10-Q

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

FORM 10-Q

(Mark One)

x	Quarterly Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
	For the quarterly period ended September 30, 2006
	or
o	Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
	For the transition period from        to

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 Number)

One Wilshire Building
624 South Grand Avenue, Suite 2900
Los Angeles, California 90017-3782
(Address of principal executive offices, including zip code)

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

None
(Former name, former address and former fiscal year, if changed since last report)

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 x   No o

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

Large accelerated filer  o                                         Accelerated filer  x                                          Non-Accelerated filer  o

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

Class	Outstanding as of November 3, 2006
Common Stock, $.01 par value per share	23,592,695 shares

TABLE OF CONTENTs

Part I	Financial Information
Item 1.	Financial Statements (Unaudited)
	Report of Independent Registered Public Accounting Firm
	Condensed Consolidated Balance Sheets as of September 30, 2006 and December 31, 2005
	Condensed Consolidated Statements of Income for the three months and nine months ended September 30, 2006 and 2005
	Condensed Consolidated Statement of Changes in Stockholders’ Equity for the nine months ended September 30, 2006
	Condensed Consolidated Statements of Cash Flows for the nine months ended September 30, 2006 and 2005
	Condensed Notes to Consolidated Financial Statements
Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.	Quantitative and Qualitative Disclosures About Market Risk
Item 4.	Controls and Procedures
Part II	Other Information
Item 1.	Legal Proceedings
Item 6.	Exhibits
Signatures

i

PART I — FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

The Board of Directors and Stockholders
Southwest Water Company:

We have reviewed the accompanying condensed consolidated balance sheet of Southwest Water Company and subsidiaries (“the Company”) as of September 30, 2006, the related condensed consolidated statements of income for the three-month and nine month periods ended September 30, 2006 and 2005, the related condensed consolidated statement of changes in stockholders’ equity for the nine-month period ended September 30, 2006, and the related condensed consolidated statements of cash flows for the nine-month periods ended September 30, 2006 and 2005.  These condensed consolidated financial statements are the responsibility of the Company’s management.

We conducted our reviews in accordance with the standards of the Public Company Accounting Oversight Board (United States).  A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters.  It is substantially less in scope than an audit conducted in accordance with the standards of the Public Company Accounting Oversight Board (United States), the objective of which is the expression of an opinion regarding the financial statements taken as a whole.  Accordingly, we do not express such an opinion.

Based on our reviews, we are not aware of any material modifications that should be made to the condensed consolidated financial statements referred to above for them to be in conformity with U.S. generally accepted accounting principles.

We have previously audited, in accordance with standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of the Company as of December 31, 2005, and the related consolidated statements of income, changes in stockholders’ equity, and cash flows for the year then ended (not presented herein); and in our report dated March 13, 2006, we expressed an unqualified opinion on those consolidated financial statements.  In our opinion, the information set forth in the accompanying condensed consolidated balance sheet as of December 31, 2005, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/s/  KPMG LLP

Los Angeles, California
November 9, 2006

1

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
(Unaudited)

	September 30,		December 31,
(In thousands)	2006		2005
ASSETS
Current Assets:
Cash and cash equivalents	$	3,226	$	2,764
Restricted cash	238		241
Accounts receivable, net	30,649		26,517
Other current assets	12,502		18,224
Total current assets	46,615		47,746
Property, Plant and Equipment, Net:
Regulated utilities	360,083		333,027
Non-regulated operations	11,674		11,794
Total property, plant and equipment, net	371,757		344,821
Other Assets:
Goodwill	33,262		32,977
Intangible assets	2,978		2,965
Other assets	17,534		16,216
	$	472,146	$	444,725
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities:
Current portion of long-term debt	$	1,318	$	9,492
Accounts payable	8,768		10,018
Other current liabilities	24,363		21,069
Total current liabilities	34,449		40,579
Other Liabilities and Deferred Credits:
Long-term debt	127,546		117,603
Deferred income taxes	22,023		22,609
Advances for construction	8,024		8,478
Contributions in aid of construction	103,552		94,660
Other liabilities and deferred credits	16,682		15,543
Commitments and Contingencies
Stockholders’ Equity:
Preferred stock	461		461
Common stock	234		222
Additional paid-in capital	134,335		122,368
Retained earnings	24,840		22,202
Total stockholders’ equity	159,870		145,253
	$	472,146	$	444,725

The accompanying notes are an integral part of the consolidated financial statements.

