**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

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**FORM 10-Q**

 

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**(Mark One)**

 
| **ý** | ** ** | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|------------|------------|--------------------------------------------------------------------------------------------------------|
|       |       |                                                                                                   |
|       |       | **For the  quarterly period ended June 30, 2005**                                                 |

 

**OR**

 
| **o**  | ** ** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**                                                                                                                                                                                                                                                       |
|--------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |       |                                                                                                                                                                                                                                                                                                                                                          |
|   |       | **For the  transition period from                          to                          ** |

 

**Commissionfile number: 0-8176**

 

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

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

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes  ý  No  o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Act). Yes  ý  No  o

 

Indicate the number of shares outstanding ofeach of the issuer’s classes of common stock, as of the latest practicabledate. On August 8, 2005, there were 19,730,082 common shares outstanding.

 

 

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**SOUTHWESTWATER COMPANY**

 

**INDEX**

 
| **Part I.**  | **Financial Information:** |                                                                                                                          |
|-------------------|----------------------------|-------------------------------------------------------------------------------------------------------------------------------|
|              |                       |                                                                                                                          |   |
|              | Item 1.                    | Financial  Statements:                                                                                                        |   |
|              |                       |                                                                                                                          |   |
|              |                       | Condensed Consolidated Statements of Income (unaudited) –  Three Months and Six Months Ended June 30, 2005 and 2004 |   |
|              |                       |                                                                                                                          |   |
|              |                       | Condensed Consolidated Balance Sheets –  June 30, 2005 (unaudited) and December 31, 2004 (audited)             |   |
|              |                       |                                                                                                                          |   |
|              |                       | Condensed Consolidated Statements of Cash Flows (unaudited) –  Six Months Ended June 30, 2005 and 2004              |   |
|              |                       |                                                                                                                          |   |
|              |                       | Notes to Condensed Consolidated Financial Statements (unaudited)                                                              |   |
|              |                       |                                                                                                                          |   |
|              | Item 2.                    | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                   |   |
|              |                       |                                                                                                                          |   |
|              | Item 3.                    | Quantitative and  Qualitative Disclosures About Market Risk                                                                   |   |
|              |                       |                                                                                                                          |   |
|              | Item 4.                    | Controls and  Procedures                                                                                                      |   |
|              |                       |                                                                                                                          |   |
| **Part II.** | **Other  Information:**    |                                                                                                                          |
|              |                       |                                                                                                                          |   |
|              | Item 1.                    | Legal  Proceedings                                                                                                            |   |
|              |                       |                                                                                                                          |   |
|              | Item 4.                    | Submission of  Matters to a Vote of Security Holders                                                                          |   |
|              |                       |                                                                                                                          |   |
|              | Item 6.                    | Exhibits                                                                                                                      |   |
|              |                       |                                                                                                                          |   |
| **Signatures**    |                       |                                                                                                                          |

 

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**PART I – FINANCIAL INFORMATION**

 

***Item 1. Financial Statements***

 

**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)**

 
| ** **                                                                                                                                                                    | ** ** | **Three Months Ended**                   |       | **Six Months Ended** |   |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------|--------|
| ** **                                                                                                                                                                    | ** ** | **June 30,**                        |       | **June 30,**    |   |
| ** **                                                                                                                                                                    | ** ** | **2005**                                 | ** ** | **2004**             |   | **2005** | ** ** | **2004** |   |
| ** **                                                                                                                                                                    | ** ** | **(in thousands except per share data)** |       |
| **Revenues:**                                                                                                                                                                 |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Utility group                                                                                                                                                                 | ** ** | **$**                                    | **20,295** | ** **           | $      | 16,575 |   | **$** | **35,754** | ** ** | $ | 29,639 |   |
| Services group                                                                                                                                                                | ** ** | **30,987**                               | ** ** | 26,858               |   | **60,759** | ** ** | 51,802 |   |
| ** **                                                                                                                                                                    |       | **51,282**                               | ** ** | 43,433               |   | **96,513** | ** ** | 81,441 |   |
| **Expenses:**                                                                                                                                                                 |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Operating expenses - utility group                                                                                                                                            | ** ** | **10,678**                               | ** ** | 8,623                |   | **20,657** | ** ** | 16,269 |   |
| Operating expenses - services group                                                                                                                                           | ** ** | **26,689**                               | ** ** | 24,162               |   | **52,573** | ** ** | 47,834 |   |
| Selling, general and administrative  expenses                                                                                                                                 | ** ** | **7,425**                                | ** ** | 6,020                |   | **15,308** | ** ** | 12,087 |   |
| ** **                                                                                                                                                                    |       | **44,792**                               | ** ** | 38,805               |   | **88,538** | ** ** | 76,190 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Operating Income**                                                                                                                                                          | ** ** | **6,490**                                | ** ** | 4,628                |   | **7,975** | ** ** | 5,251 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Other Income (Expense):**                                                                                                                                                   |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Interest expense                                                                                                                                                              | ** ** | **(1,896**                               | **)**      | (957                 | )      | **(3,668** | **)** | (1,925 | ) |
| Interest income                                                                                                                                                               | ** ** | **107**                                  | ** ** | 190                  |   | **214** | ** ** | 311 |   |
| Other                                                                                                                                                                         | ** ** | **71**                                   | ** ** | (147                 | )      | **58** | ** ** | (136 | ) |
| ** **                                                                                                                                                                    |       | **(1,718**                               | **)**      | (914                 | )      | **(3,396** | **)** | (1,750 | ) |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Income From Continuing Operations Before  Income Taxes**                                                                                                                    | ** ** | **4,772**                                | ** ** | 3,714                |   | **4,579** | ** ** | 3,501 |   |
| **Income Tax Provision**                                                                                                                                                      | ** ** | **1,727**                                | ** ** | 1,368                |   | **1,662** | ** ** | 1,279 |   |
| **Income from Continuing Operations**                                                                                                                                         | ** ** | **3,045**                                | ** ** | 2,346                |   | **2,917** | ** ** | 2,222 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Discontinued Operations:**                                                                                                                                                  |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Income (loss) from operations of  discontinued subsidiary (net of income tax provisions (benefit) of $(677),  $132, $(747), and $232 respectively, for the periods presented) | ** ** | **(1,105**                               | **)**      | 208                  |   | **(1,219** | **)** | 350 |   |
| Loss on disposal of discontinued operations  (net of income tax benefit of $345 for the quarter and six months ended  June 30, 2005)                                     | ** ** | **(3,683**                               | **)**      | **—**           |   | **(3,683** | **)** | **—** |   |
| **Net Income (Loss)**                                                                                                                                                         | ** ** | **(1,743**                               | **)**      | 2,554                |   | **(1,985** | **)** | 2,572 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Dividends On Preferred Shares**                                                                                                                                             | ** ** | **6**                                    | ** ** | 6                    |   | **12** | ** ** | 13 |   |
| **Net Income (Loss) Applicable To Common  Shareholders**                                                                                                                      | ** ** | **$**                                    | **(1,749** | **)**                | $      | 2,548 |   | **$** | **(1,997** | **)** | $ | 2,559 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Earnings (Loss) Per Common Share:**                                                                                                                                         |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Basic**                                                                                                                                                                     |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Income from continuing operations less  dividends on preferred shares                                                                                                         | ** ** | **$**                                    | **0.16**   | ** **           | $      | 0.14 |   | **$** | **0.15** | ** ** | $ | 0.14 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Income (loss) from discontinued operations                                                                                                                                    | ** ** | **$**                                    | **(0.25**  | **)**                | $      | 0.01 |   | **$** | **(0.25** | **)** | $ | 0.02 |   |
| **Net Income (Loss) Applicable to Common  Shareholders**                                                                                                                      | ** ** | **$**                                    | **(0.09**  | **)**                | $      | 0.15 |   | **$** | **(0.10** | **)** | $ | 0.16 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Diluted**                                                                                                                                                                   |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Income from continuing operations less  dividends on preferred shares                                                                                                         | ** ** | **$**                                    | **0.15**   | ** **           | $      | 0.13 |   | **$** | **0.14** | ** ** | $ | 0.13 |   |
|                                                                                                                                                                          |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| Income (loss) from discontinued operations                                                                                                                                    | ** ** | **$**                                    | **(0.24**  | **)**                | $      | 0.01 |   | **$** | **(0.24** | **)** | $ | 0.02 |   |
| **Net Income (Loss) Applicable To Common  Shareholders**                                                                                                                      | ** ** | **$**                                    | **(0.09**  | **)**                | $      | 0.14 |   | **$** | **(0.10** | **)** | $ | 0.15 |   |
| ** **                                                                                                                                                                    | ** ** | ** **                               | ** ** |                 |   | ** ** | ** ** |   |   |
| **Weighted Average Outstanding Common Shares:**                                                                                                                               |       |                                     | ** ** |                 |   |   | ** ** |   |   |
| **Basic**                                                                                                                                                                     |       | 19,514                                   | ** ** | 17,371               |   | 19,463 | ** ** | 16,460 |   |
| **Diluted**                                                                                                                                                                   |       | 20,263                                   | ** ** | 18,251               |   | 20,135 | ** ** | 17,386 |   |

 

*See accompanying notes to unaudited condensedconsolidated financial statements.*

 

1

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**SOUTHWEST WATER COMPANY ANDSUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)**

 
| ** **                                                           | ** ** | **June 30, 2005** | ** **  | **December 31, 2004** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|-------------|----------------------------|------------|
| ** **                                                           | ** ** | **(in thousands)**     | ** **  |
| **ASSETS**                                                           |       |                   |        |                       |       |
| **Current Assets:**                                                  |       |                   |        |                       |       |
| Cash and cash equivalents                                            | ** ** | **$**                  | **12,444**  |                       | $          | 1,388 |   |
| Restricted cash                                                      | ** ** | **9**                  |        | 221                        |       |
| Trade accounts receivable, less allowance  for doubtful accounts     | ** ** | **25,480**             |        | 22,334                     |       |
| Assets held for sale                                                 | ** ** | **—**             |        | 15,869                     |       |
| Other current assets                                                 | ** ** | **15,217**             |        | 18,279                     |       |
| ** **                                                           |       | **53,150**             |        | 58,091                     |       |
| **Property, Plant and Equipment:**                                   |       |                   |        |                       |       |
| Utility property, plant and equipment—at  cost                  | ** ** | **373,274**            |        | 359,375                    |       |
| Non-regulated operations property, plant  and equipment—at cost | ** ** | **18,148**             |        | 17,118                     |       |
| ** **                                                           |       | **391,422**            |        | 376,493                    |       |
| Less accumulated depreciation and  amortization                      | ** ** | **78,864**             |        | 74,658                     |       |
| ** **                                                           |       | **312,558**            |        | 301,835                    |       |
| **Other Assets:**                                                    |       |                   |        |                       |       |
| Goodwill                                                             | ** ** | **27,722**             |        | 26,806                     |       |
| Intangible assets, net                                               | ** ** | **3,394**              |        | 2,359                      |       |
| Other assets                                                         | ** ** | **16,547**             |        | 15,718                     |       |
| ** **                                                           |       | **$**                  | **413,371** |                       | $          | 404,809 |   |
|                                                                 |       |                   |        |                       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                       |       |                   |        |                       |       |
| **Current Liabilities:**                                             |       |                   |        |                       |       |
| Current portion of long-term debt                                    | ** ** | **$**                  | **1,304**   |                       | $          | 2,733 |   |
| Accounts payable                                                     | ** ** | **11,314**             |        | 12,242                     |       |
| Liabilities related to assets held for sale                          | ** ** | **—**             |        | 1,682                      |       |
| Other current liabilities                                            | ** ** | **20,276**             |        | 19,216                     |       |
| ** **                                                           |       | **32,894**             |        | 35,873                     |       |
| **Other Liabilities and Deferred Credits:**                          |       |                   |        |                       |       |
| Long-term debt                                                       | ** ** | **78,620**             |        | 92,792                     |       |
| Bank lines of credit                                                 | ** ** | **48,000**             |        | 23,035                     |       |
| Advances for construction                                            | ** ** | **8,995**              |        | 9,196                      |       |
| Contributions in aid of construction                                 | ** ** | **90,264**             |        | 89,623                     |       |
| Deferred income taxes                                                | ** ** | **17,063**             |        | 15,528                     |       |
| Other liabilities and deferred credits                               | ** ** | **12,982**             |        | 12,564                     |       |
| **Total Liabilities and Deferred Credits**                           | ** ** | **288,818**            |        | 278,611                    |       |
| ** **                                                           | ** ** | ** **             |        |                       |       |
| **Commitments and Contingencies**                                    |       |                   |        |                       |       |
|                                                                 |       |                   |        |                       |       |
| **Stockholders’ Equity:**                                       |       |                   |        |                       |       |
| Preferred stock                                                      | ** ** | **461**                |        | 461                        |       |
| Common stock                                                         | ** ** | **194**                |        | 194                        |       |
| Paid-in capital                                                      | ** ** | **103,811**            |        | 101,509                    |       |
| Retained earnings                                                    | ** ** | **20,087**             |        | 24,034                     |       |
| **Total Stockholders’ Equity**                                  | ** ** | **124,553**            |        | 126,198                    |       |
| ** **                                                           |       | **$**                  | **413,371** |                       | $          | 404,809 |   |

 

*See accompanying notes to unaudited condensedconsolidated financial statements.*

 

