**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**WASHINGTON,D.C. 20549**

 

**FORM 10-Q**

 

**(Mark One)**

| **ý**                          | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                                                                                                                                                                                                                                         |
|-------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** **                          | **For the quarterly  period ended June 30, 2004**                                                                                                                                                                                                                                                                                                                                                                                     |
| ** **                          | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| **OR**                              |
|                                |                                                                                                                                                                                                                                                                                                                                                                                                                                       |
| **o**                               | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**                                                                                                                                                                                                                                                                                                                                        |
| ** **                          | **For the transition  period from                                    to                                 ** |
| ** **                          | ** **                                                                                                                                                                                                                                                                                                                                                                                                                                 |
| **Commission  file number: 0-8176** |

 

----

 

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

 

| **Delaware**                                                                      | ** ** | **95-1840947**                        |
|----------------------------------------------------------------------------------------|------------|---------------------------------------|
| (State or other jurisdiction of  incorporation or organization)                        | ** ** | (I.R.S. Employer Identification  No.) |
| ** **                                                                             | ** ** | ** **                            |
| **One Wilshire Building  624 South Grand Avenue, Suite 2900  Los Angeles, California** | ** ** | **90017-3782**                        |
| (Address of principal executive  offices)                                              |       | (Zip Code)                            |

 

**(213)929-1800**(Registrant’s telephone number,including area code)

 

Indicate by check markwhether the Registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days. Yes ý No o

 

Indicate by check markwhether the Registrant is an accelerated filer (as defined in Rule 12b-2 of theAct). Yes ý No o

 

Indicate the number ofshares outstanding of each of the issuer’s classes of common stock, as of thelatest practicable date. On August 4, 2004, there were 16,568,295 commonshares outstanding.

 

 

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**SOUTHWESTWATER COMPANY**

 

**INDEX**

 
| **Part I.**    | **Financial Information:** |
|----------------|----------------------------|
|           |                       |   |
|           | Item  1.                   | Financial Statements: |
|           |                       |   |
|           |                       | Condensed  Consolidated Statements of Income (unaudited) –    Three and Six Months Ended June 30, 2004 and 2003 |
|           |                       |   |
|           |                       | Condensed  Consolidated Balance Sheets–  June 30, 2004 (unaudited)  and  December 31, 2003 |
|           |                       |   |
|           |                       | Condensed  Consolidated Statements of Cash Flows (unaudited) –    Six Months Ended June 30, 2004 and 2003 |
|           |                       |   |
|           |                       | 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  5.                   | Other Information |
|           |                       |   |
|           | Item  6.                   | Exhibits and Reports  on Form 8-K |
|           |                       |   |
| **Signatures** |

 

----

 

**PART I – FINANCIAL INFORMATION**

 

***Item1.******Financial Statements***

 

**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**CONDENSEDCONSOLIDATED STATEMENTS OF INCOME (Unaudited)**

 
| ** **                                        | ** ** | **Three Months Ended  June 30,**    | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------|------------|------------------------------------------|------------|-------------------------------------|------------|
| ** **                                        | ** ** | **2004**                                 | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                        | ** ** | **(in thousands except per share data)** | ** ** |
| **Revenues:**                                     |       |                                     |       |                                |       |   |   |   |   |
| Services group                                    |       | **$**                                    | **29,118** | ** **                          | $          | 27,702 |   | **$** | **55,782** | ** ** | $ | 52,890 |   |
| Utility group                                     |       | **16,576**                               | ** ** | 13,762                              |       | **29,639** | ** ** | 24,688 |   |
|                                              |       | **45,694**                               | ** ** | 41,464                              |       | **85,421** | ** ** | 77,578 |   |
| **Expenses:**                                     |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| Operating expenses - services group               |       | **25,055**                               | ** ** | 24,323                              |       | **50,126** | ** ** | 46,329 |   |
| Operating expenses - utility group                |       | **8,614**                                | ** ** | 8,219                               |       | **16,232** | ** ** | 15,646 |   |
| Selling, general and administrative expenses      |       | **6,857**                                | ** ** | 5,425                               |       | **12,962** | ** ** | 11,185 |   |
|                                              |       | **40,526**                               | ** ** | 37,967                              |       | **79,320** | ** ** | 73,160 |   |
|                                              |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Operating Income**                              |       | **5,168**                                | ** ** | 3,497                               |       | **6,101** | ** ** | 4,418 |   |
|                                              |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Other Income (Expense):**                       |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| Interest expense                                  |       | **(1,076**                               | **)**      | (1,109                              | )          | **(2,153** | **)** | (2,306 | ) |
| Interest income                                   |       | **188**                                  | ** ** | —                              |       | **308** | ** ** | 49 |   |
| Gain on sale of land                              |       | **—**                               | ** ** | 720                                 |       | **—** | ** ** | 720 |   |
| Other                                             |       | **(227**                                 | **)**      | (110                                | )          | **(174** | **)** | (119 | ) |
|                                              |       | **(1,115**                               | **)**      | (499                                | )          | **(2,019** | **)** | (1,656 | ) |
|                                              |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Income Before Income Taxes**                    |       | **4,053**                                | ** ** | 2,998                               |       | **4,082** | ** ** | 2,762 |   |
| **Income Tax Provision**                          |       | **1,500**                                | ** ** | 1,109                               |       | **1,511** | ** ** | 1,022 |   |
| **Net Income**                                    |       | **2,553**                                | ** ** | 1,889                               |       | **2,571** | ** ** | 1,740 |   |
| **Dividends on Preferred Shares**                 |       | **7**                                    | ** ** | 7                                   |       | **14** | ** ** | 14 |   |
| **Net Income Available for Common  Shareholders** |       | **$**                                    | **2,546**  | ** **                          | $          | 1,882 |   | **$** | **2,557** | ** ** | $ | 1,726 |   |
| ** **                                        |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Earnings Per Common Share:**                    |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Basic**                                         |       | **$**                                    | **0.15**   | ** **                          | $          | 0.14 |   | **$** | **0.16** | ** ** | $ | 0.13 |   |
| **Diluted**                                       |       | **$**                                    | **0.15**   | ** **                          | $          | 0.13 |   | **$** | **0.15** | ** ** | $ | 0.12 |   |
| ** **                                        |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Weighted Average Outstanding  Common Shares:**  |       | ** **                               | ** ** |                                |       | ** ** | ** ** |   |   |
| **Basic**                                         |       | **16,502**                               | ** ** | 13,561                              |       | **15,637** | ** ** | 13,295 |   |
| **Diluted**                                       |       | **17,338**                               | ** ** | 14,103                              |       | **16,517** | ** ** | 13,840 |   |

 

*See accompanying notes to unaudited condensedconsolidated financial statements.*

 

1

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

**CONDENSED CONSOLIDATED BALANCE SHEETS**

 
| ** **                                                           | ** ** | **June 30, 2004** | ** **  | **December 31, 2003** | ** ** |
|----------------------------------------------------------------------|------------|------------------------|-------------|----------------------------|------------|
| ** **                                                           | ** ** | **(Unaudited)**        | ** **  | ** **                 | ** ** |
| ** **                                                           | ** ** | **(in thousands)**     | ** **  |
| **ASSETS**                                                           |       |                   |        |                       |       |
| **Current Assets:**                                                  |       |                   |        |                       |       |
| Cash and cash equivalents                                            |       | **$**                  | **1,867**   | ** **                 | $          | 2,570 |   |
| Restricted cash                                                      |       | **991**                | ** **  | 2,806                      |       |
| Trade accounts receivable, less allowance  for doubtful accounts     |       | **25,475**             | ** **  | 19,759                     |       |
| Other current assets                                                 |       | **10,971**             | ** **  | 10,259                     |       |
|                                                                 |       | **39,304**             | ** **  | 35,394                     |       |
| **Property, Plant and  Equipment:**                                  |       | ** **             | ** **  |                       |       |
| Utility property, plant and equipment—at  cost                  |       | **282,129**            | ** **  | 271,502                    |       |
| Non-regulated operations property, plant  and equipment—at cost |       | **17,227**             | ** **  | 17,485                     |       |
|                                                                 |       | **299,356**            | ** **  | 288,987                    |       |
| Less accumulated depreciation and  amortization                      |       | **71,631**             | ** **  | 67,900                     |       |
|                                                                 |       | **227,725**            | ** **  | 221,087                    |       |
| **Other Assets:**                                                    |       | ** **             | ** **  |                       |       |
| Goodwill                                                             |       | **21,959**             | ** **  | 21,388                     |       |
| Intangible assets, net                                               |       | **7,141**              | ** **  | 2,026                      |       |
| Other assets                                                         |       | **15,695**             | ** **  | 16,327                     |       |
|                                                                 |       | **$**                  | **311,824** | ** **                 | $          | 296,222 |   |
|                                                                 |       | ** **             | ** **  |                       |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                        |       | ** **             | ** **  |                       |       |
| **Current  Liabilities:**                                            |       | ** **             | ** **  |                       |       |
| Current portion of long-term debt                                    |       | **$**                  | **4,125**   | ** **                 | $          | 2,697 |   |
| Accounts payable                                                     |       | **8,240**              | ** **  | 11,448                     |       |
| Other current liabilities                                            |       | **16,992**             | ** **  | 17,244                     |       |
|                                                                 |       | **29,357**             | ** **  | 31,389                     |       |
| **Other Liabilities  and Deferred Credits:**                         |       | ** **             | ** **  |                       |       |
| Long-term debt                                                       |       | **53,746**             | ** **  | 56,493                     |       |
| Bank lines of credit                                                 |       | **7,009**              | ** **  | 16,609                     |       |
| Advances for construction                                            |       | **7,203**              | ** **  | 7,238                      |       |
| Contributions in aid of construction                                 |       | **84,494**             | ** **  | 81,556                     |       |
| Deferred income taxes                                                |       | **10,772**             | ** **  | 10,590                     |       |
| Other liabilities and deferred credits                               |       | **14,954**             | ** **  | 12,680                     |       |
| **Total Liabilities  and Deferred Credits**                          |       | **207,535**            | ** **  | 216,555                    |       |
|                                                                 |       | ** **             | ** **  |                       |       |
| **Commitments and  Contingencies**                                   |       | ** **             | ** **  |                       |       |
|                                                                 |       | ** **             | ** **  |                       |       |
| **Stockholders’  Equity:**                                      |       | ** **             | ** **  |                       |       |
| Preferred stock                                                      |       | **466**                | ** **  | 507                        |       |
| Common stock                                                         |       | **165**                | ** **  | 147                        |       |
| Paid-in capital                                                      |       | **79,631**             | ** **  | 55,981                     |       |
| Retained earnings                                                    |       | **24,027**             | ** **  | 23,032                     |       |
| **Total Stockholders’  Equity**                                 |       | **104,289**            | ** **  | 79,667                     |       |
| ** **                                                           |       | **$**                  | **311,824** | ** **                 | $          | 296,222 |   |

 

*See accompanying notes to unaudited condensedconsolidated financial statements.*

 

