10-Q

UNITED STATES
SECURITIES 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 September 30, 2005
	OR
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the transition period from                                to

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

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

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

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

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date. On November 7, 2005, there were 20,502,370 common shares outstanding.

SOUTHWEST WATER COMPANY

INDEX

Part I.	Financial Information:
	Item 1.	Financial Statements:
		Condensed Consolidated Statements of Income (unaudited) – Three Months and Nine Months Ended September 30, 2005 and 2004
		Condensed Consolidated Balance Sheets – September 30, 2005 (unaudited) and December 31, 2004 (audited)
		Condensed Consolidated Statements of Cash Flows (unaudited) – Nine Months Ended September 30, 2005 and 2004
		Notes to Condensed Consolidated Financial Statements (unaudited)
	Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
	Item 3.	Quantitative and Qualitative Disclosures About Market Risk
	Item 4.	Controls and Procedures
Part II.	Other Information:
	Item 1.	Legal Proceedings
	Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds
	Item 6.	Exhibits
Signatures

i

PART I – FINANCIAL INFORMATION

Item 1. Financial Statements

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF INCOME (Unaudited)

(in thousands except per share data)

	Three Months Ended September 30,						Nine Months Ended September 30,
	2005			2004			2005			2004
Revenues:
Utility group	$	23,300		$	22,422		$	59,054		$	52,062
Services group	31,368			30,231			92,127			82,032
	54,668			52,653			151,181			134,094
Expenses:
Operating expenses - utility group	12,835			13,712			33,492			29,981
Operating expenses - services group	28,038			27,012			80,611			74,845
Selling, general and administrative expenses	7,665			6,877			22,974			18,966
	48,538			47,601			137,077			123,792
Operating Income	6,130			5,052			14,104			10,302
Other Income (Expense):
Interest expense	(1,651		)	(1,446		)	(5,251		)	(3,371		)
Interest income	119			544			332			855
Other	27			(135		)	19			(271		)
	(1,505		)	(1,037		)	(4,900		)	(2,787		)
Income From Continuing Operations Before Income Taxes	4,625			4,015			9,204			7,515
Income Tax Provision	1,619			1,484			3,280			2,762
Income from Continuing Operations	3,006			2,531			5,924			4,753
Discontinued Operations:
Income (loss) from operations of discontinued subsidiary (net of income tax provisions(benefit) of $0, $(91), $(747), and $141, respectively, for the periods presented)	—			(159		)	(1,219		)	191
Loss on disposal of discontinued operations (net of income tax benefit of $345 for the nine months ended September 30, 2005)	—			—			(3,683		)	—
Net Income	3,006			2,372			1,022			4,944
Dividends On Preferred Shares	6			6			18			19
Net Income Applicable To Common Shareholders	$	3,000		$	2,366		$	1,004		$	4,925
Earnings (Loss) Per Common Share:
Basic
Income from continuing operations less dividends on preferred shares	$	0.15		$	0.14		$	0.30		$	0.28
Income (loss) from discontinued operations	—			(0.01		)	(0.25		)	0.01
Net Income Applicable To Common Shareholders	$	0.15		$	0.13		$	0.05		$	0.29
Diluted
Income from continuing operations less dividends on preferred shares	$	0.15		$	0.13		$	0.29		$	0.26
Income (loss) from discontinued operations	—			(0.01		)	(0.24		)	0.01
Net Income Applicable To Common Shareholders	$	0.15		$	0.12		$	0.05		$	0.27
Weighted Average Outstanding Common Shares:
Basic	19,880			18,214			19,602			17,048
Diluted	20,680			19,109			20,269			17,964

See accompanying notes to unaudited condensed consolidated financial statements.

1

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

	September 30, 2005		December 31, 2004
	(in thousands)
ASSETS
Current Assets:
Cash and cash equivalents	$	6,751	$	1,388
Restricted cash	28		221
Trade accounts receivable, less allowance for doubtful accounts	28,137		22,334
Assets held for sale	—		15,869
Other current assets	12,650		18,279
	47,566		58,091
Property, Plant and Equipment:
Regulated utility property, plant and equipment—at cost	393,862		359,375
Non-regulated operations property, plant and equipment—at cost	17,502		17,118
	411,364		376,493
Less accumulated depreciation and amortization	80,182		74,658
	331,182		301,835
Other Assets:
Goodwill	27,911		26,806
Intangible assets, net	3,023		2,359
Other assets	16,107		15,718
	$	425,789	$	404,809
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Current portion of long-term debt	$	1,313	$	2,733
Accounts payable	11,327		12,242
Liabilities related to assets held for sale	—		1,681
Other current liabilities	23,125		18,535
	35,765		35,191
Other Liabilities and Deferred Credits:
Long-term debt	97,878		92,792
Bank lines of credit	27,000		23,035
Advances for construction	8,542		9,196
Contributions in aid of construction	92,429		89,623
Deferred income taxes	17,306		15,528
Other liabilities and deferred credits	13,975		13,246
Total Liabilities and Deferred Credits	292,895		278,611
Commitments and Contingencies
Stockholders’ Equity:
Preferred stock	461		461
Common stock	203		194
Paid-in capital	110,156		101,509
Retained earnings	22,074		24,034
Total Stockholders’ Equity	132,894		126,198
	$	425,789	$	404,809

See accompanying notes to unaudited condensed consolidated financial statements.

2

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

	Nine Months Ended September 30,
	2005			2004
	(in thousands)
Cash Flows From Operating Activities:
Net income	$	1,021		$	4,942
Income (loss) from discontinued operations	1,219			(191		)
Loss on disposal of discontinued operations	3,683			—
Income from continuing operations	5,923			4,751
Adjustments to reconcile net income to net cash provided by continuing operating activities:
Depreciation and amortization	7,548			5,510
Stock-based compensation expense	702			755
Loss on disposal of assets	—			365
Deferred income taxes	1,778			1,436
Changes in assets and liabilities, net of effects of acquisitions and dispositions:
Restricted cash	193			2,784
Trade accounts receivable	(4,667		)	(9,089		)
Other current assets	4,731			(3,480		)
Other assets	(265		)	2,776
Accounts payable	(3,634		)	(8,102		)
Other current liabilities	4,053			6,050
Other liabilities	441			(242		)
Other	1,143			(2,788		)
Net cash provided by continuing operating activities	17,946			726
Cash Flows From Investing Activities:
Additions to property, plant and equipment	(26,055		)	(15,963		)
Purchase of minority interest in subsidiary	—			(2,900		)
Cash used to acquire customer units	—			(575		)
Liabilities assumed in acquisition transactions	—			123
Acquisition transaction costs	(158		)	(1,005		)
Acquisition of utility companies	(8,500		)	(45,768		)
Acquisition of contract operations	(2,001		)	—
Net cash used in investing activities	(36,714		)	(66,088		)
Net proceeds from sale of discontinued operations	9,852			—
Cash Flows From Financing Activities:
Net proceeds from stock issuances	4,505			41,208
Capital improvement reimbursements	144			386
Contributions in aid of construction	2,842			2,593
Borrowings on bank notes payable	3,965			25,688
Proceeds from dividend reinvestment, employee stock purchase and stock option plans	3,074			592
Dividends paid	(2,982		)	(2,550		)
Principal payments on long-term debt	(16,395		)	(1,297		)
Borrowings on long term debt	20,000			—
Payments on advances for construction	(654		)	(185		)
Other financing activities, net	(220		)	14
Net cash provided by financing activities	14,279			66,449
Net increase in cash and cash equivalents	5,363			1,087
Cash and cash equivalents at beginning of period	1,388			1,814
Cash and cash equivalents at end of period	$	6,751		$	2,901

See accompanying notes to unaudited condensed consolidated financial statements.

3

	Nine Months Ended September 30,
	2005			2004
Supplemental Disclosure of Cash Flow Information
Cash paid (received) during the period for:
Interest	$	5,193		$	3,775
Income taxes	$	(1,345	)	$	1,269
Non-cash investing and financing activities:
Purchase of businesses
Fair value of assets acquired	$	12,336		$	67,220
Cash paid including transaction costs	(10,659		)	(46,773		)
Notes issued and settlement reserve fund	(500		)	—
Liabilities assumed	$	1,177		$	20,447
Sale of business
Fair value of assets sold	$	12,047		$	—
Disposition expenses	(1,680		)	—
Settlement reserve fund	(1,102		)	—
Cash received	$	9,265		$	—
Non-cash contributions in aid of construction and advances for construction from developers	$	2,248		$	5,394

See accompanying notes to unaudited condensed consolidated financial statements.

4

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (unaudited)

Note 1. – Basis of Presentation

Southwest Water Company and its subsidiaries (collectively referred to in this report as “Southwest,” the “Company,” “we,” “us” or “our” except where the context otherwise requires) provide a broad range of services including water production, treatment and distribution; wastewater collection and treatment; utility billing and collection; utility infrastructure construction management; and public works services. The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“US GAAP”) for interim financial information and with the instructions to Form 10-Q and with Rule 10-01 of Regulation S-X; accordingly, they do not include all information and notes required by US GAAP for complete financial statements. Except as disclosed herein, there have been no material changes in the information disclosed in the notes to the consolidated financial statements contained in our Annual Report on Form 10-K for the year ended December 31, 2004 (the “2004 Annual Report”). The unaudited condensed consolidated financial statements reflect all adjustments which, in our opinion, are necessary to present fairly the financial position of Southwest as of September 30, 2005, and our results of operations for the three and nine months ended September 30, 2005 and 2004 and our cash flows for the nine months ended September 30, 2005 and 2004.

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

Southwest Water Company was incorporated in California in 1954 and reincorporated in Delaware in 1988.

Certain reclassifications have been made to the prior period financial statement presentation to conform to the current period presentation including the reclassification related to discontinued operations described in Note 9.

Note 2. – Earnings Per Share

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

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

Dividend Reinvestment and Stock Purchase Plan (“DSPP”): We have a stockholder-approved DSPP where existing stockholders may purchase additional shares of our common stock by reinvesting all or a portion of the dividends paid on owned shares of stock and by making optional cash payments of not less than $25 up to a maximum of $10,000 per month.  We may permit optional cash payments in excess of this maximum if we approve a request for waiver.  New investors may join the plan by making an initial investment of not less than $250 up to a maximum of $10,000.  We may permit initial investments in excess of this maximum if we approve a request for waiver.  For 2005, the purchase price for newly issued shares of common stock purchased directly from us will be the market price less a discount of 5%.  The discount may range from 0% to 5% as determined from time to time by us.

Under the DSPP, we issued 317,063 and 363,289 shares to shareholders during the three and nine months ended September 30, 2005, respectively. At September 30, 2005, 500,000 shares had been authorized for issuance under the DSPP and approximately 136,711 shares remain available for issuance.

5

The following table is a reconciliation of the numerators (income or loss) and denominators (shares) used in both basic and diluted EPS calculations:

	Three Months Ended September 30,					Nine Months Ended September 30,
	2005		2004			2005			2004
	(in thousands except per share data)
Earnings (loss) per share - basic
Income from continuing operations	$	3,006	$	2,532		$	5,923		$	4,753
Less: dividends on preferred shares	6		6			18			19
Income from continuing operations applicable to common shares	3,000		2,526			5,905			4,734
Income (loss) from discontinued operations	—		(159		)	(4,902		)	191
Net income applicable to common shares	$	3,000	$	2,367		$	1,003		$	4,925
Weighted average outstanding common shares	19,880		18,214			19,602			17,048
Earnings per common share from continuing operations	$	0.15	$	0.14		$	0.30		$	0.28
Earnings (loss) per common share from discontinued operations	—		(0.01		)	(0.25		)	0.01
Earnings per common share	$	0.15	$	0.13		$	0.05		$	0.29
	Three Months Ended September 30,					Nine Months Ended September 30,
	2005		2004			2005			2004
	(in thousands except per share data)
Earnings (loss) per share - diluted
Income from continuing operations applicable to common shares	$	3,000	$	2,526		$	5,905		$	4,734
Income (loss) from discontinued operations	—		(159		)	(4,902		)	191
Net income applicable to common shares	$	3,000	$	2,367		$	1,003		$	4,925
Weighted average outstanding common shares	19,880		18,214			19,602			17,048
Plus: Shares issued on assumed exercise of stock options and warrants	800		895			667			916
Weighted average outstanding common shares	20,680		19,109			20,269			17,964
Earnings per common share from continuing operations	$	0.15	$	0.13		$	0.29		$	0.26
Earnings (loss) per common share from discontinued operations	—		(0.01		)	(0.24		)	0.01
Earnings per common share	$	0.15	$	0.12		$	0.05		$	0.27

Note 3. –Stock-Based Compensation Plans

At September 30, 2005, Southwest had three stock-based compensation plans: a Stock Option Plan (“SOP”), a Director Stock Option Plan (“DOP”), and an Employee Stock Purchase Plan (“ESPP”). In accordance with the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123, Accounting for Stock-Based Compensation, the fair value of each option grant is estimated on the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for grants in 2005 and 2004:

6

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

Compensation expense arising from stock option grants as determined using the Black-Scholes fair value option model was as follows:

	Three Months Ended September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004
	(in thousands)				(in thousands)
Stock-based compensation expense	$	236	$	307	$	702	$	755

A combined summary of shares authorized and available for issuance under the SOP, the DOP and ESPP as of September 30, 2005, was as follows:

	SOP	DOP	ESPP	Total
	(in thousands)
Shares authorized for issuance	3,031	666	1,197	4,894
Shares available for issuance	988	300	875	2,163

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

			Weighted
			Average
	Stock Options		Exercise
	and Warrants		Price
	(in thousands)
Outstanding at December 31, 2004	2,776		$	8.03
Granted	309		11.59
Exercised	(461	)	6.59
Forfeited	(79	)	11.70
Outstanding at September 30, 2005	2,545		$	8.64
Exercisable at September 30, 2005	1,564		$	7.14

7

The following table summarizes information about stock options and warrants outstanding at September 30, 2005:

				Options and Warrants Outstanding				Options and Warrants Exercisable
Range of Exercise Prices				Number Outstanding at September 30, 2005	Weighted Average Remaining Contractual Life in Years	Weighted Average Exercise Price		Number Exercisable at September 30, 2005	Weighted Average Exercise Price
				(in thousands)				(in thousands)
$	1.50	$	3.75	128	1.1	$	3.18	128	$	3.18
3.76		7.50		728	3.0	5.67		670	5.53
7.51		11.25		1,093	3.8	8.98		667	8.66
11.26		15.00		596	5.8	12.81		99	12.94
$	1.50	$	15.00	2,545	3.9	$	8.64	1,564	$	7.14

Employee Stock Purchase Plan: We have a stockholder-approved ESPP that allows eligible employees to purchase our common stock through payroll deductions of up to 10% of their salary (not to exceed $25,000 per year). The purchase price of the stock is 90% of the lower of the share price as calculated at the beginning and end of each three-month offering period. Under the ESPP, we issued 7,032 and 18,630 shares to employees during the three and nine months ended September 30, 2005, respectively. At September 30, 2005, 1,197,000 shares had been authorized for issuance under the ESPP and approximately 875,000 shares remain available for issuance.

Note 4. – Post Retirement Benefits

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

	Three Months Ended September 30,				Nine Months Ended September 30,
	2005		2004		2005		2004
	(in thousands)				(in thousands)
Service cost	$	16	$	20	$	48	$	44
Interest cost	20		25		60		57
Recognized actuarial loss	22		28		66		64
	$	58	$	73	$	174	$	165

Note 5. – Operating Segments

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

The Utility Group owns a regulated water utility in California, regulated water and wastewater utilities in New Mexico, Oklahoma and Texas, and a wastewater utility in Alabama whose rates are determined through an agreement with county authorities.  Revenues result from the production and distribution of water and the collection and treatment of sewage for residential, business, industrial and public authority customers.  State, federal and local agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations. The rates our regulated utility subsidiaries charge for water and wastewater services are established by state or county authorities.

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

8

The tables below present information about the operations of each reported segment for the three and nine months ended September 30, 2005 and 2004:

	Utility Group			Services Group (1) (3)			Total Segments Information			Corporate and Other (2)			Total Consolidated Information
	(in thousands)
For the Three Months Ended September 30, 2005
Total revenues (1)	$	23,300		$	31,368		$	54,668		$	—		$	54,668
Segment operating income	$	8,564		$	434		$	8,998		$	(2,868	)	$	6,130
Interest expense	(1,020		)	(398		)	(1,418		)	(233		)	(1,651		)
Interest income	10			71			81			38			119
Other income (expense)	(30		)	35			5			22			27
Income (loss) from continuing operations before income taxes	$	7,524		$	142		$	7,666		$	(3,041	)	$	4,625
For the Three Months Ended September 30, 2004
Total revenues (1)	$	22,422		$	30,231		$	52,653		$	—		$	52,653
Segment operating income (loss)	$	7,176		$	387		$	7,563		$	(2,511	)	$	5,052
Interest expense	(1,081		)	(428		)	(1,509		)	63			(1,446		)
Interest income	444			93			537			7			544
Other income (expense)	(25		)	(124		)	(149		)	14			(135		)
Income (loss) from continuing operations before income taxes	$	6,514		$	(72	)	$	6,442		$	(2,427	)	$	4,015
	Utility Group			Services Group (1) (3)			Total Segments Information			Corporate and Other (2)			Total Consolidated Information
	(in thousands)
For the Nine Months Ended September 30, 2005
Total revenues (1)	$	59,054		$	92,127		$	151,181		$	—		$	151,181
Segment operating income	$	20,237		$	3,311		$	23,548		$	(9,444	)	$	14,104
Interest expense	(3,357		)	(1,394		)	(4,751		)	(500		)	(5,251		)
Interest income	32			260			292			40			332
Other income (expense)	(84		)	93			9			10			19
Income (loss) from continuing operations before income taxes	$	16,828		$	2,270		$	19,098		$	(9,894	)	$	9,204
For the Nine Months Ended September 30, 2004
Total revenues (1)	$	52,062		$	82,032		$	134,094		$	—		$	134,094
Segment operating income (loss)	$	17,852		$	(416	)	$	17,436		$	(7,134	)	$	10,302
Interest expense	(2,218		)	(1,310		)	(3,528		)	157			(3,371		)
Interest income	537			284			821			34			855
Other income (expense)	(79		)	(202		)	(281		)	10			(271		)
Income (loss) from continuing operations before income taxes	$	16,092		$	(1,644	)	$	14,448		$	(6,933	)	$	7,515

(1)In addition to services provided to external customers, certain companies in our Services Group provide construction, operations, and maintenance services to companies in our Utility Group. In accordance with SFAS No. 71, Accounting for the Effects of Certain Types of Regulation, the Company does not eliminate the intersegment profit on sales to affiliated utilities when the sales price is reasonable and it is probable that, through the rate making process, future revenue approximately equal to the sales price will result from the regulated affiliate’s use of the services.  Intersegment revenue was approximately $7.9 million and $5.4 million for the three months ended September 30, 2005 and 2004, respectively.  Intersegment revenue was approximately $22.4 million and $10.3 million for the nine months ended September 30, 2005 and 2004, respectively.

(2)“Corporate and Other” consists primarily of costs that include headquarters expenses and any corporate functional departments whose costs are not allocated to reportable segments.

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

9

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

	September 30, 2005		December 31, 2004
	(in thousands)
Utility Group	$	355,226	$	322,521
Services Group	60,201		54,467
Corporate and Other	10,362		27,821
Consolidated	$	425,789	$	404,809

Note 6. – Seasonality and Weather

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

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

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

Note 7. – Commitments, Contingencies and Restrictions

Commitments Under Acquisition Agreements

We own 90% of the outstanding common stock of Operations Technologies, Inc. (“OpTech”). We have the right to acquire the remaining 10% of OpTech beginning in August 2006 based on a formula relating to the profitability of OpTech. The minority owner has the option to sell the remaining 10% of OpTech to the Company using the same formula.  However, the selling price cannot be less than $1 million.

We have an 80% interest in Windermere Utility Company (“Windermere”) in Texas. We have the right to acquire the remaining 20% ownership in Windermere for a purchase price of $6 million payable in Southwest’s common stock at any time when the market value of our common stock increases to $12.96 per share (as adjusted for stock splits and dividends).  This right has not been exercised by SWWC.  The minority owner of Windermere has the right to put the remaining 20% to us beginning in October 2005 for up to approximately 860,000 shares of Southwest’s common stock, but no fewer than 463,000 shares both adjusted for stock splits and dividends, depending on the prevailing stock price, with a value not to exceed $6 million. The minority owner has notified us of his intent to exercise his right to put the remaining 20% to us in exchange for common stock in accordance with the terms of our agreement.

