement to, and should be read in conjunction with, our condensedconsolidated financial statements and the accompanying notes to the financialstatements included in this report.

 

### **OVERVIEW**

### ** **

SouthWestWater’s principal business activity is to operate and maintain water andwastewater infrastructure.  Through ouroperating subsidiaries, we own 132 systems and operate hundreds more undercontract to cities, utility districts and private companies. SouthWest Waterwas incorporated in California in 1954 and reincorporated in Delaware in 1988.We maintain our corporate offices in Los Angeles, California.

 

Inthe past ten years, we have completed over 19 acquisitions of both utility andcontract service businesses. These acquisitions operated largely independent ofeach other, resulting in a complex business structure with varying businesspractices. In 2006, our Board of Directors appointed a new Chief ExecutiveOfficer to, among other things, review Company operations and plan for futuregrowth. Beginning in 2007, we implemented changes to better integrate thevarious segments of the business. In 2007 and 2008, we made a major change tohow we operate; we consolidated many of the departments that provide commonsupport functions such as environmental health and safety, our financial andaccounting services, information technology and our customer call center. These

 

 

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consolidateddepartments allocate their costs to each operating segment. In 2008, ouroperations were divided into four operating segments to better focus thedistinct strategies of each of our operating businesses. Each segment hasimbedded in it the direct operating cost and infrastructure to deliver itsplan, relying upon the allocated common support functions discussed above. Eachoperating segment is led by a Managing Director and a Financial Director.  We believe this management structure bringsboth direct operational and financial management accountability to each of theoperations.

 

Asa result of this reorganization, we now have four reporting segments.  We separate our segments first by whether weown the utility or we provide contract services to others. Our owned water andwastewater utilities are referred to as our Utilities operations (“Utilities”).In our financial statements we report our Texas Utilities operations (“TexasUtilities”) as a separate segment because of different economiccharacteristics. This is principally because the Texas Utilities predominantlyunder-recovered their current cost of service, which includes a reasonablereturn on equity, as we have made large investments in these operations sinceacquisition that are not yet being recovered through the rates we charge. Ourcontract operations are segmented by contract type into those that aregenerally larger, stand-alone operations (“O&M Services”) and those thatare small, full service contracts operated by a common team of personnelresulting in a model that proportions a fractional cost to each client (“TexasMUD Services”).

 

**Utilities** consist of our owned water andwastewater utilities located in California, Alabama, Mississippi and ourrecently sold New Mexico utility (see Part II Item 1, “LegalProceedings” for detailed information on the New Mexico utility sale).Residential customers make up the largest component of our Utilities customerbase, with these customers representing approximately 92% of our water andwastewater connections. Substantially all of our Utilities customers aremetered which allows us to measure and bill for each customer’s waterconsumption. Each of the operations in this segment has a unique serviceterritory that is subject to state and federal regulations regarding standardsof water quality, safety, environmental and other matters. The rates that wecan charge for water and wastewater service include the opportunity to earn areasonable rate of return on investments in these utilities as approved bystate regulatory agencies; except for some of our Alabama wastewater rateswhich are governed by our service agreements. Some of these governmentalagencies approve a forward looking recovery of costs and some approve recoveryof costs based on a historical test year (backward looking). Our Utilitiesoperations are characterized by ongoing capital investments to maintain andenhance the reliability and quality of the service we provide, as well asroutine growth from rate increases and new connections.

 

**Texas Utilities** consists of 120 small, mostly ruralsystems that are grouped into nine jurisdictional utilities across Texas.Residential customers make up the largest component of our Texas Utilitiescustomer base, with these customers representing approximately 98% of our waterand wastewater connections. Substantially all of our Texas Utilities customersare metered which allows us to measure and bill for our customers’ waterconsumption. These systems are broadly dispersed geographically. The majorityof the systems are organized as one utility with a single tariff, known asMonarch Utilities.  The Monarch systems,as well as two smaller systems acquired in 2007, were in various stages ofdisrepair at the time of acquisition and we continue to spend significantamounts of capital to maintain regulatory compliance and to improve the qualityof service. We are not yet recovering all of these costs in our rates and as aresult, we have a lower rate of return than typically expected from a utility.We intend to actively pursue recovery of these costs in the rate settingprocess. All other aspects of operations for these utilities are the same asour Utilities operations; therefore, as soon as we are recovering our costs,including a reasonable return on equity, we expect to aggregate this segmentwith our Utilities segment.

 

**O&M Services** generally consists of operationsthat are project-specific contracts with cities, public agencies and privateowners. Most contracts are stand-alone operations staffed with project-specificpersonnel, with an average contract life of two to three years. Under a typicalO&M contract, we charge a fee that covers a specified level of service thatincludes facility operations and maintenance and may include other water orwastewater related services. Services are typically provided evenly throughoutthe contract period and are billed on a monthly basis. If we provide servicesbeyond the scope of a contract, we bill for the additional services on atime-and-materials basis or negotiate a unique price. These contracts arelargely located in California, Colorado, Alabama, Mississippi, and Georgia.

 

**Texas MUD Services** is a full service provider of utilityservices to a large number of small utilities in Texas that are mostly owned bymunicipal utility districts (“MUD”). A MUD is created to provide water supply,wastewater treatment and drainage service to areas where municipal services arenot available. We service over 270 MUD clients with a 

 

 

26

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commonteam of client managers, operators, customer service and billing personnel.Therefore, these contracts are allocated a proportional amount of each costcenter creating a business model that is significantly different from that ofO&M Services. Under a typical MUD contract, we bill a monthly base fee toprovide a specified level of service; usually water and/or wastewater facilityinspections, routine operations, equipment maintenance, and utility customerservice including meter reading, call center, dispatch, billing, and collectionservices. We bill for any additional services provided beyond the basiccontract on a time-and-materials basis as such services are rendered. Mostcontracts provide for an increase in the monthly base fee as the number ofcustomer connections increases and generally include inflation adjustments. Themajority of our MUD contracts are cancelable with 30 to 60 days prior notice byeither party, but tend to last for long periods due to the close workingrelationships between the operators and the clients. No one district representsmore than 4% of the overall revenue of this segment.

 

#### **Acquisitions**

#### ** **

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

#### ** **

***Utilities:***

 

·                  a Birmingham,Alabama-based wastewater collection and treatment system that servesapproximately 4,000 residential and commercial connections, in a service areadirectly adjacent to our existing Shelby County collection and treatmentsystem, acquired in January 2008 (“Riverview”);

 

·                  a MadisonCounty, Alabama-based wastewater collection and treatment system servicingapproximately 120 connections acquired in November 2007; and,

 

·                  a northernMississippi-based water and wastewater utility serving approximately 275 waterconnections and servicing approximately 355 wastewater connections through fourcollection systems acquired in February 2007.

 

***Texas Utilities:***

 

·                  two SanAntonio, Texas-based water utilities serving approximately 2,600 connectionsacquired in May 2007.

 

**Assets Held for Sale and Dispositions**

** **

During2007, we committed to a plan to sell our wholesale water and wastewateroperations in Texas.  In December 2008,we completed the sale of our wholesale wastewater business for net cashproceeds of $2.2 million and a receivable of $0.6 million.  The wastewater treatment plant soldrepresents a portion of the combined water and wastewater operations’ assets andliabilities. We are uncertain whether we can consummate the sale of theremaining business during 2009, accordingly, the business activity of the watercomponent will be reflected in consolidated continuing operations in 2009.

 

Weentered into an agreement to sell the assets of our Southwest EnvironmentalLaboratories, Inc. subsidiary in 2009 for cash consideration of $0.5million paid at close and up to an additional $0.75 million of considerationconsisting of 25% of the buyer’s quarterly aggregate invoice amounts subsequentto the sale.  The sale closed on April 1,2009.

 

InJanuary 2009 we reached a settlement in eminent domain proceedings againstour New Mexico utility, New Mexico Utilities Inc. (“NMUI”). On May 8, 2009we received $54.3 million in cash at closing ($60.0 million settlement and $1.3million escrow release, less $7.0 million retained by the condemning entity insettlement of sewer treatment fees).  Weused $12.0 million of the net proceeds to pay down NMUI bonds and the remainingcash proceeds of $42.3 million was used to pay any unassumed liabilities ofNMUI and to pay down our revolving credit facility.

 

 

27

### **Table of Contents**

 

### **RESULTSOF OPERATIONS**

### ** **

#### **Changein Presentation**

#### ** **

EffectiveJanuary 1, 2008, we launched the first phase of our financial reportingreengineering process by implementing a fully integrated financial modulethroughout the entire company. As a result, the methodology of capturing andreporting operating versus general and administrative expenses as well as theclassification of expenses between business segments has changed. As permittedby SFAS No. 131, *Disclosures about Segmentsof an Enterprise and Related Information*, prior year amounts havenot been reclassified to conform to the 2008 presentation because theinformation is not available and the cost to develop it would be excessive.