2

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**SOUTHWEST WATER COMPANY AND SUBSIDIARIES**

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

 
| ** **                                                                                                         | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                         | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                                                                         | ** ** | **(in thousands)**                  | ** ** |
| **Cash Flows From Operating  Activities:**                                                                         |       |                                |       |   |   |
| Net income                                                                                                         |       | **$**                               | **2,571**  | ** ** | $ | 1,740 |   |
| Adjustments to reconcile net income to net cash provided  by (used in) operating activities:                       |       | ** **                          | ** ** |   |   |
| Depreciation and amortization                                                                                      |       | **3,687**                           | ** ** | 4,003 |   |
| Stock-based compensation expense                                                                                   |       | **447**                             | ** ** | 467 |   |
| Gain on sale of land                                                                                               |       | **—**                          | ** ** | (720 | ) |
| Deferred income taxes                                                                                              |       | **181**                             | ** ** | 860 |   |
| Changes in assets and liabilities, net of effects  of acquisitions:                                                |       | ** **                          | ** ** |   |   |
| Restricted cash                                                                                                    |       | **1,815**                           | ** ** | — |   |
| Trade accounts receivable                                                                                          |       | **(5,716**                          | **)**      | (3,135 | ) |
| Other current assets                                                                                               |       | **(712**                            | **)**      | 838 |   |
| Other assets                                                                                                       |       | **634**                             | ** ** | 1,137 |   |
| Accounts payable                                                                                                   |       | **(3,210**                          | **)**      | (2,779 | ) |
| Other current liabilities                                                                                          |       | **2,647**                           | ** ** | (1,915 | ) |
| Other liabilities                                                                                                  |       | **1,484**                           | ** ** | (1,369 | ) |
| Other                                                                                                              |       | **(580**                            | **)**      | 11 |   |
| **Net cash provided by (used in)  operating activities**                                                           |       | **3,248**                           | ** ** | (862 | ) |
|                                                                                                               |       | ** **                          | ** ** |   |   |
| **Cash Flows From Investing  Activities:**                                                                         |       | ** **                          | ** ** |   |   |
| Additions to property, plant and equipment                                                                         |       | **(11,217**                         | **)**      | (9,179 | ) |
| Proceeds from disposition of assets                                                                                |       | **—**                          | ** ** | 741 |   |
| Purchase of minority interest in subsidiary                                                                        |       | **(2,900**                          | **)**      | — |   |
| Cash used to acquire customer units                                                                                |       | **(4,063**                          | **)**      | — |   |
| **Net cash used in investing  activities**                                                                         |       | **(18,180**                         | **)**      | (8,438 | ) |
|                                                                                                               |       | ** **                          | ** ** |   |   |
| **Cash Flows From Financing  Activities:**                                                                         |       | ** **                          | ** ** |   |   |
| Net proceeds from stock offerings                                                                                  |       | **20,573**                          | ** ** | 10,988 |   |
| Capital improvement reimbursements                                                                                 |       | **169**                             | ** ** | 2,182 |   |
| Contributions in aid of construction and LUE fees                                                                  |       | **4,891**                           | ** ** | 1,975 |   |
| Net repayment of bank notes                                                                                        |       | **(9,622**                          | **)**      | (5,934 | ) |
| Proceeds from sale/leaseback of assets                                                                             |       | **78**                              | ** ** | 1,102 |   |
| Net proceeds from dividend reinvestment, debenture  conversion, employee stock purchase and stock option plans     |       | **445**                             | ** ** | 733 |   |
| Dividends paid                                                                                                     |       | **(1,576**                          | **)**      | (1,141 | ) |
| Payments of long-term debt                                                                                         |       | **(572**                            | **)**      | (177 | ) |
| Payments on advances for construction, net                                                                         |       | **(157**                            | **)**      | (166 | ) |
| **Net cash provided by financing  activities**                                                                     |       | **14,229**                          | ** ** | 9,562 |   |
|                                                                                                               |       | ** **                          | ** ** |   |   |
| **Net (decrease) increase in cash  and cash equivalents**                                                          |       | **(703**                            | **)**      | 262 |   |
| Cash and cash equivalents at beginning of period                                                                   |       | **2,570**                           | ** ** | 1,606 |   |
| **Cash and cash equivalents at end  of period**                                                                    |       | **$**                               | **1,867**  | ** ** | $ | 1,868 |   |
|                                                                                                               |       | ** **                          | ** ** |   |   |
| **Supplemental Disclosure of Cash  Flow information**                                                              |       | ** **                          | ** ** |   |   |
| **Cash paid during the period for:**                                                                               |       | ** **                          | ** ** |   |   |
| **Interest**                                                                                                       |       | **$**                               | **2,085**  | ** ** | $ | 2,555 |   |
| **Income taxes**                                                                                                   |       | **$**                               | **125**    | ** ** | $ | 305 |   |
|                                                                                                               |       | ** **                          | ** ** |   |   |
| **Non-cash investing and financing  activities:**                                                                  |       | ** **                          | ** ** |   |   |
| **Purchase of businesses**                                                                                         |       | ** **                          | ** ** |   |   |
| Fair value of customer units acquired                                                                              |       | **$**                               | **5,502**  | ** ** | $ | — |   |
| Cash used to acquire customer units                                                                                |       | **(4,063**                          | **)**      | — |   |
| Notes issued to acquire customer units                                                                             |       | **(1,439**                          | **)**      | — |   |
| Liabilities assumed                                                                                                |       | **$**                               | **—** | ** ** | $ | — |   |
|                                                                                                               |       | ** **                          | ** ** |   |   |
| **Non-cash contributions in aid of  construction and advances for construction conveyed to Company by developers** |       | **$**                               | **2,349**  | ** ** | $ | 3,629 |   |

 

*See accompanying notes to unaudited condensedconsolidated financial statements.*

 

3

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#### **SOUTHWEST WATERCOMPANY AND SUBSIDIARIES**

 

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

 

***Note 1. – Basis of Presentation***

 

Southwest Water Company was incorporated in Californiain 1954 and reincorporated in Delaware in 1988. Southwest Water Company and itssubsidiaries (collectively referred to in this report as “Southwest Water”, the“Company”, “we”, “us” or “our” except where the context otherwise requires)provide a broad range of water and wastewater services including waterproduction and distribution, wastewater collection and treatment, public worksservices, water and wastewater infrastructure development, and utility  billing and collecting. The accompanyingunaudited condensed consolidated financial statements have been prepared inaccordance with accounting principles generally accepted in the United Statesof America (US GAAP) for interim financial information and with theinstructions to Form 10-Q and Rule 10-01 of Regulation S-X; accordingly, theydo not include all information and notes required by US GAAP for completefinancial statements. Except as disclosed herein, there have been no materialchanges in the information disclosed in the notes to the consolidated financialstatements contained in our Annual Report on Form 10-K for the year endedDecember 31, 2003 (the 2003 Annual Report). The unaudited condensed consolidatedfinancial statements reflect all adjustments which, in our opinion, arenecessary to present fairly the financial position of Southwest Water as ofJune 30, 2004, and our results of operations for the three and six monthsended June 30, 2004 and 2003 and the results of cashflows for the sixmonths ended June 30, 2004 and 2003. These adjustments are of a normalrecurring nature.

 

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

 

***Note 2. – Earnings Per Share***

 

We recordearnings per share (EPS) by computing “basic EPS” and “diluted EPS”. Basic EPSmeasures our performance over the reporting period by dividing net incomeavailable to common stockholders by the weighted average number of commonshares outstanding during the period. Diluted EPS measures our performance overthe reporting period after giving effect to all potentially dilutive commonshares that would have been outstanding if the dilutive common shares had beenissued. Stock options, convertible debentures and warrants give rise topotentially dilutive common shares.  InJuly 2001, we issued $20.0 million of 6.85% fixed-rate convertiblesubordinate debentures. The debentures are convertible at any time prior tomaturity, unless previously redeemed, at a conversion price of $12.148. Whenour annual diluted earnings exceed $0.53 per share, the debentures will beincluded in the calculation of diluted earnings per share after adjusting netincome for the after-tax effect of the debenture interest expense.

 

We effected a 4-for-3 stock split in the form of a stockdividend on January 1, 2004. All per share amounts and numbers of sharesoutstanding reflect this dividend.  Thefollowing table is a reconciliation of the numerators (income) and denominators(shares) used in both basic and diluted EPS calculations:

 

On August 6, 2004 we announceda 10.5 percent increase in our quarterly common share cash dividend, from$.0475 to $.0525 per share. The Company's Board of Directors also declared aquarterly cash dividend of $.65625 per share of Series A preferred stock. Thecash dividends will be paid on October 21, 2004, to stockholders of record onSeptember 30, 2004.

 

**Basic EPS**

 
| ** **                                 | ** ** | **For the three months ended  June 30,** | ** ** | **For the six months ended****June 30,** | ** ** |
|--------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                 | ** ** | **2004**                                      | ** ** | **2003**                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **(in thousands except per share data)**      | ** ** |
| **Net income per share**                   |       |                                          |       |                                          |       |   |   |   |   |
| Net income                                 |       | **$**                                         | **2,553**  | ** **                                    | $          | 1,889 |   | **$** | **2,571** | ** ** | $ | 1,740 |   |
| Less: dividends on preferred shares        |       | **(7**                                        | **)**      | (7                                            | )          | **(14** | **)** | (14 | ) |
| Net income available for common shares     |       | **$**                                         | **2,546**  | ** **                                    | $          | 1,882 |   | **$** | **2,557** | ** ** | $ | 1,726 |   |
|                                       |       | ** **                                    | ** ** |                                          |       | ** ** | ** ** |   |   |
| Weighted average outstanding common shares |       | **16,502**                                    | ** ** | 13,561                                        |       | **15,637** | ** ** | 13,295 |   |
|                                       |       | ** **                                    | ** ** |                                          |       | ** ** | ** ** |   |   |
| Earnings per common share - basic          |       | **$**                                         | **0.15**   | ** **                                    | $          | 0.14 |   | **$** | **0.16** | ** ** | $ | 0.13 |   |

 

4

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**Diluted EPS**

 
| ** **                                                                   | ** ** | **For the three months ended  June 30,** | ** ** | **For the six months ended****June 30,** | ** ** |
|------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                      | ** ** | **2003**                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                   | ** ** | **(in thousands except per share data)**      | ** ** |
|                                                                         |       |                                          |       |                                          |       |   |   |   |   |
| **Net income per  share - assuming dilution**                                |       |                                          |       |                                          |       |   |   |   |   |
| Net income available for common shares                                       |       | $                                             | 2,546      |                                          | $          | 1,882 |   | $ | 2,557 |   | $ | 1,726 |   |
|                                                                         |       |                                          |       |                                          |       |   |   |   |   |
| Weighted average outstanding common shares                                   |       | 16,502                                        |       | 13,561                                        |       | 15,637 |   | 13,295 |   |
| Plus:   shares issued on assumed exercise of stock options and warrants |       | 836                                           |       | 541                                           |       | 880 |   | 545 |   |
| Weighted average outstanding common shares                                   |       | 17,338                                        |       | 14,103                                        |       | 16,517 |   | 13,840 |   |
|                                                                         |       |                                          |       |                                          |       |   |   |   |   |
| Earnings per common share - diluted                                          |       | $                                             | 0.15       |                                          | $          | 0.13 |   | $ | 0.15 |   | $ | 0.12 |   |

 

***Note 3. –Stock-Based Compensation***

 

At June 30, 2004,Southwest Water had three stock-based plans: the Stock Option Plan (SOP), theDirector Stock Option Plan (DOP), and the Employee Stock Purchase Plan. Inaccordance with the provisions of Statement of Financial Accounting Standards(SFAS) No. 123, *Accounting for Stock-BasedCompensation*, the fair value of each option grant is estimated onthe date of grant using the Black-Scholes option pricing model with thefollowing weighted average assumptions used for grants in 2004 and 2003:

 

| ** **              | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|-------------------------|------------|---------------------------------------------|------------|
| ** **              | ** ** | **2004**                                    | ** ** | **2003** | ** ** |
| Dividend yield          |       | 1.3                                         | %          | 1.8 | % |
| Expected volatility     |       | 24.4                                        | %          | 26.6 | % |
| Risk free interest rate |       | 3.7                                         | %          | 2.7 | % |
| Expected life in years  |       | 6.0                                         |       | 5.5 |   |

 

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

 
| ** **                       | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                       | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| Stock-based compensation expense |       | $                                     | 169,000    |                                | $          | 252,000 |   | $ | 447,000 |   | $ | 467,000 |   |
|                                  |            |                                       |            |                                     |            |  |  |  |  |  |  |  |  |

 

***Note 4. – Common Stock Issued***

 

On December 29, 2003, we filed a shelf registration statement withthe Securities and Exchange Commission for the issuance from time to time of upto $50 million aggregate principal amount of common stock, debt securitiesand warrants.  In March 2004, wecompleted a public offering of 1,610,000 shares of our common stock under theshelf registration statement.  Theseshares were sold at $13.58 per share and our net proceeds were approximately$20.6 million.  We may offer additionalsecurities under this shelf registration.