Commitments Under Divestiture Agreements

As part of the agreement to sell our submetering subsidiary (see Note 9), we were required to calculate a working capital adjustment, adjust for the net loss of customers and complete a transmitter replacement program.  These items were estimated and recorded as liabilities in the 2^nd quarter of 2005.  Adjustments to the sales price arising from these items are to be paid or collected through an escrow account of approximately $1.2 million that was established and recorded in other current assets at the close of the transaction in June 2005.  As of September 30, 2005, we have accrued for all expected expenses.  The escrow account will be closed in March 2006 and any amounts remaining on deposit at that time will be remitted to us.

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Commitments Under Long-term Service Contracts

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

During construction of the CVWD plant, we received payments upon completion of construction phases. Construction of the plant commenced in December 2002 and was substantially completed as of September 30, 2005. The plant became primarily operational in 2004 and the Company now operates and maintains the facility under a separate 20-year operations and maintenance contract.

In January 2003, we obtained an unsecured line of credit facility from a commercial bank that was used to issue a $3.4 million standby letter of credit as collateral for performance under a contract to design and construct the CVWD plant. This standby letter of credit was in force for the construction period of the project.  On April 1, 2005, the standby letter of credit was transferred to the New Credit Facility (see Note 10) and the prior line of credit was cancelled.

As part of the financing of this project, the CVWD issued insured municipal bonds. We entered into an agreement with the bond insurer to guarantee our performance under the CVWD contract, subject to certain liability limits to the bond insurer in the event of a default. Such liability limits will not exceed an amount equal to $6.0 million during the construction period of the project, and afterwards, during the 20-year operation of the facility, the liability limits will not exceed an amount equal to $4.0 million plus an amount no greater than the replacement cost of the reverse osmosis filtration unit within the facility, estimated to be approximately $1.5 million.

Legal Proceedings

Southwest and a subsidiary were named as defendants in several lawsuits alleging various injuries as a result of water contamination in the San Gabriel Valley Main Basin. The California Supreme Court has ruled that the plaintiffs cannot challenge the adequacy of the water quality standards established by California Department of Health Services and the United States Environmental Protection Agency (“EPA”) but can sue us if they can prove that we served water that did not meet those standards. In August 2004 a trial court dismissed the case against us, finding that there was no evidence that we violated any water quality standards.  The plaintiffs appealed the dismissal to the Court of Appeals for the State of California, Second Appellate District, where the matter is pending. To date, liability insurance carriers have absorbed the costs of defense of the lawsuits.

On May 5, 2005, one of the Company’s operating subsidiaries received a subpoena to provide records to a grand jury.  The requested records relate to the operations of the San Simeon wastewater treatment plant in California for the period January 2002 to present.  The facility was also served with search warrants executed by the EPA.  The Company’s subsidiary has operated this facility since September 2004.  The Company is cooperating with the investigation and is also performing its own internal investigation.

On May 18, 2005, the EPA executed a search warrant at one of the Company’s operating subsidiaries in Texas.  The search warrant sought information relating to the subsidiary’s laboratory operations.  The Company is cooperating with the investigation and is also performing its own internal investigation.

Southwest Water Company and its subsidiaries are subject to litigation arising in the ordinary course of operations. We believe the ultimate resolution of all matters that have been brought to our attention will not materially adversely affect our consolidated financial position, results of operations or cash flows.

Groundwater Settlement

One of the water sources for our California water utility has been affected by the presence of certain groundwater contaminants. These contaminants consist mainly of chemicals disposed of by various industrial companies in the 1940s and 1950s. In 2001 and 2002, this contamination necessitated the removal from service of a number of our wells, and we purchased replacement water at a cost substantially higher than the cost of water pumped from our own wells.

As a result of this contamination, under the terms of an agreement with the responsible parties, we have received payments from these parties, and we expect to continue to receive payments until completion of remediation or until our production capacities have been restored.  These payments represent the incremental cost of purchasing water over the cost that would have been incurred by us to pump water from our wells.  Our agreement with the responsible parties provided for ongoing reimbursement of our excess water costs and, as such, we bill and collect reimbursements monthly.  These monthly reimbursements are recorded as a reduction to

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operating expenses-utility group.  During the nine months ended September 30, 2005 and 2004, these reimbursements were approximately $2.3 million and $2.8 million, respectively.

The settlement agreement also provides for contributions by the responsible parties to construct new wells and to develop additional interconnections with nearby water sources. Funds from the settlement agreement will also be used to develop long-term solutions that will potentially enable us to use our own less costly groundwater supplies in the future.  These contributions, recorded as contributions in aid of construction (“CIAC”), were approximately $0.1 million and approximately $0.4 million for the nine months ended September 30, 2005 and 2004, respectively.

Note 8. – Acquisitions

In March 2005, we completed the acquisition of a contract operations company located in Shelby County, Alabama.  The aggregate purchase price was approximately $2.5 million, of which $0.7 million was deferred, plus liabilities we assumed in the amount of approximately $1.2 million.  We incurred transactions cost of approximately $0.2 million.

In September 2005, we completed the acquisition of a wastewater system located in Shelby County, Alabama.  The aggregate purchase price and related transaction costs were approximately $8.5 million and $0.1 million, respectively.

The acquisitions were asset purchases and the assets acquired and liabilities assumed have been recorded at their estimated fair values.  The difference between the total purchase price and the fair value of the net assets acquired of approximately $0.9 million was recorded as goodwill.  The purchase price allocations are preliminary and may change upon the completion of the final valuations of the net assets acquired.

Note 9. – Discontinued Operations

In June 2005, we completed the sale of our submetering subsidiary that provided utility billing and collection services for multi-family residential properties in our Services Group.  The sales price was approximately $12.0 million.  We received approximately $10.8 million in cash and approximately $1.2 million of the sales price was placed into an escrow account and is included in other current assets in the accompanying consolidated financial statements.  As part of the sale, we provided certain representations and warranties that are customary in sales transactions and committed to a specified level of working capital of the subsidiary as of the closing date.  We expect to receive the escrow balance in March 2006.  We utilized the net proceeds from the sale of approximately $10.8 million (less transaction costs of $1.0 million) to subsequently repay our bank lines of credit.  The sale of our sub-metering subsidiary will not affect the operations of our remaining operating subsidiaries.

In the second quarter we recorded a loss from discontinued operations (net of income tax benefit of approximately $0.7 million) of approximately $1.2 million and a loss on sale of stock of approximately $3.7 million (net of income tax benefit of approximately $0.3 million).

Note 10. - Debt Obligations

In April 2005, we established the New Credit Facility.  The New Credit Facility provides for a $100 million revolving credit facility, which includes a $40 million letter of credit subfacility and a $10 million swingline subfacility.  The New Credit Facility contains customary covenants, as well as customary events of default.  Certain of our subsidiaries have guaranteed our obligation to repay borrowings under the New Credit Facility.

Loans under the New Credit Facility (other than swingline loans) will bear interest at a rate equal to (i) a Eurodollar rate plus the applicable margin (as defined in the New Credit Facility), or (ii) a base rate (as defined) minus the applicable margin.  At September 30, 2005, we had approximately $27 million of outstanding borrowings under our New Credit Facility and the adjusted average borrowing rate was approximately 4.8%.  The New Credit Facility replaced our lines of credit which had provided for up to $50 million of borrowings and we used the New Credit Facility to repay amounts outstanding under those lines of credit.  As of September 30, 2005, we were in compliance with all applicable covenants under the New Credit Facility.

In January 2003, we received a $3.4 million line of credit with one of our commercial banks that we used to issue a standby letter of credit in that amount as collateral for performance under a contract to design and construct the CVWD plant.  On April 1, 2005, the standby letter of credit was transferred to the New Credit Facility, and the separate line of credit was cancelled.

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In September, 2005 we entered into a $20 million, 26-year loan with a commercial bank at a fixed rate of 6.1% per annum that is partially offset by an annual patronage payment of approximately 0.5%.  The note requires interest only payments until maturity at June 30, 2031, at which time a balloon payment for the face amount of the note is due.  The funds were used to reduce our borrowing under our credit facility and to give us additional flexibility to invest in future capital projects.

Note 11. –Effects of Hurricanes Katrina and Rita

Hurricanes Katrina and Rita affected the Gulf Coast region of the United States during the third quarter of 2005 causing significant damage.  Our Services Group provides contract operations and maintenance services to clients in Mississippi and Texas, among other states.

The water and wastewater infrastructure for five clients we service in Mississippi was disabled by Katrina.  The contracts with our clients provide that we can incur and bill additional expenses during an emergency situation to restore water supply and wastewater treatment services to customers.  In addition, our clients requested we assist with the removal of debris to enable access for emergency vehicles and residents.  We incurred approximately $622,000 of overtime labor costs and emergency out-of-pocket operating expenses related to these emergency recovery efforts.  These costs were reflected as operating expenses in the third quarter of 2005.  We have billed (or will bill in certain cases) our clients approximately $536,000 to $700,000 for these emergency services and we are assisting our clients in requesting reimbursement from the Federal Emergency Management Agency (“FEMA”) pursuant to guidelines established in FEMA’s Applicant Handbook.  We recognized revenues of $500,000 based on the revenue recognition criteria set forth in Staff Accounting Bulletin No. 104, Revenue Recognition with respect to these costs.  Additional revenues, if any, resulting from billings to our clients beyond $500,000 will be recognized if and when collection is reasonable assured.  The $500,000 we have billed for these emergency services is reflected in trade accounts receivable as of September 30, 2005.

We also incurred $64,000 of costs related to preparing for Hurricane Rita, principally temporary infrastructure relocation expenses.  These costs were recorded as an operating expense during the third quarter of 2005 and are not reimbursable by FEMA or recoverable through insurance.

Note 12. - Adoption of Share-Based Payment (SFAS 123R)

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised December 2004), Share-Based Payment (“SFAS 123R”).  This Statement is a revision of SFAS No. 123.  SFAS 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services.  SFAS 123R is effective for the Company as of the beginning of the first annual reporting period that begins after June 15, 2005.  The Company has already adopted SFAS No. 123, and management believes the impact of the adoption of SFAS 123R on the Company’s consolidated financial statements will not be material.

Note 13. – Subsequent Event

As described in Note 7, we have an 80% interest in Windermere Utility Company (“Windermere”) in Texas. We have the right to acquire the remaining 20% ownership in Windermere for a purchase price of $6 million payable in Southwest’s common stock at any time when the market value of our common stock increases to $12.96 per share (as adjusted for stock splits and dividends).  This right has not been exercised by SWWC.  The minority owner of Windermere has the right to put the remaining 20% to us beginning in October 2005 for shares of Southwest’s common stock, adjusted for stock splits and dividends, depending on the prevailing stock price, with a value not to exceed $6 million. The minority owner has notified us of his intent to exercise his right to put the remaining 20% to us in exchange for common stock in accordance with the terms of our agreement.  We anticipate issuing approximately 465,000 shares of common stock to the minority owner.

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

The information in this discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended and Section 21E of the Securities Exchange Act of 1934, as amended (the”34 Act”). Such statements are based upon current expectations that involve risks and uncertainties including those set forth under “Risk Factors” in this report and under “Business-Risk Factors” in our 2004 Annual Report.  Factors that could affect forward-looking statements relating to the resolution of the material weakness with respect to internal controls discussed in Item 9A of the 2004 Annual Report include, among other things: the Company’s ability to design and maintain policies and procedures which enable the Company to avoid any recurrence of the matters which gave rise to the material weakness and the Company’s ability to identify and retain qualified and experienced financial personnel.  Any statements contained herein that are not statements of historical facts may be deemed to be forward-looking statements. For example, words such as “may”, “will”, “should”, “estimates”, “predicts”, “potential”, “continue”, “strategy”, “believes”, “expects”, “anticipates”, “plans”, “intends”, and similar expressions are intended to identify forward-looking statements. Our actual results and the timing of certain events may differ significantly from the results discussed in the forward-looking statements. We undertake no obligation to publicly update or revise any forward-looking statements to reflect current or future events or circumstances.

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

Overview

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

The Utility Group owns a regulated water utility in California, regulated water and wastewater utilities in New Mexico, Oklahoma and Texas, and a wastewater utility in Alabama whose rates are determined through an agreement with county authorities.  Various governmental agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations, as well as establish the rates that we can charge for our water and wastewater services.

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

In July 2004, we acquired a Texas regulated water and wastewater utility consisting of a collection of 87 rural water systems and 11 wastewater systems serving approximately 21,000 water connections and 3,500 wastewater connections from Tecon Water Holdings, L.P. for approximately $66 million, and renamed the utility Monarch Utilities, Inc. (“Monarch”).

In March 2005, we completed the acquisition of the assets of a contract operations company located in Shelby County, Alabama.  The aggregate purchase price was approximately $2.5 million, of which $0.7 million was deferred, plus liabilities we assumed in the amount of approximately $1.2 million.  We incurred transactions cost of approximately $0.2 million.

In June 2005, we completed the sale of our submetering subsidiary that provided utility billing and collection services for multi-family residential properties.  The sale price was approximately $12.0 million.  We received approximately $10.8 million in cash, and approximately $1.2 million of the sales price was placed into an escrow account.  We incurred transaction costs of approximately $1.0 million to complete the sale and our net proceeds on the sale of our submetering subsidiary were approximately $9.8 million.

In the second quarter of 2005, we recorded a loss from discontinued operations (net of income tax benefit of approximately $0.7 million) of approximately $1.2 million and a loss on sale of stock of approximately $3.7 million (net of income tax benefit of approximately $0.3 million) in connection with the sale of our submetering subsidiary.

In September 2005, we completed the acquisition of a wastewater system located in Shelby County, Alabama.  The aggregate purchase price and related transaction costs were approximately $8.5 million and $0.1 million respectively.

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Results of Operations

A summary of our consolidated results for continuing operations for the three and nine months ended September 30, 2005 and 2004 is as follows:

	Three Months Ended September 30,										Nine Months Ended September 30,
				% of					% of					% of					% of
	2005			Revenue		2004			Revenue		2005			Revenue		2004			Revenue
	($ amounts in millions)
Revenues:
Utility group	$	23.3		43		$	22.4		43		$	59.1		39		$	52.1		39
Services group	31.4			57		30.2			57		92.1			61		82.0			61
	54.7			100		52.6			100		151.2			100		134.1			100
Expenses:
Operating expenses - utility group	12.8			23		13.7			26		33.5			22		30.0			22
Operating expenses - services group	28.0			51		27.0			50		80.6			53		74.8			56
Selling, general and administrative expenses	7.7			14		6.9			13		23.0			15		19.0			14
	48.5			88		47.6			89		137.1			90		123.8			92
Operating Income	6.2			12		5.0			11		14.1			10		10.3			8
Other Income (Expense):
Interest expense	(1.7		)	(3	)	(1.4		)	(3	)	(5.3		)	(4	)	(3.4		)	(3	)
Interest income	0.2			—		0.5			1		0.3			—		0.9			1
Other	—			—		(0.1		)	—		—			—		(0.3		)	—
	(1.5		)	(3	)	(1.0		)	(2	)	(5.0		)	(4	)	(2.8		)	(2	)
Income from Continuing Operations before Income Taxes	4.7			9		4.0			9		9.1			6		7.5			6
Income Tax Provision	1.6			3		1.5			3		3.3			2		2.8			2
Income from Continuing Operations	$	3.1		6		$	2.5		6		$	5.8		4		$	4.7		4

Effects of Hurricanes Katrina and Rita

Hurricanes Katrina and Rita affected the Gulf Coast region of the United States during the third quarter of 2005 causing significant damage.  Our Services Group provides contract operations and maintenance services to clients in Mississippi and Texas, among other states.

The water and wastewater infrastructure for five clients we service in Mississippi was disabled by Katrina.  The contracts with our clients provide that we can incur and bill additional expenses during an emergency situation to restore water supply and wastewater treatment services to customers.  In addition, our clients requested we assist with the removal of debris to enable access for emergency vehicles and residents.  We incurred approximately $622,000 of overtime labor costs and emergency out-of-pocket operating expenses related to these emergency recovery efforts.  These costs were reflected as operating expenses in the third quarter of 2005.  We have billed (or will bill in certain cases) our clients approximately $536,000 to $700,000 for these emergency services and we are assisting our clients in requesting reimbursement from the Federal Emergency Management Agency (“FEMA”) pursuant to guidelines established in FEMA’s Applicant Handbook.  We recognized revenues of $500,000 based on the revenue recognition criteria set forth in Staff Accounting Bulletin No. 104, Revenue Recognition with respect to these costs.  Additional revenues, if any, resulting from billings to our clients beyond $500,000 will be recognized if and when collection is reasonably assured.  The $500,000 we have billed for these emergency services is reflected in trade accounts receivable as of September 30, 2005.

We also incurred approximately $64,000 of costs related to preparing for Hurricane Rita, principally temporary infrastructure relocation expenses.  These costs were recorded as an operating expense during the third quarter of 2005 and are not reimbursable by FEMA or recoverable through insurance.

Adoption of Share-Based Payment (SFAS 123R)

In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards No. 123 (revised December 2004), Share-Based Payment (“SFAS 123R”).  This Statement is a revision of SFAS No. 123.  SFAS 123R establishes standards for the accounting for transactions in which an entity exchanges its equity instruments for goods or services.  SFAS 123R is effective for the Company as of the beginning of the first annual reporting period that begins after June 15, 2005.  The

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Company has already adopted SFAS No. 123, and management believes the impact of the adoption of SFAS 123R on the Company’s consolidated financial statements will not be material.

Discussion of Results of Operations for Three Months Ended September 30, 2005 and 2004

Revenues

Utility Group

Utility Group revenues are derived from the production and distribution of water and the collection and treatment of sewage for residential, industrial and commercial use. Our Utility Group results of operations are seasonal, as rainfall and weather conditions affect water consumption.  In our service areas, the second and third quarters of each year typically account for the highest volume of water consumption when weather tends to be hot and dry. Drought conditions may result in lower revenue due to consumer conservation efforts and a shortage of water. Drought conditions may also result in increased water costs to us, which could adversely affect our profitability. Conversely, unusually wet conditions may result in decreased customer demand, lower revenues and lower profit in our Utility Group operations.  

Revenues in the Utility Group increased approximately $0.9 million, or 4%, to $23.3 million during the three months ended September 30, 2005, from $22.4 million during the same period of the prior year. The increase in Utility Group revenue was primarily due to the following:

1.A $0.8 million increase in revenues attributable to Monarch Utility which we acquired in mid-July 2004.

2.An increase of $0.3 million due to higher volume and increased number of connections severd by our New Mexico and other Texas utilites.

3.An increase in rates of approximately $0.3 million at our California utility. 

4.These increases were partially offset by a decrease in our California utility revenues of $0.5 million due to lower water consumption as a result of cooler temperatures and somewhat higher rainfall versus the prior year.

Services Group

Services Group revenues represent fees earned for water and wastewater facility operations and maintenance (O&M) services, equipment maintenance and repair, sewer pipeline cleaning, construction management services, state-certified water and wastewater laboratory analysis and public works. Revenues for the three months ended September 30, 2005 increased approximately $1.2 million, or 4%, to $31.4 million from $30.2 million during the same period of the prior year.  

The increase in Services Group revenues was primarily due to the following:

1.A $1.9 million increase in revenue associated with contract operations, primarily those performed for our Utility Group, as well as increased project work.  Of this increase approximately $0.5 million is billable work associated with Hurricane Katrina.  See “Effects of Hurricanes Katrina and Rita” at beginning of Management Discussion and Analysis.

2.A $1.4 million increase due to the recent acquisition of contract operations in Alabama and a $0.2 million increase from revenues generated by a laboratory we acquired in the latter part of 2004.

3.These revenue increases were partially offset by a decrease of approximately $2.3 million in construction-related revenues for the reverse osmosis plant, which had been under construction since 2003 and was substantially completed as of September 30, 2005.

Expenses

Operating expenses – Utility Group

Operating expenses–Utility Group represent the costs of purchasing and producing water, treating wastewater, salaries, wages and employee benefits, facilities costs, power and electricity, supplies and equipment, repairs and maintenance, professional fees and other costs. Operating expenses for our Utility Group decreased $0.9 million, or 7%, to $12.8 million during the three months ended September 30, 2005, from $13.7 million during the comparable period of 2004.  The decrease in operating expenses was primarily due to reduced operating expenses of $0.7 million at our California utility associated with lower water consumption as a result of cooler temperatures and somewhat higher rainfall versus the prior year.  The lower consumption enabled us to reduce the amount of water purchased from outside sources, which is generally at prices higher than the cost of water pumped from our own wells. 