 

Reclassificationshave also been made to prior year’s financial statement presentation withrespect to a component of the business we are holding for sale as adiscontinued operation.

 

#### **Threemonths ended September 30, 2008 Compared to 2007**

#### ** **

**Revenue.**Revenue increased $2.8 million, or5.0%, to $60.4 million for the quarter ended September 30, 2008 from $57.6million for the same period during the prior year. By segment, revenue changedas follows:

 
| ** **                               | ** ** | **Three  Months Ended** |       |                  |       | **Percent of Revenue**   |       |
|------------------------------------------|------------|-------------------------|------------|-----------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **September 30,**  |       |                  |       |                     |       |
| ***(In thousands, except percentages)*** | ** ** | **2008**                | ** ** | **2007  As Restated** | ** ** | **Increase  (Decrease)** | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                     |       |                    |       |                  |       |                     |       |   |   |   |   |   |   |   |
| Utilities                                |       | $                       | 21,068     |                  | $          | 19,625                   |       | $ | 1,443 |   | 34.9% |   | 34.1% |   |
| Texas  Utilities                         |       | 9,876                   |       | $                     | 6,795      |                     | 3,081      |   | 16.4% |   | 11.8% |   |
| O&M  Services                        |       | 10,472                  |       | $                     | 10,734     |                     | (262       | ) | 17.3% |   | 18.7% |   |
| Texas  MUD Services                      |       | 18,944                  |       | 20,399                |       | (1,455                   | )          | 31.4% |   | 35.4% |   |
| Total                                    |       | $                       | 60,360     |                  | $          | 57,553                   |       | $ | 2,807 |   | 100.0% |   | 100.0% |   |

 

***Utilities.***Revenueincreased $1.4 million, or 7.4%, to $21.1 million for the quarter ended September 30,2008, from $19.6 million for the same period during the prior year. The increasewas primarily due to the acquisition of the Riverview wastewater treatmentplant in Alabama at the end of January 2008 and rate increases inCalifornia and Alabama. These increases were partially offset by reducedconsumption at our California utility related to customers’ conservationefforts.

 

***Texas Utilities.***Revenueincreased $3.1 million, or 45.3%, to $9.9 million for the quarter ended September 30,2008, from $6.8 million for the same period during the prior year. The increasewas primarily due to the interim rate increase from the implementation of ourMonarch filed rates in October 2007 and the implementation of new rates at3 smaller utilities, along with increased consumption as a result of weatherpatterns that were hot and dry compared to 2007 weather.

 

***O&M Services.***Revenuedecreased $0.3 million, or 2.4%, to $10.5 million for the quarter ended September 30,2008, from $10.7 million for the same period during the prior year. Thedecrease was primarily due to the decision to stop pursuing at-risk electricalcontract projects and a few lost contracts, partially offset by increasedproject work and price increases in California and the southeast.

 

***Texas MUD Services.***Revenuedecreased $1.5 million, or 7.1%, to $18.9 million for the quarter ended September 30,2008, from $20.4 million for the same period during the prior year. Thedecrease was primarily due to lost contracts and from less taps and inspectionfees for new housing starts as well as the elimination of non-core operationsincluding specialty pipe rehabilitation work in the Houston area andbookkeeping services, partially offset by contract pricing increases andincreases in service order work.

 

**Total Operating Expenses.**Total operatingexpenses increased $6.5 million, or 37.5%, to $59.0 million for the quarterended September 30, 2008 from $52.5 million for the same period during theprior year as follows:

 

 

28

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| ** **                               | ** ** | **Three  Months Ended** |       |                  |       | **Percent of Revenue (1)** |       |
|------------------------------------------|------------|-------------------------|------------|-----------------------|------------|----------------------------|------------|
| ** **                               | ** ** | **September 30,**  |       |                  |       |                       |       |   |   |
| ***(In thousands, except percentages)*** | ** ** | **2008**                | ** ** | **2007  As Restated** | ** ** | **Increase  (Decrease)**   | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                     |       |                    |       |                  |       |                       |       |   |   |   |   |   |   |   |
| Utilities                                |       | $                       | 15,396     |                  | $          | 11,907                     |       | $ | 3,489 |   | 73.1% |   | 60.7% |   |
| Texas  Utilities                         |       | 7,134                   |       | 6,588                 |       | 546                        |       | 72.2% |   | 97.0% |   |
| O&M  Services                        |       | 11,118                  |       | 10,919                |       | 199                        |       | 106.2% |   | 101.7% |   |
| Texas  MUD Services                      |       | 20,964                  |       | 19,504                |       | 1,460                      |       | 110.7% |   | 95.6% |   |
| Corporate                                |       | 4,434                   |       | 3,604                 |       | 830                        |       | — |   | — |   |
| Total                                    |       | $                       | 59,046     |                  | $          | 52,522                     |       | $ | 6,524 |   | 97.8% |   | 91.3% |   |

 

----

(1)             Segment total operating expenses arecomputed as a percent of their respective revenue. Total direct operatingexpenses are computed as a percentage of total Revenue.

 

***Utilities.***Totaloperating expenses increased $3.5 million, or 29.3%, to $15.4 million for thequarter ended September 30, 2008, from $11.9 million for the same periodduring the prior year. The increase was primarily due to the acquisition of theRiverview wastewater treatment plant in Alabama at the end of January 2008;staffing additions, salary increases, higher average unit costs of deliveredwater and depreciation expenses at our California utility; increased wastewatertreatment costs due to higher fees charged by our provider and higher waterproduction costs and higher legal costs at our New Mexico utility; andincreases due to general and administrative costs, primarily due to increasedcosts associated with the implementation of our strategy to consolidate supportfunctions.  These increases werepartially offset by lower costs of production as a result of reducedconsumption in California.

 

***Texas Utilities.***Totaloperating expenses increased $0.6 million, or 8.3%, to $7.1 million for thequarter ended September 30, 2008, from $6.6 million for the same periodduring the prior year. The increase was due to increased costs associated withincreased consumption as a result of weather patterns that were hot and drycompared to 2007 weather, increased purchased water and increases due togeneral and administrative costs, primarily due to increased costs associatedwith our strategy to consolidate support functions to achieve futureefficiencies and increased depreciation costs.

 

***O&M Services.***Totaloperating expenses increased $0.2 million, or 1.8%, to $11.1 million for thequarter ended September 30, 2008, from $10.9 million for the same periodduring the prior year. The increase was primarily due to new and expanded scopeon revenue contracts and increases due to general and administrative costsrelated to our strategy to consolidate support functions.  These increases were partially offset by thelower costs associated with lost contracts, reduced project work and reducedcosts from the decision to stop pursuing at-risk electrical contract projects.

 

***Texas MUD Services.***Totaloperating expenses increased $1.5 million, or 7.5%, to $21.0 million for thequarter ended September 30, 2008, from $19.5 million for the same periodduring the prior year. The increase was primarily due to change in mix of workperformed from new housing starts to service and maintenance work orders, andan increase in general and administrative costs, primarily due to increasedcosts associated with the implementation of our strategy to consolidate supportfunctions, offset by savings from the elimination of specialty piperehabilitation work.

 

***Corporate.***Totaloperating expenses increased $0.8 million to $4.4 million for the quarter endedSeptember 30, 2008 compared to $3.6 million for the same period during theprior year primarily related to a $0.6 million increase related to ourCornerstone internal-use software development project and a $0.2 millionincrease related to other temporary increases for business processreengineering projects.

 

**Other Income (Expense).**Aggregate otherexpenses, net increased $0.1 million, or 4.1%, to $2.0 million for the quarterended September 30, 2008, compared to $1.9 million for the same periodduring the prior year as follows:

 
| ** **           | ** ** |     |       | **2007**        |       | **(Increase)** |       |
|----------------------|------------|----------|------------|-----------------|------------|----------------|------------|
| ***(In thousands)*** | ** ** | **2008** | ** ** | **As Restated** | ** ** | **Decrease**   | ** ** |
|                 |       |     |       |            |       |           |       |   |   |   |
| Interest  expense    |       | $        | (2,340     | )               | $          | (2,162         | )          | $ | (178 | ) |
| Interest  income     |       | 343      |       | 284             |       | 59             |       |
| Other,  net          |       | —   |       | (41             | )          | 41             |       |
| Total                |       | $        | (1,997     | )               | $          | (1,919         | )          | $ | (78 | ) |

 

 

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***Interest Expense.***Interestexpense increased by $0.2 million, or 8.2%, to $2.3 million for the quarterended September 30, 2008 from $2.2 million in the same period during theprior year. The change in total interest incurred is primarily due to anincrease in borrowing levels on our revolving line of credit and offset by thedecline in interest rates. The average balance of interest bearing debtoutstanding increased to $101.2 million during the quarter ended September 30,2008 compared to $48.7 million for the prior year.  The increases related to the increasedaverage borrowing base and were partially offset by the decrease in theweighted average annual interest rate on total borrowings to approximately5.12% for the quarter ended September 30, 2008 from 6.0% for the sameperiod in the prior year.