 

InMay 2003, we completed a private placement of 1,477,377 shares of newlyissued common stock to certain institutional investors. Net proceeds from theprivate placement were approximately $11.0 million.

 

During the six months ended June 30, 2004, approximately $2.2million of our 6.85% fixed-rate convertible subordinate debentures wereconverted into approximately 180,000 shares of our common stock.

 

5

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***Note 5. –Stock Options andWarrants***

 

A combinedsummary of shares authorized and available for issuance under the SOP and theDOP as of June 30, 2004 is as follows:

 
| ** **                     | ** ** | **SOP**   | ** ** | **DOP** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-----------|------------|---------|------------|-----------|------------|
| Shares authorized for issuance |       | 4,241,178 |       | 687,555 |       | 4,928,732 |       |
| Shares available for issuance  |       | 1,074,571 |       | 363,830 |       | 1,438,401 |       |

 

A combined summary of thestatus of the SOP, the DOP and warrants as well as changes during the sixmonths ended June 30, 2004 is presented below:

 
| ** **                            | ** ** | **Stock Options  and Warrants** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|---------------------------------------|------------|---------------------------------|------------|----------------------------------------|------------|
| ** **                            | ** ** | **(in thousands)**              | ** ** |
| Outstanding at December 31, 2003 |       | 2,491                           |       | $                                      | 6.91       |   |
| Granted                               |       | 393                             |       | 13.88                                  |       |
| Exercised                             |       | (66                             | )          | 4.57                                   |       |
| Forfeited                             |       | (114                            | )          | 7.27                                   |       |
| Outstanding at June 30, 2004     |       | 2,704                           |       | $                                      | 8.26       |   |
|                                  |       |                            |       |                                   |       |
| Exercisable at June 30, 2004     |       | 1,624                           |       | $                                      | 6.59       |   |

 

The following tablesummarizes information about stock options and warrants outstanding atJune 30, 2004:

 
| **Range of  Exercise Prices** | ** **                                       | **Options and Warrants Outstanding**             | ** **                                                    | **Options and Warrants  Exercisable**  | ** **                             |
|-------------------------------|--------------------------------------------------|--------------------------------------------------|---------------------------------------------------------------|----------------------------------------|----------------------------------------|
| ** **                    | **Number  Outstanding  at  June 30,  2004** | ** **                                       | **Weighted  Average  Remaining  Contractual  Life  in Years** | ** **                             | **Weighted  Average  Exercise  Price** | ** ** | ** ** |
| ** **                    | ** **                                       | **Number  Exercisable  at  June 30,  2004** | ** **                                                    | **Weighted  Average  Exercise  Price** | ** **                             |
| ** **                    | ** **                                       | ** **                                       | ** **                                                    | **(in thousands)**                     | ** **                             | ** ** | ** ** | ** ** | ** ** | **(in thousands)** | ** ** | ** ** | ** ** |
| $                             | 1.50                                             |                                             | $                                                             | 3.75                                   |                                   | 265 |   | 0.2 |   | $ | 2.75 |   | 265 |   | $ | 2.75 |   |
| 3.75                          |                                             | 7.50                                             |                                                          | 593                                    |                                   | 1.5 |   | 5.32 |   | 575 |   | 5.30 |   |
| 7.50                          |                                             | 11.25                                            |                                                          | 1,418                                  |                                   | 5.1 |   | 8.85 |   | 739 |   | 8.66 |   |
| 11.25                         |                                             | 15.00                                            |                                                          | 428                                    |                                   | 6.5 |   | 13.78 |   | 45 |   | 11.70 |   |
| $                             | 1.50                                             |                                             | $                                                             | 15.00                                  |                                   | 2,704 |   | 4.0 |   | $ | 8.26 |   | 1,624 |   | $ | 6.59 |   |

 

***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 8,928 shares to employees during thesix months ended June 30, 2004. At June 30, 2004, 1,139,532 shareswere reserved for issuance under the ESPP and 861,321 shares were available forissuance.

 

***Note 6. – Operating Segments***

 

Southwest Water has two reportable segments: the Services Group and theUtility Group.  We have not changed thebasis of segmentation or measurement of segment profit or loss from thatreported in our 2003 Annual Report.

 

The Services Group operates and manages water and wastewater treatmentfacilities owned by cities, public agencies, municipal utility districts andprivate entities. Revenues are earned by providing operations and maintenanceservices under contracts with municipalities and other clients.  The Services Group also provides constructionmanagement and utility billing services.

 

6

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The Utility Group owns regulated water utilities in California, NewMexico and Texas, as well as wastewater facilities in New Mexico andTexas.  State and federal agencies issueregulations regarding standards of water quality, safety, environmental andother matters which affect these operations. In the regulated utility subsidiaries,the rates that we charge for water and wastewater services are established bystate authorities.

 

The following table presents information about the operations of eachreported segment for the three and six months ended June 30, 2004 and2003: 

 
| ** **                                         | ** ** | **Services  Group (1)** | ** ** | **Utility  Group** | ** ** | **Total Segments  Information** | ** ** | **Other (2)** | ** ** | **Total  Consolidated  Information** | ** ** |
|----------------------------------------------------|------------|-------------------------|------------|--------------------|------------|---------------------------------|------------|---------------|------------|--------------------------------------|------------|
| ** **                                         | ** ** | **(in  thousands)**     | ** ** |
| **For the Three  Months Ended June 30, 2004** |       |                    |       |               |       |                            |       |          |       |                                 |       |
| **Total revenues (1)**                             |       | **$**                   | **29,118** | ** **         | **$**      | **16,576**                      | ** ** | **$**         | **45,694** | ** **                           | **$**      | **—** | ** ** | **$** | **45,694** | ** ** |
| **Segment operating income (loss)**                |       | **744**                 | ** ** | **7,702**          | ** ** | **8,446**                       | ** ** | **(3,278**    | **)**      | **5,168**                            | ** ** |
| **Interest income**                                |       | **98**                  | ** ** | **83**             | ** ** | **181**                         | ** ** | **7**         | ** ** | **188**                              | ** ** |
| **Interest expense**                               |       | **(126**                | **)**      | **(626**           | **)**      | **(752**                        | **)**      | **(324**      | **)**      | **(1,076**                           | **)**      |
| **Other income (expense)**                         |       | **(616**                | **)**      | **(54**            | **)**      | **(670**                        | **)**      | **443**       | ** ** | **(227**                             | **)**      |
| **Income (loss) before income taxes**              |       | **100**                 | ** ** | **7,105**          | ** ** | **7,205**                       | ** ** | **(3,152**    | **)**      | **4,053**                            | ** ** |
|                                               |       |                    |       |               |       |                            |       |          |       |                                 |       |
| For the Three Months Ended June 30,  2003     |       |                    |       |               |       |                            |       |          |       |                                 |       |
| Total revenues (1)                                 |       | $                       | 27,702     |               | $          | 13,762                          |       | $             | 41,464     |                                 | $          | — |   | $ | 41,464 |   |
| Segment operating income (loss)                    |       | 867                     |       | 4,415              |       | 5,282                           |       | (1,785        | )          | 3,497                                |       |
| Interest income                                    |       | (21                     | )          | 21                 |       | —                          |       | —        |       | —                               |       |
| Interest expense                                   |       | (115                    | )          | (574               | )          | (689                            | )          | (420          | )          | (1,109                               | )          |
| Other income (expense)                             |       | (317                    | )          | 838                |       | 521                             |       | 89            |       | 610                                  |       |
| Income (loss) before income taxes                  |       | 414                     |       | 4,700              |       | 5,114                           |       | (2,116        | )          | 2,998                                |       |

 
| ** **                                       | ** ** | **Services  Group (1)** | ** ** | **Utility  Group** | ** ** | **Total Segments  Information** | ** ** | **Other (2)** | ** ** | **Total  Consolidated  Information** | ** ** |
|--------------------------------------------------|------------|-------------------------|------------|--------------------|------------|---------------------------------|------------|---------------|------------|--------------------------------------|------------|
| ** **                                       | ** ** | **(in  thousands)**     | ** ** |
|                                             |       |                    |       |               |       |                            |       |          |       |                                 |       |
| **For the Six Months  Ended June 30, 2004** |       |                    |       |               |       |                            |       |          |       |                                 |       |
| **Total revenues (1)**                           | ** ** | **$**                   | **55,782** | ** **         | **$**      | **29,639**                      | ** ** | **$**         | **85,421** | ** **                           | **$**      | **—** | ** ** | **$** | **85,421** | ** ** |
| **Segment operating income (loss)**              | ** ** | **12**                  | ** ** | **10,713**         | ** ** | **10,725**                      | ** ** | **(4,624**    | **)**      | **6,101**                            | ** ** |
| **Interest income**                              | ** ** | **197**                 | ** ** | **83**             | ** ** | **280**                         | ** ** | **28**        | ** ** | **308**                              | ** ** |
| **Interest expense**                             | ** ** | **(233**                | **)**      | **(1,206**         | **)**      | **(1,439**                      | **)**      | **(714**      | **)**      | **(2,153**                           | **)**      |
| **Other income (expense)**                       | ** ** | **(968**                | **)**      | **(11**            | **)**      | **(979**                        | **)**      | **805**       | ** ** | **(174**                             | **)**      |
| **Income (loss) before income taxes**            | ** ** | **(992**                | **)**      | **9,579**          | ** ** | **8,587**                       | ** ** | **(4,505**    | **)**      | **4,082**                            | ** ** |
|                                             |       |                    |       |               |       |                            |       |          |       |                                 |       |
| For the Six Months Ended June 30, 2003      |       |                    |       |               |       |                            |       |          |       |                                 |       |
| Total revenues (1)                               |       | $                       | 52,890     |               | $          | 24,688                          |       | $             | 77,578     |                                 | $          | — |   | $ | 77,578 |   |
| Segment operating income (loss)                  |       | 902                     |       | 6,614              |       | 7,516                           |       | (3,098        | )          | 4,418                                |       |
| Interest income                                  |       | 10                      |       | 39                 |       | 49                              |       | —        |       | 49                                   |       |
| Interest expense                                 |       | (233                    | )          | (1,215             | )          | (1,448                          | )          | (858          | )          | (2,306                               | )          |
| Other income (expense)                           |       | (642                    | )          | 1,058              |       | 416                             |       | 185           |       | 601                                  |       |
| Income (loss) before income taxes                |       | 37                      |       | 6,496              |       | 6,533                           |       | (3,771        | )          | 2,762                                |       |

 

----

(1)          In addition toservices provided to external customers, certain companies in our ServicesGroup provide construction, operations and maintenance services to companies inour Utility Group. In accordance with SFAS No. 71, *Accounting for the Effects of Certain Types ofRegulation*, we do not eliminate the intersegment profit on the workperformed when the sales price is reasonable and it is probable that the costswill be recoverable through the rate making process. Intersegment revenueeliminated was approximately $2.3 million and $2.2 million for thethree months ended June 30, 2004 and 2003, respectively.  Intersegment revenue eliminated wasapproximately $3.4 million and $4.2 million for the six months endedJune 30, 2004 and 2003, respectively.

 

(2)          “Other” consists primarily of costs thatinclude corporate headquarters expenses and functional departments whose costsare not allocated to the segments.