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Operating expenses–Utility Group, as a percentage of related revenues represented approximately 55% and 61% of revenues from utility operations for the three months ended September 30, 2005 and 2004, respectively.  The decrease was primarily due to a decrease in operating expenses related to higher capitalized overhead, lower property taxes and repairs and maintenance in our California utility combined with increased revenues from the mid-July 2004 acquisition of Monarch Utility.

Operating expenses – Services Group

Operating expenses–services group include salaries, wages, employee benefits, project costs, fleet expenses, facilities costs, supplies and equipment, repairs and maintenance and professional fees.  Operating expenses–services group increased approximately $1.0 million, or 4%, to $28.0 million during the three months ended September 30, 2005 from $27.0 million during the same period of 2004.  The increase in operating expense–services group was due primarily to the following:

1.An increase in operating expenses of $1.1 million resulting from the recent acquisition of contract operations in Alabama and a $0.6 million increase generated by a laboratory we acquired in the latter part of 2004.

2.An increase of $0.9 million associated with contract operations, primarily those performed for our Utility Group, as well as increased project work. 

3.An increase of $0.7 million of costs and expenses stemming from Hurricanes Katrina and Rita related to equipment losses, emergency supplies and temporary infrastructure relocation expenses.  See “Effects of Hurricanes Katrina and Rita” at beginning of Management Discussion and Analysis.

4.These increases were partially offset by a decrease of approximately $2.3 million in construction work related to the reverse osmosis plant, which has been under construction since 2003 and was substantially completed as of September 30, 2005.

Operating expenses – Services Group, as a percentage of the revenues from the related operations remained constant at 89% for the three months ended September 30, 2005 compared to the same period of 2004.  

Selling, general and administrative expenses

Selling, general and administrative expenses consist mainly of personnel, facilities, insurance and professional services costs, which support our sales, marketing, human resources, finance and administration functions.  Selling, general and administrative expenses increased $0.8 million, or 12%, to $7.7 million for the three months ended September 30, 2005 compared to $6.9 million during the same period of 2004.  Selling, general and administrative expenses increased to 14% of revenues for the three months ended September 30, 2005 from 13% for the three months ended September 30, 2004.  The increase in selling, general and administrative expenses was primarily due to an increase of $0.6 million attributable to the acquisitions of Monarch Utility, contract operations in Alabama and laboratory service in Texas.

Other Income (Expense)

Interest Expense

Interest expense increased approximately $0.3 million, or 24%, during the three months ended September 30, 2005 compared to the same period in 2004.  The major components of interest expense are as follows:

	For the Three Months Ended September 30,
	2005			2004
	(in thousands)
Interest expense - convertible subordinate debentures	$	289		$	327
Interest expense - bank lines of credit	496			322
Interest expense - mortgage bonds and bank term loan	906			889
Interest expense - other	387			85
Total interest expense before capitalized interest	2,078			1,623
Capitalized interest	(427		)	(177		)
Total interest expense	$	1,651		$	1,446

The increase in total interest expense is primarily due to an increase in our long-term debt and borrowing on our bank lines of credit resulting from acquisitions and capital spending.  This was partially offset by increased capitalization of interest as a result of increased capital spending.  Our average balances of interest-bearing debt outstanding were approximately $124 million and $114

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million for the three months ended September 30, 2005 and 2004, respectively.  In addition, our effective weighted average borrowing rate increased to 6.5% during the three months ended September 30, 2005 from 6.3% during the three months ended September 30, 2004. 

Provision for Income Taxes

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

Discussion of Results of Operations for Nine Months Ended September 30, 2005 and 2004

Revenues

Utility Group

Revenues in the Utility Group increased approximately $7.0 million, or 13%, to $59.1 million during the nine months ended September 30, 2005, from $52.1 million during the same period of the prior year. The increase in Utility Group revenue was primarily due to the following:

1.An approximate $8.3 million increase in revenues attributable to Monarch Utility which we acquired in mid-July 2004.

2.An increase in revenues from our New Mexico and Texas utilities of $0.8 million primarily due to increased connections.

3.The above increases were partially offset by a decrease in revenues of our California utility of $2.8 million due to lower consumption as a result of cooler temperatures and higher rainfall versus the prior year partially offset by an increase in rates of approximately $0.7 million.

Services Group

Revenues for the nine months ended September 30, 2005 increased approximately $10.1 million, or 12%, to $92.1 million from $82.0 million during the same period of the prior year.

The increase in Services Group revenues was primarily due to the following:

1.An approximate $12.8 million increase in revenues associated with contract operations, primarily those performed for our Utility Group, as well as increased construction work.  Of this increase approximately $0.5 million is for billable work associated with Hurricane Katrina.  See “Effects of Hurricanes Katrina and Rita” at beginning of Management Discussion and Analysis.  The increased project work is also a result of approximately 60% less rainfall in southern Texas versus the first nine months of 2004.

2.A $1.4 million increase due to the acquisition of a laboratory and a $2.2 million increase due to the acquisition of contract operations in Alabama.

3.These revenue increases were partially offset by a decrease of $6.3 million in construction work related to the reverse osmosis plant which has been under construction since 2003 and was substantially completed as of September 30, 2005.

Expenses

Operating expenses – Utility Group

Operating expenses for our Utility Group increased $3.5 million, or 12%, to $33.5 million during the nine months ended September 30, 2005, from $30.0 million during the comparable period of 2004.  The increase in operating expenses was primarily due to the following:

1.An increase of operating expenses of approximately $5.6 million attributable to Monarch which was acquired in mid-July 2004.

2.This increase was offset in part by reduced operating expenses of $2.0 million at our California utility due to lower production as a result of above average rainfall during the first half of the year.

Operating expenses—Utility Group, as a percentage of related revenues represented approximately 57% and 58% of revenues from utility operations for the nine months ended September 30, 2005 and 2004, respectively. 

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Operating expenses – Services Group

Operating expenses–services group increased approximately $5.8 million, or 8%, to $80.6 million during the nine months ended September 30, 2005 from $74.8 million during the same period of 2004.  The increase in operating expense–services group was due to the following: 

1.An increase of operating expenses of approximately $3.6 million as a result of the recent acquisition of contract operations and a laboratory services in the latter part of 2004.

2.An increase of approximately $7.8 million associated with contract operations, primarily those performed for our Utility Group, as well as increased project work.  The increased expense is also a result of increased staffing and fleet expense related to additional contract work, some of which was delayed from 2004.  The staffing increase resulted in higher salary and wage expenses as well as benefits and other related costs. 

3.An increase of approximately $0.7 million of costs and expenses stemming from Hurricanes Katrina and Rita related to equipment losses, emergency supplies and temporary infrastructure relocation expenses which we believe will not be reimbursable by FEMA.  See “Effects of Hurricanes Katrina and Rita” at beginning of Management Discussion and Analysis.

4.These increases were partially offset by a decrease of approximately $6.3 million in construction work related to the reverse osmosis plant, which has been under construction since 2003 and was substantially completed as of September 30, 2005.

Operating expenses – Services Group, as a percentage of the related revenues, decreased to 88% for the nine months ended September 30, 2005, compared to 91% for the same period of 2004.   The decrease was due to lower 2004 revenues as a result of higher rainfall relative to the expenses for additional construction, operating and maintenance work.

Selling, general and administrative expenses

Selling, general and administrative expenses increased $4.0 million, or 21%, to $23.0 million for the nine months ended September 30, 2005 compared to $19.0 million during the same period of 2004.  Selling, general and administrative expenses increased to 15% of revenues for the nine months ended September 30, 2005 from 14% during the nine months ended September 30, 2004.  The increase in selling, general and administrative expenses was primarily due to the following:

1.An increase in audit fees of $0.4 million, legal fees of $0.3 million, as well as an increase of $0.7 million in outside services, most of which is attributable to our efforts to prepare for and comply with the Sarbanes-Oxley Act of 2002 associated with our 2004 year end efforts.

2.An increase of $1.4 million primarily attributable to the Monarch acquisition which occurred in mid-July 2004.

3.A $1.2 million increase in costs compared to the prior period related to salaries and employee benefits as a result of increases in headcount to support our revenue trends.

Other Income (Expense)

Interest Expense

Interest expense increased approximately $1.9 million, or 56%, during the nine months ended September 30, 2005 compared to the same period in 2004.  The major components of interest expense are as follows:

	For the Nine Months Ended
	September 30,
	2005			2004
	(in thousands)
Interest expense - convertible subordinate debentures	$	880		$	968
Interest expense - bank lines of credit	1,372			734
Interest expense - mortgage bonds and bank term loan	2,985			1,874
Interest expense - other	523			185
Total interest expense before capitalized interest	5,760			3,761
Capitalized interest	(509		)	(390		)
Total interest expense	$	5,251		$	3,371

The increase in total interest expense is primarily due to an increase in our long-term debt and borrowings on our bank lines of credit due to acquisitions and capital spending. This was offset in part by lower interest payments on our debentures as debenture holders

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have converted these debt instruments into common stock and increased capitalization of interest as a result of our capital spending.  Our average balances of interest bearing debt outstanding were approximately $128 million and $77 million for the nine months ended September 30, 2005 and 2004, respectively. In addition, our effective weighted average borrowing rate increased to 6.4% during the nine months ended September 30, 2005 from 6.1% during the nine months ended September 30, 2004. 

Provision for Income Taxes

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

During the nine months ended September 30, 2005 we recognized a capital loss of approximately $4.0 million for income tax purposes upon the sale of our submetering subsidiary.  We will be able to carry back the capital loss to the prior three years and partially offset it against capital gains of approximately $0.9 million realized during those years.  As a result, we recognized an income tax benefit of approximately $0.3 million during the second quarter of 2005, resulting in a net loss of approximately $3.7 million on sale of this subsidiary.

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

Liquidity and Capital Resources

Our corporate objectives with respect to liquidity and capital resources are to:  (i) generate sufficient operating cash to provide for dividends, principal and interest requirements on our indebtedness, capital improvements, and taxes; (ii) obtain external financing for long-term capital improvements and acquisitions; (iii) use our credit facilities to manage seasonal cash needs; and (iv) maintain approximately equal levels of debt and equity. 

Our statements of cash flows are summarized as follows:

	Nine Months Ended September 30,
	2005			2004
	(in thousands)
Net cash provided by continuing operating activities	$	17,946		$	726
Net cash used in investing activities	(36,714		)	(66,088		)
Net proceeds from sale of discontinued operations	9,852			—
Net cash provided by financing activities	14,279			66,449
Net increase in cash and cash equivalents	$	5,363		$	1,087

Cash Flows From Continuing Operating Activities

Cash and cash equivalents increased by approximately $5.4 million for the nine months ended September 30, 2005, as compared to $1.1 million in 2004.  The increase in 2005 cash and cash equivalents was due to strong cash flow from our operating activities which was significantly higher than last year due to:

•acquisitions,

•increased customer connections,

•increased client contracts, and

•increased revenues on our existing contract operations.

For further discussion on operating revenues and expenses see Results of Operations.

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Cash Flows from Investing Activities

Our investing activities focus on capital spending related to expansion, replacement and renovation of our water and wastewater systems of approximately $26.0 million with significant spending occurring in our Texas and California utilities versus prior year spending of $16.0 million. 

Contributions in Aid of Construction (“CIAC”) represent contributions in the form of cash, services or property received from developers, governmental agencies, municipalities or individuals for the purpose of constructing utility plant. Our capital spending on our water and wastewater systems has benefited from contributions from developers to aid in construction of these facilities of approximately $2.8 million as compared to approximately $2.6 million from the same period last year. 

The following table summarizes property, plant and equipment additions for each of the first nine months in 2005 and 2004.

	Nine Months Ended September 30,
	2005		2004
	(in thousands)
Company-financed additions	$	23,069	$	12,984
Capital improvement reimbursements	144		386
Contributions paid for by developers	2,842		2,593
Total property additions paid in cash	26,055		15,963
Property contributed by developers (noncash)	2,248		5,394
Total additions to property, plant and equipment	$	28,303	$	21,357

Cash payments for acquisitions during the first nine months of 2005 and 2004 included:

•$2.6 million in 2005 in cash for the purchase of Alabama contract operations,

•$8.5 million in 2005 in cash for the purchase of an Alabama utility company,

•$2.9 million in 2004 to acquire the remaining minority interest in our submetering subsidiary which was sold in June 2005, and

•$46.7 million in 2004 to acquire Monarch, one of our Texas utilities.

Cash Flows from the Sale of Discontinued Operations

The increase of approximately $9.8 million in net proceeds from sale of our submetering subsidiary improved our cash position.  In June 2005, we completed the sale of our submetering subsidiary in our services segment for approximately $12.0 million.  We received approximately $10.8 million in cash and approximately $1.2 million of the sales price was placed into an escrow account.  We incurred transaction costs of approximately $1.0 million to complete the sale and our net proceeds on the sale of submetering subsidiary were approximately $9.8 million.  The cash from the sale was subsequently used to pay down our bank lines of credit in our New Credit Facility. 

Cash Flows from Financing Activities

Our financing activities involved the following significnat events during the first nine months of 2005 as follows:

•Net borrowings on our revolving lines of credit in 2005 of approximately $4.0 million. 

•Our net cash provided by financing activities increased through additional borrowings of long term debt of $20.0 million.  This was partially offset by repayments on our long term debt of approximately $16.4 million. 

•Sales of stock of approximately $4.5 million.

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Our financing activities involved the following significant events during the first nine months of 2004 as follows:

•Net borrowings on our revolving lines of credit of approximately $25.7 million. 

•A public offering of approximately 1.6 million shares of our common stock in March 2004, which generated net proceeds of approximately $20.5 million.

•A public offering of approximately 1.8 million shares of our common stock in August 2004, which generated net proceeds of approximately $20.7 million.

Common stockholders may elect to participate in our Amended and Restated Dividend Reinvestment and Stock Purchase Plan (“DSPP”), which gives them the option of receiving their dividends in either cash or common stock at a 5% discount from current market value.  This plan also permits optional cash purchases of stock at current market values of up to $10,000 per stockholder each month. Our cash position benefited by approximately $7.6 million as we experienced significant activity in direct stock purchase activity of approximately $4.5 million and primarily stock option exercises which contributed approximately $3.1 million. 

During 2005, we paid dividends totaling approximately $3.0 million. Our quarterly dividend rate is currently $0.05 per common share. 

Aggregate borrowings under our revolving lines of credit were approximately $27.0 million as of September 30, 2005, an increase of approximately $4.0 million since December 31, 2004, primarily used for capital expenditures. Our total borrowing availability under the New Credit Facility was approximately $69.1 million as of September 30, 2005.

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

As part of implementing the New Credit Facility the following actions were taken to reduce interest expense:

1)Redeemed $4.0 million of our New Mexico bonds on April 4, 2005,

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

3)Repayment of a term loan for one of our Texas utilities in the amount of approximately $8.8 million on April 1, 2005, and

4)Repaid a revolving credit facility for our New Mexico Utility in the amount of approximately $3.8 million on April 1, 2005.

Our capital resources are used for debt service on our bonds and debentures and are also influenced by investments we make in new business ventures, including the acquisition of companies and contract operations. We have historically generated reasonably stable operating cash flows.

We expect to spend approximately $9.0 million for cash capital expenditures for the remainder of 2005, primarily for utility property, plant and equipment.  We plan to fund those expenditures with cash flow from operations, borrowings under our New Credit Facility, long term debt financing and other sources.

At September 30, 2005, we had working capital of approximately $11.8 million including available cash and cash-equivalent balances of approximately $6.8 million (excluding restricted cash balances). 

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

Off-Balance Sheet Arrangements

We do not have any material off-balance sheet arrangements other than leases that have been classified as operating leases in accordance with accounting principles generally accepted in the United States (“US GAAP”).

Debt Obligations

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

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			Years Ending December 31,
									2009 and
	2005 (1)		2006		2007		2008		thereafter		Total
	(in thousands)
Long-term debt
Bank lines of credit	$	—	$	—	$	—	$	—	$	27,000	$	27,000
Bank term loans	238		946		938		931		31,649		34,702
Economic development revenue bonds	95		100		105		115		1,810		2,225
Mortgage bonds	—		8,000		—		—		35,000		43,000
Convertible subordinate debentures	—		—		—		—		16,842		16,842
Notes payable	7		397		420		1,598		—		2,422
	$	340	$	9,443	$	1,463	$	2,644	$	112,301	$	126,191

(1) Represents principal payments to be made the remainder of the year.

We have $8.0 million of 7.61% first mortgage bonds maturing on October 20, 2006.  We are exploring various alternatives with respect to funding this redemption obligation including refinancing the obligation through the sale of new mortgage bonds or funding the obligation with borrowings under the New Credit Facility.

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

Loans under the New Credit Facility (other than swingline loans) bear interest at a rate equal to (i) LIBOR plus the applicable margin (as provided for in the New Credit Facility), or (ii) a base rate (as defined) minus the applicable margin.  At September 30, 2005, we had $27.0 million of outstanding borrowings under our New Credit Facility and the adjusted average borrowing rate was approximately 4.8%.  The New Credit Facility replaced our existing lines of credit which had provided for up to $50.0 million of borrowings and we used the New Credit Facility to repay amounts outstanding under those lines of credit.  As of September 30, 2005, we were in compliance with all applicable covenants under our outstanding line of credit agreements.

In January 2003, we received a $3.4 million line of credit from one of our commercial banks that we used to issue a standby letter of credit in that amount as collateral for performance under a contract to design and construct the CVWD plant.  On April 1, 2005, the standby letter of credit was transferred to the New Credit Facility and the standby line of credit was cancelled.

In addition to the foregoing, the indentures governing the first mortgage bonds for our California and New Mexico utilities allow for the issuance of approximately $65.0 million of first mortgage bonds at these utilities as of September 30, 2005. 

We anticipate that our available credit facility borrowing capacity, cash flows generated from operations, long-term debt financing and other sources will be sufficient to fund our activities during the next 12 months; however, we cannot guarantee that will be the case.  If we needed additional financing and were unable to obtain it, our capital spending and any future acquisitions would be delayed, reduced, or eliminated.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with US GAAP. These accounting principles require us to make certain estimates, judgments and assumptions. We believe that the estimates, judgments and assumptions are reasonable based upon information available to us at the time that these estimates, judgments and assumptions are made. These estimates, judgments and assumptions can affect the reported amounts of assets and liabilities as of the date of the financial statements, as well as the reported amounts of revenues and expenses during the periods presented. To the extent there are material differences between these estimates, judgments or assumptions and actual results, our financial statements will be affected. The significant accounting policies that we believe are important to fully understanding and evaluating our reported financial results include the following:

•Revenue recognition,

•Valuation of long-lived and intangible assets,

•Accounting for regulated businesses,

•Stock-based compensation, and

•Deferred costs.

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Our senior management has reviewed these critical accounting policies and related disclosures with the audit committee of the Board of Directors.

Revenue recognition

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

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

Revenues for construction projects are recorded using the percentage-of-completion method of accounting. The percentage-of-completion method recognizes revenue and income as work progresses on a project based on the expected total project costs and the expected total project revenues. This method is based on an estimate of the revenue and income earned to date, less the revenue and income recognized in earlier periods. If management anticipates we will ultimately suffer a loss on a construction project, the entire estimated loss is recorded in the period such a determination is made.

If a contract involves the provision of a single product or service, revenue is generally recognized when the product or service is provided and the amount becomes billable. If services are provided evenly during the contract term but service billings are irregular, revenue is recognized on a straight-line basis over the contract term.

Certain non-refundable activation fees in our non-regulated wholesale water operations are accounted for on a completed contract basis and subsequently deferred and recognized over the expected period of performance.

If a contract involves the provision of multiple products or services (elements), total estimated contract revenue is allocated to each element based on the relative fair value of each service, provided the services qualify for separation under Emerging Issues Task Force (“EITF”) 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The amount of revenue allocated to each service is limited to the amount that is not contingent upon the delivery of another element in the future. Revenue is then recognized for each element as described above for single-element contracts, except revenue recognized on a straight-line basis for a non-construction service will not exceed amounts currently billable unless the excess revenue is recoverable from the client upon any contract termination event. If the amount of revenue allocated to a construction service is less than its relative fair value, costs to deliver such service, limited to the difference between allocated revenue and the relative fair value, are deferred and amortized over the contract term. If total construction service costs are estimated to exceed the relative fair value for the construction service contained in a multiple-element arrangement, then a provision for the estimated loss is made in the period in which the loss first becomes apparent.

Valuation of long-lived and intangible assets

In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we assess intangible assets and other long-lived assets, excluding goodwill, for recoverability whenever events or changes in circumstances indicate that their carrying value may not be recoverable through the estimated undiscounted future cash flows resulting from the use of the assets. If we determine that the carrying value of intangible assets or other long-lived assets may not be recoverable, we measure impairment by using the projected discounted cash-flow method in accordance with Statement No. 144.