2

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
Condensed Consolidated Statements of Income
(Unaudited)

	Three Months Ended September 30,						Nine Months Ended September 30,
(In thousands, except share data)	2006			2005			2006			2005
Revenues:
Utility Group	$	25,839		$	23,300		$	64,602		$	59,054
Services Group	34,302			31,368			101,701			92,127
Total revenues	60,141			54,668			166,303			151,181
Expenses:
Utility Group operating expenses	14,539			12,835			35,442			33,492
Services Group operating expense	29,801			28,038			88,822			80,611
Selling, general and administrative	7,783			7,665			25,376			22,974
Impairment of goodwill	261			—			929			—
Total expenses	52,384			48,538			150,569			137,077
Operating income	7,757			6,130			15,734			14,104
Other income (expense):
Interest expense	(2,081		)	(1,651		)	(6,333		)	(5,251		)
Interest income	108			119			363			332
Other, net	11			27			—			19
Income from continuing operations before income taxes	5,795			4,625			9,764			9,204
Provision for income taxes	(2,123		)	(1,619		)	(3,575		)	(3,280		)
Income from continuing operations	3,672			3,006			6,189			5,924
Cumulative effect of change in accounting principle, net of tax	—			—			71			—
Loss from discontinued operations, net of tax	—			—			—			(4,902		)
Net income	3,672			3,006			6,260			1,022
Preferred stock dividends	(6		)	(6		)	(18		)	(18		)
Net income applicable to common stockholders	$	3,666		$	3,000		$	6,242		$	1,004
Earnings per common share:
Basic:
Income from continuing operations	$	0.16		$	0.14		$	0.27		$	0.29
Cumulative effect of change in accounting principle	—			—			0.01			—
Loss from discontinued operations	—			—			—			(0.24		)
Net income applicable to common stockholders	$	0.16		$	0.14		$	0.28		$	0.05
Diluted:
Income from continuing operations	$	0.16		$	0.14		$	0.27		$	0.28
Cumulative effect of change in accounting principle	—			—			—			—
Loss from discontinued operations	—			—			—			(0.23		)
Net income applicable to common stockholders	$	0.16		$	0.14		$	0.27		$	0.05
Weighted average common shares outstanding:
Basic	23,069			20,874			22,691			20,582
Diluted	23,422			21,714			23,184			21,282

The accompanying notes are an integral part of the consolidated financial statements.

3

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
Condensed Consolidated Statement of Changes in Stockholders’ Equity
(Unaudited)

	Preferred Stock			Common Stock			Additional						Total
	Number of			Number of			Paid-in			Retained			Stockholders’
(In thousands)	Shares	Amount		Shares	Amount		Capital			Earnings			Equity
Balance at December 31, 2005	9	$	461	22,185	$	222	$	122,368		$	22,202		$	145,253
Dividend reinvestment and stock purchase plans	—	—		254	2		3,268			—			3,270
Proceeds from stock options exercised	—	—		706	7		3,806			—			3,813
Excess tax benefit from stock options exercised	—	—		—	—		1,289			—			1,289
Stock-based compensation	—	—		—	—		834			—			834
Cumulative effect of change in accounting principle	—	—		—	—		(110		)	—			(110		)
Debenture conversions	—	—		275	3		2,880			—			2,883
Net income	—	—		—	—		—			6,260			6,260
Cash dividends declared	—	—		—	—		—			(3,622		)	(3,622		)
Balance at September 30, 2006	9	$	461	23,420	$	234	$	134,335		$	24,840		$	159,870

The accompanying notes are an integral part of the consolidated financial statements.

4

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
(Unaudited)