 

7

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The followingtable presents information about the identifiable assets of each reportedsegment as of June 30, 2004 and December 31, 2003:

 
| ** **          | ** ** | **June 30, 2004** | ** **  | **December 31, 2003** | ** ** |
|---------------------|------------|------------------------|-------------|----------------------------|------------|
| ** **          | ** ** | **(in thousands)**     | ** **  |
| Services Group      |       | **$**                  | **73,642**  | ** **                 | $          | 67,831 |   |
| Utility Group       |       | **232,496**            | ** **  | 222,436                    |       |
| Corporate and Other |       | **5,686**              | ** **  | 5,955                      |       |
| Consolidated        |       | **$**                  | **311,824** | ** **                 | $          | 296,222 |   |

 

***Note 7. –Seasonality***

 

Because our businesses are affected  by weather, the results of operations for onequarter do not indicate results to be expected in another quarter.  Our Services Group operations can be affectedby weather and rainfall. In general, heavy rainfall or storm conditions maylimit our ability to perform certain billable work such as pipelinemaintenance, manhole rehabilitation, construction and other outdoor services.Severe weather conditions may also result in additional labor and materialcosts to us as we meet the terms of our operations and maintenance contracts.Depending on the specific contractual terms, this additional work may bebillable to our various clients.  Asignificant portion of revenues of our Texas subsidiaries is earned under timeand materials contracts where in revenues can be affected by weather andrainfall.  Precipitation in our Texasbase of operations was 221% of average and 187% of average during the three andsix months ended June 30, 2004, respectively.  Higher than average precipitation has limitedor delayed our ability to perform billable services and construction during2004 as noted above.  Precipitation inthe Services Group’s Houston base of operations for the three and six monthperiods ended June 30, 2004 and 2003 was as follows:

 
| ** **                   | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                   | ** ** | **2004**                              | ** ** | **%****of  Average**                | ** ** | **2003** | ** ** | **%****of  Average** | ** ** | **2004** | ** ** | **%****of  Average** | ** ** | **2003** | ** ** | **%****of  Average** | ** ** |
| Actual precipitation inches  |       | 31.22                                 |       | 221                                 | %          | 5.14 |   | 36 | % | 45.04 |   | 187 | % | 13.35 |   | 55 | % |
| Average precipitation inches |       | 14.1                                  |       |                                |       | 14.1 |   |   |   | 24.12 |   |   |   | 24.12 |   |   |   |

 

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.

 

***Note 8. – Commitment,Contingencies and Restrictions***

 

*Commitments Under Acquisition Agreements.*

 

We own 90% ofthe outstanding common stock of Operations Technologies, Inc. (OpTech). We havethe right to acquire the remaining 10% of OpTech in August 2006 based on aformula relating to the profitability of OpTech, subject to a minimum priceof  $1 million. The minority owner hasthe option to sell the remaining 10% of OpTech to us using the same formula.

 

We have an 80%interest in Windermere Utility Company (Windermere) in Texas. We have the rightto acquire the remaining 20% ownership in Windermere.  The minority owner of Windermere has theright to require us to purchase the remaining 20% after October 1, 2005,for $6.0 million payable in our common stock, subject to a limitation onthe maximum and minimum number of shares issuable.

 

*CommitmentsUnder Long-term Service Contracts*

 

InSeptember 2002, we agreed to facilitate the engineering and constructionof a $25.0 million reverse osmosis water treatment system in the city ofSan Juan Capistrano, California, for the Capistrano Valley Water District(CVWD). The project includes the drilling of new wells and the development ofassociated water lines. We have entered into subcontractor agreements with anengineering firm and a large construction firm to fulfill significantobligations of this service contract.

 

8

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We account forthe project under the percentage of completion method. In doing so, we makeimportant judgments in estimating revenue and cost and in measuring progresstoward completion. Percentage complete is determined based upon the actual costsincurred compared to the total estimated costs to complete, subject to cashreceived and milestones accomplished. Milestones include specific constructionobjectives that must be completed and accepted by the CVWD. Thesejudgments underlie our determinations regarding overall contract value,contract profitability and timing of revenue recognition. Revenue and cost estimatesare revised periodically based on changes in circumstances; any expected losseson contracts are recognized immediately upon contract signing or as soonthereafter as identified. During construction of the CVWD plant, we havereceived payments upon completion of construction milestones and we expect tocontinue to receive such payments until final completion of the construction.Construction of the plant commenced in December 2002. As of June 30,2004, the plant was approximately 84% complete. We expect construction to becompleted in the latter portion of 2004, at which time we will begin to operateand maintain the facility under the 20-year contract. Upon completion, theplant will have the capacity to treat in excess of 5.0 million gallons ofwater per day.

 

OnJanuary 8, 2003, we obtained an unsecured line of credit facility from acommercial bank used to issue a $3.4 million standby letter of credit ascollateral for performance under a contract with the CVWD to manage the designand construction project. This standby letter of credit is in force for theestimated two-year construction period of the project. Upon final acceptance ofthe completed project by the CVWD, the standby letter of credit facility willbe terminated.

 

The CVWDservice contract contains certain guarantees related to our performance,including certain liquidated damages in the event of our failure to perform notcaused by uncontrollable circumstances as defined in the service contract.Among other things, we are obligated to produce from the completed plant aspecified volume of treated water by December 4, 2004. In the event of adelay beyond this date, not caused by a defined uncontrollable circumstance,specified delay liquidated damages are to be paid to CVWD. To help mitigatethese risks, we have secured from our construction subcontractors bothcontractual liquidated damage provisions and performance and completion bonds.In addition, we may also be liable for liquidated damages relating to any lostpayments from an agreement with a state water agency providing financialassistance to CVWD. During the 20-year operation period, we have made certainother operating guarantees to CVWD.

 

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 theservice contract, subject to certain liability limits to the bond insurer inthe event of a default. Such liability limits will not exceed an amount equalto $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 actual reverse osmosis filtration unit withinthe facility estimated to be approximately $1.5 million.

 

*Credit Line Expansion*

 

In April 2004, we obtained a firm commitment fromtwo of our commercial banks to expand our lines of credit by an additional $30million in the aggregate and to extend the maturity of our two existing linesfrom September 2005 to September 2006.  The line of credit expansions were enteredinto to provide us with additional funds to facilitate the Monarch acquisition(see note 9 following).

 

*Legal Proceedings*

 

Southwest Water and a subsidiary have been named asdefendants in several lawsuits alleging various injuries as a result of watercontamination in the San Gabriel Valley Main Basin. The California SupremeCourt ruled in February 2002 that the plaintiffs cannot challenge theadequacy of the water quality standards established by California Department ofHealth Services (DOHS). The plaintiffs may sue and collect damages fromCPUC-regulated water companies only by proving that water delivered did not meetthese water quality standards. The California Supreme Court directed that thecases be sent to a trial court for further proceedings. A number of cases,including those involving Southwest Water Company, were consolidated before asingle judge. Southwest Water Company requested defense and indemnificationfrom its liability insurance carriers for these lawsuits. Several of theliability insurance carriers absorbed the costs of defense of the lawsuits. Afterdiscovery, the plaintiffs admitted that they could not prove any violation ofDOHS water quality standards by Southwest Water Company. On August 4, 2004 thecase against Southwest Water was dismissed.

 

Southwest Water and its subsidiaries are subject tolitigation arising in the ordinary course of operations. We believe theultimate resolution of such matters will not materially adversely affect ourfinancial position, results of operations or cash flows.

 

9

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*Groundwater Settlement*

 

One of the water sources forour California water utility has been affected by the presence of certaingroundwater contaminants. These contaminants consist mainly of chemicalsdisposed of by various industrial companies in the 1940s and 1950s. In 2001 and2002, this contamination necessitated the shutdown of a number of our wells,and we purchased replacement water at a cost substantially higher than the costof water pumped from our own wells.

 

As a result of thiscontamination, under the terms of an agreement with the responsible parties, wehave received payments from these parties, and we expect to continue to receivepayments until completion of remediation or until our production capacitieshave been restored.  These paymentsrepresent the incremental cost of purchasing water over the cost that wouldhave 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, 2004 and 2003 these reimbursements wereapproximately $1.6 million and $1.9 million, respectively.

 

The settlement agreementalso provides for contributions by the responsible parties to construct newwells and to develop additional interconnections with nearby water sources.Funds from the settlement agreement will also be used to develop long-termsolutions that will potentially enable us to use our own less costlygroundwater supplies in the future. These contributions, recorded as contributions in aid of construction(CIAC), were approximately $169,000 and $2.2 million for the six months ended June 30,2004 and 2003, respectively.

 

***Note9. – Acquisitions***

 

On July 14, 2004, we acquired a Texas utility consisting ofapproximately 86 rural regulated water systems and 11 wastewater systemsfrom Tecon Water Holdings, L.P, and renamed the utility, Monarch Utilities Inc.(Monarch).  The acquired waterand wastewater systems provide service to approximately 21,000 water andapproximately 4,000 wastewater connections in Texas and recorded revenues ofapproximately $13 million in 2003.  Theacquisition will expand our regulated operations in the state of Texas whereour Utility Group currently serves approximately 6,000 customers.  We expect the proximity of these new systemsto our existing Services Group and Utility Group operations to allow us toobtain operating efficiencies by sharing overhead costs and employee competencyin this region.  The aggregate purchaseprice, which is subject to post-closing adjustment, was approximately $63million, comprised of approximately $45 million in cash payments and theassumption of approximately $18 million in debt.  Transaction costs incurred in the acquisitionare expected to be approximately $1.1 million. The final purchase price for water and wastewater systems will be adjustedwhen certain contingencies are resolved. Monarch filed a general rate case withthe Texas Commission on Environmental Quality (TCEQ) in June 2003, and putthe requested rates into effect in August 2003.  The requested rates would represent anincrease of approximately 21% from the rates previously approved by theTCEQ.  Neither the Monarch acquisitionnor its operations are reflected in the accompanying financial statements, asthe acquisition closed subsequent to June 30, 2004.

 

In July 2004, we expanded our lines of credit by an additional $30million to $70 million in the aggregate and extended the maturity of our twolines from September 2005 to September 2006.  The expansions provided us with liquidity to effectthe Tecon transaction.  Our balanceoutstanding on the lines was $57 million immediately after the Tecon transaction.

 

During 2004, we completed several acquisitions in the utility billingand collection market.  Theseacquisitions were structured as asset purchases, primarily of accountcontracts, account lists, software and other assets. Under the purchaseagreements we acquired approximately 136,000 active billing and collectionunits at a cost of approximately $5.5 million. The aggregate purchase price for the account lists was approximately$4.1 million in cash and approximately $1.4 million in notes payable.  Substantially all of the purchase price wasallocated to the account lists and the resulting intangible assets are to beamortized over eight years.

 

10

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***Item 2: Management’s Discussionand Analysis of Financial Condition and Results of Operations***

 

*The information in this discussion containsforward-looking statements within the meaning of Section 27A of theSecurities Act of 1933, as amended and Section 21E of the SecuritiesExchange Act of 1934, as amended (the”34 Act”). Such statements are based uponcurrent expectations that involve risks and uncertainties including those set forth under “RiskFactors” in this report**.  Any statements containedherein that are not statements of historical facts may be deemed to beforward-looking statements. For example, words such as “may”, “will”, “should”,“estimates”, “predicts”, “potential”, “continue”, “strategy”, “believes”,“expects”, “anticipates”, “plans”, “intends”, and similar expressions areintended to identify forward-looking statements. Our actual results and thetiming of certain events may differ significantly from the results discussed inthe forward-looking statements.*

 

The following discussion should beread in conjunction with the accompanying unaudited condensed consolidatedfinancial statements and related notes thereto and the consolidated financialstatements and the notes thereto contained in our Annual Report on Form 10-Kfor the year ended December 31, 2003.

 

**Overview**

 

Southwest Water Company and subsidiaries (“Southwest”, “we” or the“Company”) provide a broad range of water and waste water services includingwater production and distribution, wastewater collection and treatment, publicworks services, utility infrastructure and construction management, and utilitybilling and collecting. We provide services to more than two million people in35 states. Our business is segmented into two operating groups: our ServicesGroup and our Utility Group.