2

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(Unaudited)**

 
| ** **                                                                                                           | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                                                           | ** ** | **June 30,**    | ** ** |
| ** **                                                                                                           | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                                                                           | ** ** | **(in thousands)**   | ** ** |
| **Cash Flows From Operating Activities:**                                                                            |       |                 | ** ** |   |   |
| Net income (loss)                                                                                                    | ** ** | **$**                | **(1,985** | **)** | $ | 2,572 |   |
| Income (loss) from operations of discontinued  subsidiary                                                            | ** ** | **(1,219**           | **)**      | 350 |   |
| Loss on disposal of discontinued operations                                                                          | ** ** | **(3,683**           | **)**      | — |   |
| Income from continuing operations                                                                                    | ** ** | **2,917**            | ** ** | 2,222 |   |
| Adjustments to reconcile income from  continuing operations to net cash provided by continuing operating activities: |       |                 | ** ** |   |   |
| Depreciation and amortization                                                                                        | ** ** | **5,044**            | ** ** | 3,471 |   |
| Stock-based compensation expense                                                                                     | ** ** | **466**              | ** ** | 447 |   |
| Deferred income taxes                                                                                                | ** ** | **1,535**            | ** ** | 181 |   |
| Changes in assets and liabilities, net of  effects of acquisitions:                                                  |       |                 | ** ** |   |   |
| Restricted cash                                                                                                      | ** ** | **212**              | ** ** | 1,815 |   |
| Trade accounts receivable                                                                                            | ** ** | **(2,510**           | **)**      | (5,415 | ) |
| Other current assets                                                                                                 | ** ** | **2,664**            | ** ** | (764 | ) |
| Other assets                                                                                                         | ** ** | **(956**             | **)**      | 610 |   |
| Accounts payable                                                                                                     | ** ** | **(2,597**           | **)**      | (3,174 | ) |
| Other current liabilities                                                                                            | ** ** | **1,195**            | ** ** | 2,821 |   |
| Other liabilities                                                                                                    | ** ** | **(236**             | **)**      | 1,632 |   |
| Other                                                                                                                | ** ** | **(297**             | **)**      | (4,823 | ) |
| **Net cash provided (used) by continuing  operating activities**                                                     | ** ** | **7,437**            | ** ** | (977 | ) |
| ** **                                                                                                           | ** ** | ** **           | ** ** |   |   |
| **Cash Flows From Investing Activities:**                                                                            |       |                 | ** ** |   |   |
| Additions to property, plant and equipment                                                                           | ** ** | **(14,284**          | **)**      | (11,217 | ) |
| Purchase of minority interest in subsidiary                                                                          | ** ** | **—**           | ** ** | (2,900 | ) |
| Cash used to acquire customer units                                                                                  | ** ** | **—**           | ** ** | (4,063 | ) |
| Acquisition of contract operations                                                                                   | ** ** | **(2,008**           | **)**      | — |   |
| **Net cash used in investing activities**                                                                            | ** ** | **(16,292**          | **)**      | (18,180 | ) |
|                                                                                                                 |       |                 | ** ** |   |   |
| **Net proceeds from sale of discontinued  operations**                                                               | ** ** | **9,852**            | ** ** | — |   |
|                                                                                                                 |       |                 | ** ** |   |   |
| **Cash Flows From Financing Activities:**                                                                            |       |                 | ** ** |   |   |
| Net proceeds from stock offering                                                                                     | ** ** | **—**           | ** ** | 20,573 |   |
| Capital improvement reimbursements                                                                                   | ** ** | **139**              | ** ** | 169 |   |
| Contributions in aid of construction                                                                                 | ** ** | **1,118**            | ** ** | 4,891 |   |
| Borrowings (repayments) on bank notes  payable                                                                       | ** ** | **24,965**           | ** ** | (9,600 | ) |
| Proceeds from dividend reinvestment, employee  stock purchase and stock option plans                                 | ** ** | **1,341**            | ** ** | 445 |   |
| Dividends paid                                                                                                       | ** ** | **(1,962**           | **)**      | (1,576 | ) |
| Principal payments on long-term debt                                                                                 | ** ** | **(15,341**          | **)**      | (572 | ) |
| Payments on advances for construction                                                                                | ** ** | **(201**             | **)**      | (157 | ) |
| Other financing activities, net                                                                                      | ** ** | **—**           | ** ** | 60 |   |
| **Net cash provided by financing activities**                                                                        | ** ** | **10,059**           | ** ** | 14,233 |   |
| ** **                                                                                                           | ** ** | ** **           | ** ** |   |   |
| **Net increase (decrease) in cash and cash  equivalents**                                                            | ** ** | **11,056**           | ** ** | (4,924 | ) |
| Cash and cash equivalents at beginning of  period                                                                    | ** ** | **1,388**            | ** ** | 6,793 |   |
| **Cash and cash equivalents at end of period**                                                                       | ** ** | **$**                | **12,444** | ** ** | $ | 1,869 |   |
| ** **                                                                                                           | ** ** | ** **           | ** ** |   |   |
| **Supplemental Disclosure of Cash Flow  information**                                                                |       |                 | ** ** |   |   |
| **Cash paid (received) during the period for:**                                                                      |       |                 | ** ** |   |   |
| **Interest**                                                                                                         | ** ** | **$**                | **3,859**  | ** ** | $ | 2,085 |   |
| **Income taxes**                                                                                                     | ** ** | **$**                | **(1,360** | **)** | $ | 125 |   |
|                                                                                                                 |       |                 | ** ** |   |   |
| **Non-cash contributions in aid of  construction and advances for construction from developers**                     | ** ** | **$**                | **1,110**  | ** ** | $ | 2,349 |   |

 

*See accompanying notes to unaudited condensedconsolidated financial statements.*

 

3

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**SOUTHWESTWATER COMPANY AND SUBSIDIARIES**

 

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

 

***Note 1. – Basis of Presentation***

 

Southwest Water Company and its subsidiaries (collectively referred toin this report as “Southwest,” the “Company,” “we,” “us” or “our” except wherethe context otherwise requires) provide a broad range of services includingwater production, treatment and distribution; wastewater collection andtreatment; utility billing and collection; utility infrastructure constructionmanagement; and public works services. The accompanying unaudited condensedconsolidated financial statements have been prepared in accordance withaccounting principles generally accepted in the United States of America (“USGAAP”) for interim financial information and with the instructions to Form 10-Qand with Rule 10-01 of Regulation S-X; accordingly, they do not includeall information and notes required by US GAAP for complete financialstatements. Except as disclosed herein, there have been no material changes inthe information disclosed in the notes to the consolidated financial statementscontained in our Annual Report on Form 10-K for the year ended December 31,2004 (the “2004 Annual Report”). The unaudited condensed consolidated financialstatements reflect all adjustments which, in our opinion, are necessary topresent fairly the financial position of Southwest as of June 30, 2005,and our results of operations for the three and six months ended June 30,2005 and 2004 and our cash flows for the six months ended June 30, 2005and 2004.  Other than the adjustmentsdescribed in Note 9 these adjustments are of a normal recurring nature.

 

The results of interim periods are not necessarily indicative ofresults that may be expected for any other interim period or for the full year.

 

Southwest Water Company was incorporated in California in 1954 andreincorporated in Delaware in 1988.

 

Certain reclassifications have been made to the prior period financialstatement presentation to conform to the current period presentation.

 

***Note 2. – Earnings Per Share***

 

We reportearnings per share (“EPS”) by computing “basic EPS” and “diluted EPS.”  Basic EPS measures our performance over thereporting period by dividing net income (loss) applicable to commonstockholders by the weighted average number of common shares outstanding duringthe period. Diluted EPS measures our performance over the reporting periodafter giving effect to all potentially dilutive common shares that would havebeen outstanding if the dilutive common shares had been issued. Stock options,convertible debentures and warrants give rise to potentially dilutive commonshares.  In July 2001, we issued$20.0 million of 6.85% fixed-rate convertible subordinate debentures. Thedebentures are convertible at any time prior to maturity in 2021, unlesspreviously redeemed, at a conversion price of $11.569. At such time as theassumed conversion of the debentures has a dilutive effect on earnings pershare, the debentures will be included in the calculation of diluted earningsper share, after adjusting net income for the after-tax effect of the debentureinterest expense.

 

We declared a 5% stock dividend on January 3, 2005. All per shareamounts and numbers of shares outstanding reflect this dividend.

 

4

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The following table is a reconciliation of the numerators (income orloss) and denominators (shares) used in both basic and diluted EPScalculations:

 
| ** **                                                     | ** ** | **Three Months Ended**                   |       | **Six Months Ended** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------|------------|----------------------|------------|
| ** **                                                     | ** ** | **June 30,**                        |       | **June 30,**    | ** ** |
| ** **                                                     | ** ** | **2005**                                 | ** ** | **2004**             |       | **2005** | ** ** | **2004** | ** ** |
| ** **                                                     | ** ** | **(in thousands except per share data)** | ** ** |
| **Earnings (loss) per share - basic**                          |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| ** **                                                     |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Income from continuing operations                              | ** ** | **$**                                    | **3,045**  | ** **           | $          | 2,346 |   | **$** | **2,917** | ** ** | $ | 2,222 |   |
| Less: dividends on preferred shares                            | ** ** | **(6**                                   | **)**      | (6                   | )          | **(12** | **)** | (13 | ) |
|                                                           |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Income from continuing operations  applicable to common shares | ** ** | **3,039**                                | ** ** | 2,340                |       | **2,905** | ** ** | 2,209 |   |
|                                                           | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Income (loss) from discontinued operations                     | ** ** | **(4,788**                               | **)**      | 208                  |       | **(4,902** | **)** | 350 |   |
|                                                           | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Net income (loss) applicable to common  shares                 | ** ** | **(1,749**                               | **)**      | 2,548                |       | **(1,997** | **)** | 2,559 |   |
|                                                           | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Weighted average outstanding common shares                     | ** ** | **19,514**                               | ** ** | 17,371               |       | **19,463** | ** ** | 16,460 |   |
|                                                           |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Earnings per common share from continuing  operations          | ** ** | **0.16**                                 | ** ** | 0.14                 |       | **0.15** | ** ** | 0.14 |   |
|                                                           | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Earnings (loss) per common share from  discontinued operations | ** ** | **(0.25**                                | **)**      | 0.01                 |       | **(0.25** | **)** | 0.02 |   |
|                                                           | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Earnings (loss) per common share                               | ** ** | **$**                                    | **(0.09**  | **)**                | $          | 0.15 |   | **$** | **(0.10** | **)** | $ | 0.16 |   |
|                                                           |       |                                     | ** ** |                 |       |   | ** ** |   |   |

 
| ** **                                                             | ** ** | **Three Months Ended**                   | ** ** | **Six Months Ended** | ** ** |
|------------------------------------------------------------------------|------------|------------------------------------------|------------|----------------------|------------|
| ** **                                                             | ** ** | **June 30,**                        | ** ** | **June 30,**    | ** ** |
| ** **                                                             | ** ** | **2005**                                 | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                             | ** ** | **(in thousands except per share data)** | ** ** |
| **Earnings (loss) per share - diluted**                                |       |                                     | ** ** |                 |       |   | ** ** |   |   |
|                                                                   |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Income from continuing operations  applicable to common shares         | ** ** | **$**                                    | **3,039**  | ** **           | $          | 2,340 |   | **$** | **2,905** | ** ** | $ | 2,209 |   |
|                                                                   |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Income (loss) from discontinued operations                             | ** ** | **(4,788**                               | **)**      | 208                  |       | **(4,902** | **)** | 350 |   |
|                                                                   | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Income (loss) applicable to common shares                              | ** ** | **(1,749**                               | **)**      | 2,548                |       | **(1,997** | **)** | 2,559 |   |
|                                                                   |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Weighted average outstanding common shares                             | ** ** | **19,514**                               | ** ** | 17,371               |       | **19,463** | ** ** | 16,460 |   |
|                                                                   |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Plus: shares issued on assumed exercise of  stock options and warrants | ** ** | **749**                                  | ** ** | 880                  |       | **672** | ** ** | 926 |   |
| Weighted average outstanding common shares                             | ** ** | **20,263**                               | ** ** | 18,251               |       | **20,135** | ** ** | 17,386 |   |
|                                                                   |       |                                     | ** ** |                 |       |   | ** ** |   |   |
| Earnings per common share from continuing  operations                  | ** ** | **0.15**                                 | ** ** | 0.13                 |       | **0.14** | ** ** | 0.13 |   |
|                                                                   | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Earnings (loss) per common share from  discontinued operations         | ** ** | **(0.24**                                | **)**      | 1.00                 |       | **(0.24** | **)** | 0.02 |   |
|                                                                   | ** ** | ** **                               | ** ** |                 |       | ** ** | ** ** |   |   |
| Earnings (loss) per common share                                       | ** ** | **$**                                    | **(0.09**  | **)**                | $          | 0.14 |   | **$** | **(0.10** | **)** | $ | 0.15 |   |

 

5

----

 

***Note 3. –Stock-Based Plans***

 

At June 30, 2005, Southwest had three stock-based compensationplans: a Stock Option Plan (“SOP”), a Director Stock Option Plan (“DOP”), andan Employee Stock Purchase Plan. In accordance with the provisions of Statementof Financial Accounting Standards (“SFAS”) No. 123, *Accounting for Stock-Based Compensation*,the fair value of each option grant is estimated on the date of grant using theBlack-Scholes option pricing model with the following weighted averageassumptions used for grants in 2005 and 2004:

 
| ** **              | ** ** | ** ** | ** ** | **Six Months Ended** | ** ** |
|-------------------------|------------|------------|------------|----------------------|------------|
| ** **              | ** ** | ** ** | ** ** | **June 30,**    | ** ** |
| ** **              | ** ** | ** ** | ** ** | **2005**             | ** ** | **2004** | ** ** |
| Dividend yield          |       |       |       | 1.7                  | %          | 1.3 | % |
| Expected volatility     |       |       |       | 24.3                 | %          | 24.4 | % |
| Risk free interest rate |       |       |       | 4.1                  | %          | 3.7 | % |
| Expected life in years  |       |       |       | 5.7                  |       | 6.0 |   |

 