We have made acquisitions in the past that resulted in recording goodwill and intangible assets. In September 2001, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives are not amortized, but instead are tested for impairment at least annually. For intangible assets with finite useful lives, SFAS No. 142 requires amortization over their estimated useful lives. SFAS No. 142 became effective for fiscal years beginning after December 15, 2001. We evaluate goodwill impairment, at least annually, using discounted cash flow methodologies, transaction values for comparable companies, and other valuation techniques for our reporting units with significant goodwill balances.  Our reporting units, generally subsidiaries one level below operating segments, constitute separate businesses for which we maintain discrete financial information that is regularly reviewed by segment and chief operating decision maker.  There were no impairment charges to goodwill as of September 30, 2005 and no events have occurred that indicated diminution in the value of recorded goodwill.

Under the provisions of SFAS No. 141, Business Combinations, we have identified intangible assets apart from goodwill such as contract costs and account lists.  These intangible assets are amortized over their estimated useful lives ranging from four to eight years. 

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Accounting for regulated businesses

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

Our Services Group has contracted with our utilities in Alabama, Oklahoma, New Mexico and Texas to perform operating services, maintenance, construction work, and to manage capital projects.  In accordance with SFAS No. 71, our Services Group recognizes profit on sales to regulated affiliates and does not eliminate the intercompany profit when the sales price is reasonable and it is probable that, through the rate making process, future revenue approximately equal to the sales price will result from the regulated affiliate’s use of the services.  However, all revenue in excess of profits is eliminated.  Accordingly, the intercompany profit for construction as well as operations and maintenance services provided to Utility Group affiliates has not been eliminated in the accompanying consolidated financial statements.  Based upon our Services Group’s experience of providing operations and maintenance services in more than 400 contracts with unaffiliated customers, and a history of regulator approval of the construction service fees charged by the Services Group to utility affiliates, we believe that the contract sales prices between our Services Group and our Texas and New Mexico utilities are reasonable and that it is probable that the price of these services will be recovered in the rate-making process.

Stock-based Compensation

In 2002, we adopted 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 pricing model and recognition of this value as an expense over the period in which the options vest. In accordance with the provisions of SFAS No. 148, we elected to recognize stock-based compensation using the retroactive restatement method. Under this change in accounting method, we restated our accompanying consolidated financial statements for periods prior to 2002 to reflect stock-based compensation expense under a fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994.

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

Deferred Costs

We defer and subsequently amortize certain direct contract acquisition costs related to activities that enable the provision of contracted services to our customers. Deferred contract acquisition costs are amortized on a straight-line basis over the remaining original contract term unless revenue patterns indicate a more accelerated method is appropriate. The recoverability of all long-lived assets associated with a particular contract, including deferred contract costs, is analyzed on a periodic basis. If we conclude that long-lived assets are impaired, an impairment loss is recognized for the amount by which the carrying value of the long-lived assets exceeds the fair value of those assets.

RISK FACTORS

The following factors, which are described more fully in our 2004 Annual Report, represent risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. Factors that could affect forward-looking statements relating to the resolution of the material weakness with respect to internal controls discussed in Item 4 below and Item 9A of our 2004 Annual Report, include among other things: our ability to identify and retain qualified and experienced financial personnel and our ability to design and maintain policies and procedures which enable us to avoid any recurrence of the matters which gave rise to the material weakness.   See “Risk Factors” in our 2004 Annual Report for further disclosure related to risk factors.

Risks Related to Our Business

Risk Factors that affect our Utility Group operations

•Weather conditions can affect the financial results of our Utility Group.  

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•Changes in the regulatory environment, including restrictions on rates we are allowed to charge customers, may adversely affect our results of operations.  Changes in policies allowing our Services Group to provide services to our regulated utilities, at fair market values, may adversely impact our operating results.

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

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

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

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

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

Risk factors that affect our Services Group operations

•We operate in a competitive market with low operating margins.

•Our revenue growth depends on our ability to enter into new, and maintain our existing, operating contracts with cities, agencies and municipal utility districts.

•Our business depends on trained, qualified employees.

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

•Our Services Group’s contracts have certain performance risks.

•Services Group contracts for the design and construction of water and wastewater facilities may expose us to certain completion and performance risks.

•We use third party equipment and subcontractors.

•Our Services Group is subject to environmental and water quality risks.

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

•Our operating costs may rise faster than our revenues.

•Our operating contracts may be canceled, reducing our revenues and backlog. Also we may not secure new construction and construction management projects on a consistent basis, leading to fluctuations in revenues and backlog.

Risks Related to Our Common Stock

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

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

•The market price of our shares of common stock could be volatile.

•Our results could fall below the expectations of market analysts or investors. 

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•We may issue additional shares of our common stock.

Other Risk Factors

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

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

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

•We are subject to debt covenants.

•Rating agencies may downgrade our debt.

•We are subject to increasing costs of producing products and services.

•Our operations are subject to certain risks due to their locations.

•Internal control weaknesses could have an adverse effect on us.  We may not be able to remediate the material weakness noted in the 2004 Annual Report in a timely manner.

•The United States Environmental Protection Agency closely regulates many of our businesses and we must comply with its rules and regulations.

•We rely on a number of complex business systems that could malfunction.

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

Item 3. Quantitative and Qualitative Disclosures about Market Risk

There are no material changes from our 2004 Annual Report.

Item 4. Controls and Procedures

We maintain disclosure controls and procedures designed to ensure that information required to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commission and that such information is accumulated and communicated to management, including our Chief Executive Officer and Chief Financial Officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

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

We are in the process of implementing improvements to our internal controls to address the aforementioned material weakness.  We have implemented procedures in our accounting review and approval process over non-routine transactions.  These include implementation of additional checklists, more timely review and accounting for non-routine transactions and timely identification of non-routine issues with our auditors.  We have evaluated appropriate staffing and experience levels in our corporate controllership function and have hired the additional experienced personnel we feel appropriate.  In addition, during the second and third quarters of 2005, we have made significant progress in preparation for complying with the Sarbanes-Oxley Act for the year end 2005.

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Specifically, we have 1) updated key controls and documentation since year end 2004, 2) established a Steering Committee to monitor the progress of the effectiveness of the controls and 3) started the testing for our 2005 management testing.  Management anticipates completing the testing during the fourth quarter and believes it will have adequate time to remediate any significant deficiencies or material weaknesses.  While we feel that management has made progress in improving controls and in complying with the Act for 2005, the material weakness identified above has not yet been rectified and will not be fully rectified until we have successfully completed our year end testing.       

In September 2005, we discovered that we had improperly billed several of our clients for reimbursable expenses.  We engaged legal counsel and forensic accountants to conduct an independent investigation.  We have terminated the employee responsible for the improper billings and have determined such improper billings were not material to our consolidated financial statements.  We have designed and implemented additional controls relating to employee reimbursements.  We believe the added controls will be effective in reducing the potential for this kind of impropriety in the future.

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

For the quarter ended September 30, 2005, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were not effective as of September 30, 2005.

While we continue to devote significant resources to meeting the internal control over financial reporting requirements of the rules adopted by the SEC pursuant to Section 404 of the Sarbanes-Oxley Act of 2002, we cannot assure you that the policies and procedures we have adopted and our continued efforts will successfully remediate the material weakness we have identified and any control deficiencies or material weaknesses that we or our outside auditors may identify before the end of our fiscal year.

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PART II - - OTHER INFORMATION

Item 1. Legal Proceedings

Southwest and a subsidiary were named as defendants in several lawsuits alleging various injuries as a result of water contamination in the San Gabriel Valley Main Basin. The California Supreme Court has ruled that the plaintiffs cannot challenge the adequacy of the water quality standards established by California Department of Health Services and the United States Environmental Protection Agency (“EPA”) but can sue us if they can prove that we served water that did not meet those standards. In August 2004 a trial court dismissed the case against us, finding that there was no evidence that we violated any water quality standards.  The plaintiffs appealed the dismissal to the Court of Appeals for the State of California, Second Appellate District, where the matter is pending. To date, liability insurance carriers have absorbed the costs of defense of the lawsuits.

On May 5, 2005, one of the Company’s operating subsidiaries received a subpoena to provide records to a grand jury.  The requested records relate to the operations of the San Simeon wastewater treatment plant in California for the period January 2002 to present.  The facility was also served with search warrants executed by the EPA.  The Company’s subsidiary has operated this facility since September 2004.  The Company is cooperating with the investigation and is also performing its own internal investigation. 

On May 18, 2005, the EPA executed a search warrant at one of the Company’s operating subsidiaries in Texas.  The search warrant sought information relating to the subsidiary’s laboratory operations.  The Company is cooperating with the investigation and is also performing its own internal investigation.

Southwest Water Company and its subsidiaries are subject to litigation arising in the ordinary course of operations. We believe the ultimate resolution of all matters that have been brought to our attention will not materially adversely affect our consolidated financial position, results of operations or cash flows.

Item 2.  Changes In Securities And Use Of Proceeds

The following table summarizes the Company’s purchases of its common stock for the quarter ended September 30, 2005.

Period	Total Number of Shares (or Units) Purchased(1)	Average Price Paid per Share (or Unit)	Total Number of Shares (or Units) Purchased as Part of Publicly Announced Plans or Programs	Maximum Number (or Approximate Dollar Value) of Shares (or Units) that May Yet Be Purchased Under the Plans or Programs
July 1, 2005 – July 31, 2005	N/A	N/A	N/A	N/A
August 1, 2005 – August 31, 2005	33,299	13.92	N/A	N/A
September 1, 2005 – September 30, 2005	N/A	N/A	N/A	N/A
Total	33,299	13.92	N/A	N/A

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

Item 6. Exhibits

3.1	Restated Certificate of Incorporation of Southwest Water Company dated May 24, 2005 (incorporated by reference to the Registrants Form 10-Q for the quarterly period ended June 30, 2005)
10.1	Amended and Restated Dividend Reinvestment and Stock Purchase Plan dated April 8, 2005 (incorporated by reference to Registrant’s S-3/A Registration Statement filed with the Commission on April 5, 2005).

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10.2	Credit Agreement dated as of April 1, 2005 among the Registrant, as borrower, the several lenders parties thereto, Bank of America, N.A., as administrative agent, swing line lender and letter of credit issuer, Banc of America Securities LLC and Union Bank of California, N.A., as co-lead arrangers and co-book managers, and Union Bank of California, N.A., as syndication agent (incorporated by reference to Registrant’s Form 8-K filed with the Commission on April 6, 2005).
10.3	First Amendment to Severance Compensation Agreement, dated July 22, 2005, between Southwest Water Company and Anton C. Garner (incorporated by reference to Exhibit 10.1 to the Registrant’s Form 8-K filed with the Commission on July 22, 2005)
10.4	Amended and Restated Master Loan Agreement date September 12, 2005 (MLA No. RX 0936) between Monarch Utilities I L.P. and CoBank, ACB (filed herewith)
10.4.1	Promissory Note and Supplement dated May 1, 2002 (Loan No. ML0936T1)  between Tecon Water Company, L.P. (now Monarch Utilities I L.P.) and CoBank, ACB (filed herewith)
10.4.2	First Amendment to Promissory Note and Supplement dated September 12, 2005 (Loan No. ML0936T1) between Monarch Utilities I L.P. (formerly known as Tecon Water Company, L.P.) and CoBank, ACB (filed herewith)
10.4.3	Promissory Note and Supplement dated May 1, 2002 (Loan No. ML0936T2 between Tecon Water Company, L.P. (now Monarch Utilities I L.P.) and CoBank, ACB (filed herewith)
10.4.4	First Amendment to Promissory Note and Supplement dated September 12, 2005 (Loan No. ML0936T2) between Monarch Utilities I L.P. (formerly known as Tecon Water Company, L.P.) and CoBank, ACB (filed herewith)
10.4.5	Promissory Note and Supplement dated September 12, 2005 (Loan No. RX0936T3) between Monarch Utilities I L.P. and CoBank, ACB (filed herewith)
31.1	Certification of Chief Executive Officer pursuant to Securities Exchange Act Rules 13a-14(a) and 15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 (filed herewith).
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 (filed herewith).
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 (filed herewith).
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 (filed herewith).

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SIGNATURES

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

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

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EX-10.4

Exhibit 10.4

MLA No. RX0936

AMENDED AND RESTATED MASTER LOAN AGREEMENT

THIS AMENDED AND RESTATED MASTER LOAN AGREEMENT (this “Agreement”) is entered into as of  September 12, 2005, between MONARCH UTILITIES I L.P. (formerly known as Tecon Water Company, L.P.), a Texas limited partnership (the “Company”), and CoBANK, ACB,  a federally chartered instrumentality of the United States (“CoBank”).

BACKGROUND

CoBank and the Company are parties to a Master Loan Agreement dated as of May 1, 2002 (as amended, the “Existing MLA”). The parties now desire to amend and restate the Existing MLA

NOW, THEREFORE, for good and valuable consideration, the receipt and sufficiency of which are hereby acknowledged, the Existing MLA is hereby amended and restated in its entirety to read  as follows:

ARTICLE 1

DEFINITIONS AND ACCOUNTING TERMS

SECTION 1.01.    Definitions.  Capitalized terms used in this Agreement and defined in Exhibit A hereto shall have the meanings set forth in such Exhibit.

SECTION 1.02.    Rules of Interpretation. The rules of interpretation set forth in Exhibit A shall apply to this Agreement.

ARTICLE 2

THE SUPPLEMENTS

SECTION 2.01.    Promissory Notes and Supplements. In the event the Company desires to borrow from CoBank and CoBank is willing to lend to the Company, the parties will enter into a promissory note and supplement hereto (each a “Promissory Note and Supplement”). Each Promissory Note and Supplement will set forth CoBank’s commitment to make a Loan or Loans to the Company, the amount of the Loan(s), the purpose of the Loan(s), the interest rate or interest rate options applicable to the Loan(s), the Company’s promise to repay the Loans, and any other terms and conditions applicable to the particular Loan(s). Each Loan will be governed by the terms and conditions set forth in this Agreement and in the Promissory Note and Supplement relating to that Loan. In the absence of a Promissory Note and Supplement hereto duly executed by CoBank, CoBank shall have no obligation to make a Loan to the Company under this Agreement. As of the date of this Agreement, the following Promissory Notes and Supplements are outstanding hereunder and shall be governed by the terms hereof: (1) Promissory Note and Supplement dated as of May 1, 2002, and numbered ML0936T1; and (2) Promissory Note and Supplement dated as of May 1, 2002, and numbered ML0936T2 (the “Existing Promissory Notes and Supplements”).

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SECTION 2.02.    Notice and Manner of Borrowing New Loans.  Except as otherwise provided in a Promissory Note and Supplement: (A) Loans will be made available on any Business Day upon the written or telephonic request of an authorized employee of the Company (which telephonic request, if required by CoBank, shall be promptly confirmed in writing by the Company); (B) Requests for Loans must be received by 12:00 noon Mountain time on the date the Loan is to be made; and (C) Loans will be made available by wire transfer of immediately available funds to such account or accounts as may be authorized by the Company on forms supplied by CoBank.

SECTION 2.03.    Method of Payment. The Company shall make all payments to CoBank under this Agreement and each Promissory Note and Supplement hereto by wire transfer of immediately available funds or, if specified by separate agreement between the Company and CoBank, by automated clearing house or other similar cash handling processes.  Wire transfers shall be made to ABA No. 307088754 for advice to and credit of “CoBANK” (or to such other account as CoBank may direct by notice).  The Company shall give CoBank telephonic notice no later than 12:00 noon Mountain time of its intent to pay by wire, and funds received after 3:00 p.m. Mountain time shall be credited on the next Business Day.

SECTION 2.04.    Security.  The Company’s obligations hereunder and under each other Loan Document to which the Company is a party (whether executed contemporaneously herewith or at a later date) shall be secured by: (A) a statutory first priority Lien on all equity which the Company may now own or hereafter acquire or be allocated in CoBank; (B) except as otherwise provided in Section 6.01 hereof, a first priority lien and security interest in all real and personal property of the Company of every type and description (other than  property excluded in the last sentence of this Section 2.04), whether existing on the date hereof or acquired at a later date; and (C) all proceeds thereof. The Company agrees to take such steps (including the execution and recording of such instruments and documents) as CoBank may from time to time require in order to enable CoBank to obtain, perfect and maintain its Lien on the collateral. Notwithstanding the foregoing, CoBank shall not have a Lien on: (1) rolling stock financed by another lender; (2) assets which, under Law, may not be subjected to a Lien; provided, however, that if such provision of Law is later changed or has been or is later overruled by any other provision of Law, then such assets shall be subject to CoBank’s Lien; and (3) assets subject to agreements that prohibit the Company from granting a Lien on the assets; provided, however, that: (i) the maximum amount of assets that may be subject to any such agreement at any one time shall not exceed $500,000; (ii) the Company may not enter into any such agreement with an Affiliate; and (iii) to the extent that applicable Law renders such restrictions unenforceable, then the foregoing exception shall not be applicable.

ARTICLE 3

CONDITIONS PRECEDENT

SECTION 3.01.    Conditions Precedent to This Agreement and the 2005 Promissory Note and Supplement. This Agreement and CoBank’s obligation to make a Loan or Loans under the 2005 Promissory Note and Supplement are subject to the following conditions precedent, which, in the case of instruments and documents, must be in form and content reasonably acceptable to CoBank:

(A)          This Agreement. CoBank shall have received a duly executed original copy of this Agreement.

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(B)          Supplements. CoBank shall have received a duly executed original copy of: (1) an amendment to the Promissory Note and Supplement dated as of May 1, 2002, and numbered ML0936T1; (2)  an amendment to the Promissory Note and Supplement dated as of May 1, 2002, and numbered ML0936T2; and (3) the 2005 Promissory Note and Supplement and all Loan Documents required by the 2005 Promissory Note and Supplement.

(C)          Evidence of Authority. CoBank shall have received such evidence as CoBank may reasonably require that this Agreement, the 2005 Promissory Note and Supplement, and all Loan Documents executed in connection herewith or therewith have been duly authorized, executed an delivered.

(D)          [Intentionally Omitted]

(E)           Delegation and Wire Transfer Form. CoBank shall have received a duly executed original copy of a delegation and wire transfer authorization form.

(F)           Security Documentation. CoBank shall have received: (1) a duly executed original copy of an amendment to that certain Security Agreement dated as of May 1, 2002, executed by the Company in favor of CoBank; (2) an account control agreement, duly executed by CoBank, the Company, and its Depository Bank; and (3) such evidence as CoBank may reasonably require (including one or more Lien searches) that: (a) CoBank has a duly perfected first priority Lien (subject only to Liens which are both permitted under Section 6.01 hereof and otherwise entitled to priority under Law) on all personal property of the Company in which a Lien can be perfected by filing a UCC-1 financing statement or recording a security instrument with the Secretary of State of Texas; and (b) there are no other Liens on any personal property of the Company (other than Liens permitted under Section 6.01 hereof).

(G)          Commitment to Issue Endorsement to Existing Title Policy, Closing Agreement, Deeds of Trust, Etc.  (1) Republic Title of Texas, Inc., as agent for First American Title Insurance Company (in such role, “Republic Title”) shall have furnished to CoBank a commitment to issue an endorsement to the Title Policy; (2) Republic Title, the Company, and CoBank shall have entered into a closing agreement (the “Closing Agreement”); (3) CoBank and Republic Title shall each have received an original copy,  duly executed by the Company, as Trustor and Grantor, and Steve Moore, as Trustee,  of an amendment to the Deed of Trust; (4) Republic Title shall have received original copies, duly executed by the Company, of Statutory Utility Notices for each county in Texas in which the Company does business or owns property; and (5) all conditions precedent to funding set forth in the Closing Agreement shall have occurred.

(H)          Agreements with Affiliates.  CoBank shall have reviewed and approved all agreements between the Company and its Affiliates, and CoBank shall have received from each Affiliate that performs services for or on behalf of the Company, a duly executed copy of a consent and agreement.

(I)            Organizational Documents.  CoBank shall have reviewed and approved (which approval will not be unreasonably withheld or delayed) Certified Copies of the Organizational Documents of the Company and Texas Water Services Group, LLC.

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(J)           Consents and Approvals. CoBank shall have received such evidence as CoBank may reasonably require that all consents and approvals referred to in Section 4.01(M) hereof have been obtained and are in full force and effect.

(K)          Fees and Other Charges. CoBank shall have received all fees or other charges provided for herein or in the 2005 Promissory Note and Supplement.