	Nine Months Ended
	September 30,
(In thousands)	2006			2005
				(Revised — See Note 1)
Cash flows from operating activities of continuing operations:
Net income	$	6,260		$	1,022
Adjustments to reconcile net income to net cash provided by operating activities:
Cumulative effect of change in accounting principle, net of tax	(71		)	—
Loss from discontinued operations, net of tax	—			4,902
Depreciation and amortization	8,115			7,548
Deferred income taxes	1,020			1,778
Stock-based compensation expense	834			702
Impairment of goodwill	929			—
Gain on sales of land	(407		)	—
Changes in assets and liabilities, net of effects of acquisitions:
Restricted cash	3			193
Accounts receivable	(4,114		)	(4,667		)
Other current assets	5,333			4,731
Other assets	(1,701		)	(265		)
Accounts payable	(1,286		)	(2,242		)
Other current liabilities	2,086			4,053
Other liabilities	826			441
Other, net	34			1,143
Net cash provided by operating activities	17,861			19,339
Cash flows from investing activities of continuing operations:
Additions to property, plant and equipment	(29,699		)	(26,055		)
Acquisitions of businesses, net of cash acquired	(1,809		)	(10,659		)
Purchase of minority interest	(1,013		)	—
Proceeds from sale of discontinued operations	—			9,852
Proceeds from sales of land	427			—
Net cash used in investing activities	(32,094		)	(26,862		)
Cash flows from financing activities of continuing operations:
Proceeds from issuance of long-term debt	—			20,000
Proceeds from stock option and stock purchase plans	7,083			7,579
Borrowings under lines of credit	6,000			3,965
Contributions in aid of construction	2,969			2,842
Capital improvement reimbursements	2,630			144
Excess tax benefit from stock options exercised	1,289			—
Dividends paid	(3,622		)	(2,982		)
Payments on long-term debt	(1,101		)	(16,395		)
Repayment of advances for construction	(507		)	(654		)
Deferred financing costs	(46		)	(220		)
Net cash provided by financing activities	14,695			14,279
Cash flows from discontinued operations:
Operating activities	—			(788		)
Investing activities	—			(73		)
Financing activities	—			(532		)
Net cash used in discontinued operations	—			(1,393		)
Net increase in cash and cash equivalents	462			5,363
Cash and cash equivalents at beginning of year	2,764			1,388
Cash and cash equivalents at end of year	$	3,226		$	6,751

The accompanying notes are an integral part of the consolidated financial statements.

5

SOUTHWEST WATER COMPANY AND SUBSIDIARIES
Condensed Notes to Consolidated Financial Statements
(Unaudited)

Note 1. Summary of Significant Accounting Policies

Basis of Presentation

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

Preparation of these consolidated financial statements in conformity with U.S. generally accepted accounting principles (“GAAP”) requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.

Certain information and disclosures normally included in financial statements prepared in accordance with GAAP have been omitted in accordance with Securities and Exchange Commission’s rules and regulations for interim financial reporting.  These interim consolidated financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations and the audited financial statements and related notes included in the Company’s 2005 Annual Report on Form 10-K.  The Company’s businesses are seasonal because they are affected by weather.  As a result, operating results for interim periods do not necessarily predict the operating results for any other interim period or for the full year.

Revised 2005 Statement of Cash Flows Presentation

In 2006, the Company has separately disclosed the operating, investing and financing portions of the cash flows attributable to discontinued operations, which in 2005 were reported within the operating cash flow category.

Balancing Accounts

In April 2006, the California Public Utilities Commission (the “CPUC”) issued a decision which eliminates a required earnings test that had prevented some utilities from recovering balancing account under-collections, or receivables, from customers.  Because of the uncertainties associated with under-collections this earnings test had created, the Company’s California utility had established a practice of not recording balancing account under-collections (receivables) but instead recording these costs as expenses until such time the CPUC actually authorized their recovery.  This decision removes that uncertainty.  In the second quarter of 2006, the Company recorded $1.4 million of receivables related to balancing account under-collections ($0.7 million attributable to 2005 and $0.7 million attributable to the first six months of 2006) that are now reasonably assured of recovery from customers.  During the third quarter of 2006, an additional $0.6 million of receivables related to balancing account under-collections were recorded.

Gain on Sale of Land

During the first quarter of 2006, the Company recorded a $0.4 million gain on the sale of land that was no longer used or useful to its California utility’s operations.  The gain is reflected as a reduction of Utility Group operating expenses in the consolidated financial statements.

6

Change in Accounting Principle

Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123(R), Share-Based Payment (“SFAS 123(R)”), using the modified prospective method.  Generally, SFAS 123(R) is similar in approach to SFAS 123, which the Company adopted in 2002, and requires that compensation cost relating to share-based payments be recognized in the financial statements based on the fair value of the equity or liability instruments issued.  The adoption of SFAS 123(R) required the Company to change from recognizing the effect of forfeitures as they occur to estimating the number of outstanding instruments for which the requisite service is not expected to be rendered.  As a result, the Company recorded a benefit of $0.1 million ($0.07 million, net of tax) on January 1, 2006, which is reported as a cumulative effect of a change in accounting principle.  See Note 9 for additional information.