Compensationexpense arising from stock option grants as determined using the Black-Scholesfair value option model was as follows:

 
| ** **                       | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|----------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                       | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                       | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                       | ** ** | **(in  thousands)**    | ** ** | **(in  thousands)**  | ** ** |
| Stock-based compensation expense |       | $                      | 214        | ** **           | $          | 169 |   | $ | 466 | ** ** | $ | 447 |   |
|                                  |            |                        |            |                      |            |  |  |  |  |  |  |  |  |

 

A combinedsummary of shares authorized and available for issuance under the SOP and theDOP as of June 30, 2005, is as follows:

 
| ** **                     | ** ** | **SOP**            | ** ** | **DOP** | ** ** | **Total** | ** ** |
|--------------------------------|------------|--------------------|------------|---------|------------|-----------|------------|
| ** **                     | ** ** | **(in thousands)** | ** ** |
| Shares authorized for issuance |       | 3,386              |       | 666     |       | 4,052     |       |
| Shares available for issuance  |       | 1,007              |       | 300     |       | 1,307     |       |

 

Following is a combined summary of changes in the status of the SOP,the DOP and warrants during the six months ended June 30, 2005:

 
| ** **                            | ** ** | ** **         | ** ** | **Weighted** | ** ** |
|---------------------------------------|------------|--------------------|------------|--------------|------------|
| ** **                            | ** ** | ** **         | ** ** | **Average**  | ** ** |
| ** **                            | ** ** | **Stock Options**  | ** ** | **Exercise** | ** ** |
| ** **                            | ** ** | **and Warrants**   | ** ** | **Price**    | ** ** |
| ** **                            | ** ** | **(in thousands)** | ** ** | ** **   | ** ** |
| Outstanding at December 31, 2004 |       | 2,776              |       | $            | 8.03       |   |
| Granted                               |       | 287                |       | 11.75        |       |
| Exercised                             |       | (105               | )          | 8.04         |       |
| Forfeited                             |       | (77                | )          | 11.67        |       |
| Outstanding at June 30, 2005     |       | 2,881              |       | $            | 8.30       |   |
|                                  |       |               |       |         |       |
| Exercisable at June 30, 2005     |       | 1,907              |       | $            | 6.94       |   |

 

6

----

 

The following table summarizes information about stock options andwarrants outstanding at June 30, 2005:

 
| ** **          | ** ** | ** **        | ** ** | ** **                           | ** ** | ** **      | ** ** | ** **        | ** ** | **Options and Warrants** | ** ** |
|---------------------|------------|-------------------|------------|--------------------------------------|------------|-----------------|------------|-------------------|------------|--------------------------|------------|
| ** **          | ** ** | ** **        | ** ** | **Options and Warrants Outstanding** | ** ** | **Exercisable** | ** ** |
| ** **          | ** ** | ** **        | ** ** | ** **                           | ** ** | **Weighted**    | ** ** | ** **        | ** ** | ** **               | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **        | ** ** | **Number**                           | ** ** | **Average**     | ** ** | ** **        | ** ** | **Number**               | ** ** | ** ** | ** ** |
| ** **          | ** ** | ** **        | ** ** | **Outstanding**                      | ** ** | **Remaining**   | ** ** | **Weighted**      | ** ** | **Exercisable**          | ** ** | **Weighted** | ** ** |
| ** **          | ** ** | ** **        | ** ** | **at**                               | ** ** | **Contractual** | ** ** | **Average**       | ** ** | **at**                   | ** ** | **Average** | ** ** |
| **Range of**        | ** ** | **June 30,** | ** ** | **Life**                             | ** ** | **Exercise**    | ** ** | **June 30,** | ** ** | **Exercise**             | ** ** |
| **Exercise Prices** | ** ** | **2005**          | ** ** | **in Years**                         | ** ** | **Price**       | ** ** | **2005**          | ** ** | **Price**                | ** ** |
| ** **          | ** ** | ** **        | ** ** | **(in thousands)**                   | ** ** | ** **      | ** ** | ** **        | ** ** | **(in thousands)**       | ** ** | ** ** | ** ** |
| $                   | 1.50       |              | $          | 3.75                                 |       | 211             |       | 1.0               |       | $                        | 2.84       |   | 211 |   | $ | 2.84 |   |
| 3.76                |       | 7.50              |       | 869                                  |       | 3.2             |       | 5.75              |       | 811                      |       | 5.64 |   |
| 7.51                |       | 11.25             |       | 1,226                                |       | 4.4             |       | 8.94              |       | 792                      |       | 8.65 |   |
| 11.26               |       | 15.00             |       | 575                                  |       | 6.0             |       | 12.78             |       | 93                       |       | 13.02 |   |
| $                   | 1.50       |              | $          | 15.00                                |       | 2,881           |       | 4.0               |       | $                        | 8.30       |   | 1,907 |   | $ | 6.94 |   |

 

***Employee Stock Purchase Plan (“ESPP”):***Wehave a stockholder-approved ESPP that allows eligible employees to purchase ourcommon stock through payroll deductions of up to 10% of their salary (not toexceed $25,000 per year). The purchase price of the stock is 90% of the lowerof the share price as calculated at the beginning and end of each three-monthoffering period. Under the ESPP, we issued 6,163 and 11,598 shares to employeesduring the three and six months ended June 30, 2005, respectively. At June 30,2005, 1,197,000 shares had been authorized for issuance under the ESPP andapproximately 882,000 shares remain available for issuance.

 

***Note 4. – PostRetirement Benefits***

 

The Company has a non-qualified supplemental executive retirement plan(“SERP”) for certain key executive officers. The following table sets forth the components of the net periodicbenefit costs for the SERP plan:

 
| ** **                | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                | ** ** | **June 30,**      | ** ** | **June 30,**    | ** ** |
| ** **                | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                | ** ** | **(in thousands)**     | ** ** | **(in thousands)**   | ** ** |
| Service cost              |       | $                      | 16         |                 | $          | 15 |   | $ | 32 |   | $ | 30 |   |
| Interest cost             |       | 20                     |       | 19                   |       | 40 |   | 38 |   |
| Recognized actuarial loss |       | 22                     |       | 21                   |       | 44 |   | 42 |   |
|                      |       | $                      | 58         |                 | $          | 55 |   | $ | 116 |   | $ | 110 |   |

 

***Note 5. – Operating Segments***

 

Southwest has two reportable segments: the Utility Group and theServices Group.  We have not changed thebasis of presentation or measurement of segment profit or loss from thatreported in our 2004 Annual Report.

 

The Utility Group owns a regulated water utility in California, andregulated water and wastewater utilities in New Mexico, Oklahoma andTexas.  Revenues result from theproduction and distribution of water and the collection and treatment of sewagefor residential, business, industrial and public authority customers.  State, federal and local agencies issueregulations regarding standards of water quality, safety, environmental andother matters which affect these operations. The rates our regulated utilitysubsidiaries charge for water and wastewater services are established by stateauthorities.

 

The Services Group operates and manages water and wastewater treatmentfacilities owned by cities, public agencies, municipal utility districts,private entities and investor-owned utilities (including Utility Groupaffiliates). Revenues are earned by providing operations and maintenanceservices under contracts with these clients. The Services Group also provides construction management and utilitybilling services. In June 2005, we sold our submetering subsidiary whichprovided utility billing and collection services for multi-family residentialproperties such as apartment buildings and which was previously recorded as apart of the Services Group (see Note 9).

 

7

----

 

The tables below present information about the operations of eachreported segment for the three and six months ended June 30, 2005 and2004:

 
| ** **                                                        | ** ** | ** **         | ** ** | **Services**     |       | **Total**       | ** ** | ** **        |       | **Total**        |   |
|-------------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|------------|-------------------|------------|------------------|--------|
| ** **                                                        | ** ** | ** **         | ** ** | **Group**        |       | **Segments**    | ** ** | **Corporate and** |       | **Consolidated** |   |
| ** **                                                        | ** ** | **Utility Group**  | ** ** | **(1) (3)** |       | **Information** | ** ** | **Other (2)**     |       | **Information**  |   |
| ** **                                                        | ** ** | **(in thousands)** |       |
|                                                              |       |               | ** ** |             |       |            | ** ** |              |       |             |   |
| **For the Three Months Ended June 30,  2005**                |       |               | ** ** |             |       |            | ** ** |              |       |             |   |
| **Total revenues (1)**                                            | ** ** | **$**              | **20,295** | ** **       | **$**      | **30,987**      | ** ** | **$**             | **51,282** | ** **       | **$**  | **—** |   | **$** | **51,282** |   |
| **Segment operating income**                                      | ** ** | **7,665**          | ** ** | **1,660**        | ** ** | **9,325**       | ** ** | **(2,835**        | **)**      | **6,490**        |   |
| **Interest expense**                                              | ** ** | **(1,209**         | **)**      | **(483**         | **)**      | **(1,692**      | **)**      | **(204**          | **)**      | **(1,896**       | **)**  |
| **Interest income**                                               | ** ** | **11**             | ** ** | **96**           |       | **107**         | ** ** | **—**        | ** ** | **107**          |   |
| **Other income (expense)**                                        | ** ** | **34**             | ** ** | **37**           |       | **71**          | ** ** | **—**        | ** ** | **71**           |   |
| **Income (loss) from continuing operations  before income taxes** | ** ** | **6,501**          | ** ** | **1,310**        |       | **7,811**       | ** ** | **(3,039**        | **)**      | **4,772**        |   |
|                                                              |       |               | ** ** |             |       |            | ** ** |              |       |             |   |
| **For the Three Months Ended June 30,  2004**                |       |               | ** ** |             |       |            | ** ** |              |       |             |   |
| Total revenues (1)                                                |       | $                  | 16,575     |             | $          | 26,858          |       | $                 | 43,433     |             | $      | — |   | $ | 43,433 |   |
| Segment operating income (loss)                                   |       | 6,884              |       | 215              |       | 7,099           |       | (2,471            | )          | 4,628            |   |
| Interest expense                                                  |       | (635               | )          | (450             | )          | (1,085          | )          | 128               |       | (957             | )      |
| Interest income                                                   |       | 88                 |       | 94               |       | 182             |       | 8                 |       | 190              |   |
| Other income (expense)                                            |       | (40                | )          | (99              | )          | (139            | )          | (8                | )          | (147             | )      |
| Income (loss) from continuing operations  before income taxes     |       | 6,297              | ** ** | (240             | )          | 6,057           | ** ** | (2,343            | )          | 3,714            |   |

 
| ** **                                                        | ** ** | ** **         | ** ** | **Services**     | ** ** | **Total**       | ** ** | ** **        | ** ** | **Total**        | ** ** |
|-------------------------------------------------------------------|------------|--------------------|------------|------------------|------------|-----------------|------------|-------------------|------------|------------------|------------|
| ** **                                                        | ** ** | ** **         | ** ** | **Group**        | ** ** | **Segments**    | ** ** | **Corporate and** | ** ** | **Consolidated** | ** ** |
| ** **                                                        | ** ** | **Utility Group**  | ** ** | **(1) (3)** | ** ** | **Information** | ** ** | **Other (2)**     | ** ** | **Information**  | ** ** |
| ** **                                                        | ** ** | **(in thousands)** | ** ** |
| **For the Six Months Ended June 30, 2005**                   |       |               |       |             |       |            |       |              |       |             |       |
| **Total revenues (1)**                                            | ** ** | **$**              | **35,754** | ** **       | **$**      | **60,759**      | ** ** | **$**             | **96,513** | ** **       | **$**      | **—** | ** ** | **$** | **96,513** | ** ** |
| **Segment operating income**                                      | ** ** | **11,673**         | ** ** | **2,877**        | ** ** | **14,550**      | ** ** | **(6,575**        | **)**      | **7,975**        | ** ** |
| **Interest expense**                                              | ** ** | **(2,403**         | **)**      | **(996**         | **)**      | **(3,399**      | **)**      | **(269**          | **)**      | **(3,668**       | **)**      |
| **Interest income**                                               | ** ** | **22**             | ** ** | **189**          | ** ** | **211**         | ** ** | **3**             | ** ** | **214**          | ** ** |
| **Other income (expense)**                                        | ** ** | **13**             | ** ** | **59**           | ** ** | **72**          | ** ** | **(14**           | **)**      | **58**           | ** ** |
| **Income (loss) from continuing operations before  income taxes** | ** ** | **9,305**          | ** ** | **2,129**        | ** ** | **11,434**      | ** ** | **(6,855**        | **)**      | **4,579**        | ** ** |
| ** **                                                        | ** ** | ** **         | ** ** | ** **       | ** ** | ** **      | ** ** | ** **        | ** ** | ** **       | ** ** |
| **For the Six Months Ended June 30, 2004**                   |       |               |       |             |       |            |       |              |       |             |       |
| Total revenues (1)                                                |       | $                  | 29,639     |             | $          | 51,802          |       | $                 | 81,441     |             | $          | — |   | $ | 81,441 |   |
| Segment operating income (loss)                                   |       | 10,676             |       | (802             | )          | 9,874           |       | (4,623            | )          | 5,251            |       |
| Interest expense                                                  |       | (1,137             | )          | (883             | )          | (2,020          | )          | 95                |       | (1,925           | )          |
| Interest income                                                   |       | 94                 |       | 189              |       | 283             |       | 28                |       | 311              |       |
| Other income (expense)                                            |       | (54                | )          | (78              | )          | (132            | )          | (4                | )          | (136             | )          |
| Income (loss) from continuing operations  before income taxes     |       | 9,579              |       | (1,574           | )          | 8,005           |       | (4,504            | )          | 3,501            |       |

 

8

----

 

----

(1) Inaddition to services provided to external customers, certain companies in ourServices Group provide construction, operations, and maintenance services tocompanies in our Utility Group. In accordance with SFAS No. 71, *Accounting for the Effects of Certain Types ofRegulation*, the Company does not eliminate the intersegment profiton sales to affiliated utilities when the sales price is reasonable and it isprobable that, through the rate making process, future revenue approximatelyequal to the sales price will result from the regulated affiliate’s use of theservices.  Intersegment revenue wasapproximately $7.4 million and $3.3 million for the three months ended June 30,2005 and 2004, respectively. Intersegment revenue was approximately $14.5 million and $4.9million for the six months ended June 30, 2005 and 2004, respectively.