 

***Interest Income.***Interestincome remained comparable at $0.3 million for both quarters ended September 30,2008 and 2007.

 

**Provision for Income Taxes. **Our effective consolidated income tax rate on continuingoperations was a benefit of (35.0)% for the quarter ended September 30,2008 compared to an expense of 33.9% for 2007. The change is principally causedby the interaction between the newly enacted Texas franchise tax, which doesnot change proportionally with changes in pre-tax income or loss, and federaland state income taxes that do change proportionally with pre-tax income orlosses.

 

**Loss from Discontinued Operations.** Loss from discontinued operations, net of tax, which pertains to ourwholesale water and wastewater business we elected to sell, was $0.5 millionfor the quarter ended September 30, 2008 and $0.1 million for the sameperiod in 2007.

 

#### **Ninemonths ended September 30, 2008 Compared to 2007**

#### ** **

**Revenue.**Revenue increased $7.3 million, or 4.6%,to $166.9 million for the nine-month period ended September 30, 2008 from$159.6 million for the same period during the prior year. By segment, revenuechanged as follows:

 
| ** **                               | ** ** | **Nine  Months Ended** |       |                  |       | **Percent of Revenue**   |       |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|--------------------------|------------|
| ** **                               | ** ** | **September 30,** |       |                  |       |                     |       |   |   |
| ***(In thousands, except percentages)*** | ** ** | **2008**               | ** ** | **2007  As Restated** | ** ** | **Increase  (Decrease)** | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                     |       |                   |       |                  |       |                     |       |   |   |   |   |
| Utilities                                |       | $                      | 54,685     |                  | $          | 51,623                   |       | $ | 3,062 |   | 32.8% |   | 32.3% |   |
| Texas  Utilities                         |       | 26,456                 |       | $                     | 18,918     |                     | 7,538      |   | 15.9% |   | 11.9% |   |
| O&M  Services                        |       | 30,559                 |       | $                     | 29,949     |                     | 610        |   | 18.3% |   | 18.8% |   |
| Texas  MUD Services                      |       | 55,201                 |       | 59,118                |       | (3,917                   | )          | 33.1% |   | 37.0% |   |
| Total                                    |       | $                      | 166,901    |                  | $          | 159,608                  |       | $ | 7,293 |   | 100.0% |   | 100.0% |   |

 

***Utilities.***Revenueincreased $3.1 million, or 5.9%, to $54.7 million for the nine-month periodended September 30, 2008, from $51.6 million for the same period duringthe prior year. The increase was primarily due to the acquisition of theRiverview wastewater treatment plant in Alabama at the end of January 2008and rate increases in California and Alabama. These increases were partiallyoffset by reduced consumption at our California utility related to customers’conservation efforts as well as weather patterns that were cooler with moreprecipitation in spring of 2008 compared to spring of 2007.

 

***Texas Utilities.***Revenueincreased $7.5 million, or 39.8%, to $26.5 million for the nine-month periodended September 30, 2008, from $18.9 million for the same period duringthe prior year. The increase was primarily due to a full year of operationsfrom two San Antonio-based utilities acquired in May 2007 and rateincreases due to the implementation of our Monarch filed rates in October 2007and new rates at 3 smaller utilities with the remainder due to increasedconsumption as a result of weather patterns that were hot and dry compared to2007 weather.

 

***O&M Services.***Revenueincreased $0.6 million, or 2.0%, to $30.6 million for the nine-month periodended September 30, 2008, from $29.9 million for the same period duringthe prior year. The increase was primarily due to increased project work andprice increases in California and the southeast, partially offset by lostcontracts and the decision to stop pursuing at-risk electrical contractprojects in Colorado.

 

 

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***Texas MUD Services.***Revenuedecreased $3.9 million, or 6.6%, to $55.2 million for the nine-month periodended September 30, 2008, from $59.1 million for the same period duringthe prior year. The decrease was primarily due to lost contracts and from lesstaps and inspection fees for new housing starts as well as the elimination ofnon-core operations including specialty pipe rehabilitation work in the Houstonarea and bookkeeping services, partially offset by contract pricing increasesand increases in service order work.

 

**Total Operating Expenses.**Total operatingexpenses increased $14.8 million, or 10.1%, to $161.6 million for thenine-month period ended September 30, 2008 from $146.8 million for thesame period during the prior year as follows:

 
| ** **                               | ** ** | **Nine  Months Ended** |       |                  |       | **Percent of Revenue (1)** |       |
|------------------------------------------|------------|------------------------|------------|-----------------------|------------|----------------------------|------------|
| ** **                               | ** ** | **September 30,** |       |                  |       |                       |       |   |   |
| ***(In thousands, except percentages)*** | ** ** | **2008**               | ** ** | **2007  As Restated** | ** ** | **Increase  (Decrease)**   | ** ** | **2008** | ** ** | **2007** | ** ** |
|                                     |       |                   |       |                  |       |                       |       |   |   |   |   |
| Utilities                                |       | $                      | 37,827     |                  | $          | 31,239                     |       | $ | 6,588 |   | 69.2% |   | 60.5% |   |
| Texas  Utilities                         |       | 19,848                 |       | 17,413                |       | 2,435                      |       | 75.0% |   | 92.0% |   |
| O&M  Services                        |       | 31,698                 |       | 30,980                |       | 718                        |       | 103.7% |   | 103.4% |   |
| Texas  MUD Services                      |       | 57,708                 |       | 56,852                |       | 856                        |       | 104.5% |   | 96.2% |   |
| Corporate                                |       | 14,548                 |       | 10,344                |       | 4,204                      |       | — |   | — |   |
| Total                                    |       | $                      | 161,629    |                  | $          | 146,828                    |       | $ | 14,801 |   | 96.8% |   | 92.0% |   |

 

----

(1)             Segment total operating expenses arecomputed as a percent of their respective revenue. Total direct operatingexpenses are computed as a percentage of total Revenue.

 

***Utilities.***Totaloperating expenses increased $6.6 million, or 21.1%, to $37.8 million for thenine-month period ended September 30, 2008, from $31.2 million for thesame period during the prior year. The increase was primarily due to theacquisition of the Riverview wastewater treatment plant in Alabama at the endof January 2008; staffing additions, salary increases, higher average unitcosts of delivered water and depreciation expenses at our California utility;increased wastewater treatment costs due to higher fees charged by ourprovider, higher water production costs and higher legal costs at our NewMexico utility; and increases due to general and administrative costs,primarily due to increased costs associated with the implementation of ourstrategy to consolidate support functions. These increases were partially offset by lower costs of production as aresult of reduced consumption in California.

 

***Texas Utilities.***Totaloperating expenses increased $2.4 million, or 14.0%, to $19.8 million for thenine-month period ended September 30, 2008, from $17.4 million for thesame period during the prior year. The increase was primarily due to a fullyear of operations from two San Antonio-based utilities acquired in May 2007,as well as, increased costs associated with increased consumption as a resultof weather patterns that were hot and dry compared to 2007 weather, increasedpurchased water as a result of the inability of our owned sources of groundwater to produce enough water to meet the heightened demand due to droughtconditions, increases due to general and administrative costs, primarily due toincreased costs associated with our strategy to consolidate support functions,bad debt and higher depreciation costs.

 

***O&M Services.***Totaloperating expenses increased $0.7 million, or 2.3%, to $31.7 million for thenine-month period ended September 30, 2008, from $31.0 million for thesame period during the prior year. The increase was primarily due to new andexpanded scope on revenue contracts and increases due to general andadministrative costs related to our strategy to consolidate supportfunctions.  These increases werepartially offset by the lower costs associated with lost contracts, reducedproject work and the decision to stop pursuing at-risk electrical contracts.

 

***Texas MUD Services.***Totaloperating expenses increased $0.9 million, or 1.5%, to $57.7 million for thenine-month period ended September 30, 2008, from $56.9 million for thesame period during the prior year. The increase was primarily due to change inmix of work performed from new housing starts to service and maintenance workorders, as well as an increase in general and administrative costs, primarilydue to increased costs associated with the implementation of our strategy toconsolidate support functions, partially offset by savings from the eliminationof specialty pipe rehabilitation work.

 

***Corporate.***Totaloperating expenses increased $4.2 million, or 40.6%,  to $14.5 million for the nine-month periodended September 30, 2008 compared to $10.3 million for the same periodduring the prior year primarily related to a 

 

 

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$2.5million increase related to our Cornerstone internal-use software developmentproject which commenced during the second quarter of 2007, a $0.7 millionincrease related the evaluation of a strategic opportunity in the first quarterof 2008, and a $0.4 million write-down of assets, partially offset by a $0.3million collection of a receivable that was fully-reserved in 2007.