 

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 and private entities primarily inTexas, New Mexico, California, Colorado, Mississippi and Georgia. While stateand federal agencies issue regulations regarding standards of water quality,safety, environmental and other matters which affect these operations, ourServices Group prices are not subject to regulation. We also provide utilitybilling and collecting services in numerous states.

 

Our Utility Group owns and manages rate-regulated public waterutilities in California, New Mexico and Texas. We own and manage wastewaterfacilities in New Mexico and Texas. State and federal agencies issue regulations regarding standards ofwater quality, safety, environmental and other matters which affect theseoperations, as well as establish the rates that we can charge for our water andwastewater services.

 

On July 14, 2004, we acquired a Texas utility consisting ofapproximately 86 rural regulated water systems and 11 wastewater systemsfrom Tecon Water Holdings, L.P, and renamed the utility, Monarch Utilities Inc.(Monarch).  The acquired waterand wastewater systems provide service to approximately 21,000 water andapproximately 4,000 wastewater connections in Texas and generated revenues ofapproximately $13 million in 2003.  Theacquisition will expand our regulated operations in the state of Texas whereour Utility Group currently serves approximately 6,000 customers.  We expect the proximity of these new systemsto our existing Services Group and Utility Group operations to allow us toobtain operating efficiencies by sharing overhead costs and employee competencyin this region.  The aggregate purchaseprice, which is subject to post-closing adjustment, was approximately $63million, comprised of approximately $45 million in cash payments and theassumption of approximately $18 million in debt.  Transaction costs incurred in the acquisitionare expected to be approximately $1.1 million. The final purchase price for water and wastewater systems will beadjusted when certain contingencies are resolved. Monarch filed a general ratecase with the Texas Commission on Environmental Quality (TCEQ) inJune 2003, and put the requested rates into effect inAugust 2003.  The requested rateswould represent an increase of approximately 21% from the rates previouslyapproved by the TCEQ.  Neither the Monarchacquisition nor its operations are reflected in the accompanying financialstatements, as the acquisition closed subsequent to June 30, 2004.

 

11

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**Resultsof Operations**

 

A summary of our consolidated resultsfor the three and six months ended June 30, 2004 and 2003 is as follows:

 
| ** **                                   | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| ** **                                   | ** ** | **2004**                             | ** ** | **%****of  Revenue**               | ** ** | **2003** | ** ** | **%****of  Revenue** | ** ** | **2004** | ** ** | **%****of  Revenue** | ** ** | **2003** | ** ** | **%****of  Revenue** | ** ** |
| ** **                                   | ** ** | **($amounts in millions)**           | ** ** |
| **Revenues:**                                |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Services group                               |       | $                                    | 29.1       |                               | 64         |   | $ | 27.7 |   | 67 |   | $ | 55.8 |   | 65 |   | $ | 52.9 |   | 68 |   |
| Utility group                                |       | 16.6                                 |       | 36                                 |       | 13.8 |   | 33 |   | 29.6 |   | 35 |   | 24.7 |   | 32 |   |
|                                         |       | 45.7                                 |       | 100                                |       | 41.5 |   | 100 |   | 85.4 |   | 100 |   | 77.6 |   | 100 |   |
|                                         |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Expenses:**                                |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Operating expenses - services group          |       | 25.1                                 |       | 55                                 |       | 24.3 |   | 59 |   | 50.1 |   | 59 |   | 46.3 |   | 60 |   |
| Operating expenses - utility group           |       | 8.6                                  |       | 19                                 |       | 8.2 |   | 20 |   | 16.2 |   | 19 |   | 15.7 |   | 20 |   |
| Selling, general and administrative expenses |       | 6.9                                  |       | 15                                 |       | 5.5 |   | 13 |   | 13.0 |   | 15 |   | 11.2 |   | 14 |   |
|                                         |       | 40.6                                 |       | 89                                 |       | 38.0 |   | 92 |   | 79.3 |   | 93 |   | 73.2 |   | 94 |   |
|                                         |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Operating Income**                         |       | 5.1                                  |       | 11                                 |       | 3.5 |   | 8 |   | 6.1 |   | 7 |   | 4.4 |   | 6 |   |
| ** **                                   |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Other Income (Expense):**                  |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest expense                             |       | (1.1                                 | )          | 2                                  |       | (1.1 | ) | 3 |   | (2.2 | ) | 3 |   | (2.3 | ) | 3 |   |
| Interest income                              |       | 0.2                                  |       | —                             |       | — |   | — |   | 0.3 |   | — |   | — |   | — |   |
| Gain on sale of land                         |       | —                               |       | —                             |       | 0.7 |   | 2 |   | — |   | — |   | 0.7 |   | 1 |   |
| Other                                        |       | (0.2                                 | )          | —                             |       | (0.1 | ) | — |   | (0.2 | ) | — |   | (0.1 | ) | — |   |
|                                         |       | (1.1                                 | )          | 2                                  |       | (0.5 | ) | 1 |   | (2.1 | ) | 2 |   | (1.7 | ) | 2 |   |
|                                         |       |                                 |       |                               |       |   |   |   |   |   |   |   |   |   |   |   |   |
| **Income  Before Income Taxes**         |       | 4.0                                  |       | 9                                  |       | 3.0 |   | 7 |   | 4.0 |   | 5 |   | 2.7 |   | 3 |   |
| **Income Tax Provision**                     |       | 1.5                                  |       | 3                                  |       | 1.1 |   | 3 |   | 1.5 |   | 2 |   | 1.0 |   | 1 |   |
| **Net Income**                               |       | $                                    | 2.5        |                               | 6          |   | $ | 1.9 |   | 4 |   | $ | 2.5 |   | 3 |   | $ | 1.7 |   | 2 |   |

 

**Discussionof Results of Operations for Three Months Ended June 30, 2004 and 2003**

 

**Revenues**

 

**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 and state-certified water and wastewaterlaboratory analysis. Revenues for the three months ended June 30, 2004increased approximately $1.4 million, or 5%, to $29.1 million from $27.7million during the same period of the prior year.   Prolonged rainfall may limit our ability toperform certain billable work such as pipeline maintenance, manholerehabilitation, construction and other outdoor services.

 

Revenues earned at our Services Group under time and materialscontracts were in fact affected by prolonged rainfall in our Texas base ofoperations. Precipitation was 221% of average during the three months endedJune 30, 2004 and 36% of average for the same period of 2003.   The effect of prolonged rainfall was offsetby the following:

 

1.               A $0.7 million increase in operationsand maintenance revenue under a 10-year, $30 million contract to operate andmaintain the public works department of the City of Pascagoula, Mississippi,(the “Pascagoula contract”).  Revenues earnedunder the Pascagoula contract were $0.7 million and zero for the three monthsended June 30, 2004 and 2003, respectively.

 

2.               A $0.7 million increase in revenueearned from utility billing and collection contracts.  This increase was driven by additionalmulti-family utility metering equipment installations, as well as constructionactivity revenues earned from approximately 136,000 customer units acquiredduring the three months ended June 30, 2004.

 

**Utilitygroup**

 

Utility Group revenues result from the production anddistribution of water and the collection and treatment of sewage forresidential, business, industrial and public authority use. Our Utility Groupwater operations are seasonal, as rainfall and weather conditions affect 

 

12

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water consumption. In our service areas the second and third quarters of each yeartypically account for the highest volume of water consumption when weathertends to be hot and dry. Drought conditions may result in lower revenue due toconsumer conservation efforts and a shortage of water. Drought conditions mayalso result in increased water costs to us, which could adversely affect ourprofitability. Conversely, unusually wet conditions may result in decreasedcustomer demand, lower revenues and lower profit in our Utility Groupoperations.

 

Revenues in the Utility Group increased approximately$2.8 million, or 20%, to $16.6 million during the three months endedJune 30, 2004 from $13.8 million during the same period of the prioryear. The increase is in Utility group revenue is primarily due to thefavorable effect of rate increases in our California and Texas utilities andincreased customer connections in our New Mexico and Texas utilities.  The changes are represented as follows:

 
| ** **                                     | ** ** | **(in millions)** | ** ** |
|------------------------------------------------|------------|-------------------|------------|
| Favorable effect of rate increase in  revenues |       | $                 | 1.4        |   |
| Favorable effect of increase in connections    |       | 0.2               |       |
| Increase in water consumption                  |       | 1.2               |       |
| Net increase in revenues                       |       | $                 | 2.8        |   |

 

**Expenses**

 

**Operating expenses – services group**

 

Operating expenses – services group consist primarily of salaries,wages and employee benefits, fleet expenses, facilities costs, supplies andequipment, repairs and maintenance, professional fees and other costs.  Operating expenses – services group increasedapproximately $0.8 million, or 3%, to $25.1 million during the three monthsended June 30, 2004 from $24.3 million during the same period of2003.   We have  incurred increased costs in providing servicesto newer customers and under new contracts. Costs to provide services under the Pascagoula contract wereapproximately $0.4 million during the three months ended June 30,2004.  The contract commenced in thethird quarter of 2003.   Operatingexpenses for multi-family utility billing contracts increased approximately$0.4  million due to the servicing ofapproximately 136,000 units purchased during the three months endedJune 30, 2004 as well as increased installation of utility meteringequipment.  Operating expenses for ourgovernment services operations were approximately $0.2 million during the threemonths ended June 30, 2004.  Theseoperations began in the fourth quarter of 2003.

 

Operating expenses – services group, as a percentage of the relatedrevenues decreased from 88% for the three months ended June 30, 2003 to86% for the three months ended June 30, 2004 and 2003 due to thefollowing:

 

1.               In the third quarter of 2003, theServices Group instituted certain cost reduction efforts in its utility billingand collection services as well as its operations and maintenance services.  These costs reduction efforts includedheadcount reductions and better management of overtime.

 

2.               As noted above, prolonged rainfallprevented this group from performing certain pipeline maintenance, manholerehabilitation, construction services.   Theseservices are “materials intensive” and consequently, provide lower margins thanother operations and maintenance services provided by the Services Group.

 

3.               In the second quarter of 2003, theServices Group provided certain services under warranty.  The Services Group did not earn revenue forthese services in 2003.

 

**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—utility group representedapproximately 52% and 59% of revenues from utility operations for the threemonths ended June 30, 2004 and 2003, respectively.  The decrease in operating expenses as apercentage of revenues was due to the aforementioned increase in Utility Grouprevenues, which was primarily due to an increase in rates at our Californiautility.  Operating expenses for ourUtility Group increased $0.4 million, or 5%, to $8.6 million duringthe three months ended June 30, 2004 from $8.2 million during thecomparable period of 2003 due to an increase in consumption of water due toweather conditions at our California utility.

 

Waterproduction costs at our California utility decreased approximately 12% from$225 per acre foot for the three months ended June 30, 2003 to $198 peracre foot for the three months ended June 30, 2004.  Thisdecrease resulted from a shift from higher cost purchased watertoward less expensive produced water from our own wells.  Thisincreased water production related to two new wells which were notavailable during the three months ended June 30, 2003.  The percentage of water used in ouroperations that was produced from our own wells was 41% and 29%during the three months ended June 30, 2004 and 2003, respectively.Depreciation expense at our California utility decreased $0.2 million to $0.7million for the three months ended June 30, 2004 from $0.9 million for 

 

13

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the three months ended June 30, 2003.  The decrease in depreciation was due to an extensionin the estimated useful lives of certain utility assets, this extension wasreviewed and accepted by the CPUC in conjunction with the California utility’sJune  2003 rate case.

 

However, the benefit from the change in mix of water produced waspartially offset by (i) increased utility plant maintenance and repair costsand (ii) increased energy costs.

 

Operating expenses at our New Mexico and Texas utilities increasedduring the three months ended June 30, 2004 as compared to the comparableperiod of 2003. The increase was primarily due to an increase in volume and inthe number of connections served by our New Mexico and Texas utilities.