 

(2)          “Corporate and Other” consists primarily of costs that includeheadquarters expenses and any corporate functional departments whose costs arenot allocated to reportable segments.

 

(3)          Services Group amounts have been adjusted to reflect the discontinuedoperations from the sale of our submetering subsidiary as discussed in Note 9.

 

The following table presents information about theidentifiable assets of each reported segment as of June 30, 2005 and December 31,2004:

 
| ** **          | ** ** | ** ** | ** ** | **June 30, 2005** | ** **  | **December 31, 2004** | ** ** |
|---------------------|------------|------------|------------|------------------------|-------------|----------------------------|------------|
| ** **          | ** ** | ** ** | ** ** | **(in thousands)**     | ** **  |
| Utility Group       | ** ** | ** ** | ** ** | **$**                  | **331,874** |                       | $          | 322,521 |   |
| Services Group      | ** ** | ** ** | ** ** | **58,212**             |        | 54,467                     |       |
| Corporate and Other | ** ** | ** ** | ** ** | **23,285**             |        | 27,821                     |       |
| Consolidated        | ** ** | ** ** | ** ** | **$**                  | **413,371** |                       | $          | 404,809 |   |

 

***Note 6. –Seasonality and Weather***

 

As our businesses are affected by weather, the results of operationsfor one quarter do not indicate results to be expected in another quarter.

 

Our Utility Group water operations are seasonal, as rainfall andweather conditions affect water consumption. The second and third quarters of each year typically account for thehighest volume of water consumption when weather tends to be hot and dry and asignificant part of our water sales are for outside usage such as landscape andpools.  Drought conditions may result inlower revenue due to consumer conservation efforts and a shortage of water.Drought conditions may also result in increased water costs to us, which couldadversely affect our profitability. Conversely, unusually wet conditions mayresult in decreased customer demand, lower revenues and lower profit.

 

While our Services Group operations are not as seasonal, they aresubject to the effects of weather. Heavy rainfall or storm conditions may limitour ability to perform certain billable work such as pipeline maintenance,manhole rehabilitation, construction and other outdoor services. Severe weatherconditions may also result in additional labor and material costs as we meetthe terms of our operations and maintenance contracts. Depending on thespecific contractual terms, this additional work may be billable to certainclients.  A significant portion of therevenues of our Texas subsidiaries is earned under time and materials contractswhere revenues are affected by weather and rainfall.

 

***Note 7. – Commitments, Contingencies andRestrictions***

 

*Commitments Under Acquisition Agreements*

 

We own 90% ofthe outstanding common stock of Operations Technologies, Inc. (“OpTech”).We have the right to acquire the remaining 10% of OpTech beginning in August 2006based on a formula relating to the profitability of OpTech. The minority ownerhas the option to sell the remaining 10% of OpTech to the Company using thesame formula.  However, the selling pricecannot be less than $1 million.

 

We have an 80%interest in Windermere Utility Company (“Windermere”) in Texas. We have theright to acquire the remaining 20% ownership in Windermere for a purchase priceof $6 million payable in Southwest’s common stock at any time when the marketvalue of our common stock increases to $12.96 per share (as adjusted for stocksplits and dividends).  This right hasnot been exercised by SWWC.  The minorityowner of Windermere has the right to put the remaining 20% to us beginning in October 2005for up to 450,000 shares of Southwest’s common stock, but no less than 270,000shares, depending on the prevailing stock price, with a value not to exceed $6million.

 

9

----

 

*Commitments Under Divestiture Agreements*

 

As part of theagreement to sell our submetering subsidiary (see Note 9), we are required tocalculate a working capital adjustment, adjust for the net loss of customersand complete a transmitter replacement program. Adjustments to the sales price arising from these items are to be paidor collected through an escrow account of approximately $1.2 million that wasestablished at the close of the transaction in June 2005.   The escrow account will be closed in March 2006and any amounts remaining on deposit at that time will be remitted to us.

 

*Commitments Under Long-term Service Contracts*

 

In September 2002,we won a bid to facilitate the engineering and construction of a reverseosmosis water treatment system in the City of San Juan Capistrano, California,for the Capistrano Valley Water District (“CVWD”). The project included thedrilling of several new wells and the development of associated water lines. Weentered into subcontractor agreements with an engineering firm and a largeconstruction firm to fulfill significant obligations of this contract.

 

Duringconstruction of the CVWD plant, we received payments upon completion ofconstruction. Construction of the plant commenced in December 2002 and wassubstantially complete as of December 31, 2004. The plant becameoperational in 2004 and the Company now operates and maintains the facilityunder a separate 20-year operations and maintenance contract.

 

In January 2003, we obtained an unsecured line of credit facilityfrom a commercial bank that was used to issue a $3.4 million standbyletter of credit as collateral for performance under a contract to design andconstruct a reverse osmosis water treatment facility. This standby letter ofcredit is in force for the construction period of the project.  On April 1, 2005, the standby letter ofcredit was transferred to the New Credit Facility (see Note 10) and the priorline of credit was cancelled.

 

As part of thefinancing of this project, the CVWD issued insured municipal bonds. We enteredinto an agreement with the bond insurer to guarantee our performance under theCVWD contract, subject to certain liability limits to the bond insurer in theevent of a default. Such liability limits will not exceed an amount equal to$6.0 million during the construction period of the project, andafterwards, during the 20-year operation of the facility, the liability limitswill not exceed an amount equal to $4.0 million plus an amount no greaterthan the replacement cost of the reverse osmosis filtration unit within thefacility, estimated to be approximately $1.5 million.

 

*Legal Proceedings*

 

Southwest anda subsidiary were named as defendants in several lawsuits alleging variousinjuries as a result of water contamination in the San Gabriel Valley MainBasin. The California Supreme Court has ruled that the plaintiffs cannotchallenge the adequacy of the water quality standards established by CaliforniaDepartment of Health Services and the United States Environmental ProtectionAgency (“EPA”) but can sue us and the other CPUC-Regulated Water Companies ifthey can prove that the company served water that did not meet those standards.In August 2004 the trial court dismissed the case against us finding thatthere was no evidence that we violated any water quality standards.  The plaintiffs appealed the dismissal to theCourt of Appeals for the State of California, Second Appellate District, wherethe matter is pending. To date, liability insurance carriers have absorbed thecosts of defense of the lawsuits.

 

On May 5, 2005, one of the Company’s operating subsidiariesreceived a subpoena to provide records to a grand jury.  The requestedrecords relate to the operations of the San Simeon wastewater treatment plantin California for the period January 2002 to present.  The facilitywas also served with search warrants executed by the EPA.  The Company’ssubsidiary has operated this facility since June 2004.  The Companyis cooperating with the investigation and is also performing its own internalinvestigation.

 

On May 18, 2005, the EPA executed a search warrant at one of theCompany’s operating subsidiaries in Texas.  The search warrant soughtinformation relating to the subsidiary’s laboratory operations.  TheCompany is cooperating with the investigation and is also performing its owninternal investigation.

 

Southwest Water Company and its subsidiaries are subject to litigationarising in the ordinary course of operations. We believe the ultimateresolution of such matters will not materially adversely affect ourconsolidated financial position, results of operations or cash flows.

 

10

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*Groundwater Settlement*

 

One of the water sources for our California water utility has beenaffected by the presence of certain groundwater contaminants. Thesecontaminants consist mainly of chemicals disposed of by various industrialcompanies in the 1940s and 1950s. In 2001 and 2002, this contaminationnecessitated the removal from service of a number of our wells, and wepurchased replacement water at a cost substantially higher than the cost ofwater pumped from our own wells.

 

As a result of this contamination, under the terms of an agreement withthe responsible parties, we have received payments from these parties, and weexpect to continue to receive payments until completion of remediation or untilour production capacities have been restored. These payments represent the incremental cost of purchasing water overthe cost that would have been incurred by us to pump water from our wells.  Our agreement with the responsible partiesprovided for ongoing reimbursement of our excess water costs and, as such, webill and collect reimbursements monthly. These monthly reimbursements are recorded as a reduction to operatingexpenses–utility group.  During the sixmonths ended June 30, 2005 and 2004, these reimbursements wereapproximately $1.3 million and $1.6 million, respectively.

 

The settlement agreement also provides for contributions by theresponsible parties to construct new wells and to develop additionalinterconnections with nearby water sources. Funds from the settlement agreementwill also be used to develop long-term solutions that will potentially enableus to use our own less costly groundwater supplies in the future.  These contributions, recorded ascontributions in aid of construction (“CIAC”), were approximately $0.1 millionand approximately $0.2 million for the six months ended June 30, 2005 and2004, respectively.

 

***Note8. – Acquisitions***

 

In March 2005, we completed the acquisition of the assets of aBirmingham, Alabama contract operations company.  The aggregate purchase price wasapproximately $2.5 million, of which $0.7 million was deferred, plusliabilities we assumed in the amount of approximately $1.2 million.

 

***Note 9. – DiscontinuedOperations***

 

In June 2005, we completed the sale of our submetering subsidiary thatprovided utility billing and collection services for multi-familyresidential properties in our servicessegment for approximately $12.0 million. We received approximately $10.8 million in cash and approximately $1.2million of the sales price was placed into an escrow account.  We incurred transaction costs ofapproximately $1.0 million to complete the sale and our net proceeds on thesale of our submetering subsidiary was approximately $9.8 million.  The cash was used to subsequently paydown ourbank lines of credit.

 

As part of thesale, we are required to calculate a working capital adjustment, participate ina reconciliation of billing accounts and complete a transmitter replacementprogram.  Adjustments arising from theseitems are to be paid or collected through the escrow account that wasestablished at the close of the transaction.  The escrow account will be closed in March 2006 and any amountsremaining on deposit at that time will be remitted to us.

 

In the second quarter we recorded a loss from discontinued operations(net of income tax benefit of approximately $0.7 million) of approximately $1.1million and a loss on sale of stock of approximately $3.7 million (net ofincome tax benefit of approximately $0.3 million).

 

***Note 10. – Debt Obligations***

 

In April 2005, we entered into the New Credit Facility.  The New Credit Facility provides for a $100million revolving credit facility, which includes a $40 million letter ofcredit subfacility and a $10 million swingline subfacility.  The NewCredit Facility contains customary covenants, as well as customary events ofdefault.  Certain of our subsidiarieshave guaranteed our obligation to repay borrowings under the New CreditFacility.

 

Loans under the New Credit Facility (other than swingline loans) willbear interest at a rate equal to (i) a Eurodollar rate plus the applicablemargin (as defined in the New Credit Facility), or (ii) a base rate (asdefined) minus the applicable margin.  AtJune 30, 2005, we had approximately $48 million of outstanding borrowingsunder our New Credit Facility and the adjusted average borrowing rate wasapproximately 4.3%.  The New CreditFacility replaced our lines of credit which had provided for up to $50 millionof borrowings and we used the New Credit Facility to repay amounts outstandingunder those lines of credit.  As of June 30,2005, we were in compliance with all applicable covenants under the New CreditFacility.

 

11

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In January 2003, we received a $3.4 million line of credit withone of our commercial banks that we used to issue a standby letter of credit inthat amount as collateral for performance under a contract to design andconstruct a reverse osmosis water treatment facility.  Upon final completion of the project,expected in 2005, the standby letter of credit will be terminated.  On April 1, 2005, the standby letter ofcredit was transferred to the New Credit Facility, and the separate line ofcredit was cancelled.

 

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***Item 2: Management’s Discussion and Analysis of Financial Condition andResults of Operations***

 

*Theinformation in this discussion contains forward-looking statements within themeaning of Section 27A of the Securities Act of 1933, as amended and Section 21Eof the Securities Exchange Act of 1934, as amended (the”34 Act”). Suchstatements are based upon current expectations that involve risks anduncertainties includingthose set forth under “Risk Factors” in this report and under “Business-RiskFactors” in our 2004 Annual Report**.  Factors that could affect forward-lookingstatements relating to the resolution of the material weakness with respect tointernal controls discussed in Item 9A of the 2004 Annual Report include, amongother things: the Company’s ability to design and maintain policies andprocedures which enable the Company to avoid any reoccurrence of the matterswhich gave rise to the material weakness and the Company’s ability to identifyand retain qualified and experienced financial personnel.*  *Any statements contained herein that are not statements of historicalfacts may be deemed to be forward-looking statements. For example, words suchas “may”, “will”, “should”, “estimates”, “predicts”, “potential”, “continue”, “strategy”,“believes”, “expects”, “anticipates”, “plans”, “intends”, and similarexpressions are intended to identify forward-looking statements. Our actualresults and the timing of certain events may differ significantly from theresults discussed in the forward-looking statements. We undertake no obligationto publicly update or revise any forward-looking statements to reflect currentor future events or circumstances.*

 

The following discussion should be read inconjunction with the accompanying unaudited condensed consolidated financialstatements and related notes thereto and the consolidated financial statementsand the notes thereto contained in our 2004 Annual Report.

 

**Overview**

 

Southwest Water Company and subsidiaries (“Southwest,” “we,” “us,” “our”or the “Company,” unless the context otherwise requires) provide a broad rangeof water and wastewater services including water production, treatment anddistribution; wastewater collection and treatment; utility billing andcollection; utility infrastructure construction management; and public worksservices. We provide services to more than two million people. Our business issegmented into two operating groups: our Utility Group and our Services Group.