(L)           Officers Certificate. CoBank shall have received a duly executed original copy of a certificate of an officer of the Company, which, if other than the Chief Financial Officer of the Company, must be reasonably acceptable to CoBank.

(M)          Insurance. CoBank shall have received such evidence as CoBank may reasonably require that the Company is in compliance with Section 5.03 hereof.

(N)          Opinion of Counsel.  CoBank shall have received a duly executed original copy of an opinion of counsel to the Company, which counsel must be reasonably acceptable to CoBank.

SECTION 3.02.    Conditions to Each Supplement. CoBank’s obligation to make the initial Loan under each Promissory Note and Supplement hereto (other than the 2005  Promissory Note and Supplement) is subject to the following conditions precedent (which in the case of instruments and documents, must be in form and content acceptable to CoBank):

(A)          Supplement. CoBank shall have received a duly executed original copy of the Promissory Note and Supplement and all Loan Documents required by such Promissory Note and Supplement.

(B)          Evidence of Authority. CoBank shall have received copies, certified by the Secretary of the Company as of the date of such Promissory Note and Supplement, of such evidence as CoBank may reasonably require that such Promissory Note and Supplement and all Loan Documents executed in connection therewith have been duly authorized, executed an delivered.

(C)          Consents and Approvals. CoBank shall have received such evidence as CoBank may reasonably require that all consents and approvals referred to in Section 4.01(M) hereof, have been obtained and are in full force and effect.

(D)          Fees and Other Charges. CoBank shall have received all fees or other charges provided for herein or in such Promissory Note and Supplement.

(E)           Application. CoBank shall have received a duly executed and completed original copy of an application for the credit.

(F)           Officer’s Certificate. CoBank shall have received a duly executed  original copy of a certificate of an officer of the Company, which, if other than the Chief Financial Officer of the Company, must be reasonably acceptable to CoBank.

(G)          Insurance. CoBank shall have received such evidence as CoBank may reasonably require that the Company is in compliance with Section 5.03 hereof.

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(H)          Opinion of Counsel.  CoBank shall have received a duly executed original copy of an opinion of counsel to the Company, which counsel must be reasonably acceptable to CoBank.

(I)            Security. CoBank shall have received such evidence as it shall reasonably require that: (1) the Company has taken all steps required by CoBank under Section 2.04 hereof or the Promissory Note and Supplement in order for CoBank to obtain, perfect and/or maintain its Lien, including its Lien on  any assets to be constructed and/or acquired with the proceeds of the Loan to be made under the Promissory Note and Supplement; (2) CoBank’ Lien is a first priority Lien ; and (3) there are no other Liens on any property of the Company, except as permitted under Section 6.01 hereof.

SECTION 3.03.    Conditions to Each Loan.  CoBank’s obligation under each Promissory Note and Supplement (including the 2005 Promissory Note and Supplement hereto) to make any Loan to the Company thereunder, including the initial Loan, is subject to the conditions precedent that: (A) no Default or Event of Default shall have occurred and be continuing; (B) each of the representations and warranties of the Company set forth herein and in all other Loan Documents shall be true and correct as of the date of the Loan; and (C) the Company shall have satisfied all conditions and requirements set forth in the Promissory Note and Supplement relating to that Loan.

ARTICLE 4

REPRESENTATIONS AND WARRANTIES

SECTION 4.01.    This Agreement and the 2005 Promissory Note and Supplement Hereto. To induce CoBank to enter into this Agreement and the 2005 Promissory Note and Supplement hereto, the Company represents and warrants that:

(A)          Organization, Etc. The Company: (1) is a limited partnership duly organized, validly existing, and in good standing under the Laws of the State of Texas; (2) has the power and authority to own its assets and to transact the business in which it is engaged or proposes to engage; and (3) is duly qualified to do business in, and is in good standing under the Laws of, each jurisdiction in which  failure to be qualified could reasonably be expected to have a Material Adverse Effect.

(B)          Loan Documents. This Agreement, the 2005 Promissory Note and Supplement, and all other Loan Documents executed or furnished in connection herewith or therewith: (1) have been duly authorized, executed and delivered by the Company and each other Person (other than CoBank) that is a party thereto; and (2) create legal, valid and binding obligations of the Company and each other party thereto (other than CoBank) which are enforceable in accordance with their terms, except to the extent that enforcement may be limited by applicable bankruptcy, insolvency or similar Laws affecting creditors’ rights generally.

(C)          Operation of Business. The Company possesses all licenses, certificates, permits, authorizations, approvals, franchises, patents, copyrights, trademarks, trade names, rights thereto, or the like which are material to the operation of its business or required by Law, and the Company is not in violation in any material respect of the rights of others with respect thereto. Without limiting the foregoing, the Company has all Certificates of Convenience

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and Necessity and effluent discharge permits necessary for the operation of its water and wastewater systems.

(D)          Litigation.  Except as disclosed in any application or officer’s certificate submitted in connection with this Agreement and the 2005 Promissory Note and Supplement, there are no pending or threatened actions or proceedings against or affecting the Company or any of its Affiliates before any court, governmental agency, mediator, arbitrator, or the like which could, in any one case or in the aggregate, reasonably be expected to have a Material Adverse Effect.

(E)           Ownership of Company and Subsidiaries. The: (1) general partner of the Company is Texas Water Services Group, LLC, and there are no other general partners of the Company; (2) limited partner or partners of the Company are owned 100% directly or indirectly by Southwest; (3) the general partner is owned 100% directly or indirectly by Southwest; (4)  the Company has no Subsidiaries, other than TWC Utility Company, LLC; and (5) as of the date hereof, TWC Utility Company, LLC owns no assets and conducts no business.

(F)           Southwest Financial Statements. The consolidated balance sheet of. Southwest as of December 31, 2004, and the related consolidated statements of income and retained earnings of Southwest for the fiscal year then ended, and the accompanying notes and schedules, together with the opinion thereon, dated March 25, 2005, and the interim consolidated balance sheet of Southwest and the related consolidated statements of income and retained earnings for the three month period ending March 31, 2005, copies of which have been furnished to CoBank, fairly present in all material respects the financial condition of Southwest and its consolidated subsidiaries as at such dates and the results of their operations for the periods covered by such statements, all in accordance with GAAP consistently applied (subject to normal year-end adjustments in the case of the interim financial statements). There are no liabilities of Southwest and its consolidated subsidiaries, fixed or contingent, which are material but not reflected in the year end financial statements or in the notes thereto or in a writing furnished to CoBank and referencing this Subsection.

(G)          Company Financial Statements.  The balance sheet of the Company as of December 31, 2004, and the related statements of income and retained earnings of the Company for the fiscal year then ended, and the accompanying notes and schedules, and the interim balance sheet of the Company and the related statements of income and retained earnings for the six month period ending June 30, 2005, copies of which have been furnished to CoBank, fairly present in all material respects the financial condition of Company as at such dates and the results of the operations of the Company for the periods covered by such statements, all in accordance with GAAP consistently applied (subject to normal year-end adjustments in the case of the interim financial statements). There are no liabilities of the Company, fixed or contingent, which are material but not reflected in the year end financial statements or in the notes thereto or in a writing furnished to CoBank and referencing this Subsection.

(H)          Ownership and Liens. The Company has title to, or valid easement or leasehold interests in, all of its properties, real and personal, including the property and leasehold interests reflected in the balance sheet referred to in Section 4.01(G) hereof (other than any property disposed of in the ordinary course of business), and none of the properties or leasehold interests of the Company is subject to any Lien, except such as may be permitted under Section 6.01 of this Agreement.

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(I)            [Reserved]

(J)           Compliance with Law. Except as disclosed in any application or officer’s certificate submitted in connection with this Agreement and the 2005 Promissory Note and Supplement hereto, all of the properties owned by the Company and all of its operations, are in compliance in all material respects with all Laws (including all Laws relating to the environment) which, if not complied with, could reasonably be expected to have a Material Adverse Effect.

(K)          Environment. Except as disclosed in Schedule 4.01(K) hereto or in any application or officer’s certificate submitted in connection with this Agreement and the 2005 Promissory Note and Supplement: (1) no property owned or leased by the Company is being used, or to its knowledge, has been used for the disposal, treatment, storage, processing or handling of hazardous waste or materials (as defined under any applicable environmental Law); (2) no investigation, claim, litigation, proceedings, order, judgment, decree, settlement, Lien or the like with respect to any environmental matter is proposed, threatened, anticipated or in existence with respect to the properties or operations of the Company; and (3) no environmental contamination or condition currently exists on any property of the Company which could reasonably be expected to delay the sale or other disposition of such property or could reasonably be expected to have, or already has had, a material adverse effect on the value of such property.

(L)           ERISA.  The Company and each of its ERISA Affiliates is in compliance in all material respects with all requirements of ERISA, the Company and each ERISA Affiliate have met their minimum funding requirements under ERISA with respect to each plan governed thereby, no grounds exist entitling the Pension Benefit Guaranty Corporation to institute proceedings to terminate a plan maintained by the Company or any ERISA Affiliate this is subject to ERISA, and neither the Company nor any ERISA Affiliate has any liability arising form the withdrawal or termination of any plan subject to ERISA which liability could reasonably be expected to result in material liability to the Company.

(M)          Consents and Approvals.   Except for such as shall have been obtained and are in full force and effect, no consent, permission, authorization, order or license of any governmental authority or of any party to any material agreement to which the Company is a party or by which it or any of its material property may be bound or affected, is necessary in connection with: (1) the execution, delivery, performance or enforcement of the Loan Documents; and (2) the project, acquisition, or other activity being financed by the 2005 Promissory Note and Supplement hereto.

(N)          Conflicting Agreements.  None of the Loan Documents conflicts with, or constitutes (with or without the giving of notice and/or the passage of time and/or the occurrence of any other condition) a default under, any other material agreement to which the Company is or expects to become a party or by which the Company or any of its material properties may be bound or affected, and do not conflict with any provision of the Organizational Documents of the Company.

(O)          Compliance and No Default.  The Company is operating its business in compliance with all of the terms of the Loan Documents, and no Default or Event of Default exists.

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(P)           Applications, Officer’s Certificate, Etc.  Each representation and warranty and all information set forth in the application and officer’s certificate submitted in connection with, or to induce CoBank to enter into, this Agreement and the 2005 Promissory Note and Supplement hereto is correct in all material respects.

(Q)          Budgets, Etc.  All budgets, projections, feasibility studies, and other documentation submitted by the Company to CoBank in connection with, or to induce CoBank to enter into, this Agreement and the 2005 Promissory Note and Supplement hereto are based upon assumptions that are reasonable and realistic, and no fact has come to light, and no event has occurred, which would cause any material assumption made therein to not be reasonable or realistic.

(R)          Water Rights. The Company: (1) has water rights with such amounts, priorities and qualities as are necessary to adequately serve the customers of the Company; (2) controls, owns, or has access to all such water rights free and clear of the interests of any third party; (3) has not suffered or permitted any transfer or encumbrance of such water rights, has not abandoned such water rights, or any of them, and has not done any act or thing which would impair or cause the loss of any such water rights.

(S)           Facilities.  The Company’s utility facilities: (1) meet present demand in all material respects; (2) are constructed in a good and professional manner; (3) are in good working order and condition; and (4) comply in all material respects with all applicable Laws.

(T)           Rate Matters.  Except as disclosed in Schedule 4.01(T) hereto or in any application or officer’s certificate furnished in connection herewith and the 2005 Promissory Note and Supplement: (1) the Company’s rates for the provision of water and the treatment and/or disposal of wastewater have been approved by any and all necessary governmental authorities (including all regulatory authorities, public service commissions, or public utilities commissions) which have jurisdiction over the operations and rates of the Company, including the TCEQ; (2) the Company is in compliance with all TCEQ tariffs and other rate policies; and (3) there is no pending and, to the Company’s knowledge, threatened action or proceeding before the TCEQ or any other governmental authority, the objective or result of which is or could reasonably be expected to: (a) reduce or otherwise adversely change any of the rates for the provision of water and/or wastewater services; (b) limit or revoke any Certificate of Convenience and Necessity; or (c) otherwise have a Material Adverse Effect.

(U)           Enforcement Actions.  Except as disclosed in the application or officer’s certificate furnished in connection herewith and the 2005 Promissory Note and Supplement, the Company is not subject to any Enforcement Action.

SECTION 4.02.    Each Supplement.  The execution by the Company of each Promissory Note and Supplement hereto (other than the 2005 Promissory Note and Supplement) shall constitute a representation and warranty that each of the representations and warranties set forth in Section 4.01 hereof are true and correct as of the date of the Promissory Note and Supplement, except that: (A) the references to the financial statements in Section 4.01(F) hereof shall be deemed to be to the latest annual financial statements furnished to CoBank under Section 5.06(I) hereof; (B) the references to the financial statements in Section 4.01(G) hereof, and all references in Section 4.01(H) hereof to such statements, shall be deemed to be to the latest annual financial statements and, if more recent than the latest annual financial statements, to the

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latest quarterly financial statements furnished to CoBank under Section 5.07(A) and (B) hereof; (C) all references to the 2005 Promissory Note and Supplement shall be deemed to refer to the Promissory Note and Supplement being executed at the time; (D) the references in Sections 4.01(D), (J), (K), (P), (T), and (U) to the application and officer’s certificate furnished in connection with this Agreement and the 2005 Promissory Note and Supplement shall be deemed to refer to any application and officer’s certificate furnished in connection with the Promissory Note and Supplement being executed at the time; and (C) the reference in Section 4.01(Q) to budgets, projections and other documentation and information referred to therein, shall be deemed to refer to all budgets, projections and other documentation furnished in connection with Promissory Note and Supplement being executed at the time.

ARTICLE 5

AFFIRMATIVE COVENANTS

Unless otherwise agreed to in writing by CoBank, while this Agreement is in effect, the Company agrees to:

SECTION 5.01.    Maintenance of  Existence, Etc.  Preserve and maintain its existence and good standing in the jurisdiction of its formation, qualify and remain qualified to transact business in all jurisdictions in which the failure to be qualified could reasonably be expected to have a Material Adverse Effect, and obtain and maintain all licenses, permits, franchises, patents, copyrights, trademarks, tradenames, or rights thereto which are material to the conduct of its business or required by Law.

SECTION 5.02.    Compliance With Laws.  Comply in all material respects with all applicable Laws (including all Laws relating to the environment), which, if not complied with, could reasonably be expected to have a Material Adverse Effect or result in criminal sanctions. In addition, the Company agrees to cause all Persons occupying or present on any of its properties to comply in all material respects with all such Laws.

SECTION 5.03.    Insurance.  Maintain insurance with financially sound and reputable insurance companies or associations in such amounts and covering such risks as are usually carried by companies engaged in the same business and similarly situated. Without limiting the foregoing, in the event any property of the Company is located in a flood zone (as reasonably determined by CoBank), then the Company shall obtain such flood insurance as may reasonably be required by CoBank. Each such policy insuring any collateral for the Company’s obligations to CoBank shall have lender or mortgagee loss payee clauses in form and content reasonably acceptable to CoBank. The Company agrees to furnish to CoBank such proof of compliance with this Section as CoBank may from time to time reasonably require.

SECTION 5.04.    Property Maintenance.  Maintain all of its properties that are necessary to or useful in the proper conduct of its business in good repair, working order and condition, ordinary wear and tear excepted, and make all alterations, replacements and improvements thereto as may from time to time be reasonably necessary in order to ensure that its properties remain in good working order and condition.

SECTION 5.05.    Books and Records.  Keep adequate records and books of account in which complete entries will be made in accordance with GAAP.

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SECTION 5.06.    Reports and Notices.  Furnish to CoBank:

(A)          Annual Financial Statements. As soon as available, but in no event more than 120 days after the end of each fiscal year of the Company occurring during the term hereof, annual financial statements of the Company prepared in accordance with GAAP consistently applied.  Such financial statements shall: (a) be audited by a firm of independent certified public accountants selected by the Company and reasonably acceptable to CoBank; (b) be accompanied by a report of such accountants containing an opinion to the effect that the financial statements: (i) were audited in accordance with generally accepted auditing standards; and (ii) present fairly, in all material respects, the financial position of the Company as at the end of the year and the results of its operations for the year then ended, in conformity with GAAP; (c) be prepared in reasonable detail and in comparative form; and (d) include a balance sheet, a statement of income, a statement of retained earnings, a statement of cash flows, and all notes and schedules relating thereto.

(B)          Interim Financial Statements.  As soon as available, but in no event more than 60 days after the end of each fiscal quarter of the Company occurring during the term hereof, a balance sheet of the Company as of the end of such quarter, a statement of income for the Company for such period and for the period year to date, a statement of retained earnings, and a statement of cash flow, all prepared in reasonable detail and in comparative form in accordance with GAAP consistently applied and, if required by notice from CoBank, certified by the President, Vice President, Chief Financial Officer or Treasurer  of the Company.

(C)          Officer’s Certificate. Together with each set of financial statements delivered to CoBank pursuant to Subsection (A) and (B) of this Section 5.06, a certificate of the President, Vice President, Chief Financial Officer or Treasurer of the Company : (1) computing the financial covenants set forth in Article 7 hereof that are required to be measured as of the end of the period for which the financial statements are being delivered; and (2) certifying that, to the best knowledge of such officer, no Default or Event of Default has occurred and is continuing, and, if continuing, the action which is proposed to be taken with respect thereto.

(D)          Notice of Litigation, Material Matters, Etc.  Promptly after becoming aware thereof, notice of: (1) the commencement of any action, suit or proceeding before any court, governmental instrumentality, arbitrator, mediator or the like which, if adversely decided, could reasonably be expected to have a Material Adverse Effect; (2) the commencement of any Enforcement Action; (3) the receipt of any notice, indictment, pleading, or other communication alleging a condition that: (a) may require the Company to undertake or to contribute to a clean-up or other response under any environmental Law, or which seeks penalties, damages, injunctive relief, or other relief as a result of an alleged violation of any such Law, or which claims personal injury or property damage as a result of environmental factors or conditions; and (b) if true or proven, could have a Material Adverse Effect or result in criminal sanctions; and (4) the occurrence of any other event or matter (including the rendering of any order, judgment, ruling and the like) which could reasonably be expected to have a Material Adverse Effect.

(E)           Notice of Default. Promptly after becoming aware thereof, notice of the occurrence of a Default or an Event of Default.

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(F)           Notice of the Acquisition of Property. Promptly after acquiring same, notice of the acquisition of any real property in a transaction involving consideration of at least $50,000.

(G)          Notice of Certain Events.  Notice of each of the following at least 30 (or, in the case of clause (2) below, 10) days prior thereto: (1) any change in the Company’s name, structure or organizational identification number; provided, however, that the Company may not effect any such change unless the Company, at its expense, takes all action required by CoBank to enable CoBank to maintain the perfection of its Lien; (2) any change in the principal place of business of the Company or the office where its records concerning its accounts are kept; or (3) any change in its Deposit Account or Accounts; provided, however, that: (i) if the Company uses the same Depository Bank and such Depository Bank and the Company acknowledges to CoBank in writing on or before the date of the change that the agreement referred to in Section 3.01(F)(2) covers the new Deposit Account or Accounts, then no prior notice shall be required; and (ii) the Company may not effect any such change unless the new Depository Bank has entered into an agreement of the type referred to in Section 3.01(F).

(H)          Other Notices.  Such other notices as may be required by any Promissory Note and Supplement or any other Loan Document.

(I)            Southwest Financial Statements. As soon as available, but in no event more than 120 days after the end of each fiscal year of Southwest occurring during the term hereof, annual consolidated financial statements of Southwest and its consolidated subsidiaries prepared in accordance with GAAP consistently applied and the related consolidating financial statements.  Such financial statements shall: (a) in the case of the consolidated statements, be audited by a nationally recognized firm of independent certified public accountants selected by Southwest; (b) in the case of the consolidated statements, be accompanied by a report of such accountants containing an opinion on such statements to the effect that such statements: (i) were audited in accordance with generally accepted auditing standards; and (ii) present fairly, in all material respects, the financial position of Southwest and its consolidated subsidiaries as at the end of the year and the results of its and their operations for the year then ended, in conformity with GAAP; (c) be prepared in reasonable detail and in comparative form; and (d) include a balance sheet, a statement of income, a statement of retained earnings, a statement of cash flows, and all notes and schedules relating thereto (including all consolidating schedules).

(J)           Other Information.  Such other information regarding the condition or operations, financial or otherwise, of the Company as CoBank may from time to time reasonably request, including, but not limited to, copies of all pleadings, notices and communications referred to in Section 5.06(D) hereof.

SECTION 5.07.    Conduct of Business. Engage in an efficient and economical manner in the business conducted by it.