 

**Other Income (Expense).**Other expenses, netincreased $0.6 million, or 10.8%, to $6.5 million for the nine-month periodended September 30, 2008, compared to $5.9 million for the same periodduring the prior year as follows:

 
| ** **           | ** ** |     |       | **2007**        |       | **(Increase)** |       |
|----------------------|------------|----------|------------|-----------------|------------|----------------|------------|
| ***(In thousands)*** | ** ** | **2008** | ** ** | **As Restated** | ** ** | **Decrease**   | ** ** |
|                 |       |     |       |            |       |           |       |   |   |   |
| Interest  expense    |       | $        | (6,932     | )               | $          | (6,247         | )          | $ | (685 | ) |
| Interest  income     |       | 436      |       | 490             |       | (54            | )          |
| Other,  net          |       | 4        |       | (102            | )          | 106            |       |
| Total                |       | $        | (6,492     | )               | $          | (5,859         | )          | $ | (633 | ) |

 

***Interest Expense.***Interestexpense increased by $0.7 million, or 11.0%, to $6.9 million for the nine-monthperiod ended September 30, 2008 from $6.2 million compared to the sameperiod during the prior year. The change in total interest incurred isprimarily due to an increase in borrowing levels on our revolving line ofcredit and the decline in interest rates. The average balance of interestbearing debt outstanding increased to $77.7 million during the nine-monthperiod ended September 30, 2008 compared to $48.7 million for the sameperiod in the prior year.  The increasesrelated to the increased average borrowing base were offset by the decrease inthe weighted average annual interest rate on total borrowings to approximately5.12% for the nine-month period ended September 30, 2008 from 5.74% forthe same period in the prior year.

 

***Interest Income.***Interestincome decreased by 11.0 % to $0.4 million for the nine-month period ended September 30,2008, related to decreased interest rates.

 

**Provision for Income Taxes. **Our effective consolidated income tax rate on continuingoperations was a benefit of (35.1)% for the nine-month period ended September 30,2008 compared to an expense of 33.9% for 2007. The change is principally causedby the interaction between the newly enacted Texas franchise tax, which doesnot change proportionally with changes in pre-tax income or loss, and federaland state income taxes that do change proportionally with pre-tax income orlosses.

 

**Loss from Discontinued Operations.** Loss from discontinued operations, net of tax, which pertains to ourwholesale water and wastewater business we elected to sell, was $1.2 millionfor the nine-month period ended September 30, 2008 and $0.4 million for thesame period in 2007.

 

### **RECENTACCOUNTING PRONOUNCEMENTS**

### ** **

Seethe discussions under the caption “Recent Accounting Pronouncements” containedin Note 1 to the condensed consolidated financial statements included in Part I,Item 1 of this report.

 

### **LIQUIDITYAND CAPITAL RESOURCES**

### ** **

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

 

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

 

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

 

·                  obtainexternal financing for major acquisitions; and

 

·                  maintainapproximately equal levels of debt and equity consistent with the investor-ownedwater utility industry.

 

Ourstatements of cash flows are summarized as follows:

 

 

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**Tableof Contents**

** **
|                                              |       | **Nine Months Ended**  |       |                  |       |
|---------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
|                                              |       | **September 30,** |       |                  |       |
| ***(In thousands)***                              | ** ** | **2008**               | ** ** | **2007  As Restated** | ** ** | **Change** | ** ** |
|                                              |       |                   |       |                  |       |   |   |
| Net  cash provided by (used in):                  |       |                   |       |                  |       |   |   |
| Continuing  operations:                           |       |                   |       |                  |       |   |   |
| Operating  activities                             |       | $                      | 778        |                  | $          | 13,838 |   | $ | (13,060 | ) |
| Investing  activities                             |       | (49,034                | )          | (31,924               | )          | (17,110 | ) |
| Financing  activities                             |       | 46,824                 |       | 16,351                |       | 30,473 |   |
| Total  continuing operations                      |       | (1,432                 | )          | (1,735                | )          | 302 |   |
| Discontinued  operations:                         |       |                   |       |                  |       |   |   |
| Operating  activities                             |       | 1,738                  |       | 326                   |       | 1,412 |   |
| Investing  activities                             |       | (3                     | )          | (466                  | )          | 464 |   |
| Total  discontinued operations                    |       | 1,735                  |       | (140                  | )          | 1,876 |   |
| Increase  (decrease) in cash and cash equivalents |       | $                      | 303        |                  | $          | (1,875 | ) | $ | 2,178 |   |

 

**Cash Flows from Operating Activities of Continuing Operations.**Net cashprovided by operating activities was $0.8 million for the nine months endedSeptember, 2008 versus $13.8 million for the same period last year. Operationalaspects of our businesses that affected working capital in 2008 versus 2007 arehighlighted below:

 

·                  a $6.3million increase in receivables primarily resulting from our January 2008acquisition of a wastewater collection system and treatment plant in theBirmingham, Alabama area; the seller retained all receivables as of theacquisition date so the increase relates to the initial, one-time buildup ofreceivables as customers pay the seller for the services rendered prior to theacquisition date and the slower payments by some customers which we believe maybe attributable, in part, to the overall economic downturn;

 

·                  a $3.6million increase in other assets, primarily in our Utilities segment, in 2008;and,

 

·                  a $4.3million increase in other liabilities primarily related to the timing ofpayments on accruals at the Corporate segment in 2007.

 

**Cash Flows from Investing Activities of Continuing Operations.**Cash used ininvesting activities totaled $49.0 million for the nine months ended September 30,2008 compared to $31.9 million for the same period during the prior year asfollows:

 
|                                                    |       | **Nine Months Ended**  |       |                  |       |
|---------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
|                                                    |       | **September 30,** |       |                  |       |
| ***(In thousands)***                                    | ** ** | **2008**               | ** ** | **2007  As Restated** | ** ** | **Change** | ** ** |
|                                                    |       |                   |       |                  |       |   |   |
| Cash  flows (used in) provided by investing activities: |       |                   |       |                  |       |   |   |
| Acquisition  of businesses, net of cash acquired        |       | $                      | (23,330    | )                     | $          | (6,547 | ) | $ | (16,783 | ) |
| Additions  to property, plant and equipment             |       | (25,883                | )          | (25,419               | )          | (464 | ) |
| Proceeds  from sale of a business                       |       | 170                    |       | —                |       | 170 |   |
| Proceeds  from sales of equipment                       |       | 9                      |       | 42                    |       | (33 | ) |
| Net cash used in  investing activities                  |       | $                      | (49,034    | )                     | $          | (31,924 | ) | $ | (17,110 | ) |

 

Theprincipal reason for the increase was the January 2008 acquisition of aBirmingham, Alabama wastewater collection system and treatment plant for $23.3million in cash.

 

Additionsto property, plant and equipment include capital projects relating to theexpansion, replacement and renovation of our water and wastewater systems,particularly at our California, Texas and New Mexico utilities and includeexpenditures related to our Cornerstone internal-use software developmentproject.

 

Forthe entire 2008 year, we spent approximately $33.7 million on cash additions,principally within our utilities segments.

 

**Cash Flows from Financing Activities of Continuing Operations.**During thenine months ended September 30, 2008, we financed our growth through abroad range of capital initiatives:

 

·                  borrowed anet amount of $49.0 million under our revolving line of credit;

 

 

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·                  received $2.6million of capital improvement reimbursements and contributions in aid ofconstruction; and

 

·                  received $2.8million of proceeds from our share-based equity incentive plans and stockpurchase plans.

 

Revolvinglines of credit were primarily used to fund our investing activities and, to alesser extent, to fund operations. Additional borrowing availability under ourrevolving credit facility was $48.0 million as of September 30, 2008.

 

Duringthe nine months ended September 30, 2008, we paid dividends totaling $4.4million and our quarterly dividend rate was $0.06 per common share.  In the fourth quarter of 2008, we decreasedour quarterly common stock dividend rate by 58% to $0.025 per share.