 

Our Utility Group owns and manages a rate-regulated public waterutilities in California, water and wastewater facilities in New Mexico,Oklahoma and Texas.  State and federalagencies issue regulations regarding standards of water quality, safety,environmental and other matters which affect these operations, as well asestablish the rates that we can charge for our water and wastewater services.

 

Our Services Group operates our contract service businesses in which weoperate and maintain water supply and wastewater facilities owned by cities,public agencies, municipal utility districts, private entities andinvestor-owned utilities (including Utility Group affiliates) primarily inAlabama, California, Colorado, Georgia, Mississippi, New Jersey, New Mexico,South Dakota and Texas. While state and federal agencies issue regulationsregarding standards of water quality, safety, environmental and other matterswhich affect these operations, our Services Group prices are not subject toregulation. We also provided utility billing and collection services.

 

In July 2004, we acquired a Texas water and wastewater utilityconsisting of a collection of approximately 87 rural regulated water systemsand 13 wastewater systems serving approximately 21,000 water connections and3,500 wastewater connections from Tecon Water Holdings, L.P. for approximately$66 million, and renamed the utility Monarch Utilities, Inc. (“Monarch”).

 

In June 2005, we completed the sale of our submetering subsidiary thatprovided utility billing and collection services for multi-familyresidential properties for approximately$12.0 million.  We received approximately$10.8 million in cash and approximately $1.2 million of the sales price wasplaced into an escrow account.  Weincurred transaction costs of approximately $1.0 million to complete the saleand our net proceeds on the sale of our submetering subsidiary wereapproximately $9.8 million.

 

In the second quarter we recorded a loss from discontinued operations(net of income tax benefit of approximately $0.7 million) of approximately $1.1million and a loss on sale of stock of approximately $3.7 million (net ofincome tax benefit of approximately $0.3 million) in connection with the saleof our submetering subsidiary.

 

13

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**Results of Operations**

 

A summary of ourconsolidated results for continuing operations for the three and six monthsended June 30, 2005 and 2004 is as follows:

 
| ** **                                                 | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|------------------------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                                 | ** ** | ** **                           | ** ** | **% of**                           | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** | ** ** | ** ** | **% of** | ** ** |
| ** **                                                 | ** ** | **2005**                             | ** ** | **Revenue**                        | ** ** | **2004** | ** ** | **Revenue** | ** ** | **2005** | ** ** | **Revenue** | ** ** | **2004** | ** ** | **Revenue** | ** ** |
| ** **                                                 | ** ** | **($ amounts in millions)**     | ** ** |
| **Revenues:**                                              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Utility group                                              |       | $                                    | 20.3       |                               | 40         |   | $ | 16.6 |   | 38 |   | $ | 35.8 |   | 37 |   | $ | 29.6 |   | 36 |   |
| Services group                                             |       | 31.0                                 |       | 60                                 |       | 26.8 |   | 62 |   | 60.8 |   | 63 |   | 51.8 |   | 64 |   |
|                                                       |       | 51.3                                 |       | 100                                |       | 43.4 |   | 100 |   | 96.6 |   | 100 |   | 81.4 |   | 100 |   |
| **Expenses:**                                              |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating expenses - utility group                         |       | 10.7                                 |       | 21                                 |       | 8.6 |   | 20 |   | 20.7 |   | 21 |   | 16.3 |   | 20 |   |
| Operating expenses - services group                        |       | 26.7                                 |       | 52                                 |       | 24.2 |   | 55 |   | 52.6 |   | 54 |   | 47.8 |   | 59 |   |
| Selling, general and administrative  expenses              |       | 7.4                                  |       | 14                                 |       | 6.0 |   | 14 |   | 15.3 |   | 16 |   | 12.1 |   | 15 |   |
|                                                       |       | 44.8                                 |       | 87                                 |       | 38.8 |   | 89 |   | 88.6 |   | 91 |   | 76.2 |   | 94 |   |
| **Operating Income**                                       |       | 6.5                                  |       | 13                                 |       | 4.6 |   | 11 |   | 8.0 |   | 9 |   | 5.2 |   | 6 |   |
| ** **                                                 |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Other Income (Expense):**                                |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense                                           |       | (1.9                                 | )          | (4                                 | )          | (1.0 | ) | (2 | ) | (3.7 | ) | (4 | ) | (1.9 | ) | (2 | ) |
| Interest income                                            |       | 0.1                                  |       | —                             |       | 0.2 |   | — |   | 0.2 |   | — |   | 0.3 |   | — |   |
| Other                                                      |       | 0.1                                  |       | —                             |       | (0.1 | ) | — |   | 0.1 |   | — |   | (0.1 | ) | — |   |
|                                                       |       | (1.7                                 | )          | (4                                 | )          | (0.9 | ) | (2 | ) | (3.4 | ) | (4 | ) | (1.7 | ) | (2 | ) |
|                                                       |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Income from Continuing Operations before Income  Taxes** |       | 4.7                                  |       | 9                                  |       | 3.7 |   | 9 |   | 4.6 |   | 5 |   | 3.5 |   | 4 |   |
| **Income Tax Provision**                                   |       | 1.7                                  |       | 3                                  |       | 1.4 |   | 3 |   | 1.7 |   | 2 |   | 1.3 |   | 2 |   |
| **Net Income from Continuing Operations**                  |       | $                                    | 3.0        |                               | 6          |   | $ | 2.3 |   | 6 |   | $ | 2.9 |   | 3 |   | $ | 2.2 |   | 2 |   |

 

**Discussion of Resultsof Operations for Three Months Ended June 30, 2005 and 2004**

 

**Revenues**

 

**Utility Group**

 

Utility Group revenues are derived from the production and distributionof water and the collection and treatment of sewage for residential, industrialand commercial use. Our Utility Group water operations are seasonal, asrainfall and weather conditions affect water consumption.  In our service areas, the second and thirdquarters of each year typically account for the highest volume of waterconsumption when weather tends to be hot and dry. Drought conditions may resultin lower revenue due to consumer conservation efforts and a shortage of water.Drought conditions may also result in increased water costs to us, which couldadversely affect our profitability. Conversely, unusually wet conditions mayresult in decreased customer demand, lower revenues and lower profit in ourUtility Group operations.

 

Revenues in the Utility Group increased approximately$3.7 million, or 22%, to $20.3 million during the three months ended June 30,2005, from $16.6 million during the same period of the prior year. Theincrease in Utility Group revenue was primarily due to the following:

 

1.               A $4.1 millionincrease in revenues attributable to Monarch, which we acquired in July 2004.

2.               An increase of $0.2million due to higher volume and increased number of connections served by ourNew Mexico and other Texas utilities.

 

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3.               These increaseswere partially offset by a decrease in our California utility revenues of $0.7million due primarily to significantly higher rainfall in southern Californiaduring the second quarter of 2005 versus the second quarter of 2004 which was aperiod of unseasonably low rainfall.

 

**Services Group**

 

Services Group revenues represent fees earned for water and wastewaterfacility operations and maintenance (O&M) services, equipment maintenanceand repair, sewer pipeline cleaning, utility billing and collection services,construction management services, state-certified water and wastewaterlaboratory analysis and public works. Revenues for the three months ended June 30,2005 increased approximately $4.2 million, or 16%, to $31.0 million from $26.8million during the same period of the prior year.

 

The increase in Services Group revenues was primarily due to thefollowing:

 

1.               A$4.5 millionincrease in revenue associated with contract operations, primarily thoseperformed for our Utility Group, as well as increased project work.  The increased project work is also a resultof approximately 76% less rainfall in southern Texas versus the second quarterof 2004 which allowed work crews to complete projects.

2.               A $1.2 millionincrease due to the recent acquisition of contract operations in Alabama and a$0.5 million increase from revenues generated by a laboratory we acquired inthe latter part of 2004.

3.               These revenueincreases were partially offset by a decrease of approximately $2.0 million inconstruction work related to the reverse osmosis plant, which was underconstruction since 2003 and was substantially completed as of December 31,2004.

 

**Expenses**

 

**Operating expenses – utility group**

 

Operatingexpenses–utility group represent the costs of purchasing and producing water,treating wastewater, salaries, wages and employee benefits, facilities costs,power and electricity, supplies and equipment, repairs and maintenance,professional fees and other costs. Operating expenses for our Utility Groupincreased $2.1 million, or 24%, to $10.7 million during the three monthsended June 30, 2005, from $8.6 million during the comparable period of2004.  The increase in operating expenseswas primarily due to the following:

 

1.               Operating costs of approximately $2.8million attributable to Monarch.

2.               This increase was offset in part byreduced operating expenses of $0.6 million at our California utility dueprimarily to lower production as a result of above average rainfall.

 

Operating expenses–utility group represented approximately 53% and 52%of revenues from utility operations for the three months ended June 30,2005 and 2004, respectively.  Theincrease was primarily due to the July 2004 acquisition of Monarch whichincurs higher operating expenses as a percentage of revenue, as we hadanticipated.

 

**Operating expenses – services group**

 

Operating expenses–services group include salaries, wages and employeebenefits, project costs, fleet expenses, facilities costs, supplies andequipment, repairs and maintenance and professional fees.  Operating expenses–services group increasedapproximately $2.5 million, or 10%, to $26.7 million during the three monthsended June 30, 2005 from $24.2 million during the same period of2004.  The increase in operating expense–servicesgroup was due primarily to the increased staffing, fleet and other related directexpense associated with the additional contract work stemming from theacquisition of contract operations in Alabama and work that was delayed from2004.  The staffing increase resulted inhigher salary and wage expenses as well as benefits and other related costs.

 

Operating expenses – services group, as a percentage of the revenuesfrom the related operations decreased to 86% for the three months ended June 30,2005 compared to 90% for the same period of 2004.   The decrease was due to the increase inrevenues relative to expenses for additional construction, operating andmaintenance work.

 

**Selling, general and administrative expenses**

 

Selling, general and administrative expenses consist mainly ofpersonnel, facilities, insurance and professional services costs, which supportour sales, marketing, human resources, finance and administrationfunctions.  Selling, general andadministrative expenses increased $1.4 million, or 23%, to $7.4 million for thethree months ended June 30, 2005 compared to $6.0 million during the sameperiod of 2004.  Selling, general and administrative expensesremained constant at 14% of revenues for the three months ended June 30,2005 and the three months ended

 

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June 30,2004.  The increase inselling, general and administrative expenses was primarily due to thefollowing:

 

1.               Compensation andbenefits increased approximately $0.6 million due to increase in staffheadcount to support our revenue trends.

2.               An increase of $0.8million attributable to acquisitions of Monarch, contract operations in Alabamaand laboratory service in Texas.

 

**Other Income (Expense)**

 

**InterestExpense**

 

Interest expense increased approximately $0.9 million or 93%, duringthe three months ended June 30, 2005 compared to the same period in2004.  The major components of interestexpense are as follows:

 
| ** **                                             | ** ** | ** ** | ** ** | **For the Three Months Ended** | ** ** |
|--------------------------------------------------------|------------|------------|------------|--------------------------------|------------|
| ** **                                             | ** ** | ** ** | ** ** | **June 30,**              | ** ** |
| ** **                                             | ** ** | ** ** | ** ** | **2005**                       | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | ** ** | ** ** | **(in thousands)**             | ** ** |
| Interest expense - convertible subordinate  debentures | ** ** | ** ** | ** ** | **$**                          | **295**    | ** ** | $ | 316 |   |
| Interest expense - bank lines of credit                | ** ** | ** ** | ** ** | **574**                        | ** ** | 165 |   |
| Interest expense - mortgage bonds and bank  term loan  | ** ** | ** ** | ** ** | **1,032**                      | ** ** | 493 |   |
| Interest expense - other                               | ** ** | ** ** | ** ** | **7**                          | ** ** | 54 |   |
| Total interest expense before capitalized  interest    | ** ** | ** ** | ** ** | **1,908**                      | ** ** | 1,028 |   |
| Capitalized interest                                   | ** ** | ** ** | ** ** | **(12**                        | **)**      | (71 | ) |
| Total interest expense                                 | ** ** | ** ** | ** ** | **$**                          | **1,896**  | ** ** | $ | 957 |   |

 

The increase in total interest expense is primarily due to an increasein our long-term debt and borrowing on our bank lines of credit.  Our average balances of interest bearing debtoutstanding were approximately $133 million and $63 million for the threemonths ended June 30, 2005 and 2004, respectively.  The increase in our average balances oflong-term debt was driven primarily by debt assumed in our acquisition ofMonarch in July 2004 and $27 million of first mortgage bonds issued by ourCalifornia and New Mexico utilities in the fourth quarter of 2004.  In addition, our effective weighted averageborrowing rate decreased to 6.2% during the three months ended June 30,2005 from 6.9% during the three months ended June 30, 2004.

 

**Provision for Income Taxes**

 

Our effective consolidated income tax rates on combined continuing anddiscontinued operations for the three months ended June 30, 2005 and 2004were approximately 35% and 37%, respectively.

 

During the quarter ended June 30, 2005 we recognized a capitalloss of approximately $4.0 million for income tax purposes upon the sale of oursubmetering subsidiary.  We will be ableto carry back the capital loss to the prior three years and partially offset itagainst capital gains of approximately $0.9 million realized during thoseyears.  As a result, we have recognizedan income tax benefit of approximately $0.3 million during the second quarter of2005, resulting in a net loss of approximately $3.7 million on sale of thissubsidiary.

 

The remaining capital loss of approximately $3.1 million may be carriedforward for a period of up to 15 years and offset against future capital gains,if any, which may be realized during those years. No income tax benefit hasbeen recorded for this capital loss carryforward.