Recent Accounting Pronouncements

FIN No. 48

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”).  This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes.  FIN 48 prescribes a recognition threshold and measurement model for tax positions taken or expected to be taken in tax returns.  FIN 48 requires a company to recognize in its financial statements the impact of a tax position if it is “more-likely-than-not” (more than 50%) the position will be sustained upon examination, based on the technical merits of the position.  The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  The provisions of FIN 48 are effective as of the beginning of the Company’s 2007 fiscal year, with the cumulative effect of the change in accounting principle, if any, recorded as an adjustment to opening retained earnings.  The Company does not expect the adoption of FIN 48 will have a material effect on its consolidated financial statements.

SFAS No. 157

In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”).  This statement establishes a single authoritative definition of fair value, sets out framework for establishing fair value, and requires additional disclosures about fair value measurements.  This statement applies only to fair value measurements that are already required or permitted by other accounting standards and is expected to increase the consistency of those measurements.  Adoption of SFAS 157 is required for the Company’s fiscal year beginning January 1, 2008 and is applied prospectively; the Company does not meet the criteria for earlier adoption.  While the Company is still evaluating the impact this statement will have on it consolidated financial statements, it does not currently believe the impact will be material.

SFAS No. 158

In September 2006, the FASB also issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS 158”).  The new statement amends SFAS No. 87, 88, 106, 132(R) and other related accounting literature, but retains most of their measurement and disclosure requirements and will not change the amount of net periodic benefit cost recognized in the income statement.  SFAS 158 will require employers to recognize as an asset or liability on their balance sheets the over-funded or under-funded status of a defined benefit postretirement plan.  SFAS 158 will also require employers to measure defined benefit plan assets and obligations as of the dates of the employers’ fiscal year-end balance sheet.  The provisions of SFAS 158 require the Company to: i) initially recognize the funded status of the defined benefit postretirement plan as of the end of its fiscal year on December 31, 2006; and ii) measure defined benefit plan assets and obligations as of the dates of its year-end balance sheets starting December 31, 2008.  The Company does not expect the adoption of SFAS 158 will have a material effect on its consolidated financial statements.

7

SAB No. 108

In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108 (Topic 1N), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”).  SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements.  SAB 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors.  This SAB does not change the SEC staff’s previous guidance in SAB No. 99 (Topic 1M), Materiality, on evaluating the materiality of misstatements.  When applying the new guidance for the first time, if companies identify material errors that were in existence at the beginning of their current fiscal year, they may correct those errors through a one-time cumulative-effect adjustment to beginning-of-year retained earnings.  The Company’s fiscal year ending December 31, 2006 will be the initial year of applying the new guidance.  The Company is still evaluating the effect this new guidance will have on its consolidated financial statements.

Note 2.       Acquisitions and Dispositions

Acquisitions

During 2006, the Company has acquired two small water utilities and the rights to provide water and wastewater utility service in developing areas located near Austin, Texas.  The aggregate purchase price for these acquisitions was $1.5 million in cash; liabilities assumed in connection with the acquisitions were negligible.  The assets acquired and liabilities assumed have been recorded at their estimated fair values based upon preliminary valuations, including $0.3 million of goodwill.  The consolidated financial statements include the operations of the acquired utilities subsequent to their respective acquisition dates.  The acquisitions are not material, either individually or in the aggregate, to the Company’s consolidated results of operations.  During 2006, the Company also recorded $0.3 million of contingent consideration earned by the sellers of businesses acquired in prior years as additional goodwill.

On March 21, 2006, the 10% minority interest stockholder in Operations Technology, Inc. (“OpTech”), a Georgia-based non-regulated business in the Company’s Services Group, exercised its right to require the Company to purchase the remaining 10% of OpTech stock that it did not already own for $1.0 million in cash (Note 6).  In connection with this acquisition, the Company has allocated $0.5 million of the purchase price to finite-lived intangible assets and the remaining $0.5 million to goodwill.  The intangible assets, principally customer relationships and tradenames, are being amortized on a straight-line basis over a weighted-average amortization period of 8.1 years.