 

### **CONTRACTUALOBLIGATIONS**

### ** **

Thefollowing table summarizes our known contractual obligations to make futurecash payments as of September 30, 2008, as well as an estimate of theperiods during which these payments are expected to be made.

 
|                                                  |       | **Years Ending December 31,** |       |
|-------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                            | ** ** | ** **                         | ** ** | **Remainder** | ** ** | **2009** | ** ** | **2011** | ** ** | **2013** |   |
| ** **                                            | ** ** | ** **                         | ** ** | **of** | ** ** | **and** | ** ** | **and** | ** ** | **and** |   |
| ***(In thousands)***                                  | ** ** | **Total**                          | ** ** | **2008** | ** ** | **2010** | ** ** | **2012** | ** ** | **Beyond** | ** ** |
|                                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Long-term debt (1):                                   |       |                               |       |   |   |   |   |   |   |   |   |
| Bank  line of credit (2)                              |       | $                                  | 100,000    |   | $ | — |   | $ | — |   | $ | — |   | $ | 100,000 |   |
| Mortgage  bonds (3)                                   |       | 45,000                             |       | — |   | 12,000 |   | — |   | 33,000 |   |
| Bank  term loans (4)                                  |       | 31,178                             |       | 204 |   | 1,646 |   | 1,646 |   | 27,682 |   |
| Convertible  subordinated debentures (5)              |       | 12,002                             |       | — |   | — |   | — |   | 12,002 |   |
| Capital  lease obligations (6)                        |       | 4,599                              |       | 268 |   | 2,313 |   | 2,018 |   | — |   |
| Economic  development revenue bonds (7)               |       | 1,925                              |       | 115 |   | 245 |   | 280 |   | 1,285 |   |
| Notes  payable and other (8)                          |       | 78                                 |       | — |   | 78 |   | — |   | — |   |
| Total  long-term debt                                 |       | 194,782                            |       | 587 |   | 16,282 |   | 3,944 |   | 173,969 |   |
|                                                  |       |                               |       |   |   |   |   |   |   |   |   |
| Repayment of advances for  construction (9)           |       | 14,004                             |       | 319 |   | 1,366 |   | 864 |   | 11,455 |   |
| Water purchase commitment (10)                        |       | 7,282                              |       | 115 |   | 920 |   | 920 |   | 5,327 |   |
| Operating lease obligations                           |       | 22,863                             |       | 1,692 |   | 6,503 |   | 5,207 |   | 9,461 |   |
| Total obligations as of  September 30, 2008 (11) |       | $                                  | 238,931    |   | $ | 2,713 |   | $ | 25,071 |   | $ | 10,935 |   | $ | 200,212 |   |

----

(1)    Excludes interest payments, whichare described in the following notes. The terms of the long-term debt are morefully described in the notes to the condensed consolidated financial statementsincluded in this report and in our 2008 Annual Report on Form 10-K.

 

(2)    The bank lines of credit bearinterest at variable rates and therefore the amount of future interest paymentsare uncertain. Borrowings bear interest, at our option, based on a margineither: a) over the LIBOR rate; or b) under the prime rate. The margins varybased on our consolidated debt to equity ratio. The weighted-average annualinterest rate on our bank line of credit borrowings was 3.86% as of September 30,2008.

 

(3)    $12.0 million has been included as apayment in 2009 related to the 2009 NMUI settlement and the resulting repaymentof the NMUI mortgage bonds.  Interest onthe mortgage bonds is fixed at a weighted-average annual interest rate of 6.52%and is payable semiannually.

 

(4)    Interest on the bank term loans isfixed at a weighted-average annual interest rate of 6.52% and is payablesemiannually.

 

(5)    Interest on the convertibledebentures is fixed at a 6.85% annual rate and is payable quarterly. Thedebentures are convertible, at the option of the holder, into shares of ourcommon stock at any time prior to their maturity.

 

(6)    Interest on the capital leaseobligations is imputed at a weighted-average annual interest rate of 4.59% andis payable monthly.

 

(7)    Interest on the economic developmentbonds is fixed at a weighted-average annual interest rate of 6.00% and ispayable semiannually.

 

(8)    Interest is payable either monthlyor quarterly at rates ranging from 5.0% to 8.0% per year.

 

(9)    Advances for construction arenon-interest bearing.

 

(10)   Reflects the minimum annualcontractual commitment to purchase water through 2024. The amount is subject toincreases in future periods for production costs increases and may alsoincrease, but not decrease, if average actual usage exceeds a specified amount.

 

(11)   Excludes preferred stock dividendobligations. Preferred stockholders are entitled to receive annual dividends of$2.625 per share and there are 9,156 shares of preferred stock currentlyoutstanding. The preferred stock is redeemable by the Company at any time for $52.00per share and, from time to time, we have elected to repurchase shares offeredto us by preferred stockholders at prices less than $52.00 per share.

 

 

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### **FINANCIALCONDITION**

### ** **

Weexpect our existing sources of liquidity to remain sufficient to meet ouranticipated obligations. Our business is capital intensive, requiringsignificant resources to fund operating expenses, construction expenditures,and interest and dividend payments. During 2009 and in subsequent years, we mayfrom time to time satisfy these requirements with a combination of cash fromoperations and funds from the capital markets as conditions warrant. We expectthat borrowing capacity under our revolving credit facility will continue to beavailable to manage working capital during those periods.

 

AtSeptember 30, 2008, we had working capital of $14.6 million compared toworking capital of $4.5 million at December 31, 2007.

 

AtSeptember 30, 2008 we had access to $150 million in financing under arevolving credit facility that expires February 15, 2013. A total of eightbanks participate in the facility. At September 30, 2008, we had $48million of additional borrowings available under our revolving credit facility.Subsequent to the end of the quarter, we entered into amendments to our Creditagreement which waived existing and anticipated defaults, specifically relatedto additional time with regards to financial filings and with regards to thedebt to capitalization ratio. The agreement requires we maintain a ratio below60%. We anticipated the impact of the restatement on our retained earnings,combined with the additional borrowings on the facility during 2008, wouldcreate a default under the debt to capitalization covenant. The default wascured due to the second amendment to the credit agreement dated May 28,2009.  Our credit facility was reducedfrom $150 million to $110 million as part of the second amendment, leaving $38million of available liquidity on the facility under the new amendment as of May 28,2009.  Our ability to comply withfinancial covenants, pay principal or interest and refinance our debtobligations will depend on our future operating performance as well as otherfactors beyond our control. Continued opportunity for operating improvements,cash management and suspension of elective capital expenditures should improveour ability to comply with the covenants in the revolving credit facility. Asof June 30, 2009, our debt to capitalization ratio was estimated at 56%.Under the amendments discussed above, we also were provided additional time tofile our March 31, 2009 Quarterly Report on Form 10-Q and June 30,2009 Quarterly Report on Form 10-Q. It is our intention to meet the extended filing deadlines provided inthe amendment, and to remain current on our filings thereafter.

 

Aspart of the Amended Credit Agreement with our primary working capital line, wehave agreed to only utilize up to an additional $12.5 million under our capitallease facility.  Our California and NewMexico mortgage bond indentures permit the issuance of an additional $91.2million of first mortgage bonds at September 30, 2008. However, the termsof our revolving credit facility do not permit additional first mortgage bondindebtedness without prior consent from the credit facility lenders. Themortgage bond indentures also limit the amount of cash and property dividendsour California and New Mexico utilities paid to the parent company. Dividendshave averaged $5.0 million to $5.6 million per year and are less than theaggregate cumulative dividend restriction threshold by $50.4 million at September 30,2008. We were in compliance with all loan agreement covenants during thenine-month period ended September 30, 2008.

 

Wehave on file a registration statement with the Securities and ExchangeCommission, which is effective for the issuance of up to $50.0 millionaggregate principal amount of common stock, debt securities and warrants. Todate we have issued approximately $43.6 million of common stock under the shelfregistration, and about $6.4 million remains available for issuance at September 30,2008. As we were unable to timely file our required SEC filings for the September 30,2008 and the March 31, 2009 Quarterly Reports on Form 10-Q and our2008 Annual Report on this Form 10-K, we can not use RegistrationStatements on Form S-3 for registration of our securities with the SEC atthis time. Use of Form S-3 requires, among other things, that the issuerbe current and timely in its reports under the Exchange Act for at least twelvemonths. Accordingly, we will have to meet more demanding requirements toregister additional securities, which may make it more difficult for us toeffect public offering transactions, and our range of available financingalternatives could be limited.

 

InJanuary 2009 we reached a settlement of eminent domain proceedings againstour New Mexico utility. On May 8, 2009 we received $54.3 million in cashat closing ($60 million settlement and $1.3 million escrow release, less $7.0million retained by ABCWA in settlement of sewer treatment fees).  We used $12.0 million of the net proceeds to pay

 

 

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downNMUI bonds and we used the remaining cash proceeds of $42.3 million to pay anyunassumed liabilities of NMUI and to pay down our revolving credit facility.

 

### **CERTAINCONTRACTUAL COMMITMENTS AND INDEMNITIES**

### ** **

AtSeptember 30, 2008, we had irrevocable standby letters of credit in theamount of $2.0 million issued and outstanding under our credit facility.

 

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

 

### **OFF-BALANCESHEET ARRANGEMENTS**

### ** **

Throughthe date of this report, we did not have any relationships with unconsolidatedentities or financial partnerships, such as entities often referred to asstructured finance or special purpose entities, which would have beenestablished for the purpose of facilitating off-balance sheet arrangements orother contractually narrow or limited purposes. In addition, we do not engagein trading activities involving non-exchange traded contracts. We are notmaterially exposed to any financing, liquidity, market or credit risk thatcould arise if we had engaged in these relationships. We do not haverelationships or transactions with persons or entities that derive benefitsfrom their non-independent relationship with our subsidiaries or us.

 

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

 

 

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

## ** **

Asof September 30, 2008, we had $194.8 million of long-term variable andfixed-rate debt. We are exposed to market risk based on changes in prevailinginterest rates.