 

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**Discussion of Resultsof Operations for Six Months Ended June 30, 2005 and 2004**

 

**Revenues**

 

**Utility Group**

 

Revenues in the Utility Group increased approximately$6.2 million, or 21%, to $35.8 million during the six months ended June 30,2005, from $29.6 million during the same period of the prior year. Theincrease in Utility Group revenue was primarily due to the following:

 

1.               A $7.6 millionincrease in revenues attributable to Monarch which we acquired in July 2004.

2.               An increase inrevenue from our New Mexico and Texas utilities of $0.5 million primarily dueto increased connections.

3.               The above increaseswere partially offset by a decrease in revenues of our California utility of$1.9 million due primarily to significantly higher rainfall in southernCalifornia during the first half of 2005 versus the first half of 2004 whichwas a period of unseasonably low rainfall.

 

**Services Group**

 

Revenues for the six months ended June 30, 2005 increasedapproximately $9.0 million, or 17%, to $60.8 million from $51.8 million duringthe same period of the prior year.

 

The increase in Services Group revenues was primarily due to thefollowing:

 

1.               A $10.6 millionincrease in revenue associated with contract operations, primarily thoseperformed for our Utility Group, as well as increased construction work.  The increased project work is also a resultof approximately 53% less rainfall in southern Texas versus the first half of2004 which allowed work crews to complete projects.

2.               A $1.1 millionincrease due to the acquisition of a laboratory and a $1.4 million due toacquisition of contract operations.

3.               These revenueincreases were partially offset by a decrease of $4.3 million increase inconstruction work related to the reverse osmosis plant which has been underconstruction since 2003 and was substantially completed as of December 31,2004.

 

**Expenses**

 

**Operating expenses – utility group**

 

Operatingexpenses—utility group represent the costs of purchasing and producing water,treating wastewater, salaries, wages and employee benefits, facilities costs,power and electricity, supplies and equipment, repairs and maintenance,professional fees and other costs. Operating expenses for our Utility Groupincreased $4.4 million, or 27%, to $20.7 million during the six monthsended June 30, 2005, from $16.3 million during the comparable period of2004.  The increase in operating expenseswas primarily due to the following:

 

1.               Operating costs of approximately $5.5million attributable to Monarch.

2.               This increase was offset in part byreduced operating expenses of $1.2 million at our California utility due tolower production as a result of above average rainfall.

 

Operating expenses—utility group represented approximately 58% and 55%of revenues from utility operations for the six months ended June 30, 2005and 2004, respectively.  The increase wasprimarily due to the July 2004 acquisition of Monarch which incurs higheroperating expenses as a percentage of revenue, as we had anticipated.

 

**Operating expenses – services group**

 

Operating expenses–services group include salaries, wages and employeebenefits, project costs, fleet expenses, facilities costs, supplies andequipment, repairs and maintenance and professional fees.  Operating expenses—services group increasedapproximately $4.8 million, or 10%, to $52.6 million during the six monthsended June 30, 2005 from $47.8 million during the same period of 2004.  The increase in operating expense–servicesgroup was due to the increased staffing and fleet expense related to additionalcontract

 

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work, some of which was delayed from 2004.  The staffing increase resulted in highersalary and wage expenses as well as benefits and other related costs.

 

Operating expenses – services group, as a percentage of the relatedrevenues decreased to 87% for the six months ended June 30, 2005 comparedto 92% for the same period of 2004.   Thedecrease was due to the increase in revenues relative to expenses foradditional construction, operating and maintenance work.

 

**Selling, general and administrative expenses**

 

Selling, general and administrative expenses consist mainly of personnel,facilities, insurance and professional services costs, which support our sales,marketing, human resources, finance and administration functions.  Selling, general and administrative expensesincreased $3.2 million, or 26%, to $15.3 million for the six months ended June 30,2005 compared to $12.1 million during the same period of 2004.  Selling, general and administrative expensesincreased to 16% of revenues for the six months ended June 30, 2005 from15% during the six months ended June 30, 2004.  The increase in selling, general andadministrative expenses was primarily due to the following:

 

1.               An increase inaudit fees of $0.4 million as well as an increase of $0.4 million in outsideservices most of which is attributable to our efforts to prepare for and complywith the Sarbanes-Oxley Act of 2002.

2.               An increase of $1.2million attributable to acquisitions, most of which relates to the Monarchacquisition in July 2004.

3.               A $1.2 millionincrease in costs compared to the prior period related to salaries and employeebenefits due to increases in headcount to support our revenue trends.

 

**Other Income (Expense)**

 

**InterestExpense**

 

Interest expense increased approximately $1.7 million, or 95%, duringthe six months ended June 30, 2005 compared to the same period in2004.  The major components of interestexpense are as follows:

 
| ** **                                             | ** ** | ** ** | ** ** | **For the Six Months Ended** | ** ** |
|--------------------------------------------------------|------------|------------|------------|------------------------------|------------|
| ** **                                             | ** ** | ** ** | ** ** | **June 30,**            | ** ** |
| ** **                                             | ** ** | ** ** | ** ** | **2005**                     | ** ** | **2004** | ** ** |
| ** **                                             | ** ** | ** ** | ** ** | **(in thousands)**           | ** ** |
| Interest expense - convertible subordinate  debentures | ** ** | ** ** | ** ** | **$**                        | **591**    | ** ** | $ | 642 |   |
| Interest expense - bank lines of credit                | ** ** | ** ** | ** ** | **876**                      | ** ** | 412 |   |
| Interest expense - mortgage bonds and bank  term loan  | ** ** | ** ** | ** ** | **2,146**                    | ** ** | 985 |   |
| Interest expense - other                               | ** ** | ** ** | ** ** | **137**                      | ** ** | 99 |   |
| Total interest expense before capitalized  interest    | ** ** | ** ** | ** ** | **3,750**                    | ** ** | 2,138 |   |
| Capitalized interest                                   | ** ** | ** ** | ** ** | **(82**                      | **)**      | (213 | ) |
| Total interest expense                                 | ** ** | ** ** | ** ** | **$**                        | **3,668**  |   | $ | 1,925 |   |

 

The increase in total interest expense is primarily due to an increasein our long-term debt and borrowings on our bank lines of credit.  Our average balances of interest bearing debtoutstanding were approximately $129 million and $71 million for the six monthsended June 30, 2005 and 2004, respectively.  The increase in our average balances oflong-term debt was driven primarily by debt assumed in our acquisition ofMonarch in July 2004 and $27 million of first mortgage bonds issued by ourCalifornia and New Mexico utilities in the fourth quarter of 2004.  In addition, our effective weighted averageborrowing rate decreased to 6.4% during the six months ended June 30, 2005from 6.6% during the six months ended June 30, 2004.

 

**Provision for Income Taxes**

 

Our effective consolidated income tax rates on combined continuing anddiscontinued operations for the six months ended June 30, 2005 and 2004were approximately 35% and 37%, respectively.

 

During the six months ended June 30, 2005 we recognized a capitalloss of approximately $4.0 million for income tax purposes upon the sale of oursubmetering subsidiary in the amount of approximately $4.0 million.  We will be able to carry back the capitalloss to the prior three years and partially offset it against capital gains ofapproximately $0.9 million realized during those years.  As a result,

 

18

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we have recognized an income tax benefit of approximately $0.3 million duringthe second quarter of 2005, resulting in a net loss of approximately $3.7million on sale of this subsidiary.

 

The remaining capital loss of approximately $3.1 million may be carriedforward for a period of up to 15 years and offset against future capital gains,if any, which may be realized during those years. No income tax benefit hasbeen recorded in 2005 for this capital loss carryforward.

 

**Liquidityand Capital Resources**

 

Our corporate objectives with respect to liquidity and capitalresources are to:  (i) generatesufficient operating cash to provide for dividends, principal and interestrequirements on our indebtedness, capital improvements, and taxes; (ii) obtainexternal financing for long term capital improvements and acquisitions; (iii) useour credit facilities to manage seasonal cash needs; and (iv) maintainapproximately equal levels of debt and equity.

 

Our statements of cash flows are summarized as follows:

 
| ** **                                                   | ** ** | ** ** | ** ** | **Six Months Ended** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|----------------------|------------|
| ** **                                                   | ** ** | ** ** | ** ** | **June 30,**    | ** ** |
| ** **                                                   | ** ** | ** ** | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                   | ** ** | ** ** | ** ** | **(in thousands)**   | ** ** |
| Net cash provided (used) by continuing  operating activities | ** ** | ** ** | ** ** | **$**                | **7,437**  | ** ** | $ | (977 | ) |
| Net cash used in investing activities                        | ** ** | ** ** | ** ** | **(16,292**          | **)**      | (18,180 | ) |
| Net proceeds from sale of discontinued  operations           | ** ** | ** ** | ** ** | **9,852**            | ** ** | — |   |
| Net cash provided by financing activities                    | ** ** | ** ** | ** ** | **10,059**           |       | 14,233 |   |
| Net increase (decrease) in cash and cash  equivalents        | ** ** | ** ** | ** ** | **$**                | **11,056** |   | $ | (4,924 | ) |

 

Despite a net loss for the quarter, net cash flow increased byapproximately $11.0 million for the six months ended June 30, 2005 ascompared to a decrease of $4.9 million in 2004. The increase in net cash flow was primarily the result of net proceedsreceived from the sale of our submetering subsidiary of approximately $9.8million.  Other cash flow activityincluded net borrowings on our line of credit of $9.6 million andcontributions in aid of construction of $1.1 million and proceeds from ourdividend reinvestment, employee stock purchase and stock option plan ofapproximately $1.3 million which were offset by purchases of property plant andequipment of approximately $14.3 million and dividends of approximately $1.9million.  (For further discussion onoperating revenues and expenses see Results of Operations.)

 

*Cash Flows From Operating Activities*

 

Net cash provided by operating activities during the six months ended June 30,2005 consisted of a net loss of approximately $2.0 million adjusted for certainnon-cash items including loss on discontinued operations of approximately $1.2million and loss on sale of our submetering subsidiary of approximately $3.7 millionand approximately $5.0 million of depreciation and amortization expense, stockbased compensation expense of approximately $0.5 million**,**an increase in deferred income taxes ofapproximately $1.5 million, and a decrease in other current assets of $4.3million.  Cash flow declined due to adecrease of our accounts payable of approximately $2.6 million and anincrease in accounts receivable of approximately $2.5 million.  The increase in our accounts receivablerepresents an increase in billings to our customers due to increasedconsumption of water.

 

*Cash Flows from Investing Activities*

 

Cash used in investing activities totaled $16.3 million in the firstsix months of 2005 and was the result of capital improvements in our utilitybusiness of approximately $14.3 million and acquisitions in our servicesbusiness of approximately $2.0 million. Capital expenditures of $14.3 million were primarily invested inregulated water utility assets for purposes of expansion, replacement orrenovation.  The following tablesummarizes property, plant and equipment additions for each of the first sixmonths in 2005 and 2004.

 

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| ** **                                        | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------|------------|----------------------|------------|
| ** **                                        | ** ** | **June 30,**    | ** ** |
| ** **                                        | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                        | ** ** | **(in thousands)**   | ** ** |
| Company-financed additions                        | ** ** | **$**                | **13,027** |   | $ | 6,179 |   |
| Capital improvement reimbursements                | ** ** | **139**              |       | 169 |   |
| Contributions paid for by developers              | ** ** | **1,118**            |       | 4,869 |   |
| Net cash used in investing activities             | ** ** | **14,284**           |       | 11,217 |   |
| Property contributed by developers                | ** ** | **1,110**            |       | 2,349 |   |
| Total additions to property, plant and  equipment | ** ** | **$**                | **15,394** |   | $ | 13,566 |   |

 

Cash payments for acquisitions during the first six months of 2005 and2004 included:

 

•                  $2.0million in 2005 in cash for the purchase of Alabama contract operations, and

 

•                  $6.9million in 2004 to acquire the remaining minority interest and additionalcontracts for our submetering subsidiary which was sold in June 2005.

 

*Cash Flows from the Sale of DiscontinuedOperations*

 

InJune 2005, we completed the sale of our submetering subsidiary in our services segment for approximately $12.0million.  We received approximately $10.8million in cash and approximately $1.2 million of the sales price was placedinto an escrow account.  We incurredtransaction costs of approximately $1.0 million to complete the sale and ournet proceeds on the sale of submetering subsidiary were approximately $9.8million.  The cash from the sale wassubsequently used to paydown our bank lines of credit in our New CreditFacility.

 

*Cash Flows from Financing Activities*

 

Our financing activities involved the following events during the firstsix months ended in 2005 and 2004 as follows:

 

•                  Netborrowings on our revolving lines of credit in 2005 of approximately $25.0million.  These borrowings were usedprimarily for principal payments on long-term debt of $15.3 million inconjunction with the establishment of our New Credit Facility.

 

•                  Apublic offering of approximately 1.7 million shares of our common stock inMarch 2004, which generated net proceeds of approximately $20.6 million.

 

Aggregate borrowings under our revolving lines of credit wereapproximately $48.0 million as of June 30, 2005, an increase ofapproximately $25.0 million since December 31, 2004 for increased capitalexpenditures and prepayments of long-term debt of approximately $15.3 millionin conjunction with the establishment of our New Credit Facility (details arediscussed below).  Our total borrowingavailability under the New Credit Facility was approximately $48.1 million asof June 30, 2005.

 

As more fully discussed below, we entered into a new 5-year creditfacility with a syndicate of banks in April 2005, which provides for a$100 million revolving credit facility. In April 2005, we used a portion of our borrowings from the NewCredit Facility to repay amounts outstanding, and to extinguish, our lines ofcredit and certain other indebtedness.

 

During 2005, we paid dividends totaling approximately $2.0 million. Ourquarterly dividend rate is currently $0.05 per common share.  Common stockholders may elect to participatein our Amended and Restated Dividend Reinvestment and Stock Purchase Plan,which gives them the option of receiving their dividends in either cash orcommon stock at a 5% discount from current market value.  This plan also permits optional cashpurchases of stock at current market values of up to $10,000 per stockholdereach month. Proceeds from this plan were approximately $0.5 million.