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

Disposition of Master Tek

During the second quarter of 2005, the Company sold Master Tek International, Inc., a subsidiary in its Services Group that provided utility submetering and billing and collection services for multi-family residential properties.  The Company sold Master Tek for $12.2 million and received $11.1 million in cash at closing with the remaining $1.1 million deposited into an escrow account which was to be released to the Company in April 2006 at the end of a specified indemnification (under representations and warranties) period.

8

On March 29, 2006, the Company received a $1.65 million claim from the buyer for indemnification by reason of alleged breach of certain specified representations and warranties.  The Company reached a settlement with the buyer by agreeing to release $0.6 million from the escrow account to the buyer with the remaining escrow balance being released to the Company.  The $0.6 million released from escrow to the buyer was applied against a liability established at closing for certain retained liabilities and estimated post-closing obligations that were expected to be paid by the Company pursuant to the purchase and sale agreement.  The settlement agreement was finalized during the third quarter of 2006 and the remaining $0.5 million escrow account balance was released to the Company.

As a result of the sale, Master Tek is presented as a discontinued operation in the accompanying consolidated financial statements and the results of operations and cash flows for 2005 have been reclassified to segregate Master Tek’s results for that period.

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

	Nine Months
	Ended
	September 30,
(In thousands)	2005
Services Group revenues	$	3,679
Expenses:
Services Group operating expense	3,947
Selling, general and administrative	1,330
Total expenses	5,277
Operating loss	(1,598		)
Interest expense	(369		)
Interest income	1
Loss before income taxes	(1,966		)
Income tax benefit	688
Loss from operations	(1,278		)
Loss on sale, net of $345 tax benefit	(3,624		)
Loss from discontinued operations	$	(4,902	)

Note 3.       Accounts Receivable

The Company’s Services Group provides contract operations and maintenance services to clients in Mississippi and Texas, among other states.  Hurricanes Katrina and Rita caused significant damage in the Gulf Coast region of the United States during the third quarter of 2005.  The water and wastewater infrastructures for five clients in Mississippi were disabled by Hurricane Katrina.  The contracts with these clients provide that the Company can incur and bill additional expenses during an emergency situation to restore water supply and wastewater treatment services to customers.  In addition, the clients requested our assistance with the removal of debris to enable access for emergency vehicles and residents.

9

The Company incurred $0.8 million of overtime labor costs and emergency out-of-pocket operating expenses in 2005 and $0.1 million in 2006, related to these recovery efforts for these clients, which are reflected as operating expenses during those periods.  The Company has billed its clients $0.9 million for these emergency services and is assisting its clients in requesting reimbursement from the Federal Emergency Management Agency (“FEMA”) pursuant to guidelines established in FEMA’s Applicant Handbook with respect to these costs.  The Company recognized revenues of $0.8 million during 2005 and $0.1 million during the first quarter of 2006 based on the revenue recognition criteria set forth in Staff Accounting Bulletin No. 104, Revenue Recognition.  Through September 30, 2006, the Company has collected $0.6 million of the $0.9 million billed to date and the remaining $0.3 million is reflected in accounts receivable as of September 30, 2006.  The Company expects to collect the remaining receivables during the fourth quarter of 2006.

Note 4.       Goodwill

The table below summarizes the changes in the carrying amount of goodwill, by business segment (Note 12), during the nine months ended September 30, 2006.

	Utility		Services
(In thousands)	Group		Group			Total
Balance, December 31, 2005	$	15,609	$	17,368		$	32,977
Businesses acquired during the year	343		—			343
Acquisition of minority interest	—		523			523
Contingent consideration earned	—		348			348
Impairment of goodwill	—		(929		)	(929		)
Balance, September 30, 2006	$	15,952	$	17,310		$	33,262

The Company has acquired several businesses during 2006, all of which were accounted for as purchases (Note 2).  As a result, the assets acquired and liabilities assumed have been recorded at their estimated fair values based on preliminary valuations with the difference between the aggregate purchase price and the fair value of the identifiable net assets acquired recorded as goodwill.  During 2006, the Company also recorded contingent consideration earned by the sellers of businesses acquired as additional goodwill.

The Company tests goodwill annually for impairment at the reporting unit level, as of October 31st of each year, or when events or circumstances indicate the carrying values may not be recoverable.  The Company evaluates goodwill for impairment using discounted cash flow methodologies, transaction values for comparable companies, and other valuation techniques for reporting units with goodwill balances.  The realizability of the Company’s long-lived assets, including goodwill, is dependent on expected future cash flows from the underlying operations.