SECTION 5.08.    Capital.  Acquire non-voting participation certificates in CoBank in such amounts and at such times as CoBank may from time to time require in accordance with its bylaws and capital plan (as each may be amended from time to time), except that the maximum amount of certificates that the Company may be required to purchase in connection with a Loan may not exceed the maximum amount permitted by the bylaws at the time the Promissory Note and Supplement relating to such Loan is

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entered into or such Loan is renewed or refinanced by CoBank.  The rights and obligations of the parties with respect to such certificates and any patronage or other distributions made by CoBank shall be governed by CoBank’s bylaws.

SECTION 5.09.    Inspection.  Permit CoBank or its agents, upon reasonable notice and during normal business hours or at such other times as the parties may agree, to examine the properties, books and records of the Company, and to discuss its or their affairs, finances and accounts with its or their officers, directors, and independent certified public accountants; provided, however, that unless an Event of Default has occurred and is continuing, the Company shall not be required to pay the expenses for more than one such visit per year.

SECTION 5.10.    Water Rights, Title to Property, Etc.  Obtain and maintain: (A) water rights and discharge rights in such amounts, priorities and qualities as are necessary at all time to adequately service the customers in its service territories; and (B) title to, or valid easement or leasehold interests in, all real property, including all real property on which all water wells, pumping stations, treatment plants, and storage facilities are located.

SECTION 5.11.    Deposit Account.  Maintain at all times, one or more Deposit Accounts in its own name and deposit all of its revenues and the proceeds of the collateral therein.

ARTICLE 6

NEGATIVE COVENANTS

Unless otherwise agreed to in writing by CoBank, while this Agreement is in effect, the Company will not:

SECTION 6.01.    Liens.  Create, incur, assume, or suffer to exist any Lien on any of its properties, except:

(A) Liens in favor of CoBank;

(B) Liens for taxes or assessments or other governmental charges or levies if not delinquent or, if delinquent: (i) the Company is contesting same in good faith by appropriate proceedings; (ii) the Company has established and maintains reserves in amounts required in accordance with GAAP; and (iii) foreclosure or other action to enforce the Lien is stayed.

(C) Liens in favor of mechanics, landlords, material suppliers, warehouses, carriers, and like Persons that secure obligations that are not past due or if past due: (1) no foreclosure or other action to enforce the Liens have been commenced or, if commenced, have been stayed; and (2) if the property is material to the operations of the Company’s business as a whole or to the operations of any one of the Company’s water or wastewater systems, reserves have been established and maintained in accordance with GAAP.

(D) Liens under workers’ compensation, unemployment insurance, Social Security, or similar legislation (other than ERISA).

(E)  Deposits and pledges to secure the performance of bids, tenders, contracts (other than contracts for the payment of money), public and statutory obligations, surety, stay,

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appeal, indemnity, performance or other similar bonds, or other similar obligations, in each case arising in the ordinary course of business.

(F) Judgment and similar Liens arising in connection with court proceeding, provided that: (1) no Event of Default arises under Section 8.07 hereof; and (2)  the claims secured thereby are being actively contested in good faith and by appropriate proceedings; and (3) reserves have been established and maintained in accordance with GAAP.

(G) Easements, rights-of-way, restrictions, and other similar encumbrances which, in the aggregate, do not materially interfere with the occupation, use, and enjoyment by the Company of the property or assets encumbered thereby in the normal course of its business or materially impair the value of the property subject thereto.

(H)  Purchase money Liens on, or Capital Leases with respect to,  rolling stock, equipment, and the proceeds thereof, provided that the debt secured by such purchase money Liens and such Capital Leases is permitted under Section 6.02 hereof.

(I)   Purchase money Liens on water or sewer system assets, acquired with seller financing  permitted under Section 6.02 hereof, and on the proceeds received on the sale thereof (but not any account or revenues derived therefrom unless the acquired system is maintained in a permitted Subsidiary).

SECTION 6.02.    Debt.  Create, incur, assume, or suffer to exist, any indebtedness of liability for borrowed money, the deferred purchase price of property or services, or for letters of credit, except for: (A) debt of the Company to CoBank; (B) accounts payable to trade creditors incurred in the ordinary course of business; (C) purchase money debt on, and Capital Leases with respect to, rolling stock and equipment; provided, however, that the maximum principal amount of purchase money debt on, or Capital Leases with respect to, equipment may not exceed $500,000 at any one time; (D) loans and advances from Southwest or any subsidiary of Southwest; provided, however, that such debt is subordinate to all Loans made by CoBank on terms and conditions reasonably acceptable to CoBank; (E) purchase money debt owing to the sellers of assets of water and/or wastewater systems in a principal amount not to exceed $5,000,000 at any one time outstanding; and (F) other current operating liabilities (other than for borrowed money) incurred in the ordinary course of business.

SECTION 6.03.    Sale, Transfer or Lease of Assets.  Sell, transfer, lease or otherwise dispose of any of its assets except for: (A) the sale of water and wastewater services in the ordinary course of business; (B) the sale, lease or other disposition of property or equipment which is obsolete, worn-out or no longer necessary for, or useful in, the provision of water and wastewater services to customers in its service territories; and (C) provided no Default or Event of Default exists: (i) the sale or other disposition of water rights or wastewater discharge rights which are not needed in the operations of the Company or to meet the expected future demands of the Company; and (ii) other sales, transfers, leases or other dispositions in an aggregate amount not to exceed $500,000 in any fiscal year. At the request and expense of the Company, CoBank will release its Lien on any property or equipment which is disposed of by the Company pursuant to this Section 6.03.

SECTION 6.04.    Distributions.  Declare or pay, directly or indirectly, any Distribution, except that, as long as no Default or Event of Default shall have occurred and be

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continuing or would result therefrom, the Company can pay Distributions in cash not more than once a quarter; provided, however, that in no event may the Company make a Distribution unless, after giving effect thereto: (1) the Net Worth of the Company would be equal to or greater than the Net Worth of the Company on December 31, 2001; and (2) the ratio of the Company’s Total Debt to Total Capitalization would not be greater than .60 to 1.00.

SECTION 6.05.    Contingent Liabilities. Assume, guarantee, endorse, or otherwise be or become directly or contingently responsible or liable for the obligations of any Person (including by means of an agreement to: (A) purchase any obligation, stock, assets, or services; (B) supply or advance any funds, assets, or services; or (C) cause any Person to maintain a minimum working capital or net worth or other financial test), except: (1) by endorsement of negotiable instruments for deposit or collection or similar transactions in the ordinary course of business; (2) guaranties for the benefit of suppliers (other than Affiliates) in the ordinary course of business; and (3) in the event the Company acquires the assets of any water system, guaranties issued by the seller of those assets prior to (and not in anticipation of) the acquisition of the water system and assumed by the Company in connection with the acquisition; provided, however, that the maximum amount of debt or other obligations that may be guarantied any one time under Subsections (2) and (3) hereof may not exceed $1,000,000.

SECTION 6.06.    Mergers, Etc.  Merge or consolidate with any other Person or acquire all or a material part of the assets of any other Person; provided, however, that the Company may: (i) acquire water and/or wastewater systems in the State of Texas; or (ii) merge with another Person that is engaged principally in the business of owing and operating water and/or wastewater systems in the State of Texas, as long as: (A) in the case of a merger, the Company is the surviving entity; (B) after giving effect thereto, no Default or Event of Default would exist, including as a result of a violation of Section 7.03 hereof; (C) on a combined basis, the Company would have been able to meet the financial covenants set forth in Section 7.01 and 7.02 hereof for the 12 month period ending with the end of the last fiscal quarter of the Company had such merger or acquisition taken place at the beginning of such 12 month period; and (D) not less than 30 days prior to the effective date thereof, the Company furnishes written notice to CoBank of such acquisition and merger and certifies to CoBank that each of the conditions set forth in this Section have been met.

SECTION 6.07.    Change in Business. Engage in any business activities or operations substantially different from or unrelated to its present business activities or operations.

SECTION 6.08.    Prepayment; Payments on Debt To Southwest.  While any Default or Event of Default shall have occurred and be continuing: (A) prepay, directly or indirectly, any debt (other than debt to CoBank); or (B) make any payments on any debt owing to Southwest.

SECTION 6.09     Loans and Investments.  Make any loan or advance to, or purchase or otherwise acquire any capital stock, obligations, or other securities of, make any capital contribution to, or otherwise invest in or acquire any interest in, any Person, or participate as a partner or joint venture with any other Person (collectively, “Investments”), except:  (A) direct obligations of the United States or any agency thereof with maturities of six (6) monthsor lessfrom the date of acquisition; (B) commercial paper of a domestic issuer rated at least “A-1” by Standard & Poor’s Corporation or “P-1” by Moody’s Investors Service, Inc.;

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(C) certificates of deposit with maturities of six (6) monthsor less from the date of acquisition issued by any commercial bank having capital and surplus in excess of $500 million; (D) Investments in CoBank; (E) repurchase agreements for investments of the types referred to in clause (A) hereof entered into by Company with a bank or trust company or recognized securities dealer having capital and surplus in excess of $500 million; (F) variable or fixed rate notes issued by any issuer rated as least A-1 by Standard & Poor’s Corporation or at least P-1 by Moody’s Investors Services, Inc. and maturing within six (6) months or less from the date of acquisition; (G) money market funds which invest primarily in assets of the types referred to in clauses (A) through (G); and (H) as long as no Default or Event of Default exists, loans and advances to Southwest that are payable upon demand.

SECTION 6.10.    Certain Agreements.  Amend, alter, waive any provision of, breach or terminate any agreement if such action could reasonably be expected to have a Material Adverse Effect.

SECTION 6.11.    Transactions with Affiliates.  Enter into any transaction with an Affiliate: (A) except in the ordinary course of and pursuant to the reasonable requirements of its business and upon fair and reasonable terms no less favorable to the Company than would obtain in a comparable arm’s-length transaction with a Person not an Affiliate; and (B) unless, in the case of contracts that provide for the ongoing operation or management of any portion of the Company, the Company furnishes notice thereof to CoBank not less than 10 Business Days before the date of such agreement and, if requested by CoBank, the Company and Affiliate enter into a consent and agreement with CoBank in form and content substantially similar to the agreements delivered pursuant to Section 3.01(H).

SECTION 6.12.    Subsidiaries, Etc.  Notwithstanding any other provision hereof: (A) permit TWC Utility Company, LLC to conduct any business or acquire any assets; (B) form or create any new Subsidiary; or (C) commence operations under any other name or in any joint venture.

ARTICLE 7

FINANCIAL COVENANTS

Unless otherwise agreed to in writing by CoBank, while this Agreement is in effect:

SECTION 7.01.    Debt Service Coverage Ratio. The Company and its consolidated Subsidiaries shall have for each fiscal year of the Company, a Debt Service Coverage Ratio of not less than 1.25 to 1:00.

SECTION 7.02.    Total Debt to EBITDA Ratio. The Company and its consolidated Subsidiaries shall have a ratio of Total Debt at the end of each fiscal year of the Company shown below to EBITDA for each fiscal year of the Company shown below of not greater than the ratio shown next to each fiscal year shown below:

Fiscal Year	Ratio
2005 through 2008	10 to 1
2009 and thereafter	8 to 1

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SECTION 7.03.    Total Debt to Capitalization Ratio.  The Company and its consolidated Subsidiaries shall have at the end of each fiscal quarter of the Company, a ratio of Total Debt to Total Capitalization of not more than .60 to 1.00.

SECTION 7.04.    Fiscal Year. The Company will not change its fiscal year.

ARTICLE 8

EVENTS OF DEFAULT

Each of the following shall constitute an “Event of Default” hereunder:

SECTION 8.01.    Payment Default.  The Company should fail to make when due any payment to CoBank hereunder, under any Promissory Note and Supplement, or under any other Loan Document, and such failure continues for five (5) days after written notice thereof shall have been delivered to the Company by CoBank; provided, however, that CoBank shall not be required to give the Company notice and an opportunity to cure: (A) more than twice in any consecutive 12 month period; or (B) if one or more other Events of Default shall have occurred and be continuing at the time the payment was due.

SECTION 8.02.    Representations and Warranties. Any opinion, certificate or like document furnished to CoBank by or on behalf of the Company, or any representation or warranty made or deemed made by the Company herein or in any other Loan Document, shall prove to have been false or misleading in any material respect on or as of the date furnished, made or deemed made.

SECTION 8.03.    Covenants.  The Company should fail to perform or comply with any covenant set forth in Articles 5 or 6 hereof (other than Sections 5.01, 5.06(E), 6.03, 6.04, 6.06, 6.08, and 6.09 hereof) or any other covenant or agreement contained herein (other than Section 7.01) or in any Promissory Note and Supplement and such failure continues for 30 days after written notice thereof shall have been delivered to the Company by CoBank.

SECTION 8.04.    Other Covenants and Agreements.  The Company should fail to perform or comply with Sections 5.06(E), 6.03, 6.04, 6.06, 6.08,  6.09, or 7.01  hereof, or shall use the proceeds of any Loan for any unauthorized purpose.

SECTION 8.05.    Cross Default. The Company should breach or be in default under the terms of any Loan Document or other agreement with CoBank and such default continues for the longer of:  (A) any grace period set forth in such Loan Document or other agreement, or (B) 30 days after written notice thereof shall have been delivered to the Company by CoBank; provided, however, that if any other Subsection of this Article 8 does not provide a grace period for such default or provides a shorter grace period for such default, then no grace period or such shorter grace period shall control.

SECTION 8.06.    Other Indebtedness.  The Company’s obligation to repay any indebtedness for borrowed money or for the deferred purchase price of property or services in an amount in excess of $500,000 shall be accelerated or declared due and payable prior to its

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scheduled due date as a result of the occurrence of any breach or default under any agreement relating to such indebtedness or obligation.

SECTION 8.07.    Judgments.  One or more judgments, decrees, or orders for the payment of money in excess of $500,000 in the aggregate shall have been rendered against the Company and either: (A) enforcement proceedings shall have been commenced; or (B) such judgments, decrees, or orders shall continue unsatisfied and in effect for a period of 30 consecutive days without being vacated, bonded, discharged, satisfied, or stayed pending appeal.

SECTION 8.08.    Insolvency, Etc. The Company shall: (A) become insolvent or shall generally not, or shall be unable to, or shall admit in writing its inability to, pay its debts as they become due; or (B) suspend its business operations or a material part thereof; or (C) apply for, consent to, or acquiesce in the appointment of a trustee, receiver, or other custodian for it or any of its property; or (D) have commenced against it any action or proceeding for the appointment of a trustee, receiver, or other custodian, or a trustee, receiver, or other custodian is appointed for all or any part of its property; (E) have commenced against it any proceeding under any bankruptcy, reorganization, arrangement, readjustment of debt, dissolution, or liquidation law of any jurisdiction; or (F) make an assignment for the benefit of creditors or commence any proceeding under any bankruptcy, reorganization, arrangement, readjustment of debt, dissolution, or liquidation law of any jurisdiction.

SECTION 8.09.    Casualty or Condemnation.   All or a material portion of the assets of the Company: (1) is destroyed in an uninsured casualty or like event (regardless of the cause); or (2) is taken in a condemnation action or proceeding or in a like proceeding or is sold or otherwise transferred in lieu thereof or pursuant to any right of any governmental authority to direct the sale of transfer thereof.

SECTION 8.10.    Ownership. Any of the following take place without the prior written consent of CoBank: (A) Texas Water Services Group, LLC shall cease to be a general partner in the Company, or one or more new general partners are added to the Company; (B) Southwest  and/or other Persons owned 100% directly or indirectly by Southwest should cease to be the only limited partners in the Company; or (C) Southwest  and/or other Persons owned 100% directly or indirectly by Southwest should cease to own, directly or indirectly, 100% of the membership interests and other equity interests in Texas Water Services Group, LLC.

SECTION 8.11.    Affiliates. (A) A Relevant Affiliate breaches or is otherwise in default in any material respect under a Relevant Agreement; (B) Southwest, any general partner in the Company, or any Subsidiary of the Company becomes subject to an event of the type referred to in Section 8.06, 8.07 or 8.08 hereof (including, for avoidance of doubt, the dollar amounts specified therein; provided that if any such Person is subject to Indebtedness and the documents entered into in connection with such Indebtedness contain cross default or cross acceleration provisions for other Indebtedness of such Person, the dollar amounts for purposes of this clause (B) shall be the dollar amounts in such documents rather than the dollar amounts in this Agreement); (C) any Person which succeeds to the direct ownership of any general partner in the Company should become subject to an event of the type referred to in Section 8.08 hereof; or (D) within thirty (30) days after a Relevant Affiliate (other than Southwest or a Subsidiary) becomes subject to an Event of the type referred to in Section 8.06, 8.07 or 8.08 hereof, the Company fails to provide CoBank with assurance reasonably satisfactory to CoBank that the services furnishes to the Company by such Relevant Affiliate will continue without interruption,

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whether by the Relevant Affiliate or another entity (it being agreed that until such assurance is provided, CoBank shall have the right to suspend making further Loans to the Company).

SECTION 8.12.    Existence, Etc. The Company shall: (A) fail to preserve and maintain its existence and good standing in the jurisdiction of its formation or fail to qualify and remain qualified to transact business in all jurisdictions where failure to maintain such qualification could reasonably be expected to have a Material Adverse Effect; or (B) fail to obtain and/or maintain any governmental license, permit, franchise or the like which is material to its business or required by Law; provided, however, that such failure shall not be considered to be an Event of Default if: (i) the Company made timely application for same, such application has not been rejected, and the Company is diligently pursuing the acquisition of same; and (ii) no governmental authority or other Person has required the Company to discontinue the operations governed by the license, permit, franchise or other right, or has commenced any Enforcement Action  against the Company or taken any other action which could reasonably be expected to have a Material Adverse Effect on the Company for or on account of the failure; and (C) fail to obtain and maintain any other franchise or any patent, copyrights, trademark, tradename or right thereto which is material to the conduct of its business or required by Law and the failure to obtain or maintain such other franchise or such patent, copyright, trademark, tradename or right thereto continues for 30 days after written notice shall have been furnished by CoBank to the Company.

SECTION 8.13.    Title Insurance.  Republic Title or any title insurance company providing coverage to CoBank for or on account of any Loans shall breach or otherwise be in default under any commitment or other agreement with CoBank and such breach is not cured within 30 days after CoBank shall have furnished notice of same to the Company and Republic Title or other title insurance company.

SECTION 8.14.    Partnership Agreement. The Partnership Agreement is amended without CoBank’s consent.

ARTICLE 9

REMEDIES UPON DEFAULT

SECTION 9.01.  Remedies.  Upon the occurrence and during the continuance of a Default or Event of Default, CoBank shall have no obligation to make any Loan to the Company and may discontinue doing so at any time without prior notice. In addition, upon the occurrence and during the continuance of an Event of Default, CoBank may, upon notice to the Company:

(A)          Termination and Acceleration. Terminate any commitment and declare the unpaid principal balance of the Loans, all accrued interest thereon, and all other amounts payable under this Agreement, the Promissory Notes and Supplements, and all other Loan Documents to be immediately due and payable; provided, however, that upon the occurrence of an Event of Default under Section 8.08(F), any commitments shall automatically be terminated and all such amounts shall automatically become due and payable. Upon such a declaration (or automatically, as provided above), the unpaid principal balance of the Loans and all such other amounts shall become immediately due and payable, without protest, presentment, demand, or further notice of any kind, all of which are hereby expressly waived by the Company.

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(B)          Enforcement.   Proceed to protect, exercise, and enforce such rights and remedies as may be provided by this Agreement, any other Loan Document, or under Law. Each and every one of such rights and remedies shall be cumulative and may be exercised from time to time, and no failure on the part of CoBank to exercise, and no delay in exercising, any right or remedy shall operate as a waiver thereof, and no single or partial exercise of any right or remedy shall preclude any future or other exercise thereof, or the exercise of any other right. Without limiting the foregoing, CoBank may hold and/or set off and apply against the Company’s obligations to CoBank the proceeds of any equity in CoBank, any cash collateral held by CoBank, or any other balances held by CoBank for the Company’s account (whether or not such balances are then due).

(C)          Application of Funds.   Apply all payments received by it to the Company’s obligations to CoBank in such order and manner as CoBank may elect in its sole discretion.

In addition to the rights and remedies set forth above and notwithstanding the terms of any Promissory Note and Supplement, upon the occurrence and during the continuance of an Event of Default,  at CoBank’s option in each instance (and automatically following an acceleration), interest on the unpaid principal balance of the Loans and, to the extent permitted by Law, overdue interest, fees and other charges,  shall bear interest  at the Default Rate. All such interest, together with all overdue amounts, shall be payable on demand.