 

Contributions in Aid of Construction (CIAC) represent contributions inthe form of cash, services or property received from developers, governmentalagencies, municipalities or individuals for the purpose of constructing utilityplant.

 

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Our capital resources are used for debt service on our bonds anddebentures and are also influenced by investments we make in new businessventures, including the acquisition of companies and acquisition of contractoperations. We have historically generated reasonably stable operating cashflows.

 

We expect to expend approximately $10 million for cash capitalexpenditures for the remainder of 2005, primarily for utility property, plantand equipment.  We plan to fund thoseexpenditures with cash flow from operations, borrowings under our New CreditFacility , long term debt financing and other sources.

 

We augmentedour operating cash flow with borrowings under our lines of credit.  At June 30, 2005, we had a workingcapital of approximately $20.3 million including available cash andcash-equivalent balances of approximately $12.4 million (excludingrestricted cash balances).  EffectiveApril 1, 2005, we implemented the New Credit Facility and took thefollowing actions to reduce interest expense.

 

1)              Issued a redemption notice to holders of$4.0 million of our New Mexico bonds on April 4, 2005 with a redemptiondate of May 9, 2005,

2)              Redeemed notes payable of approximately $2.5 millionon April 29, 2005,

3)              Extinguished a term loan for our TexasUtility in the amount of approximately $8.8 million on April 1, 2005, and

4)              Repaid a revolving credit facility forour New Mexico Utility in the amount of approximately $3.8 million onApril 1, 2005.

 

**Off-BalanceSheet Arrangements**

 

We do not haveany material off-balance sheet arrangements other than leases that have beenclassified as operating leases in accordance with US GAAP for interim financialinformation.

 

**Debt Obligations**

 

Following is a summary of our debt obligations and commitments due inthe remaining six months of 2005 and in the specified periods thereafter.  Amounts represent the expected cash principalpayments related to our long-term debt.

 
| ** **                         | ** ** | ** **         | ** ** | **Years Ending December 31,** | ** ** | ** ** | ** ** |
|------------------------------------|------------|--------------------|------------|------------------------------------|------------|------------|------------|
| ** **                         | ** ** | ** **         | ** ** | ** **                         | ** ** | ** ** | ** ** | ** ** | ** ** | **2009 and** | ** ** | ** ** | ** ** |
| ** **                         | ** ** | **2005**           | ** ** | **2006**                           | ** ** | **2007**   | ** ** | **2008** | ** ** | **thereafter** | ** ** | **Total** | ** ** |
| ** **                         | ** ** | **(in thousands)** | ** ** |
| Long-term debt                     |       |               |       |                               |       |       |       |   |   |   |   |   |   |
| Bank lines of credit               |       | $                  | —     |                               | $          | —     |       | $ | — |   | $ | — |   | $ | 48,000 |   | $ | 48,000 |   |
| Bank term loans                    |       | 471                |       | 946                                |       | 938        |       | 931 |   | 11,660 |   | 14,946 |   |
| Economic development revenue bonds |       | 95                 |       | 100                                |       | 105        |       | 115 |   | 1,810 |   | 2,225 |   |
| Mortgage bonds                     |       | —             |       | 8,000                              |       | —     |       | — |   | 35,000 |   | 43,000 |   |
| Convertible subordinate debentures |       | —             |       | —                             |       | —     |       | — |   | 17,235 |   | 17,235 |   |
| Notes payable                      |       | 103                |       | 397                                |       | 420        |       | 1,598 |   | — |   | 2,518 |   |
|                               |       | $                  | 669        |                               | $          | 9,443      |       | $ | 1,463 |   | $ | 2,644 |   | $ | 113,705 |   | $ | 127,924 |   |

 

In April 2005, we entered into the New Credit Facility.  The New Credit Facility provides for a $100million revolving credit facility, which includes a $40 million letter ofcredit subfacility and a $10 million swingline subfacility.  The NewCredit Facility contains customary covenants, as well as customary events ofdefault.  Certain of our subsidiarieshave guaranteed our obligation to repay borrowings under the New CreditFacility.

 

Loans under the New Credit Facility (other than swingline loans) bearinterest at a rate equal to (i) LIBOR plus the applicable margin (asprovided for in the New Credit Facility), or (ii) a base rate (as defined)minus the applicable margin.  AtJune 30, 2005, we had $48.0 million of outstanding borrowings under ourNew Credit Facility and the adjusted average borrowing rate was approximately4.3%.  The New Credit Facility replacedour existing lines of credit which had provided for up to $50.0 million ofborrowings and we used the New Credit Facility to repay amounts outstandingunder those lines of credit.  As of June 30,2005, we were in compliance with all applicable covenants under our thenoutstanding line of credit agreements.

 

In January 2003, we received a $3.4 million line of credit fromone of our commercial banks that we used to issue a standby letter of credit inthat amount as collateral for performance under a contract to design andconstruct a reverse osmosis water treatment facility.

 

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Upon final completion of the project, expected in 2005, the standbyletter of credit will be terminated.  OnApril 1, 2005, the standby letter of credit was transferred to the NewCredit Facility and the standby line of credit was cancelled.

 

In addition to the foregoing, the indentures governing the firstmortgage bonds for our California and New Mexico utilities permitted theissuance of approximately $65.7 million of first mortgage bonds at theseutilities as of June 30, 2005.

 

We anticipate that our available credit facility borrowing capacity,cash flows generated from operations, long term debt financing and othersources will be sufficient to fund our activities during the next12 months, however we cannot guarantee that will be the case.  If we needed additional financing and wereunable to obtain it, our capital spending and any future acquisitions would bedelayed, reduced, or eliminated.

 

We have an effective registration statement on file with the Securitiesand Exchange Commission (“SEC”). Approximately $6 million remains available for issuance as ofJune 30, 2005 under this registration statement. We may offer any of thesesecurities for sale at any time and from time to time.

 

**CriticalAccounting Policies**

 

Ourconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States (“US GAAP”). Theseaccounting principles require us to make certain estimates, judgments andassumptions. We believe that the estimates, judgments and assumptions arereasonable based upon information available to us at the time that theseestimates, judgments and assumptions are made. These estimates, judgments andassumptions can affect the reported amounts of assets and liabilities as of thedate of the financial statements, as well as the reported amounts of revenuesand expenses during the periods presented. To the extent there are materialdifferences between these estimates, judgments or assumptions and actualresults, our financial statements will be affected. The significant accountingpolicies that we believe are important to fully understanding and evaluatingour reported financial results include the following:

 

•                  Revenuerecognition,

•                  Valuationof long-lived and intangible assets,

•                  Accountingfor regulated businesses,

•                  Stock-basedcompensation, and

•                  Deferredcosts.

 

In many cases,the accounting treatment of a particular transaction is specifically dictatedby GAAP and does not require management’s judgment in its application. Thereare also areas which require management’s judgment in selecting among availableGAAP alternatives. Our senior management has reviewed these critical accountingpolicies and related disclosures with the audit committee of the Board ofDirectors.

 

**Revenue recognition**

 

Water utilityrevenues are recognized when water is delivered to customers. At the end of anaccounting period, estimated amounts for unbilled revenues are accrued forwater usage since the previous billing period.

 

Revenues forcontract operations are recognized and billed at the end of the month based ona monthly fee to provide a specific level of service as outlined in eachindividual contract. We generally bill for additional services provided beyondthe scope of the base contract on a time-and-materials basis as such servicesare rendered.

 

Revenues forconstruction projects are recorded using the percentage-of-completion method ofaccounting. The percentage-of-completion method recognizes revenue and incomeas work progresses on a project based on the expected total project costs andthe expected total project revenues. This method is based on an estimate of therevenue and income earned to date, less the revenue and income recognized inearlier periods. If management anticipates we will ultimately suffer a loss ona construction project, the entire estimated loss is recorded in the periodsuch a determination is made.

 

Revenues formultiple-family utility billing and collecting services are recognized andbilled at the end of the month in which services are performed. Revenues forinstallation of multiple-family utility billing and collection equipment areaccounted for using the percentage-of-completion method which is included inour discontinued operations.

 

If a contractinvolves the provision of a single product or service, revenue is generallyrecognized when the product or service is provided and the amount becomesbillable. If services are provided evenly during the contract term but servicebillings are irregular,

 

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revenue isrecognized on a straight-line basis over the contract term.

 

Certainnon-refundable activation fees in our non-regulated wholesale water operationsare accounted for on a completed contract basis and subsequently deferred andrecognized over the expected period of performance.

 

If a contractinvolves the provision of multiple products or services (elements), totalestimated contract revenue is allocated to each element based on the relativefair value of each service, provided the services qualify for separation underEmerging Issues Task Force (EITF) 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*. The amount ofrevenue allocated to each service is limited to the amount that is notcontingent upon the delivery of another element in the future. Revenue is thenrecognized for each element as described above for single-element contracts,except revenue recognized on a straight-line basis for a non-constructionservice will not exceed amounts currently billable unless the excess revenue isrecoverable from the client upon any contract termination event. If the amountof revenue allocated to a construction service is less than its relative fairvalue, costs to deliver such service, limited to the difference betweenallocated revenue and the relative fair value, are deferred and amortized overthe contract term. If total construction service costs are estimated to exceedthe relative fair value for the construction service contained in amultiple-element arrangement, then a provision for the estimated loss is madein the period in which the loss first becomes apparent.

 

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

 

In accordancewith SFAS No. 144, *Accounting for theImpairment or Disposal of Long-Lived Assets,*we assess intangibleassets and other long-lived assets, excluding goodwill, for recoverabilitywhenever events or changes in circumstances indicate that their carrying valuemay not be recoverable through the estimated undiscounted future cash flowsresulting from the use of the assets. If we determine that the carrying valueof intangible assets or other long-lived assets may not be recoverable, wemeasure impairment by using the projected discounted cash-flow method inaccordance with Statement No. 144.

 

We have madeacquisitions in the past that resulted in recording goodwill and intangibleassets. In June 2001, the Financial Accounting Standards Board (FASB)issued SFAS No. 142,*Goodwill and OtherIntangible Assets.*SFAS No. 142 requires that goodwill andintangible assets with indefinite useful lives are not amortized, but insteadare tested for impairment at least annually. For intangible assets with finiteuseful lives, SFAS No. 142 requires amortization over their estimateduseful lives. SFAS No. 142 became effective for fiscal years beginningafter December 15, 2001. We evaluate goodwill impairment, at leastannually, using discounted cash flow methodologies, transaction values forcomparable companies, and other valuation techniques for our reporting unitswith significant goodwill balances.  Ourreporting units, generally subsidiaries one level below operating segments,constitute separate businesses for which we maintain discrete financialinformation that is regularly reviewed by segment and chief operating decisionmaker.  There were no impairment chargesto goodwill as of June 30, 2005 and no events have occurred that indicateddiminution in the value of recorded goodwill.

 

Under theprovisions of SFAS No. 141, *BusinessCombinations*, we have identified intangible assets apart fromgoodwill such as contract costs and account lists.  These intangible assets are amortized overtheir estimated useful lives ranging from four to eight years.

 

**Accounting for regulated businesses**

 

Our regulatedbusinesses, which include our utilities in California, New Mexico, and Texas,are required to be accounted for under the provisions of SFAS No. 71, *Accounting for the Effects of Certain Types ofRegulation,* which specifies certain revenue, expense and balancesheet treatment as required by each state’s regulatory authority. Each stateauthority establishes rates which are intended to permit each utility torecover its costs and earn a reasonable rate of return.

 

Our Services Group has contracted with our utilities in Texas and NewMexico to perform operating services, maintenance, construction work, and tomanage capital projects.  In accordancewith SFAS No. 71, our Services Group recognizes profit on sales toregulated affiliates and does not eliminate the intercompany profit when thesales price is reasonable and it is probable that, through the rate makingprocess, future revenue approximately equal to the sales price will result fromthe regulated affiliate’s use of the services. However, all revenue in excess of profits is eliminated.  Accordingly, the intercompany profit forconstruction as well as operations and maintenance services provided to UtilityGroup affiliates has not been eliminated in the accompanying consolidatedfinancial statements.  Based upon ourServices Group’s experience of providing operations and maintenance services inmore than 400 contracts with unaffiliated customers, and a history of regulatorapproval of the construction service fees charged by the Services Group toutility affiliates, we believe that the contract sales prices between ourServices Group and our Texas and New Mexico utilities are reasonable and thatit is probable that the price of these services will be recovered in therate-making process.

 

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**Stock-based compensation**

 

In 2002, weadopted the fair value recognition provisions of SFAS No. 123, *Accounting for Stock-Based Compensation*,which requires valuation of stock options issued based upon an option pricingmodel and recognition of this value as an expense over the period in which theoptions vest. In accordance with the provisions of SFAS No. 148, weelected to recognize stock-based compensation using the retroactive restatementmethod. Under this change in accounting method, we restated our accompanyingconsolidated financial statements for periods prior to 2002 to reflect stock-basedcompensation expense under a fair value based accounting method for all optionsgranted, modified or settled in fiscal years beginning after December 15,1994.

 

We use theBlack-Scholes option valuation model to estimate the fair value of our stockoptions. This option valuation model was developed for use in estimating thefair value of traded options that do not have vesting restrictions and that arefully transferable. Option valuation models require subjective assumptions suchas the expected future volatility of the stock price. Because the stock optionswe grant have characteristics that are significantly different from those oftraded options, and because changes in the subjective input assumptions canmaterially affect the calculated results, in management’s opinion, the stockoption valuation models, including Black-Scholes, may not necessarily providean exact measure of the fair value of employee stock options.