 

**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 costs increased $1.4 million, or 25%, to $6.9 million for thethree months ended June 30, 2004 from $5.5 million during the same periodof the prior year.  Selling, generaland administrative expenses increased to 15% of revenues for the three monthsended June 30, 2004 from 13% during the three months ended June 30,2003 due to the increased size and complexity of our operations.  In particular, the change was due to:

 

1.               Increases in insurance costs, auditfees, legal fees, facilities costs and. benefit costs for administrativeemployees, and

 

2.               Our efforts to prepare for and complywith the Sarbanes Oxley Act of 2002 and related regulations.

 

**Other Income (Expense)**

 

**Interest Expense**

 

The major components of interest expense for threemonths ended June 30, 2004 and 2003 are as follows:

 
| ** **                                             | ** ** | **For the Three Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|-----------------------------------------------|------------|
| ** **                                             | ** ** | **2004**                                      | ** ** | **2003** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                            | ** ** |
| Interest expense - convertible subordinate  debentures |       | **$**                                         | **316**    | ** ** | $ | 335 |   |
| Interest expense - bank lines of credit                |       | **165**                                       | ** ** | 124 |   |
| Interest expense - mortgage bonds and bank  term loan  |       | **493**                                       | ** ** | 579 |   |
| Interest expense - other                               |       | **173**                                       | ** ** | 187 |   |
| Total interest expense before capitalized  interest    |       | **1,147**                                     | ** ** | 1,225 |   |
| Capitalized interest                                   |       | **(71**                                       | **)**      | (116 | ) |
| Total interest expense                                 |       | **$**                                         | **1,076**  | ** ** | $ | 1,109 |   |

 

The decrease in total interest expense is primarilydue to a reduction in our long-term debt. Average long-term debt outstanding was $62.6 million and $80.0 millionfor the three months ended June 30, 2004 and 2003, respectively.  Proceeds from our March 2004 stockoffering were used to pay down line of credit balances.  Interest rates on these lines are lower thanour other debt and the reduction of the line of credit debt had the effect ofincreasing the weighted average borrowing rate during the three months endedJune 30, 2004. The effect of decrease in average debt outstanding waspartially offset by an increase in our weighted average borrowing rate from5.6% during the three months ended June 30, 2003 to 6.9% during the threemonths ended June 30, 2004.

 

In the second quarter of 2003, we recognized a $720,000 pretax gain onthe sale of surplus land at our California utility.

 

**Provision for Income Taxes**

 

Our effective income tax rates for the three monthsended June 30, 2004 and 2003 were approximately 37%.

 

14

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**Discussionof Results of Operations for the Six Months Ended June 30, 2004 and 2003**

 

**Revenues**

 

**Services group**

 

Revenues for the six months ended June 30, 2004 increasedapproximately $2.9 million, or 5%, to $55.8 million from $52.9 million duringthe same period of the prior year.  Revenues earned under time and materials contracts were affected byprolonged rainfall in our Texas base of operations.  Actual rainfall exceeded average rainfall byapproximately 87% during the six months ended June 30, 2004.  Rainfall was only 55% of average for the sixmonths ended June 30, 2003.  Inaddition, during the first quarter of 2004, we determined that certainreceivables of $0.3 million would not likely be collected.  Accordingly, the receivables and the relatedrevenue were reversed.

 

The effect of the prolonged rainfall was offset by the following:

 

1.               A $1.2 million dollar increase inrevenues earned from our construction management project for the city of SanJuan Capistrano, California.  Revenuesearned under the construction management contract were approximately $4.5million and $3.3 million for the six months ended June 30, 2004 and 2003,respectively.

 

2.               A$1.4 million increase in operations and maintenance revenue under a 10-year,$30 million contract to operate and maintain the public works department of theCity of Pascagoula, Mississippi. Revenues earned under the Pascagoula contract were $1.6 million and $0.2million for the six months ended June 30, 2004 and 2003, respectively.

 

3.               Approximately$1.3 million in revenues earned from utility billing units purchased orsubsidiaries acquired subsequent to June 30, 2003.

 

**Utilitygroup**

 

Revenues inthe Utility Group increased approximately $4.9 million, or 20%, to $29.6million during the six months ended June 30, 2004 from $24.7 millionduring the same period of the prior year. The increase is primarily due to thefavorable effect of rate increases in our California and Texas utilities,increased consumption at our California utility due to weather, and increasedcustomer connections in our New Mexico and Texas utilities.  The changes are represented as follows:

 
| ** **                                     | ** ** | **(in millions)** | ** ** |
|------------------------------------------------|------------|-------------------|------------|
| Favorable effect of rate increase in  revenues |       | $                 | 3.0        |   |
| Favorable effect of increase in connections    |       | 0.4               |       |
| Increase in water consumption                  |       | 1.5               |       |
| Net increase in revenues                       |       | $                 | 4.9        |   |

 

**Expenses**

 

**Operating expenses – services group**

 

Our operating expenses in the Services Group increased approximately$3.8 million, or 8%, to $50.1 million during the six months ended June 30,2004 from $46.3 million during the same period of 2003.   These operating expenses were approximately90% of Services Group revenues for the six months ended June 30, 2004 and88% of revenues for the same period of 2003. The increases were due primarilyto the following:

 

1.               Approximately $1.2 million of theincrease was due to increased activity under our construction management contractwith the CVWD.

 

2.               Approximately $0.8 million of theincrease was due to costs to provide service under our new contract with theCity of Pascagoula, Mississippi.

 

3.               Operating expenses for utility billingand collection contracts increased approximately $0.6 million due to anincrease in installation of utility metering equipment and the purchase ofapproximately 136,000 customer units which were acquired during the secondquarter of 2004.

 

15

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These increases were partially offset by reductions of operatingexpenses as the company responded to a general decrease in activity in itsTexas base of operations.   Higher thanaverage precipitation has limited or delayed our ability to perform billableservices and construction during 2004 as noted above.

 

**Operating expenses – utility group**

 

Operatingexpenses—utility group represented approximately 55% and 64% of revenues fromutility operations for the six months ended June 30, 2004 and 2003,respectively.  The decrease in operatingexpenses as a percentage of revenue was due to the aforementioned increase inUtility Group revenues, which was primarily due to an increase in rates at ourCalifornia and Texas utilities. Operating expenses for our Utility Group increasedapproximately $0.5 million, or 3%, to $16.2 million during the sixmonths ended June 30, 2004 from $15.7 million during the comparable periodof 2003.

 

Waterproduction costs at our California utility decreased approximately 20% from$232 per acre foot for the six months ended June 30, 2003 to $195 per acrefoot for the six months ended June 30, 2004.  Thisdecrease resulted from a shift from higher cost purchased watertoward less expensive produced water from our own wells.  Thisincreased water production related to two new wells which were notavailable during the six months ended June 30, 2003.  The percentage of water producedfrom our own wells was 51% and 29% during the six months endedJune 30, 2004 and 2003, respectively. Depreciation expense at ourCalifornia utility decreased approximately $0.4 million to $1.8 million for thesix months ended June 30, 2004 from $1.4 million for the six months endedJune 30, 2003.  The decrease was dueto an extension in the estimated useful lives of certain utility assets, thisextension was reviewed and accepted by the CPUC in conjunction with theCalifornia utility’s June  2003 rate case.

 

However the effects of the change in the mix of water produced versuspurchased and the reduction in depreciation expense were partially offset byincreased utility plant maintenance and repair costs and increased energycosts.

 

Operating expenses at our New Mexico and Texas utilities increasedduring the six months ended June 30, 2004 as compared to the comparableperiod of 2003. The increase was primarily due to a increase in volume and inthe number of connections served by our New Mexico and Texas utilities.

 

**Selling, general and administrative expenses**

 

Selling, general and administrative costs increased approximately $1.8million, or 16%, to $13.0 million for the six months ended June 30, 2004from $11.2 million during the same period of the prior year.  Selling, general and administrative expenses as apercentage of revenues increased to 15% for the six months ended June 30,2004 from 14% during the six months ended June 30, 2003.  The increase was due to the increased sizeand complexity of our operations.  Inparticular, the change was due to:

 

1.               Increases in insurance costs, auditfees, legal fees, facilities costs and benefits costs for administrativeemployees, and

 

2.               Our efforts to prepare for and complywith the Sarbanes Oxley Act of 2002 and related regulations.

 

16

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**Other Income (Expense)**

 

**Interest Expense**

 

The major components of interest expense for sixmonths ended June 30, 2004 and 2003 are as follows:

 
| ** **                                             | ** ** | **For the Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                             | ** ** | **2004**                                    | ** ** | **2003** | ** ** |
| ** **                                             | ** ** | **(in thousands)**                          | ** ** |
| Interest expense - convertible subordinate  debentures |       | **$**                                       | **642**    | ** ** | $ | 676 |   |
| Interest expense - bank lines of credit                |       | **412**                                     | ** ** | 351 |   |
| Interest expense - mortgage bonds and bank  term loan  |       | **985**                                     | ** ** | 1,161 |   |
| Interest expense - other                               |       | **327**                                     | ** ** | 316 |   |
| Total interest expense before capitalized  interest    |       | **2,366**                                   | ** ** | 2,504 |   |
| Capitalized interest                                   |       | **(213**                                    | **)**      | (198 | ) |
| Total interest expense                                 |       | **$**                                       | **2,153**  | ** ** | $ | 2,306 |   |

 

The decrease in total interest expense is primarilydue to a reduction in our long-term debt. Average long-term debt outstanding was $78.2 million and $71.2 millionfor the six months ended June 30, 2003 and 2004, respectively.  Proceeds from our March 2004 stockoffering were used to pay down our line of credit balances.  Interest rates on these lines aresignificantly lower than our other debt and the reduction of the line of creditdebt had the effect of increasing the weighted average interest rate subsequentto the stock offering in the second quarter of 2004.  The effect of the decrease in average debtoutstanding was partially offset by an increase in our weighted averageinterest rate from 5.9% during the six months ended June 30, 2003 to 6.0%during the six months ended June 30, 2004.

 

In the second quarter of 2003, we recognized a $720,000 pretax gain onthe sale of surplus land at our California utility.

 

**Provision for Income Taxes**

 

Our effective income tax rates were approximately 37%for the six months ended June 30, 2004 and 2003.

 

17

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**Liquidityand Capital Resources**

 

Following is a summary of the primary sources and uses of cash duringthe six months ended June 30, 2004 and 2003: 

 
| ** **                                                          | ** ** | **Six Months Ended  June 30,** | ** ** |
|---------------------------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                                          | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                                          | ** ** | **(in thousands)**                  | ** ** |
| Sources of cash                                                     |       |                                |       |   |   |
| Net income, net of adjustments to reconcile net income  to cash     |       | $                                   | 6,886      |   | $ | 6,350 |   |
| Net proceeds from public and private sales of stock                 |       | 20,573                              |       | 10,988 |   |
| Contributions in aid of construction, LUE fees and                  |       |                                |       |   |   |
| capital improvement reimbursements                                  |       | 5,060                               |       | 4,157 |   |
| Proceeds from sale leaseback transactions                           |       | 78                                  |       | 1,102 |   |
| Proceeds from disposition of land                                   |       | —                              |       | 741 |   |
| Net other sources of cash                                           |       | 288                                 |       | 43 |   |
|                                                                |       | 32,885                              |       | 23,381 |   |
|                                                                |       |                                |       |   |   |
| Uses of cash                                                        |       |                                |       |   |   |
| Changes in assets and liabilities, net of effects  of acquisitions: |       | (3,638                              | )          | (7,212 | ) |
| Net repayment of lines of credit and long-term  debt                |       | (10,194                             | )          | (6,111 | ) |
| Additions to property, plant and equipment                          |       | (11,217                             | )          | (9,179 | ) |
| Purchase of minority interest in subsidiary                         |       | (2,900                              | )          | — |   |
| Purchase of businesses                                              |       | (4,063                              | )          | — |   |
| Dividends paid                                                      |       | (1,576                              | )          | (1,141 | ) |
|                                                                |       | (33,588                             | )          | (23,643 | ) |
|                                                                |       |                                |       |   |   |
| Net decrease in cash and cash equivalents                           |       | $                                   | (703       | ) | $ | (262 | ) |

 

In March 2004, we completed a public offering of 1,610,000 sharesof our common stock. The 1,610,000 shares were sold at $13.58 per share and ournet proceeds were approximately $20.6 million. We used proceeds from this offering to reduce amounts outstanding underour lines of credit.  In May 2003, wecompleted a private placement of 1,477,000 shares of newly issued common stockto select institutional investors. Gross proceeds from the private placement wereapproximately $11 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. We collected more CIAC during the six months ended June 30, 2004than the same period of the previous year due to an increase in theconstruction of plant equipment during the 2004 period as compared to the 2003period.  The effect of increasedconstruction was partially offset by a reduction in payments received as partof a settlement agreement relating to ground water contamination at ourCalifornia utility.  The settlementagreement provided for contributions for the construction of new wells andinterconnections with nearby water sources. These contributions were approximately $0.2 million and $2.2 millionduring the six month ended June 30, 2004 and 2003, respectively.