 

Marketrisk related to our variable-rate debt is estimated as the potential decreasein pre-tax earnings resulting from an increase in interest rates. We have$100.0 million of long-term debt that bears interest at variable rates based oneither the prime rate or LIBOR rate. Our variable-rate debt had a weightedaverage annual interest rate of 3.86% as of September 30, 2008. Ahypothetical one percent (100 basis points) increase in the average annualinterest rates charged on our variable-rate debt would reduce our pre-taxearnings by approximately $1.0 million per year.

 

Ourfixed-rate debt, which has a carrying value of $94.8 million, has a fair valueof $88.9 million as of September 30, 2008. Market risk related to ourfixed-rate debt is deemed to be the potential increase in fair value resultingfrom a decrease in prevailing interest rates. Our fixed-rate debt had aweighted average annual interest rate of 6.5% as of September 30, 2008. Ahypothetical ten percent decrease in annual interest rates, from 6.5% to 5.9%,would increase the fair value of our fixed-rate debt by approximately $5.9million.

 

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

 

 

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## **ITEM4.    CONTROLS AND PROCEDURES**

## ** **

ThisReport includes the certifications attached as Exhibits 31.1 and 31.2 ofour Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”)required by Rule 13a-14 of the Exchange Act. This Item 4 includesinformation concerning the controls and control evaluations referred to inthose certifications.

 

Asdiscussed in the Explanatory Note at the beginning of this report, we haverestated our previously filed financial statements. As a result of the errorsdiscovered, certain accounts had to be restated. In this Form 10-Q, we arerestating our condensed consolidated balance sheet as of December 31,2007, and the related condensed consolidated statements of operations for the threeand nine months ended September 30, 2007, and cash flows for the ninemonths ended September 30, 2007.

 

Detailsof the restatement and its underlying circumstances are discussed in theExplanatory Note at the beginning of this report and in Note 2 of Notes toCondensed Consolidated Financial Statements in Part I, Item 1 of thisreport.

 

### **DISCLOSURECONTROLS AND PROCEDURES**

### ** **

Disclosurecontrols and procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act) are designed to provide reasonable assurance that informationrequired to be disclosed in reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported within the time periods specifiedin the rules and forms of the SEC and that such information is accumulatedand communicated to our management, including the CEO and CFO, as appropriateto allow timely decisions regarding required disclosures.

 

Ourmanagement, under the supervision and with the participation of our CEO andCFO, evaluated the effectiveness of the design and operation of our disclosurecontrols and procedures as of September 30, 2008. Based on our evaluationand the identification of the material weaknesses in internal control overfinancial reporting described below, our CEO and CFO concluded that, as of September 30,2008, our disclosure controls and procedures were not effective.

 

Inconnection with our assessment of our disclosure controls and procedures, wehave identified the following deficiencies that constituted individually, or inthe aggregate, material weaknesses in our internal control over financialreporting as of September 30, 2008:

 

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

 

·                  We did notmaintain an environment that consistently emphasized strict adherence togenerally accepted accounting principles. This control deficiency, in certaininstances, led to inappropriate accounting decisions and entries. This controldeficiency was magnified by the decentralized nature of the accounting functionthat existed at our various operating locations.

 

·                  We did notmaintain in certain areas of our internal audit, finance and accountingdepartments, a sufficient complement of resources with an appropriate level ofaccounting knowledge, experience and training commensurate with our financialreporting requirements.  These areasinclude period-end financial reporting process, acquisition accounting,goodwill, regulatory accounting, stock-based compensation, property, plant andequipment, estimates and accruals.

 

·                  We did notmaintain complete and accurate business documentation to support certaintransactions and accounting records. The controls in these areas with respectto the creation, maintenance and retention of complete and accurate businessrecords were not effective.  This controldeficiency was magnified by the number of legacy financial systems and thedecentralized nature of the accounting function that existed at our various operatinglocations.

 

2.   We did notmaintain effective monitoring of controls over areas including period endfinancial reporting process, acquisition accounting, goodwill, regulatoryaccounting, stock-based compensation, property, plant and 

 

 

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equipment,estimates and accruals.  This deficiencyresulted in either not having adequate controls designed and in place or notachieving the intended operating effectiveness of controls.

 

3.   We did notmaintain effective controls over risk assessments.  Specifically, we did not maintain processesto perform and evaluate the annual business and fraud risks affecting financialreporting processes.  This deficiency resultedin either not having adequate controls designed and in place or not achievingthe intended operating effectiveness of controls.

 

Thematerial weaknesses in control environment, monitoring of controls and riskassessment described above contributed to the material weaknesses set forthbelow.

 

4.   We did notmaintain and communicate sufficient and consistent accounting policies withrespect to generally accepted accounting principles. This control deficiency,among other things, limited our ability to detect and correct accounting errorsin previously issued financial statements.

 

5.   We did not maintain effective controls overthe recording of journal entries, both recurring and non-recurring.  Specifically, effective controls were notdesigned and in place to ensure that journal entries were properly preparedwith sufficient supporting documentation or were reviewed and approved toensure the accuracy and completeness of the journal entries.

 

6.    We did notmaintain effective controls over the completeness and accuracy of keyspreadsheets and system-generated reports. Specifically, effective controls were not designed and in place toensure that key spreadsheets and system-generated reports were properly reviewedfor accuracy and completeness.

 

7.    We did notmaintain effective controls over the application of generally acceptedaccounting principles commensurate with financial reporting requirements.  This deficiency led to, in certain instances,inappropriate accounting decisions and entries related to the income taxprovision, termination benefits, recognition of revenue, bonus accrual, assetretirement obligations, and various cost and expense accounts.

 

8.   We did notmaintain effective controls over the completeness and accuracy of our accountingfor acquisitions.  Specifically, we didnot design and maintain effective controls with respect to the application ofrelevant GAAP and the deficiency resulted in errors in the allocation of thepurchase price to the underlying assets acquired, including goodwill and theliabilities assumed.  This deficiencyaffected property, plant and equipment, deferred income tax and liabilities,goodwill and long-term liability accounts.

 

9.  We did notmaintain effective controls over the completeness, accuracy and valuation ofour accounting estimates related to our claims process associated with medical,automobile and workers’ compensation self-insurance.  Specifically, we did not design and maintaineffective controls with respect to the maintenance and reconciliation of claimsand the review of actuarial valuations. This deficiency affected accrued liabilities and expense accounts.

 

10.  We did notmaintain effective controls over the completeness and accuracy of ouraccounting for the impairment of goodwill.  Specifically, we did not design and maintain effective controls toensure proper identification of reporting units, triggering events and propercash flow projections to determine fair value. This deficiency affected goodwill related accounts.

 

11.  We did notmaintain effective controls over the completeness and accuracy of ouraccounting for regulated entities. Specifically, we did not design and maintain effective controls withrespect to the application of relevant GAAP and the deficiency resulted inerrors in the accounting for intercompany profit, regulatory assets andliabilities.  This deficiency affectedrevenue, property, plant and equipment, and regulatory asset and regulatoryliability accounts.

 

12.  We did notmaintain effective controls over the accuracy and valuation of stock-basedcompensation.  Specifically, we did notmaintain effective controls over the assumptions used in the calculation ofstock-based compensation.  Thisdeficiency affected stock-based compensation related accounts.

 

 

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13.       We did notmaintain effective controls over the completeness and accuracy of property,plant and equipment and related depreciation expense.  Specifically, we did not design and maintaineffective controls to ensure that there was timely transfer of property, plantand equipment additions from construction work in progress; that retirementswere properly recorded; that depreciation expense was accurately recorded basedon appropriate useful lives assigned to the related property, plant andequipment; that assets are capitalized properly; and that impairment losseswere timely identified and determined. This deficiency affected property, plant and equipment, deprecationexpense and operating expense accounts.

 

14.       We did notmaintain effective controls over the completeness and accuracy of unbilledutilities revenue.  Specifically, we didnot maintain effective controls to standardize a process and methodology ofcalculating and recording unbilled revenue in the proper period.  This deficiency affected utility revenue andunbilled receivable accounts.

 

15.       We did notmaintain effective controls to ensure the completeness of the recording ofaccounts payable and accrued liabilities, operating expenses and property,plant and equipment additions on a timely basis.  Specifically, we did not review and approveinvoices and their supporting documentation on a timely basis.  Material outstanding liabilities were notrecorded for which goods were received or services were rendered by vendorsprior to the balance sheet date. Consequently, our accounts payable and accrued liability balances wereunderstated at the period end by the aggregate value of these unpaid invoices whichrelate to construction work in progress and other selling and administrativeexpenses.

 

Webelieve that because of the substantial work performed restating our historicalaccounting records, the performance of additional procedures by managementdesigned to ensure the reliability of our financial reporting and the ongoingefforts to remediate the material weaknesses in internal control over financialreporting described below, the condensed consolidated financial statements forthe periods covered by and included in this report are fairly stated in allmaterial respects.