 

**Deferred Costs**

 

We defer andsubsequently amortize certain direct contract acquisition costs related toactivities that enable the provision of contracted services to our customers.Deferred contract acquisition costs are amortized on a straight-line basis overthe remaining original contract term unless revenue patterns indicate a moreaccelerated method is appropriate. The recoverability of all long-lived assetsassociated with a particular contract, including deferred contract costs, isanalyzed on a periodic basis. If we conclude that long-lived assets areimpaired, an impairment loss is recognized for the amount by which the carryingvalue of the long-lived assets exceeds the fair value of those assets.

 

**RISK FACTORS**

 

The following factors, which are described more fully in our 2004Annual Report, represent risks and uncertainties that could cause actualresults to differ materially from our historical experience and our presentexpectations or projections. Factors that could affect forward-lookingstatements relating to the resolution of the material weakness with respect tointernal controls discussed in Item 4 below and Item 9A of our 2004 AnnualReport, include among other things: our ability to identify and retainqualified and experienced financial personnel and our ability to design andmaintain policies and procedures which enable us to avoid any reoccurrence ofthe matters which gave rise to the material weakness.   See “Risk Factors” in our 2004 Annual Reportfor further disclosure related to risk factors.

 

**Risks Related to Our Business**

 

***Risk Factors that affect ourUtility Group operations***

 

•                  *Weather conditions can affect the financial resultsof our Utility Group.*

 

•                  *Changes in the regulatory environment, includingrestrictions on rates we are allowed to charge customers, may adversely affectour results of operations.  Changes in policiesallowing our Services Group to provide services to our regulated utilities, atfair market values, may adversely impact our operating results.*

 

•                  *We may discover additional contamination of our watersources which may adversely affect our operations.  We may not recover costs incurred or revenueslost due to such contamination from responsible parties or from rate payers.*

 

•                  *We own assets in areas subject to natural disastersor that may be the target of terrorist activities.*

 

•                  *We are subject to regulatory and environmental risksand we may not be able to provide an adequate supply of water to our customers.*

 

•                  *We need access to capital to continue to invest inour utility assets.*

 

•                  *We may be limited in our ability to mitigate water costs related tonon-paying customers due to environmental considerations*.

 

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***Risk factors that affect ourServices Group operations***

 

•                  *We operate in a competitive market with low operatingmargins.*

 

•                  *Our revenue growth depends on our ability to enterinto new, and maintain our existing, operating contracts with cities, agenciesand municipal utility districts.*

 

•                  *Our business depends on trained, qualified employees.*

 

•                  *Events such as heavy rain, hurricanes, tornadoes andfloods may adversely affect our results of operations.*

 

•                  *Our Services Group’s contracts have certainperformance risks.*

 

•                  *Services Group contracts for the design andconstruction of water and wastewater facilities may expose us to certaincompletion and performance risks.*

 

•                  *We use third party equipment and subcontractors.*

 

•                  *Our Services Group is subject to environmental andwater quality risks.*

 

•                  *We operate a large fleet of vehicles that couldexpose us to liabilities.*

 

•                  *Our operating costs may rise faster than ourrevenues.*

 

•                  *Our operating contracts may be canceled, reducing ourrevenues and backlog. Also we may not secure new construction and constructionmanagement projects on a consistent basis, leading to fluctuations in revenuesand backlog.*

 

**Risks Related to Our Common Stock**

 

•                  *We are a holding company that depends on cash flowfrom our subsidiaries to meet our obligations.*

 

•                  *Our outstanding indebtedness may adversely affect ourfinancial condition and the value of our common stock.*

 

•                  *The market price of our shares of common stock couldbe volatile.*

 

•                  *Our results could fall below the expectations ofmarket analysts or investors.*

 

•                  *We may issue additional shares of our common stock.*

 

**Other Risk Factors**

 

•                  *Our capital resources may restrict our ability tooperate and expand our business.*

 

•                  *If we continue to grow, we may fail to effectivelymanage our growth or we may fail to effectively manage the growth we haveexperienced.*

 

•                  *Our business may be affected by the general economicconditions of real estate development in the United States.*

 

•                  *We are subject to debt covenants.*

 

•                  *Rating agencies may downgrade our debt.*

 

•                  *We are subject to increasing costs of producingproducts and services.*

 

•                  *Our operations are subject to certain risks due to theirlocations.*

 

•                  *Internal control weaknesses could have an adverseeffect on us.  We may not be able toremediate the material weakness noted in the 2004 10-K in a timely manner.*

 

•                  *The United States EnvironmentalProtection Agency may investigate operations of our subsidiaries. We are unableto predict the outcome thereof.*

 

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•                  *We rely on a number of complex business systems thatcould malfunction.*

 

•                  *We retain certain risks not covered by our insurance policies.*

 

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

 

There are no material changes from our 2004 Annual Report.

 

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

 

We maintaindisclosure controls and procedures designed to ensure that information requiredto be disclosed in our Exchange Act reports is recorded, processed, summarizedand reported within the time periods specified by the Securities and ExchangeCommission and that such information is accumulated and communicated tomanagement, including our Chief Executive Officer and Chief Financial Officer,as appropriate, to allow for timely decisions regarding required disclosure. Indesigning and evaluating the disclosure controls and procedures, managementrecognizes that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and management necessarily is required to apply itsjudgment in evaluating the cost-benefit relationship of possible controls andprocedures.

 

As discussedin our 2004 Annual Report, filed with the SEC on March 31, 2005,accounting errors were identified during the fourth quarter of 2004 that werecaused by lack of an effective review by appropriate accounting personnel ofthe accounting for certain non-routine transactions. The transactions involveda) purchase accounting for an acquisition, b) balance sheet classification oflong-term debt, and c) accounting for a gain contingency.  As a result of this internal controldeficiency, there was more than a remote likelihood that the Company’s interimor annual financial statements could have been materially misstated, andaccordingly, such deficiency was considered a material weakness in internalcontrol over financial reporting as of December 31, 2004.  A material weakness is a control deficiency,or combination of control deficiencies, that results in more than a remotelikelihood that a material misstatement of the annual or interim financialstatements would not be prevented or detected. Because of the material weakness described above, management concludedthat, as of December 31, 2004, our internal control over financialreporting was not effective.

 

We are in the process of implementing improvements to our internalcontrols to address the aforementioned material weakness.  We have implemented procedures in ouraccounting review and approval process over non-routine transactions.  These include implementation of additionalchecklists, more timely review and accounting for non-routine transactions andtimely identification of non-routine issues with our independent auditors.  We have evaluated appropriate staffing andexperience levels in our corporate controllership function and are activelysearching for the additional personnel. In addition, during the second quarter of 2005, we have (i) updatedkey controls and documentation since year end 2004, (ii) established aSteering Committee to monitor the progress of the effectiveness of thecontrols, (iii) further developed our 2005 internal control testing planand (iv) started the documentation of Monarch.  While management believes it has madeprogress in improving controls, we believe that the material weaknessidentified above has not yet been rectified.

 

There were no other changes in the Company’s internal control overfinancial reporting during the second quarter of 2005 that have materiallyaffected, or are reasonably likely to materially affect the Company’s internalcontrol over financial reporting.

 

For thequarter ended June 30, 2005, the Company carried out an evaluation, underthe supervision and with the participation of the Company’s management,including the Company’s Chief Executive Officer and Chief Financial Officer, ofthe effectiveness of the design and operation of the Company’s disclosurecontrols and procedures. Based on the foregoing, the Company’s Chief ExecutiveOfficer and Chief Financial Officer concluded that the Company’s disclosurecontrols and procedures were not effective as of June 30, 2005.

 

While we continue to devote significant resources to meeting theinternal control over financial reporting requirements of therules adopted by the SEC pursuant to Section 404 of theSarbanes-Oxley Act of 2002, we cannot assure you that the policies andprocedures we have adopted and our continued efforts will successfullyremediate the material weakness we have identified and any control deficienciesor material weaknesses that we or our outside auditors may identify before theend of our fiscal year.

 

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**PART II - OTHER INFORMATION**

 

***Item 1. Legal Proceedings***

 

Southwest anda subsidiary were named as defendants in several lawsuits alleging variousinjuries as a result of water contamination in the San Gabriel Valley MainBasin. The California Supreme Court has ruled that the plaintiffs cannotchallenge the adequacy of the water quality standards established by CaliforniaDepartment of Health Services and the United States Environmental ProtectionAgency (“EPA”) but can sue us and the other CPUC-Regulated Water Companies ifthey can prove that the company served water that did not meet those standards.In August 2004 the trial court dismissed the case against us finding thatthere was no evidence that we violated any water quality standards.  The plaintiffs appealed the dismissal to theCourt of Appeals for the State of California, Second Appellate District, wherethe matter is pending. To date, liability insurance carriers have absorbed thecosts of defense of the lawsuits.

 

On May 5, 2005, one of the Company’s operating subsidiariesreceived a subpoena to provide records to a grand jury.  The requestedrecords relate to the operations of the San Simeon wastewater treatment plantin California for the period January 2002 to present.  The facilitywas also served with search warrants executed by the EPA. The Company’ssubsidiary has operated this facility since June 2004.  The Companyis cooperating with the investigation and is also performing its own internalinvestigation.

 

On May 18, 2005, the EPA executed a search warrant at one of theCompany’s operating subsidiaries in Texas.  The search warrant soughtinformation relating to the subsidiary’s laboratory operations.  TheCompany is cooperating with the investigation and is also performing its owninternal investigation.

 

Southwest Water Company and its subsidiaries are subject to litigationarising in the ordinary course of operations. We believe the ultimateresolution of such matters will not materially adversely affect ourconsolidated financial position, results of operations or cash flows.

 

***Item 4. Submission of Matters to a Vote ofSecurity Holders.***

 

At the Annual Meeting of Stockholders held on May 12, 2005 thefollowing proposals were submitted to stockholders with the following results:

 

Proposal 1.                                  Toelect three persons as Class I Directors to a three-year term and untiltheir successors are duly elected and qualified.

 
| ** **                                 | ** ** | ** ** | ** ** | **James C.** | ** ** | **William D.** | ** ** | **Maureen A.** | ** ** |
|--------------------------------------------|------------|------------|------------|--------------|------------|----------------|------------|----------------|------------|
| ** **                                 | ** ** | ** ** | ** ** | **Castle**   | ** ** | **Jones**      | ** ** | **Kindel**     | ** ** |
| Votes *“For”*                    |       |       |       | 16,925,279   |       | 16,690,975     |       | 16,890,034     |       |
| Votes to *“Withhold  Authority”* |       |       |       | 238,924      |       | 473,228        |       | 274,169        |       |

 

After the meeting, Linda Griego, Donovan D.Huennekens and Richard G. Newman continued to serve as Class II Directorsof the Company for terms which expire in 2006 and until their successors areelected and qualified. H. Frederick Christie, Anton C. Garnier and PeterJ. Moerbeek continued to serve as Class III Directors of the Company forterms which expire in 2007 and until their successors are elected andqualified.

 

Proposal 2.                                  Toapprove an amendment to the Company’s Amended and Restated Certificate ofIncorporation deleting all references to Series D Preferred Stock.

 

Votes *“For”*—16,917,741 shares

Votes *“Against”*—138,716 shares

Votes *“Abstained”*—107,743 shares

 

Proposal 3.                            Toapprove an amendment to the Company’s Amended and Restated Certificate ofIncorporation to provide that the authorized number of directors of the Boardof Directors will be as set forth in the Company’s Bylaws.

 

Votes *“For”*—14,847,623 shares

Votes *“Against”*—2,188,955 shares

Votes *“Abstained”*—127,621 shares

Broker “Non-Vote*”*—4,645,230 shares

 

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***Item 6. Exhibits***

 
| 3.1    |   | Restated Certificate of Incorporation of  Southwest Water Company dated May 24, 2005 (filed herewith).                                                                                                                                                                                                                                                                                                                                                                                                         |
|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.1   |   | Amended and Restated Dividend Reinvestment  and Stock Purchase Plan dated April 8, 2005 (incorporated by reference  to Registrant’s S-3/A Registration Statement filed with the Commission on  April 5, 2005).                                                                                                                                                                                                                                                                                       |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.2   |   | Credit Agreement dated as of April 1,  2005 among the Registrant, 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 and Union Bank of California,  N.A., as co-lead arrangers and co-book managers, and Union Bank of  California, N.A., as syndication agent (incorporated by reference to  Registrant’s Form 8-K filed with the Commission on April 6, 2005). |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 10.3   |   | Stock Purchase Agreement by and between the  Registrant and Minol L.P. dated June 27, 2005 (filed herewith)                                                                                                                                                                                                                                                                                                                                                                                                         |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.1   |   | Certification of Chief Executive Officer  pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a),  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 31.2   |   | Certification of Chief Financial Officer  pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a),  as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                  |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 32.1   |   | Certification of Chief Executive Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                      |
|   |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                |
| 32.2   |   | Certification of Chief Financial Officer  pursuant to 18 U.S.C. Section 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                                                                                                                                                                                                                                      |

 

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**SIGNATURES**

 

Pursuant to the requirements of the Securities Exchange Act of 1934,the Registrant has duly caused this report to be signed on its behalf by theundersigned thereunto duly authorized.

 
|                              | SOUTHWEST WATER COMPANY                                                                   |
|-----------------------------------|-------------------------------------------------------------------------------------------|
|                              | (Registrant)                                                                              |
|                              |                                                                                      |
| Dated:   August 9, 2005 | /s/ CHERYL L. CLARY                                                                       |   |
|                              | ** Cheryl L. Clary**                                                                 |
|                              | ** Chief Financial Officer**                                                         |
|                              | ** (Principal Financial Officer and duly  authorized to sign this report on behalf** |
|                              | ** of the Regisrtant)**                                                              |

 

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