 

Our liquidity is influenced primarily by cash flows from operations andby capital expenditures at our Utility Group for the addition, replacement andrenovation of water and wastewater utility facilities. The following tablesummarizes our activity for additions to property, plant and equipment duringthe six months ended June 30, 2004 and 2003:

 
| ** **                                       | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------|------------|-------------------------------------|------------|
| ** **                                       | ** ** | **2004**                            | ** ** | **2003** | ** ** |
| ** **                                       | ** ** | **(in thousands)**                  | ** ** |
| Company-financed additions                       |       | **$**                               | **6,179**  | ** ** | $ | 5,022 |   |
| Capital improvement reimbursements               |       | **169**                             | ** ** | 2,182 |   |
| Contributions paid for by developers             |       | **4,869**                           | ** ** | 1,975 |   |
| Net cash used in investing activities            |       | **11,217**                          | ** ** | 9,179 |   |
| Property contributed by developers               |       | **2,349**                           | ** ** | 3,629 |   |
| Total additions to property, plant and equipment |       | **$**                               | **13,566** | ** ** | $ | 12,808 |   |

 

18

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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.

 

InDecember 2003, we agreed to purchase the minority interest in Master Tek,a subsidiary. The settlement payout of approximately $2.9 million was madein January 2004.   During the sixmonths ended June 30, 2004 we acquired the customer account lists ofcertain utility billing and collection firms for approximately $5.5 million,consisting of $4.1 million in cash and $1.4 million in notes payable.

 

We augment our operating cashflow needs with borrowings under our linesof credit.   On June 30, 2004, wehad working capital of approximately $9.9 million with available cash andcash-equivalent balances of approximately $1.9 million (excludingrestricted cash balances). On June 30, 2004 we had aggregate lines ofcredit totaling $40.0 million consisting of three separate unsecured linesof credit from three commercial banks. On April 13, 2004, we obtained afirm commitment from two of our commercial banks to expand our lines of creditby an additional $30 million to $70 million in the aggregate and to extend thematurity of our two existing lines from September 2005 toSeptember 2006.  The expansion ofour lines of credit was finalized in July 2004.  These increases provided us with additionalfunds to consummate the Monarch transaction. Our total borrowing availability under lines of credit was approximately$62.5 million on June 30, 2004 and $12.0 million immediatelyfollowing the Monarch transaction.  Theadditional borrowing available under our current commercial lines of credit islimited by financial covenants that restrict additional borrowing to an amountno greater than the remaining unused credit line amount.

 

Wecontinuously seek opportunities to increase our cash flow through eitherimproving cash flow from operations or reducing our interest cost. We have nothistorically experienced difficulty in obtaining financing or refinancingexisting debt. We expect to continue to seek such opportunities in the futureto the extent such opportunities are available to us.

 

**Off-BalanceSheet Arrangements**

 

We do not haveany material off-balance sheet arrangements, other than leases that have beentreated as operating leases in accordance with U.S. GAAP.

 

**Debt Obligations**

 

Following is a summary of our debt obligations and commitments due inthe remaining six months of 2004 and in the following specified periodsthereafter.  Amounts represent theexpected cash payments (principal and interest) related to our long-term debtand do not include any fair value adjustments or bond premiums or discounts.

 
| ** **                             | ** ** | ** **         | ** ** | **Years Ending December 31,** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------------|------------|--------------------|------------|------------------------------------|------------|------------|------------|------------|
| ** **                             | ** ** | **2004**           | ** ** | **2005**                           | ** ** | **2006**   | ** ** | **2007**   | ** ** | **2008 and  thereafter** | ** ** | **Total** | ** ** |
| ** **                             | ** ** | **(in thousands)** | ** ** |
| Long-term debt                         |       |               |       |                               |       |       |       |       |   |   |   |   |   |
| Bank lines of credit                   |       | $                  | —     |                               | $          | —     |       | $          | 7,009 |   | $ | — |   | $ | — |   | $ | 7,009 |   |
| Bank term loan                         |       | 250                |       | 500                                |       | 500        |       | 500        |   | $ | 7,375 |   | 9,125 |   |
| Economic development revenue bonds     |       | 90                 |       | 95                                 |       | 100        |       | 105        |   | 1,925 |   | 2,315 |   |
| Mortgage bonds (1)                     |       | 900                |       | 900                                |       | 13,500     |       | —     |   | $ | 8,000 |   | 23,300 |   |
| Convertible subordinate debentures (2) |       | —             |       | —                             |       | —     |       | —     |   | 17,496 |   | 17,496 |   |
| Notes payable                          |       | 1,506              |       | 1,959                              |       | 1,378      |       | 386        |   | 406 |   | 5,635 |   |
| Advances for construction              |       | 180                |       | 180                                |       | 180        |       | 180        |   | 6,483 |   | 7,203 |   |
|                                   |       | $                  | 2,926      |                               | $          | 3,634      |       | $          | 22,667 |   | $ | 1,171 |   | $ | 41,685 |   | $ | 72,083 |   |

 

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(1)          We expect to issue new mortgage backed bondsin the second half of 2004.  The proceedswill be used to repay approximately $7.3 million of bonds due in 2006.  We expect to refinance the remaining $6.2million of bonds, due in 2006.

 

(2)          The convertible subordinate debentures are duein 2021.  There are no intermediatematerial put rights attached to the debentures.

 

InJanuary 2003, we expanded one of our lines of credit from one of ourcommercial banks by $3.4 million. This facility was utilized to issue astandby letter of credit in that amount as collateral for performance under acontract to design and construct a reverse osmosis water treatment facility andassociated wells. This standby letter of credit is in force for the estimatedtwo-year construction period of the project. Upon acceptance of the completedproject, expected in the latter portion of this year, the standby letter ofcredit and the related credit facility will be terminated.

 

We anticipatethat our available lines of credit borrowing capacity and cash flows generatedfrom operations will be sufficient to fund our activities during the next12 months. If we were unable to renew our existing lines of credit or ifwe were unable to execute 

 

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additionalfinancing alternatives, our capital spending and any future acquisitions wouldbe reduced, eliminated or delayed.

 

We expect tomaintain our lines of credit in the normal course of business. Each of the lineof credit agreements contains certain financial covenants. During the sixmonths ended June 30, 2004, we were in compliance with all applicablecovenants under each of the line of credit agreements.

 

In addition toour lines of credit, we have excess borrowing capacity under our first mortgagebond indentures of approximately $79.2 million as of June 30, 2004.

 

On December 29, 2003, we filed a shelf registration statement withthe Securities and Exchange Commission for the issuance from time to time of upto $50 million aggregate principal amount of common stock, debt securitiesand warrants.  As of June 30, 2004,we had approximately $28 million available under this shelf registration.  We may offer additional securities under theshelf registration statement at any time.

 

**CriticalAccounting Policies**

 

Ourconsolidated financial statements are prepared in accordance with accountingprinciples generally accepted in the United States (GAAP). These accountingprinciples require us to make certain estimates, judgments and assumptions. Webelieve that the estimates, judgments and assumptions are reasonable based uponinformation available to us at the time that these estimates, judgments andassumptions are made. These estimates, judgments and assumptions can affect thereported amounts of assets and liabilities as of the date of the financialstatements, as well as the reported amounts of revenues and expenses during theperiods presented. To the extent there are material differences between theseestimates, judgments or assumptions and actual results, our financialstatements will be affected. The significant accounting policies that webelieve are important to fully understanding and evaluating our reportedfinancial results include the following:

 

•                  Revenuerecognition,

•                  Valuation oflong-lived and intangible assets,

•                  Accounting forregulated business in accordance with SFAS 71,

•                  Stock-basedcompensation, and

•                  Deferred costs.

 

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 in which require management’s judgment in selecting among availableGAAP alternatives. Our senior management has reviewed these critical accountingpolicies and related disclosures with our audit committee.

 

**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 billed based on a monthly fee to provide a specificlevel of service as outlined in each individual contract. We generally bill foradditional services provided beyond the scope of the base contract on atime-and-materials basis as such services are 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.

 

We providedesign, build and operation services under time-and-material and fixed-pricecontracts, which may extend up to 20 or more years.

 

Revenues forutility billing and collecting services are recognized and billed at the end ofthe month in which services are performed. Revenues for installation of utilitybilling and collection equipment are accounted for using thepercentage-of-completion method.

 

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, revenue is recognized on a straight-line basis over thecontract term.

 

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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 services 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**

 

Ouracquisitions have been accounted for using the purchase method of accounting.In accordance with SFAS No. 144, *Accountingfor the Impairment of or Disposal of Long-Lived Assets,*we assessintangible assets and other long-lived assets for recoverability wheneverevents or changes in circumstances indicate that their carrying value may notbe recoverable through the estimated undiscounted future cash flows resultingfrom the use of the assets. If we determine that the carrying value ofintangible assets or other long-lived assets may not be recoverable, we measureimpairment by using the projected discounted cash-flow method in accordancewith Statement No. 144.

 

We have 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 withdefinite useful lives, SFAS No. 142 requires amortization over theirestimated useful lives. SFAS No. 142 became effective for fiscal yearsbeginning after December 15, 2001. At June 30, 2004, other assetsinclude approximately $22.0 million of goodwill, which was no longersubject to amortization beginning in 2002. There were no impairment charges togoodwill as of June 30, 2004 and no events have occurred during the sixmonths ended June 30, 2004 that indicated diminution in the value ofrecorded goodwill.

 

Under theprovisions of SFAS No. 141, *BusinessCombinations*, we identified approximately $0.2 million ofintangible contract costs in connection with our acquisition of Aqua Servicesand approximately $1.1 million of intangible contract costs in connectionwith our acquisition of OpTech. We are amortizing these intangible contractcosts over a period of four years, which is the average estimated life of thecontracts.

 

During 2004, we acquired approximately 136,000 utility billing andcollection units at a cost of approximately $5.5 million. Substantially all ofthe purchase price was allocated to the account lists and the resultingintangible assets will be amortized over 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 regulatory authority. Each stateauthority establishes rates which are intended to permit each utility torecover its costs and earn a reasonable rate of return. Each utility may fileand process general rate applications on a periodic basis. Since theestablished rates may be in effect for several years, our utilities attempt toanticipate cost increases and apply for rates sufficient to permit recovery ofthose cost increases when incurred, where permitted by state law.