 

### **CHANGES ININTERNAL CONTROL OVER FINANCIAL REPORTING**

### ** **

Therewas no change in our controls during the three months ended September 30,2008 that has materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting.

 

### **PLANS FORREMEDIATION OF MATERIAL WEAKNESSES**

### ** **

Wehave engaged in and are continuing to engage in substantial efforts to improveour internal control over financial reporting and disclosure controls andprocedures related to the preparation of our financial statements anddisclosures. We have begun the implementation of some of the measures describedbelow and concentrated our efforts on (i) communicating, both internallyand externally, our commitment to a strong effective control environment, highethical standards and financial reporting integrity, (ii) certainpersonnel actions, (iii) comprehensive training for Finance and AccountingDepartment personnel, (iv) the implementation of policies and proceduresto ensure that we retain important business and accounting records and (v) morerigorous period end reporting policies and processes involving journal entryapproval, account reconciliations and supporting documentation includingmanually prepared spreadsheets.

 

Subsequentto September 30, 2008, we have implemented a formal remediation plan (“thePlan”) to address the material weaknesses for each of the affected areaspresented above. The Plan builds upon many of the initiatives we started overthe past two years, such as development of a centralized financial servicesplatform and consolidation of financial accounts onto a common system.  The Plan will ensure that each area affectedby a material control weakness is put through a comprehensive remediationprocess.  The remediation process entailsa thorough analysis which includes the following phases:

 

a)             Define and assess the deficiency:ensure a thorough understanding of the “as is” state, process owners, and gapsin the deficiency. This work is underway for all identified areas.

 

 

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b)             Design and evaluate a remediationaction for each weakness for each affected area: validate or improve therelated policy and procedures, evaluate skills of the process owners withregards to the policy and adjust as required. The Plan will require anassessment of all failures; we expect that many of the recent improvements willprovide an excellent starting point for the specific action plans.

 

c)              Implement specific remediationactions: train process owners, allow time for process adoption and adequatetransaction volume for next steps.

 

d)             Test and measure the design andeffectiveness of the remediation plan: internal audit to test and providefeedback on the design and operating effectiveness of the control.

 

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

 

ThePlan will be administered by a Controls Committee comprised of key leaders fromcross functional portions of the organization, including the CFO. The Directorof Internal Control will chair the Committee. Each specific area of actionwithin the Plan will be assigned a project leader to coordinate the resourcesrequired for timely completion of the remediation process. The Committee willreport quarterly and as needed to the Audit Committee of our Board of Directorson progress made.

 

Webelieve the steps taken to date have improved the effectiveness of our internalcontrol over financial reporting, however, we have not completed the correctiveprocesses and procedures identified herein, that we believe necessary.Accordingly, as we continue to monitor the effectiveness of our internalcontrol over financial reporting in the areas affected by the materialweaknesses described above, we will perform additional procedures prescribed bymanagement, including the use of manual mitigating control procedures and theutilization of external technical advisors to ensure that our financialstatements continue to be fairly stated in all material respects.

 

Subsequentto September 30, 2008, we have engaged in and are continuing to engage insubstantial efforts to improve our internal control over financial reportingand disclosure controls and procedures related to the preparation of ourfinancial statements and disclosures. We have begun the implementation of someof the measures described above including the establishment of the ControlsCommittee. The Controls Committee has concentrated their efforts on (i) communicating,both internally and externally, our commitment to a strong effective controlenvironment, emphasizing accountability and a strict adherence to generallyaccepted accounting principles and financial reporting integrity, (ii) takingcertain personnel actions, (iii) clarification and documentation of keyaccounting policies and processes, (iv) comprehensive training for Financeand Accounting Department personnel, (v) the implementation of policiesand procedures to ensure that we retain important business and accountingrecords, and (vi) more rigorous period end reporting policies andprocesses involving journal entry approval, account reconciliations andsupporting documentation including manually prepared spreadsheets.

 

### **INHERENTLIMITATIONS OF DISCLOSURE CONTROLS AND PROCEDURES**

### ** **

Wedo not expect that our disclosure controls and procedures will prevent ordetect all errors. A control system, no matter how well designed and operated,can provide only reasonable, not absolute, assurance that the control system’sobjectives will be met. Further, the design of a control system mustacknowledge the fact that there are resource constraints and the benefits ofcontrols must be considered relative to their costs. These inherent limitationsinclude the realities that judgments in decision making can be faulty and thatbreakdowns can occur because of simple error or mistake. Controls can also becircumvented by the deliberate acts of one or more persons. The design of anysystem of controls is based, in part, upon certain assumptions about thelikelihood of future events and there can be no assurance that any design willsucceed in achieving its stated goals under all potential future conditions.Over time, controls may become inadequate because of changes in conditions ordeterioration in the degree of compliance with associated policies orprocedures. Because of the inherent limitations in a cost-effective controlsystem, misstatements due to error may occur and not be detected.

 

# ** **

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# **PART II – OTHER INFORMATION**

 

## **ITEM 1.          LEGALPROCEEDINGS**

## ** **

Informationrequired by this Item 1 is contained in Note 6 to the condensed consolidatedfinancial statements, Part I, Item 1 of this report, under the caption “LegalProceedings.”  The text under suchcaption is incorporated by reference into this Item 1.

 

## **ITEM 1A.        RISKFACTORS**

## ** **

Therisk factors noted below represent material changes in our Annual Report on Form 10-Kfor the year ended December 31, 2007. These risk factors are included in our Annual Report on Form 10-Kfor the year ended December 31, 2008.

 

#### **InternalControl Weaknesses**

#### ** **

We have identified material weaknesses in our internalcontrol over financial reporting, which could continue to impact our ability toreport our results of operations and financial condition accurately and in atimely manner.

 

·                  As requiredby Section 404 of the Sarbanes-Oxley Act of 2002, we have conducted anassessment of our internal control over financial reporting, identifiedmaterial weaknesses and concluded that our internal control over financialreporting was not effective at September 30, 2008. For a detaileddescription of these material weaknesses, see Part I, Item 4, “Controlsand Procedures” included in this Quarterly Report.  Each of our material weaknesses result in thelikelihood that a material misstatement in our financial statements will not beprevented or detected. As a result, we must perform additional work atadditional expense to obtain reasonable assurance regarding the reliability ofour financial statements. Even with this additional work, given the materialweaknesses identified, we can not assure that additional financial statementerrors will be prevented or detected or that in the future other materialweaknesses may not be identified.

 

Wehave work remaining to remedy the material weaknesses in our internal controlover financial reporting.

 

·                  We are in theprocess of developing and implementing remediation efforts for the identifiedmaterial weaknesses, and this work will continue during fiscal year 2009 andthereafter. There can be no assurance as to when the remediation plan will befully developed, when it will be implemented and the aggregate cost ofimplementation. Until our remedial efforts are completed, we will continue todevote significant time and attention to these efforts. If we do not completeour remediation in a timely fashion, or at all, there will also continue to bean increased risk that we will be unable to timely file future periodic reportswith the SEC and that our future financial statements could contain errors thatwill be undetected. We will rely upon additional interim control proceduresprescribed by management, including the use of manual mitigating controlprocedures and the utilization of external technical advisors, to fairly stateour financial statements in all material respects. However, we can not assurethat these interim controls will be sufficient to assure that all errors willbe detected.

 

#### **CapitalResources**

#### ** **

Ourcapital resources may restrict our ability to operate and expand our business.

 

·                   We may beunable to renew our credit facilities when they expire. We may be unable toexecute additional financing alternatives at terms that we find acceptable. Ifwe are unable to renew our existing lines of credit, or if we are unable toexecute additional financing alternatives, our capital spending could bereduced, delayed or eliminated and any future acquisitions could also bedelayed or eliminated, which could negatively impact our revenue, revenuegrowth and profitability.

 

 

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·                   We have acapital planning process that evaluates our capital needs. We believe the planis adequate at this time to fund our capital spending. However, we can notassure that conditions will not change that will make this plan insufficientwhich could result in the need for our capital spending to be reduced whichcould negatively impact our revenue, revenue growth and profitability.

 

·                   See “Item 7. Management’sDiscussion and Analysis of Financial Condition and Results ofOperations—Certain Contractual Commitments and Indemnities” for additionalinformation with respect to our credit facilities.

 

**Capital Market Transactions**

Wewere unable to timely file our required SEC filings for the September 30,2008 and March 31, 2009 Quarterly Reports on Form 10-Q and our 2008Annual Report on Form 10-K.  As a result, this has adversely affectedour eligibility to use Registration Statements on Form S-3 for registrationof our securities with the SEC. Use of Form S-3 requires, among otherthings, that the issuer be current and timely in its reports under the ExchangeAct for at least twelve months. Because of our inability to use Form S-3,we will have to meet more demanding requirements to register securities, whichmay make it more difficult for us to effect public offering transactions, andour range of available financing alternatives could also be narrowed. We arerequired to continue to suspend our Dividend Reinvestment and Direct StockPurchase Plans for one year from the time our re-audited and restatedfinancials are filed with the SEC and we are compliant with all timely filings.