ARTICLE 10

MISCELLANEOUS

SECTION 10.01.   Broken Funding Surcharge.  The Company agrees that in the event it repays any Loan balance bearing interest at a fixed rate prior to the last day of the fixed rate period relating thereto (whether such payment is made voluntarily, as a result of an acceleration, or otherwise), or fails to borrow any fixed rate balance on the date scheduled therefor, the Company will pay to CoBank a surcharge in the amount set forth in (or in an amount calculated in accordance with) the Promissory Note and Supplement relating thereto. Notwithstanding the foregoing: (A) if for any reason any Promissory Note and Supplement executed after the date hereof fails to contain a surcharge, then the applicable surcharge shall be the surcharge set forth in the Promissory Note and Supplement dated as of May 1, 2002 and numbered ML0936T1 (which reference shall survive the repayment and termination of that Promissory Note and Supplement); and (B) in the event the parties enter into a forward fixed rate agreement or other agreement regarding interest rate products, and such agreement provides for a different surcharge, then such other agreement shall control.

SECTION 10.02.  Complete Agreement, Amendments, Etc.  The Loan Documents are intended by the parties to be a complete and final expression of their agreement. No amendment or modification of this Agreement or the other Loan documents shall be effective unless approved in writing by the Company and CoBank and no waiver of any provision of the Loan Documents, and no consent to any departure by the Company herefrom or therefrom, shall be effective unless approved by CoBank and contained in a writing signed by or on behalf of CoBank, and then such waiver or consent shall be effective only in the specific instance and for the specific purpose for which given. In the event this Agreement is amended or restated, each such amendment or restatement shall be applicable to all Promissory Notes and Supplements hereto. Each Promissory Note and Supplement shall be deemed to incorporate all of the terms and conditions of this Agreement as if fully set forth therein.

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SECTION 10.03.   Applicable Law, Jurisdiction. Except to the extent governed by applicable federal Law, this Agreement and each Promissory Note and Supplement shall be governed by the Laws of the State of Colorado, without reference to choice of law doctrine. The parties agree to submit to the non-exclusive jurisdiction of any federal or state court sitting in Colorado for any action or proceeding arising out of or relating to this Agreement or any other Loan Document. The Company hereby waives any objection that it may have to any such action or proceeding on the basis of forum non-conveniens.

SECTION 10.04.   Notices. All notices hereunder shall be in writing and shall be deemed to have been duly given upon delivery if personally delivered or sent by overnight mail or by facsimile or similar transmission, or three (3) days after mailing if sent by express, certified or registered mail, to the parties at the following addresses (or such other address as either party may specify by like notice):

If to CoBank, as follows:	If to the Company, as follows:
CoBank, ACB	Southwest Water Company.
5500 South Quebec Street	One Wilshire Building, 29th floor
Greenwood Village, Colorado 80111	624 South Grand Ave, Suite 2900
Facsimile: (303) 740-4002	Los Angeles, CA 90017
Attention: Energy Banking Group	Facsimile: (213) 929-1888
	Attention: Chief Financial Officer

SECTION 10.05.  Costs, Expenses, and Taxes.  To the extent allowed by Law, the Company agrees to pay all reasonable out-of-pocket costs and expenses (including the fees and expenses of counsel retained or employed by CoBank) incurred by CoBank in connection with the origination, administration, interpretation, collection, and enforcement of this Agreement and the other Loan Documents, including, without limitation, all costs and expenses incurred in perfecting, maintaining, determining the priority of, and releasing any security for the Company’s obligations to CoBank, and any stamp, intangible, transfer or like tax incurred in connection with this Agreement or any other Loan Document or the recording hereof or thereof.

SECTION 10.06.   Effectiveness and Severability.  This Agreement shall continue in effect until: (A) all indebtedness and obligations of the Company under this Agreement and the other Loan Documents shall have been paid or satisfied; (B) CoBank has no commitment to extend credit to or for the account of the Company under any Promissory Note and Supplement; (C) all Promissory Notes and Supplements shall have been terminated; and (D) either party sends written notice to the other party terminating this Agreement. Any provision of this Agreement or any other Loan Document which is prohibited or unenforceable shall be ineffective to the extent of such prohibition or unenforceability without invalidating the remaining provisions hereof or thereof.

SECTION 10.07.  Successors and Assigns.  This Agreement and the other Loan Documents shall be binding upon and inure to the benefit of the Company and CoBank and their respective successors and assigns, except that the Company may not assign or transfer its rights or obligations under this Agreement or the other Loan Documents without the prior written consent of CoBank. From time to time, CoBank may sell a participation in one or more of the

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Loans. However, no such participation shall relieve CoBank of any commitment made to the Company hereunder.  In connection with the foregoing, CoBank may disclose information concerning the Company and its Subsidiaries, if any, to any participant or prospective participant, provided that such participant or prospective participant agrees, subject to normal qualifications, to keep all non-public information confidential.  A sale of a participation interest may include certain voting rights of the participants regarding the Loans hereunder (including without limitation the administration, servicing and enforcement thereof).  CoBank agrees to give written notification to the Company of any sale of a participation interest.

SECTION 10.08. Headings.  Captions and headings used in this Agreement are for reference and convenience of the parties only, and shall not constitute a part of this Agreement.

IN WITNESS WHEREOF, the parties have caused this Agreement to be executed by their duly authorized officers as of the date shown above.

CoBANK, ACB		MONARCH UTILITIES I L.P.
		a Texas limited partnership
		By: Texas Water Services Group, LLC
		a Texas limited liability company
		Its: General Partner
By:	/s/ Penny Probasco	By:	/s/ Michael O. Quinn
Title:	Assistant Corporate Secretary	Title:	President

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EXHIBIT A

DEFINITIONS AND RULES OF INTERPRETATION

SECTION 1.01 Definitions.  As used in the Agreement, any amendment thereto, or in any Promissory Note and Supplement, the following terms shall have the following meanings:

Affiliate shall mean any Person: (1) which directly or indirectly controls, or is controlled by, or is under common control with, the Company, Monarch Utilities, Inc., or Southwest; (2) which directly or indirectly beneficially owns or holds five percent (5%) or more of any class of voting stock of, or other interests in, the Company,  Monarch Utilities, Inc., or Southwest; or (3) five percent (5%) or more of the voting stock of, or other interest in, which is directly or indirectly beneficially owned or held by the Company, Monarch Utilities, Inc., or Southwest. The term “control” means the possession, directly or indirectly, of the power to direct or cause the direction of the management and policies of a Person, whether through the ownership of voting securities, by contract or otherwise.

Agreement  shall mean the Amended and Restated Master Loan Agreement dated as of September 12, 2005, between the Company and CoBank, as it may be amended or modified from time to time.

Assets shall mean total assets, as computed in accordance with GAAP consistently applied.

Business Day  means any day other than a Saturday, Sunday, or other day on which CoBank or the Federal Reserve Banks is closed for business.

Capital Lease shall mean a lease which should be capitalized on the books of the lessee in accordance with GAAP.

Certified Copies shall mean copies, certified true and correct and in full force and effect as of the date of certification, by the secretary or other officer acceptable to CoBank of the Person furnishing same.

Closing Agreement shall have the meaning set forth in Section 3.01(G) of the Agreement.

CoBank shall mean CoBank, ACB and its successors and assigns.

CoBank Base Rate shall mean the rate of interest established by CoBank from time to time as the CoBank Base Rate, which Rate is intended by CoBank to be a reference rate and not its lowest rate. The CoBank Base Rate shall change on the date established by CoBank as the effective date of each change in the CoBank Base Rate.

Company shall mean Monarch Utilities I L.P. and its permitted successors and assigns.

Debt Service Coverage Ratio shall mean a ratio of: (1) net income (after taxes and after eliminating any gain or loss on sale of assets or other extraordinary gain or loss), plus depreciation expense, amortization expense, and total interest expense, minus non-cash patronage and non-cash income from Subsidiaries and/or joint ventures; to (2) all principal payments due or, in the case of amounts paid on guaranties of indebtedness, otherwise made, within the period on all Long-Term Debt,

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plus total interest expense, plus Distributions (all as calculated on a consolidated basis for the applicable period in accordance with GAAP consistently applied).

Debt To Capitalization Ratio shall mean a ratio of Total Debt at the end of the fiscal year to Total Capitalization at the end of the fiscal year.

Deed of Trust  shall mean that certain Deed of Trust, Security Agreement And Assignment of Rents and Leases dated as of May 1, 2002, among the Company, as Grantor and Trustor, and Steve Moore, as Trustee for the benefit of CoBank.

Deed of Trust Amendment shall have the meaning set forth in Section 2.01(G) of the Agreement.

Default shall mean the occurrence of any event which with the giving of notice or the passage of time would become an Event of Default under the Agreement, including the occurrence of an event giving rise to the right to accelerate any indebtedness referred to in Section 8.06 of the Agreement (whether or not such right is conditioned upon the giving of notice and/or the passage of time and/or the occurrence of any other condition).

Default Rate shall mean 3% per annum in excess of the rate or rates that would otherwise be in effect under the terms of the Promissory Note and Supplement, except that in the case of overdue interest, fees, and, prior to the final maturity of a Loan (whether as a result of acceleration or otherwise) principal, the term Default Rate shall mean 3% per annum in excess of any variable rate option provided in the Promissory Note and Supplement, or, in the event no such option is provided, 3% per annum in excess of the rate established by CoBank from time to time during that period as  the CoBank Base Rate.

Deposit Account shall mean a demand deposit account maintained at an federally  insured financial institution.

Distribution shall mean the: (1) payment of any dividend or distribution of any kind, whether in cash, assets, obligations or otherwise; and (2) the acquisition by the Company of any general or limited partnership interest in the Company.

Dollars and the sign “$” shall mean lawful money of the United States of America.

EBITDA  shall mean, for the Company, on a consolidated basis, operating revenues minus operating expenses, plus depreciation and amortization expenses (all as calculated for the fiscal year being measured on a consolidated basis in accordance with GAAP consistently applied).

Enforcement Action shall mean a formal judicial or administrative proceeding  filed by the TCEQ,  the Attorney General of Texas, or any  governmental authority to enforce any Law.

Equity shall mean total assets minus total liabilities, as computed in accordance with GAAP consistently applied.

ERISA shall mean the Employee Retirement Income Security Act of 1974, as amended from time to time, and the regulations and published interpretations thereof.

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ERISA Affiliate means any trade or business (whether or not incorporated) that is treated as a single employer together with the Company under section 414 of the Internal Revenue Code of 1986, as amended from time to time, and the rules and regulations promulgated thereunder from time to time.

Event of Default shall mean any of the events specified in Article 8 of the Agreement and any event specified in any Promissory Note and Supplement or other Loan Document as an Event of Default.

Existing MLA shall have the meaning set forth in the Background to the Agreement.

Existing Promissory Notes and Supplements shall have the meaning given in Section 2.01 of the Agreement.

GAAP shall mean generally accepted accounting principles in the United States.

Laws  shall mean all laws, rules, regulations, codes, orders and the like.

Lien shall mean any mortgage, deed of trust, pledge, security interest, hypothecation, assignment, deposit arrangement, encumbrance, lien (statutory or other), or preference, priority or other security agreement or preferential arrangement, charge or encumbrance of any kind or nature whatsoever (including, without limitation, any conditional sale or other title retention agreement).

Loan shall mean a loan and/or other type of credit made to or for the account of the Company, including letters of credit, all as described in the Promissory Note and Supplement relating to that Loan.

Loan Documents shall mean this Agreement, all Promissory Notes and Supplements hereto, and all instruments or documents relating to this Agreement or the Promissory Notes and Supplements, including, without limitation, all applications, certificates,  mortgages, deeds of trust, security agreements, guaranties, and pledge agreements.

Long Term Debt  shall mean, for the Company and its consolidated Subsidiaries,  (a) all indebtedness for borrowed money, (b) obligations which are evidenced by notes, bonds, debentures or similar instruments, (c) that portion of obligations with respect to capital leases or other capitalized agreements that are properly classified as a liability on a balance sheet in conformity with GAAP, and (d) indebtedness which is guarantied by the Company, in each case having a maturity of more than one year from the date of its creation or having a maturity within one year from such date but that is renewable or extendible, at the Company’s or any Subsidiary’s option (or, in the case of any debt which is guarantied, at the option of the obligor or the Person to whom the guaranty is furnished), to a date more than one year from such date or that arises under a revolving credit or similar agreement that obligates the lender(s) to extend credit during a period of more than one year from such date, including all current maturities in respect of such indebtedness whether or not required to be paid within one year from the date of its creation.

Material Adverse Effect shall mean a material adverse effect on the condition, financial or otherwise, operations, properties, margins or business of the Company or any Subsidiary or on the ability of the Company or any Subsidiary to perform its obligations under the Loan Documents.

Net Worth shall mean total assets minus total liabilities of the Company (both as determined on a consolidated basis in accordance with GAAP consistently applied), except that in determining Net Worth: (1) contributions in aid of construction, advances for construction, customer deposits, or similar

3

items reducing rate base calculations shall be excluded; and (2) all indebtedness which is guarantied shall be included in total liabilities.

Organizational Documents shall mean, as relevant: (A) articles or certificate of incorporation or formation (or equivalent documents); and (B) bylaws, partnership agreements, management agreements, shareholder agreements, voting trust agreements, and like instruments and documents.

Partnership Agreement  shall mean that certain Agreement of Limited Partnership of Tecon Water Company, L.P. dated as of December 10, 2001.

Person shall mean an individual, partnership, limited liability company, corporation, business trust, joint stock company, trust, unincorporated association, joint venture, governmental authority, or other entity of whatever nature.

Promissory Note and Supplement shall have the meaning set forth in Section 2.01 of the Agreement.

Relevant Affiliate shall mean Southwest, a Subsidiary and, while a party to a Relevant Agreement, another Affiliate.

Relevant Agreement shall mean an agreement that relates to the credit extended hereby and is between: (1) an Affiliate and the Company under which the Affiliate performs any service for or on behalf of the Company, including an agreement with respect to which the Affiliate has entered into an agreement with CoBank pursuant to Section 3.01(H) or has or may be require to enter into any agreement with CoBank under Section 6.11 of the Agreement; and (2) an Affiliate and CoBank (including any agreement referred to in Sections 3.01(H) and 6.11 of the Agreement and the agreement between Tecon Corporation and CoBank dated as of May 1, 2002 and assumed by Southwest pursuant to that certain Consent and Agreement dated as of July 13, 2004, among this Company (then known as Tecon Water Company, LP), Southwest and CoBank, as same may be amended or restated from time to time).

Short-Term Debt shall mean all debt which, under GAAP, should be classified as short-term debt.

Southwest shall mean Southwest Water Company, a Delaware corporation.

Subsidiary shall mean, as to the Company, a corporation, partnership, limited liability company, joint venture, or other Person of which shares of stock or other equity interests having ordinary voting power to elect a majority of the board of directors or other managers of such corporation, partnership, limited liability company, joint venture, or other Person are at the time owned, or the management of which is otherwise controlled, directly or indirectly, through one or more intermediaries, or both, by the Company.

TCEQ shall mean the Texas Commission on Environmental Quality and any governmental authority or authorities that succeed to the powers of the TCEQ.

Title Policy shall mean that certain Mortgagees Policy of Title Insurance dated May 5, 2002 and numbered 152187M, issued by First American Title Insurance Company.

Total Capitalization shall mean shall mean Total Debt plus Net Worth.

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Total Debt shall mean the sum of (a) all indebtedness for borrowed money, (b) obligations which are evidenced by notes, bonds, debentures or similar instruments, (c) that portion of obligations with respect to Capital Leases and other capitalized agreements that are properly classified as a liability on the balance sheet in conformity with GAAP; and (d) indebtedness and other obligations guarantied by the Company.

2005 Promissory Note and Supplement shall mean the Promissory Note and Supplement hereto dated as of the date hereof and bearing number RX0936T3

SECTION 1.02 Rules of Interpretation.  The following rules of interpretation shall apply to the Agreement, all Promissory Notes and Supplements, and all amendments to either of the foregoing:

Accounting Terms. All accounting terms not specifically defined herein shall be construed in accordance with GAAP, and all financial data submitted pursuant to this Agreement shall be prepared in accordance with such principles.

Number.  All terms stated in the singular shall include the plural, and all terms stated in the plural shall include the singular.

Including.  The term “including” shall mean including, but not limited to.

Default. The expression “while any Default or Event of Default shall have occurred and be continuing” (or like expression) shall be deemed to include the period following any acceleration of the Obligations (unless such acceleration is rescinded).

Permitted Encumbrances.  CoBank’s consent to the Company having one or more Liens on all or any portion of its assets shall not be construed to be an agreement to subordinate its Lien on those assets to the extent that such Lien is not otherwise entitled to priority under Law.

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EX-10.4.1

Exhibit 10.4.1

Loan No. ML0936T1

PROMISSORY NOTE AND SUPPLEMENT

THIS PROMISSORY NOTE AND SUPPLEMENT to the Master Loan Agreement dated as of May 1, 2002 (as amended or restated from time to time, the “MLA”) is entered into as of May 1, 2002, between TECON WATER COMPANY, L.P. (the “Company”) and CoBANK, ACB (“CoBank”).

SECTION 1. The Term Loan Commitment. On the terms and conditions set forth in the MLA and this Promissory Note and Supplement, CoBank agrees to make a loan (the “Loan”) to the Company in the principal amount of $15,400,000 (the “Commitment”). Under the Commitment, amounts borrowed and later repaid may not be reborrowed.

SECTION 2. Purpose. The purpose of the Commitment is to: (A) refinance the Company’s indebtedness to: (A) Bank One, NA; (B) W.C. Hankins; (C) Gary W. Hanning, Robin Hanning and the Gary W. Hanning Trust; (D) Associates Utility Company; (E) William E. Dark and Wanda M. Dark; (F) Ronald L. Payne; and (G) Highsaw Water Corporation (collectively, the “Existing Lenders”; and (B) finance general needs of the Company, and the Company agrees to use the proceeds of the Loan for those purposes.

SECTION 3. Term. The term of the Commitment shall be from the date hereof up to and including May 1, 2002, or such later date as CoBank may, in its sole discretion, authorize in writing.

SECTION 4. Availability. Notwithstanding Section 2.02 of the MLA and provided that all conditions precedent set forth herein and in the MLA shall have been satisfied, the Loan shall: (1) be made upon the receipt by CoBank of a written request therefor in the form attached hereto as Exhibit A signed by an authorized officer of the Company; and (2) be made directly to the “Title Company” (as hereinafter defined) pursuant to the “Closing Agreement” (as hereinafter defined).

SECTION 5. Interest. The Company agrees to pay interest on the unpaid principal balance of the Loan at 7.37% per annum. Interest shall be calculated on the actual number of days the Loan is outstanding on the basis of a year consisting of 360 days and shall be payable monthly in arrears by the 20^th day of the following month.

SECTION 6. Fees. In consideration of the Commitment, the Company agrees to pay to CoBank on the date hereof, a loan origination fee in the amount of $77,000 less the amount paid to CoBank on account of the Commitment pursuant to that certain letter agreement dated as of December 21, 2001, between the Company and CoBank.

SECTION 7. Promissory Note. The Company promises to repay the Loan in 240 consecutive, monthly installments in the amount of 64,166.66, payable on the 20^th day of each month, with the first such installment due on May 20, 2002; provided, however, that in the case of the last payment, such payment shall be in an amount equal to the then outstanding principal balance of the Loan. In addition to the above, the Company promises to pay interest on the unpaid principal balance of the Loans at the times and in accordance with the provisions set forth above and to pay any interest breakage surcharges as provided herein. Notwithstanding the foregoing, if any date on which principal and interest are due is not a “Business Day” (as defined

1

in the MLA), then such payment shall be due and payable on the next Business Day and, during such period, interest shall continue to accrue on the principal amount thereof.

SECTION 8. Security. The Company’s obligations hereunder and, to the extent related hereto, the MLA shall be secured as provided in Section 2.04 of the MLA.

SECTION 9. Prepayment. The Company may, on one CoBank Business Day’s prior written notice, prepay the Loan in whole or in part together with accrued interest on the amount prepaid to the date of payment and a surcharge equal to the present value of the sum of: (1) the difference, if (a) is larger than (b), between: (a) the rate estimated by CoBank in accordance with its standard methodology to be its all-in cost to fund the Loan; minus (b) the rate estimated by CoBank on the date of the prepayment (in accordance with its then standard methodology) to be its all-in cost to fund a new loan having a weighted average life equal to the weighted average life of the balance of the Loan being prepaid; plus (2) an amount equal to a yield of 1.5% on the amount being prepaid, calculated on a per annum basis through the final maturity of the Loan. In calculating the surcharge, the discount rate shall be the rate determined in accordance with (l)(b) above. All partial prepayments shall be applied to principal installments in the inverse order of their maturity.