 

Our ServicesGroup has contracted with our utilities in Texas and New Mexico to performoperating services, maintenance, and construction work, and to manage capitalprojects. These contracts were established utilizing terms and conditionsequivalent to prevailing industry rates for similar work performed by ourServices Group for non-affiliated customers. In accordance with SFASNo. 71, our Services Group recognizes profit from work performed and doesnot eliminate the intercompany profit when the contract sales price isreasonable and it is probable that the costs and capital will be recoverable bythe utility through the rate-making process. Accordingly, the intercompanyprofit, for construction as well as operations and maintenance services, andthe related receivables and payables, on such work have not been eliminated inthe accompanying condensed consolidated financial statements. However, allrevenue in excess of profits has been eliminated in consolidation.

 

Beginning inDecember 2001, our water utility has recognized all water costs asincurred. Currently the differences between actual and CPUC-adopted waterproduction costs are expensed as incurred. These differences are tracked in amemorandum account and we will attempt to recover these expenses in future ratehearings.

 

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Our California water utility recorded a balancing account receivable inthe amount of approximately $2.3 million, representing the differencebetween actual water production costs incurred and CPUC-adopted waterproduction costs. Historically, the CPUC allowed such balancing accounts in theincome statements of water utilities, with a corresponding liability or asseton the balance sheet.  On July 8,2004, the CPUC issued a decision that allows our water utility in California toincrease rates to collect approximately $3.0 million. We expectthis amount will be billed and collected within the next 24 to 36months.   The $0.7 million increase inthe balancing account receivable will be recorded in July 2004.

 

**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, *Accounting for Stock-Based Compensation – Transitionand Disclosure, an amendment of FASB Statement No. 123*, we electedto recognize stock-based compensation using the retroactive restatement method.Under this change in accounting method, we restated our consolidated financialstatements for periods prior to 2002 to reflect stock-based compensationexpense under a fair value based accounting method for all options granted,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.

 

**Stock Dividends and Splits**

 

We effected a4-for-3 stock split in the form of a stock dividend on January 1, 2004.All per share amounts and numbers of shares outstanding reflect this dividend.

 

**Deferred Costs**

 

We defercertain costs incurred in anticipation of future contract sales.  These costs include but are not limited tothe costs of mobilization, engineering, architectural, or other servicesincurred on the basis of commitments or other indications of interest innegotiating a contract.  Costs to make,buy or use assets in connection with anticipated contracts are alsoincluded.  We subsequently amortize thesedeferred contract acquisition costs on a straight-line basis over the remainingoriginal contract term unless revenue patterns indicate a more acceleratedmethod is appropriate. Deferred contract costs net of accumulated amortizationare included in other assets. The recoverability of all long-lived assetsassociated with a particular contract, including deferred contract costs, isanalyzed on a periodic basis. If long-lived assets are determined to beimpaired, impairment is recognized for the amount by which the carrying valueof the long-lived assets exceeds the fair value of those assets.  Costs incurred on failed contract proposalsare expensed immediately.

 

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**RISK FACTORS**

 

The following factors, which are described more fullyin our 2003 Annual Report, represent risks and uncertainties that could causeactual results to differ materially from our historical experience and ourpresent expectations or projections. Factors that could affect forward-lookingstatements relating to the resolution of the reportable condition with respectto internal controls discussed in Item 4 below and Item 9A of our 2003 AnnualReport, include among other things: our ability to fully resolve thedeficiencies during 2004; our ability to identify and retain qualified andexperienced financial personnel at the Services Group; our ability to designand maintain policies and procedures which enable us to avoid any reoccurrenceof the matters which gave rise to the reportable condition; and our ability toimplement policies and procedures including documentation that meets theinternal control over financial reporting requirements of the rules adopted bythe Securities and Exchange Commission pursuant to Section 404 of theSarbanes-Oxley Act of 2002. See “Risk Factors” in our 2003 Annual Report forfurther disclosure related to risk factors:

 

**Risks Related to Our Common Stock**

 

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

 

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

 

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

 

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

 

**Risks Related to Our Business**

 

***Risk factors that affect our Services Group operations***

 

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

 

•                  *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 hurricanes, floods, tornadoes andterrorist activities may adversely affect our results of operations.*

 

•                  *Services Group contracts for the design andconstruction of water and wastewater projects 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.*

 

***Risk Factors that affect our Utility Group operations***

 

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

 

•                  *Changes in the regulatory environment, may adverselyaffect our results of operations.*

 

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

 

•                  *We own assets in areas subject to natural disasters.*

 

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•                  *We are subject to regulatory and environmental risksand 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.*

 

**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 increasing costs of producingproducts and services.*

 

•                  *Our operations are subject to certain risks due totheir location.*

 

***Item 3.******Quantitative andQualitative Disclosures about Market Risk***

 

We have certain indebtedness that is subject tovariable rate interest. As a result, Southwest Water’s interest expense isaffected by changes in the general level of interest rates. The interestexpense we pay on our line of credit borrowings and certain term loans isdetermined based upon a rate formula that fluctuates with short-term LIBORrates and cannot exceed the banks’ prime rate minus one-quarter percent.

 

We completed a$20.0 million, 20-year convertible subordinate debenture offering inJuly 2001, which bears a fixed interest rate of 6.85% per annum. Theproceeds were used to pay down certain variable rate indebtedness. Ourlong-term debentures were sold with a fixed interest rate, and are not subjectto market fluctuation of interest rates. 

 

***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 reported in our 2003 Annual Report, in March 2004, management,in consultation with our independent accountants, identified deficiencies incertain aspects of the monitoring and analysis components of the internalcontrol procedures in our Services Group segment which constituted a reportablecondition (as defined in AU 325, Communication of Internal Control RelatedMatters Noted in An Audit of the AICPA Professional Standards). Theseidentified deficiencies impacted the quality and timeliness of the reportingand reconciliation of certain transactions in the Services Group. The mattersinvolving the reportable condition have been discussed in detail amongmanagement, the audit committee of our board of directors, and our independentaccountants. The identified deficiencies did not require any restatement of ourconsolidated financial statements for any prior period.

 

As discussed in our 2003 Annual Report, management isimplementing changes which we expect will rectify the those deficiencies during2004.  In the quarter ended June 30,2004 we made changes in our internal controls over financial reporting thathave materially affected, or are reasonably likely to materially affect, ourinternal controls over financial reporting, including:

 

•                  We haveincreased the number and capability of the Services Group accounting staff;

 

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•                  We haveimplemented more formal procedures in our internal review processes;

 

•                  Our auditcommittee approved the engagement of a professional internal audit firm.

 

We are continuing to identify and implementimprovements in our control environment. We believe the aforementioned changes, implemented during the threemonths ended June 30, 2004, have enhanced our internal controls overfinancial reporting.

 

**PART II - OTHER INFORMATION**

 

***Item1.******Legal Proceedings***

 

Southwest Water and a subsidiary have been named asdefendants in several lawsuits alleging various injuries as a result of watercontamination in the San Gabriel Valley Main Basin. The California SupremeCourt ruled in February 2002 that the plaintiffs cannot challenge theadequacy of the water quality standards established by California Department ofHealth Services (DOHS). The plaintiffs may sue and collect damages fromCPUC-regulated water companies only by proving that water delivered did notmeet these water quality standards. The California Supreme Court directed thatthe cases be sent to a trial court for further proceedings. At this time anumber of cases, including those involving Southwest, have been consolidatedbefore a single judge. Southwest Water requested defense and indemnificationfrom its liability insurance carriers for these lawsuits. Several of theliability insurance carriers have absorbed the costs of defense of thelawsuits. After discovery, the plaintiffs admitted that they could not proveany violation of DOHS water quality standards by Southwest. On August 4, 2004the case against Southwest Water was dismissed.

 

Southwest Water and its subsidiaries are subject tolitigation arising in the ordinary course of operations. We believe theultimate resolution of such matters will not materially adversely affect ourfinancial position, results of operations or cash flows.

 

***Item 4.******Submission of Matters toa Vote of Security Holders.***

 

Proposal 1.                                  To elect threepersons as Class III Directors to a three-year term and until theirsuccessors are duly elected and qualified.

 
| ** **                                 | ** ** | **H. Frederick  Christie** | ** ** | **Anton C.  Garnier** | ** ** | **Peter J.  Moerbeek** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|-----------------------|------------|------------------------|------------|
| Votes *“For”*                    |       | 11,823,889                 |       | 11,977,443            |       | 11,977,420             |       |
| Votes to *“Withhold  Authority”* |       | 565,197                    |       | 411,643               |       | 411,666                |       |

 

Proposal 2.                                  To approve anamendment to the Company’s Amended and Restated Certificate of Incorporationincreasing the number of authorized shares of common stock from 25,000,000shares to 75,000,000 shares.

 

Votes *“For”*— 10,205,224shares

Votes *“Against”*— 2,013,512shares

Votes *“Abstained”*—170,350 shares

 

Proposal 3.                            To approve an amendment tothe Amended and Restated Stock Option Plan for Non-Employee Directors, whichincludes an increase of 250,000 shares authorized for issuance under the plan,an increase of 5,000 shares to the initial and annual stock option grants tonon-employee directors (“Non-Employee Directors”) and a four-year extension tothe term of the plan.

 

Votes *“For”*— 4,775,775shares

Votes *“Against”*—2,570,500 shares

Votes *“Abstained”*—397,581 shares

Broker“Non-Vote*”*—4,645,230 shares

 

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***Item 5.******Other Information***

 

None

 

***Item 6.******Exhibits and Reports onForm 8-K***

 

(a)                      Exhibits:

 
| 10.1   |   | Amendment No. 2 to Amended and Restated Bylaws of  Southwest Water Company.                                                                                                              |
|--------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |   |                                                                                                                                                                                     |
| 10.2   |   | Certificate of Amendment of Restated Certificate of  Incorporation of Southwest Water Company.                                                                                           |
|   |   |                                                                                                                                                                                     |
| 10.3   |   | Amended and Restated Stock Option Plan for  Non-Employee Directors of Southwest Water Company.                                                                                           |
|   |   |                                                                                                                                                                                     |
| 10.4   |   | Amendment to the Amended and Restated Stock Option  Plan for Non-Employee Directors of Southwest Water Company.                                                                          |
|   |   |                                                                                                                                                                                     |
| 10.5   |   | Amended and Restated Credit Agreement between  Southwest Water Company and Bank of America, N.A. July 7, 2004.                                                                      |
|   |   |                                                                                                                                                                                     |
| 10.6   |   | Certificate of Amendment of Restated Certificate of  Incorporation of Southwest Water Company and Union Bank of California, N.A.  July 7, 2004.                                     |
|   |   |                                                                                                                                                                                     |
| 31.1   |   | Certification of Chief Executive Officer pursuant to  Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                     |
| 31.2   |   | Certification of Chief Financial Officer pursuant to  Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002. |
|   |   |                                                                                                                                                                                     |
| 32.1   |   | Certification of Chief Executive Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                           |
|   |   |                                                                                                                                                                                     |
| 32.2   |   | Certification of Chief Financial Officer pursuant to  18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002.                           |

 

(b)                         Reportson Form 8-K:

 

On May 11, 2004, we filed a Current Report on Form 8-K furnishing anearnings release with respect to our financial results for the three monthsended March 31, 2004.

 

On May 3, 2004, we filed a Current Report on Form 8-K furnishing apress release announcing our definitive agreement to acquire regulated waterand wastewater utility companies from Tecon Water Holdings, L.P.

 

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**SIGNATURES**

 

Pursuant to the requirements of the SecuritiesExchange Act of 1934, the Registrant has duly caused this report to be signedon its behalf by the undersigned thereunto duly authorized.

 

 
|                              | SOUTHWEST WATER COMPANY                                                        |   |
|-----------------------------------|--------------------------------------------------------------------------------|--------|
|                              | (Registrant)                                                                   |
|                              |                                                                           |
| Dated:   August 6, 2004 | /s/ RICHARD J. SHIELDS                                                         |   |
| ** **                        | **Richard J. Shields  Chief Financial Officer  (Principal Financial Officer)** |
|                                   |                                                                                |        |  |

 

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