 

Becauseof our late filings, NASDAQ has issued Staff Deficiency Letters indicating ournon-compliance with NASDAQ Marketplace rules requiring compliance with SECreporting obligations.  The Company hasexplained the circumstances of the late filings and described our plan forregaining compliance at a hearing with NASDAQ. On July 1, 2009, the Company was notified that the NASDAQ hadgranted the Company’s request to extend the current filing compliance deadlineto August 31, 2009.  However, if ourshares are not listed on NASDAQ, stockholders will likely face decreasedliquidity and it will be more difficult for us to raise capital.

 

#### **Stock PriceFluctuations**

#### ** **

Ourcommon stock, which is traded on the NASDAQ, has experienced and may continueto experience significant price and volume fluctuations that could adverselyaffect the market price of our common stock without regard to our operatingperformance. In addition, we believe that factors such as quarterlyfluctuations in financial results, earnings below analysts’ estimates andfinancial performance and other activities of other publicly traded companiesin our industry could cause the price of our common stock to fluctuatesubstantially. In the past, following periods of volatility in the market priceof a company’s securities, stockholders have often instituted class actionsecurities litigation against those companies. We can provide no assurance thatour share price will remain stable on a going-forward basis. Additionally,extended stock price declines could have an impact on our goodwill impairmentanalysis.

 

#### **We have beennamed in litigation that may adversely affect our financial condition, resultsof operations and cash flows.**

#### ** **

Weare defendants in several securities class action lawsuits. These lawsuits aredescribed in Part II, Item 1, “Legal Proceedings.” Our attention maybe diverted from our ordinary business operations by these lawsuits and we mayincur significant expenses associated with the defense of these lawsuits(including substantial fees of lawyers and other professional advisors andpotential obligations to indemnify current and former officers and directorswho may be parties to such action). Depending on the outcome of these lawsuits,we may be required to pay material damages and fines, consent to injunctions onfuture conduct, or suffer other penalties, remedies or sanctions. The ultimateresolution of these matters could have a material adverse effect on our resultsof operations, financial condition, liquidity, our ability to meet our debtobligations and, consequently, negatively impact the trading price of ourcommon stock.

 

 

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#### **Generaleconomic conditions may adversely affect our financial condition and results ofoperations.**

#### ** **

Ageneral economic downturn such as the one the U.S. economy is currentlyexperiencing may lead to a number of impacts on our business that may affectour financial condition and results of operations. Such impacts may include: areduction in discretionary and recreational water use by our residential watercustomers, particularly during the summer months when such discretionary usageis normally at its highest; a decline in usage by industrial and commercialcustomers as a result of decreased business activity; an increased incidence ofcustomers’ inability to pay or delays in paying their utility bills, or anincrease in customer bankruptcies, which may lead to higher bad debt expenseand reduced cash flow; a lower natural customer growth rate due to a decline innew housing starts; and a decline in the number of active customers due tohousing vacancies or abandonments.

 

#### **We dependsignificantly on the services of the members of our management team, and thedeparture of any of those persons could cause our operating results to suffer.**

#### ** **

Oursuccess depends significantly on the continued individual and collectivecontributions of our management team. The loss of the services of key membersof our management team or the inability to hire and retain experiencedmanagement personnel could harm our operating results.

 

#### **Risksassociated with potential acquisitions or investments may adversely affect us.**

#### ** **

Wemay continue to seek to acquire or invest in additional regulated water orwastewater systems, including by acquiring systems in markets in the UnitedStates where we do not currently operate. These possible transactions mayresult in:

 

·                   incurrence ofdebt and contingent liabilities;

 

·                   failure tohave or to maintain effective internal control over financial reporting;

 

·                   fluctuationsin quarterly results;

 

·                   exposure tounknown risk and liabilities, such as environmental liabilities; and

 

·                   otheracquisition-related expenses.

 

Wemay also experience difficulty in obtaining required regulatory approvals foracquisitions, and any regulatory approvals we obtain may require us to agree tocostly and restrictive conditions imposed by regulators. There may bedifficulties integrating new businesses, including bringing newly acquiredbusinesses up to the necessary level of regulatory compliance, retaining andintegrating key personnel, achieving strategic objectives and integratingacquired assets and technological systems. The demands of identifying andtransitioning newly acquired businesses or pursuing investment opportunitiesmay also divert management’s attention from other business concerns andotherwise disrupt our business. Any of these risks may adversely affect ourfinancial condition, results of operations and cash flows.

 

#### **Delaware lawcontains anti-takeover provisions that could deter takeover attempts that couldbe beneficial to our stockholders**

#### ** **

Provisionsof Delaware law could make it more difficult for a third-party to acquire us,even if doing so would be beneficial to our stockholders. Section 203 ofthe Delaware General Corporation Law may make the acquisition of the Companyand the removal of incumbent officers and directors more difficult byprohibiting stockholders holding 15% or more of our outstanding voting stockfrom acquiring the Company, without our board of directors’ consent, for atleast three years from the date they first hold 15% or more of the votingstock.

 

#### **Dividends**

#### ** **

Since1960, our practice has been to pay common stock cash dividends quarterly. Theamount and timing of future dividends depends on our growth, results ofoperations, profitability and financial condition, as well as other factors 

 

 

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deemedrelevant by our Board of Directors.  Manyof the risk factors noted above could have an impact on our ability to declareand pay future dividends.

 

## **ITEMS 2, 3, 4 AND 5 of PART II ARE NOTAPPLICABLE AND HAVE BEEN OMITTED.**

## ** **

## ** **

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## **ITEM 6.          EXHIBITS**

 
| **Exhibit** | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
|-------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **  | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| **Number**  | ** ** | **Exhibit Description**                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                               |
| ** **  | ** ** | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| 3.1         |       | Certificate of Amendment to  Restated Certificate of Incorporation of SouthWest Water Company  (incorporated by reference to Exhibit 3.1 included in the Company’s  Form 8 K filed with the Commission on May 22, 2008)                                                                                                                                                                                                                                                                                                                                                                                |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 3.2.5       |       | Amendment No. 5 to the Amended  and Restated Bylaws of SouthWest Water Company (incorporated by reference to  Exhibit 3.2 included in the Company’s Form 8 K filed with the  Commission on May 22, 2008)                                                                                                                                                                                                                                                                                                                                                                                     |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.17       |       | Credit Agreement dated at  February 15, 2008 among the Company, as borrower, the several lenders  parties thereto, Bank of America, N.A., as Administrative Agent, Swing Line  Lender and Letter of Credit Issuer, Banc of America Securities LLC, as Sole  Lead Arranger and Sole Book Manager, KeyBank National Association, as  Syndication Agent, and CoBank ACB, U.S. Bank National Association and  JPMorgan Chase Bank, N.A., as Documentation Agents (incorporated by reference  to Exhibit 10.1 included in the Company’s Form 8-K filed with the  Commission on February 22, 2008) |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.17.1     |       | Amendment No. 1 to Amended and  Restated Credit Agreement dated as of November 19, 2008 (incorporated by  reference to Exhibit 10.17.1 included in the Company’s Form 10-K  filed with the Commission on July 9, 2009)                                                                                                                                                                                                                                                                                                                                                                  |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.17.2     |       | Amendment No. 2 to Amended and  Restated Credit Agreement dated as of May 28, 2009 (incorporated by  reference to Exhibit 10.17.2 included in the Company’s Form 10-K  filed with the Commission on July 9, 2009)                                                                                                                                                                                                                                                                                                                                                                       |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.17.3     |       | Amendment No. 3 to Amended and  Restated Credit Agreement dated as of June 17, 2009 (incorporated by  reference to Exhibit 10.17.3 included in the Company’s Form 10-K  filed with the Commission on July 9, 2009)                                                                                                                                                                                                                                                                                                                                                                      |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.17.4     |       | Amendment No. 4 to Amended and  Restated Credit Agreement dated as of July 9, 2009 (incorporated by  reference to Exhibit 10.17.4 included in the Company’s Form 10-K  filed with the Commission on July 9, 2009)                                                                                                                                                                                                                                                                                                                                                                       |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 10.17.5     | *          | Amendment No. 5 to Amended and  Restated Credit Agreement dated as of July 31, 2009                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                              |
|        |       |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| 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                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                   |

 

----

*       Filed herewith

 

 

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# **Table of Contents**

 

# **SIGNATURES**

# ** **

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

 

 
|                  | **SOUTHWEST WATER COMPANY  (REGISTRANT)** |
|-----------------------|-------------------------------------------|
|                  | ** **                                |
|                  |                                      |
| Dated: August 3, 2009 | /s/ DAVID STANTON                         |
|                  | David Stanton                             |
|                  | Chief Financial Officer                   |

 

 

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