SECTION 10. Conditions Precedent. In addition to the conditions precedent set forth in the MLA, CoBank’s obligation to make the initial loan hereunder is subject to the condition precedent that CoBank, the Company and Republic Title of Texas, Inc. (the “Title Company”) shall have entered into a closing or escrow agreement (the “Closing Agreement”) in form and content acceptable to CoBank prescribing conditions under which the proceeds of the Loan will be released or returned to CoBank. At a minimum, such conditions shall be designed to ensure CoBank that upon disbursement of the funds by the Title Company: (1) all assets of the Company will be free and clear of all Liens (other than Liens in favor of CoBank); and (2) all claims held by the Existing Lenders will be discharged.

IN WITNESS WHEREOF, the parties have caused this Promissory Note and Supplement to the MLA to be executed by their duly authorized officers as of the date shown above.

CoBANK, ACB		TECON WATER COMPANY, L.P.
		By: Texas Water Services Group, LLC,
		Its General Partner
By:	/s/ [ILLEGIBLE]	By:	/s/ J. G. Boyles
			J. G. Boyles
Title:	Vice President	Title:	President

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EX-10.4.2

Exhibit 10.4.2

Loan No. ML0936T1A

FIRST AMENDMENT TO PROMISSORY NOTE AND SUPPLEMENT

THIS FIRST AMENDMENT TO PROMISSORY NOTE AND SUPPLEMENT (this “Amendment”) is entered into as of September 12, 2005, between MONARCH UTILITIES I L.P. (formerly known as Tecon Water Company, L.P.), a Texas limited partnership (the “Company”), and CoBANK, ACB,  a federally chartered instrumentality of the United States(“CoBank”).

BACKGROUND

The Company and CoBank are parties to a Promissory Note and Supplement dated as of May 1, 2002 and numbered ML0936T1 (the “Supplement”). Since the date of the Supplement, the Company has changed its name from Tecon Water Company, L.P. to Monarch Utilities I L.P. The parties now desire to amend the Supplement to reflect the change in the Company’s name.

NOW, THEREFORE, for good and valuable other consideration, the receipt and sufficiency of which are hereby established, the parties agree as follows:

SECTION 1.         Amendment.  The name of the Company is hereby amended from “Tecon Water Company, L.P.” to “Monarch Utilities I L.P.”. Wherever in the Supplement the name “Tecon Water Company, L.P.” appears, it shall be deemed to mean “Monarch Utilities I L.P.”

SECTION 2.         Confirmation. This Amendment reflects the entire understanding between the parties with respect to the subject matter hereof. Except as modified hereby, the Supplement shall remain in full force and effect as written.

IN WITNESS WHEREOF, the parties have caused this Amendment to be executed as of the date shown above by their duly authorized officers:

CoBANK, ACB,
a federally chartered instrumentality
of the United States
By:	/s/ Illegible
Name:				Illegible
Title:		Vice President
MONARCH UTILITIES I L.P.,
a Texas limited partnership
By:			Texas Water Services Group, LLC,
			a Texas limited liability company
			General Partner
			By:		/s/ Shelley Farnham
			Name:				Shelley Farnham
			Title:			Vice President and Secretary

EX-10.4.3

Exhibit 10.4.3

Loan No. ML0936T2

PROMISSORY NOTE AND SUPPLEMENT

THIS PROMISSORY NOTE AND SUPPLEMENT to the Master Loan Agreement dated as of May 1, 2002 (as amended or restated from time to time, the “MLA”) is entered into as of May 1, 2002, between TECON WATER COMPANY, L.P. (the “Company”) and CoBANK, ACB (“CoBank”).

SECTION 1.   The Term Loan Commitment. On the terms and conditions set forth in the MLA and this Promissory Note and Supplement, CoBank agrees to make loans (each a “Loan”) to the Company from time to time during the period set forth below in an aggregate principal amount not to exceed $1,000,000 at any one time outstanding (the “Commitment”). Within the limits and during the term of the Commitment, the Company may borrow, repay and reborrow.

SECTION 2.   Purpose. The purpose of the Commitment is to finance general partnership needs of the Company, and the Company agrees to use the proceeds of the loans for those purposes.

SECTION 3.   Term. The term of the Commitment shall be from the date hereof up to but not including the first anniversary of the date hereof, or such later date as CoBank may, in its sole discretion, authorize in writing.

SECTION 4.   Availability. Loans will be made as provided in Section 2.02 of the MLA; provided, however, that no Loans will be made hereunder unless the loan contemplated in that certain Promissory Note and Supplement dated as of the date hereof and numbered ML0936Tl (the “First Supplement”) shall have been made by CoBank and disbursed by the “Title Company” as contemplated in the “Closing Agreement” (both as defined in the First Supplement).

SECTION 5.   Interest.

(A) Interest Rate Options. The Company agrees to pay interest on the unpaid principal balance of the Loans in accordance with one or more of the following interest rate options, as selected by the Company:

(1)           Weekly Variable Rate Option. At a rate per annum equal to the rate of interest established by CoBank on the first “Business Day” (as defined in the MLA) of each week (the “Variable Rate Option”). The rate established by CoBank shall be effective until the first Business Day of the next week and may not exceed CoBank’s “National Variable Rate” (as_defined in the MLA) on that day. Each change in the rate shall be applicable to all balances subject to this Variable Rate Option and information about the then current rate shall be made available upon telephonic request.

(2)           Quoted Fixed Rate Option.   At a fixed rate to be quoted by CoBank in its sole discretion in each instance (the “Quoted Rate Option”). Under this option, balances of $100,000 or more may be fixed for such periods as may be agreeable to CoBank in its sole discretion in each instance (each a “Quoted Fixed Rate Period”).

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(3)           LIBOR Option. At a fixed rate equal to the “LIBOR Rate” (as hereinafter defined) plus a spread equal to: (A) in the case of years one through four, 1.75% per annum; and (B) in the case of years five through ten, 2.00% per annum (the “LIBOR Option”). Under this option rates may be fixed: (i) on two (2) “Banking Days’” (as hereinafter defined) prior notice; (ii) on balances of $100,000 or more; (iii) for “Interest Periods” (as hereinafter defined) of 1, 2, 3, 6, 9 and 12 months, as selected by the Company (but in no event beyond the final maturity date of the Loans); and (iv) only during years one through ten. For purposes hereof: (x) “LIBOR Rate” shall mean the rate indicated by Telerate (rounded upward to the nearest thousandth and adjusted for any reserves required to be maintain under Regulation D of the Board of governors of the Federal reserve System or other federal law or regulation) as having been quoted by the British Bankers Association at 11:00 AM London time three (3) Banking Days before the commencement of the Interest Period for the offering of U.S. Dollar deposits in the London interbank market for the Interest Period designated by the Company; (y) “Banking Day” shall mean a day that is a Business Day and also a day on which dealings in US Dollar deposits are being carried out in the London interbank market and banks are open for business in New York and London; and (z) “Interest Period” shall mean a period commencing on the day the LIBOR Option becomes effective and ending on the numerically corresponding day in the next calendar month or the month that is 2, 3, 6, 9 or 12 months thereafter, as the case may be; provided, however, that: (I) in the event such ending day is not a Banking Day, such period shall be extended to the next Banking Day unless such next Banking Day falls in the next calendar month, in which case it shall end on the preceding Banking Day; and (II) if there is no numerically corresponding day in the month, then such period shall end on the last Banking Day in the relevant month.

(B)          Elections. Subject to the limitations set forth above, the Company: (1) shall select the applicable rate option each time it requests a Loan; (2) may, on any Business Day, elect to convert balances bearing interest at the Variable Rate Option to the Quoted Fixed Rate Option; (3) may, on the last day of any Quoted Fixed Rate Period, elect to refix the rate under the Quoted Fixed Rate Option or convert the balance to the Variable Rate Option; (4) may, on the last day of any Interest Period, elect to convert the balance to the Variable Rate or Quoted Fixed Rate Option; and (5) may, on two Banking Days’ prior notice, elect to convert balances bearing interest at the Variable Rate Option or the Quoted Fixed Rate Option to the LIBOR Option or refix a rate under the LIBOR Option; provided, however, that balances bearing interest at the Quoted Fixed Rate Option or the LIBOR Option may not be converted or continued until the last day of the Quoted Fixed Rate Period or Interest Period applicable thereto. In the absence of an election provided for herein, the Company shall be deemed to have elected the Variable Rate Option. All elections provided for herein may be made telephonically or in writing and must be received by 12:00 noon Company’s local time on the applicable Business Day. Any election made telephonically, shall be promptly confirmed in writing if so requested by CoBank. Notwithstanding the foregoing in no event may the Company elect to fix a rate in such a manner as to cause the Company to have to break any fixed rate balance prior to the expiration of any fixed rate period in order to pay any installment of principal hereunder.

(C)          Calculation and Payment.   Interest shall be calculated on the actual number of days each Loan is outstanding on the basis of a year consisting of 360 days.   In calculating interest, the date each Loan is made shall be included and the date each Loan is repaid shall, if received before 3:00 P.M. Mountain time, be excluded. Interest shall be payable monthly in arrears by the twentieth (20^th) day of the following month and on the date each Loan is repaid.

SECTION 6.   Fees. In consideration of the Commitment, the Company agrees to pay to CoBank:

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(A) Loan Origination Fee. A loan origination fee in the amount of $5,000 less the amount paid to CoBank on account of the Commitment pursuant to that certain letter agreement dated as of December 21, 2001, between the Company and CoBank.

(B) Commitment Fee. A commitment fee on the average daily unused portion of the Commitment at the rate of 0.375% per annum (calculated on a 360 day basis), payable monthly in arrears and on the date the Commitment terminates. Such fee shall be payable for each month or portion thereof occurring during the original or any extended term of the Commitment.

SECTION 7. Promissory Note. The Company promises to repay the unpaid principal balance of each Loan as follows: (1) in 228 equal, consecutive monthly installments, payable on the 20^th day of each month, with the first such installment due on 20^th of the month following the month in which the Commitment expires; provided, however, that in the case of the last payment, such payment shall be in an amount equal to the then outstanding principal balance of the Loans. In addition to the above, the Company promises to pay interest on the unpaid principal balance of the Loans at the times and in accordance with the provisions set forth above and to pay the fees set forth in Section 5 hereof and any interest breakage surcharges as provided herein. Notwithstanding the foregoing, if any date on which principal and interest are due is not a Business Day, then such payment shall be due and payable on the next Business Day and, during such period, interest shall continue to accrue on the principal balance thereof.

SECTION 8. Security. The Company’s obligations hereunder and, to the extent related hereto, the MLA shall be secured as provided in Section 2.04 of the MLA.

SECTION 9. Prepayment. The Company may, on one CoBank Business Day’s prior written notice, prepay the Loans in whole or in part together with accrued interest to the date of prepayment on the amount prepaid and, in the event any balance bearing interest at either the LIBOR Option or the Quoted Fixed Rate Option is prepaid, a surcharge equal to the present value of the sum of: (1) the difference, if (a) is larger than (b), between: (a) the rate estimated by CoBank in accordance with its standard methodology to be its all-in cost to fund the Loan being prepaid; minus (b) the rate estimated by CoBank on the date of the prepayment (in accordance with its then standard methodology) to be its all-in cost to fund a new loan having a weighted average life equal to the weighted average life of the balance of the Loan being prepaid; plus (2) an amount equal to a yield of 1.5% on the amount being prepaid, calculated on a per annum basis through the balance of the fixed rate period. In calculating the surcharge, the discount rate shall be the rate determined in accordance with (1)(b) above. All partial prepayments shall be applied to principal installments in the inverse order of their maturity and to such fixed and variable rate balances outstanding on the portion prepaid as designated by CoBank.

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IN WITNESS WHEREOF,  the parties have caused this Promissory Note and Supplement to the MLA to be executed by their duly authorized officers as of the date shown above.

CoBANK, ACB		TECON WATER COMPANY, L.P.
		By: Texas Water Services Group, LLC,
		Its General Partner
By:	/s/ [ILLEGIBLE]	By:	/s/ J. G. Boyles
			J. G. Boyles
Title:	Vice President	Title:	President

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EX-10.4.4

Exhibit 10.4.4

Loan No. ML0936T2A

FIRST AMENDMENT TO PROMISSORY NOTE AND SUPPLEMENT

THIS FIRST AMENDMENT TO PROMISSORY NOTE AND SUPPLEMENT (this “Amendment”) is entered into as of September 12, 2005, between MONARCH UTILITIES I L.P. (formerly known as Tecon Water Company, L.P.), a Texas limited partnership (the “Company”), and CoBANK, ACB,  a federally chartered instrumentality of the United States(“CoBank”).

BACKGROUND

The Company and CoBank are parties to a Promissory Note and Supplement dated as of May 1, 2002 and numbered ML0936T2 (the “Supplement”). Since the date of the Supplement, the Company has changed its name from Tecon Water Company, L.P. to Monarch Utilities I L.P. The parties now desire to amend the Supplement to reflect the change in the Company’s name.

NOW, THEREFORE, for good and valuable other consideration, the receipt and sufficiency of which are hereby established, the parties agree as follows:

SECTION 1.         Amendment.  The name of the Company is hereby amended from “Tecon Water Company, L.P.” to “Monarch Utilities I L.P.”. Wherever in the Supplement the name “Tecon Water Company, L.P.” appears, it shall be deemed to mean “Monarch Utilities I L.P.”

SECTION 2.         Confirmation. This Amendment reflects the entire understanding between the parties with respect to the subject matter hereof. Except as modified hereby, the Supplement shall remain in full force and effect as written.

IN WITNESS WHEREOF, the parties have caused this Amendment to be executed as of the date shown above by their duly authorized officers:

CoBANK, ACB,
a federally chartered instrumentality
of the United States
By:	/s/ Illegible
Name:			Illegible
Title:		Vice President
MONARCH UTILITIES I L.P.,
a Texas limited partnership
By:			Texas Water Services Group, LLC,
			a Texas limited liability company
			General Partner
			By:	/s/ Michael O. Quinn
			Name:			Michael O. Quinn
			Title:		Vice President

EX-10.4.5

Exhibit 10.4.5

Loan No. RX0936T3

PROMISSORY NOTE AND SUPPLEMENT

(Single Advance Term Loan)

THIS PROMISSORY NOTE AND SUPPLEMENT (this “Promissory Note and Supplement”) is entered into as of September 12, 2005, between MONARCH UTILITIES I L.P., a Texas limited partnership (the “Company”), and CoBANK, ACB,  a federally chartered instrumentality of the United States (“CoBank”), and supplements that certain Amended and Restated Master Loan Agreement dated as of September 12, 2005, between the Company and CoBank (as amended or restated from time to time, the “MLA”).

SECTION 1.         The Term Loan Commitment.  On the terms and conditions set forth in the MLA and this Promissory Note and Supplement, CoBank agrees to make a loan (the “Loan”) to the Company in a amount up to $20,000,000.00 (the “Commitment”). CoBank’s obligation to make the Loan shall expire at 12:00 Noon, Company’s local time, on September 30, 2005, or such later date as CoBank may, in its sole discretion, authorize in writing. Under the Commitment, amounts borrowed and later repaid may not be reborrowed.

SECTION 2.         Purpose.  The purpose of the Commitment is to: (A) refinance all of the Company’s indebtedness to Southwest Water Company (“Southwest”); (B) finance capital expenditures; and (C) other corporate purposes.

SECTION 3.         Availability. Notwithstanding Section 2.02 of the MLA, the Loans will be made available: (A) on written request of an authorized officer of the Company in form and content prescribed by CoBank (the “Request for Loan”); (B) on a date to be agreed upon by the parties (the “Closing Date”); (C) in a single advance; and (D) by wire transfer of immediately available funds to “Republic Title” (as defined in the MLA), as provided in the “Closing Agreement” (as defined in the MLA). Notwithstanding the foregoing, the initial Loan to be made hereunder shall be made for the purpose of refinancing all of the Company’s indebtedness to Southwest.

SECTION 4.         Interest. The Loan will bear interest at a rate per annum to be quoted by CoBank in its sole discretion on the date the Loan is made. Interest shall be calculated on the actual number of days the Loan is outstanding on the basis of a year consisting of 360 days and shall be payable monthly in arrears by the 20^th day of the following month.

SECTION 5.         Loan Origination Fee. In consideration of the Commitment, the Company agrees to pay to CoBank on the date hereof, a loan origination fee in the amount of $50,000.00.

SECTION 7.         Promissory Note.  The Company promises to repay the Loan on June 30, 2031. Until such date, no principal payments shall be due. In addition to the above, the Company promises to pay interest on the unpaid principal balance of the Loan at the times and in accordance with the provisions set forth above. Notwithstanding the foregoing, if any date on which principal and interest are due is not a “Business Day” (as defined in the MLA), then such payment shall be due and payable on the next Business Day and, during such period, interest shall continue to accrue on the principal amount thereof.

SECTION 8.         Security. The Company’s obligations hereunder and, to the extent related hereto, the MLA shall be secured as provided in Section 2.04 of the MLA.

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SECTION 9.         Prepayment. The Company may, on one Business Day’s prior written notice, prepay the Loan in whole or in increments of $1,000,000. Any prepayment shall be accompanied by a payment of accrued interest on the amount prepaid to the date of payment and a surcharge equal to the present value of the sum of: (1) the difference, if (a) is larger than (b), between: (a) the rate estimated by CoBank in accordance with its standard methodology to be its all-in cost to fund the Loan; minus (b) the rate estimated by CoBank on the date of the prepayment (in accordance with its then standard methodology) to be its all-in cost to fund a new loan having a weighted average life equal to the weighted average life of the balance of the Loan being prepaid; plus (2) an amount equal to a yield of ½ of 1% on the amount being prepaid, calculated on a per annum basis through the final maturity of the Loan. In calculating the surcharge, the discount rate shall be the rate determined in accordance with (1)(b) above.

SECTION 10.       Conditions Precedent. In addition to the conditions precedent set forth in Article 3 of the MLA, CoBank’s obligation to make the Loan is subject to the condition precedent that CoBank shall have received a duly executed original copy of the Request for Loan.

IN WITNESS WHEREOF, the parties have caused this Promissory Note and Supplement to the MLA to be executed by their duly authorized officers as of the date shown above.

CoBANK, ACB		MONARCH UTILITIES I L.P.
		a Texas limited partnership
		By: Texas Water Services Group, LLC
		a Texas limited liability company
		Its: General Partner
By:	/s/ Illegible	By:	/s/ Michael O. Quinn
Title:	Vice President	Title:	President

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EX-31.1

EXHIBIT 31.1

Certification of Chief Executive Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Anton C. Garnier, certify that:

1.I have reviewed this quarterly report on Form 10-Q of Southwest Water Company;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b.designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c.evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d.disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b.any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated:   November 9, 2005	/s/ ANTON C. GARNIER
	Anton C. Garnier Chief Executive Officer

EX-31.2

EXHIBIT 31.2

Certification of Chief Financial Officer
Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

I, Cheryl L. Clary, certify that:

1.I have reviewed this quarterly report on Form 10-Q of Southwest Water Company;

2.Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;

3.Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;

4.The registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:

a.designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

b.designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;

c.evaluated the effectiveness of the registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

d.disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent fiscal quarter (the registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

5.The registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant’s auditors and the audit committee of the registrant’s board of directors (or persons performing the equivalent functions):

a.all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant’s ability to record, process, summarize and report financial information; and

b.any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant’s internal control over financial reporting.

Dated:   November 9, 2005	/s/ CHERYL L. CLARY
	Cheryl L. Clary Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)

EX-32.1

Exhibit 32.1

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Southwest Water Company (the “Company”) for the period ended September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Anton C. Garnier, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, to my knowledge that:

(1)the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated:   November 9, 2005	/s/ ANTON C. GARNIER
	Anton C. Garnier Chief Executive Officer

EX-32.2

Exhibit 32.2

CERTIFICATION PURSUANT TO
18 U.S.C. SECTION 1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002

In connection with the Quarterly Report on Form 10-Q of Southwest Water Company (the “Company”) for the period ended September 30, 2005 as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Cheryl L. Clary, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. § 1350, as adopted pursuant to § 906 of the Sarbanes-Oxley Act of 2002, to my knowledge that:

(1)the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and

(2)the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.

Dated:   November 9, 2005	/s/ CHERYL L. CLARY
	Cheryl L. Clary Chief Financial Officer (Principal Financial Officer and Chief Accounting Officer)