During the second quarter of 2006, management reviewed the business strategy for its water and wastewater testing laboratory reporting unit.  This review resulted in management’s decision to realign the operations by reducing the size and scope of its business activities and focusing on its core operations and customers.  The carrying value of the entity was tested for impairment using the revised cash flow projections and it was determined that carrying values were not fully recoverable.  As a result, $0.5 million of goodwill associated with the laboratory reporting unit was deemed to be impaired and was charged to expense in the second quarter of 2006.

During the third quarter of 2006, a significant contract at the testing laboratory was not renewed.  The carrying value of the entity was tested again for impairment using revised cash flow projections and it was determined that carrying values were not recoverable.  As a result, the remaining $0.3 million of goodwill associated with the laboratory reporting unit was deemed to be impaired and was charged to expense in the third quarter of 2006.

Also during the second quarter of 2006, management determined that the renewal of a primary contract for another reporting unit was not likely to occur, significantly reducing the future estimated cash flows of the reporting unit.  As a result, $0.1 million of goodwill associated with this reporting unit was deemed to be impaired and was charged to expense during the period.

10

Note 5.   Long-Term Debt

Long-term debt consists of the following as of September 30, 2006 and December 31, 2005:

	September 30,			December 31,
(In thousands)	2006			2005
$100 million revolving credit facility	$	36,000		$	30,000
6.85% convertible subordinated debentures due 2021	13,081			16,108
Term Loans:
Monarch Utilities, Inc.:
7.37% fixed rate term loan due 2022	11,999			12,577
5.77% fixed rate term loan due 2022	824			864
6.10% fixed rate term loan due 2031	20,000			20,000
First Mortgage Bonds:
Suburban Water Systems:
9.09% series B first mortgage bond due 2022	8,000			8,000
7.61% series C first mortgage bond due 2006	8,000			8,000
5.64% series D first mortgage bond due 2024	15,000			15,000
New Mexico Utilities, Inc.:
6.10% series C first mortgage bond due 2024	12,000			12,000
Economic Development Revenue Bonds:
ECO Resources, Inc.:
6.0% series 1998A due 2018	1,810			1,810
5.5% series 1998A due 2008	320			320
Acquisition-related indebtedness	912			1,395
Total long-term debt payment obligations	127,946			126,074
Unamortized Monarch term loan fair value adjustments	918			1,021
Total long-term debt	128,864			127,095
Less current portion of long-term debt	(1,318		)	(9,492		)
Long-term debt, less current portion	$	127,546		$	117,603

The $100 million revolving line of credit commitment ends on April 1, 2010, at which time all borrowings must be repaid.  Borrowings under the credit facility bear interest, at the Company’s option, based on a margin either: a) over the LIBOR rate; or b) under the prime rate.  The margins vary depending upon the Company’s consolidated debt to equity ratio.  Currently, the applicable margins are 0.875% over the LIBOR rate or 0.25% under the prime rate.  The weighted-average interest rates on all credit facility borrowings outstanding were 6.24% as of September 30, 2006 and 5.37% as of December 31, 2005.

The Company had irrevocable standby letters of credit in the amount of $4.1 million issued and outstanding under its revolving credit facility as of September 30, 2006, reducing available borrowings under the credit facility to $59.9 million as of that date.

On October 20, 2006, Suburban sold $10.0 million of Series E first mortgage bonds and used $8.0 million of the proceeds to repay its maturing Series C first mortgage bonds and the remainder of the proceeds for working capital purposes, including the funding of capital expenditure programs.  The Series E bonds bear interest at a fixed 6.295% annual rate, payable semiannually, and are due in 2026.  The $8.0 million of Series C first mortgage bonds were classified as current obligations as of December 31, 2005.  As a result of the successful refinancing of these obligations on a long-term basis, the obligations have been reclassified to long-term as of September 30, 2006.

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Note 6.   Commitments and Contingencies

Legal Proceedings

Southwest Water 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 ruled in February 2002 that the plaintiffs could not challenge the adequacy of the water quality standards established by California Department of Health Services.  In August 2004, the case against Southwest Water and its subsidiary was dismissed; however, the plaintiffs appealed the dismissal to the Court of Appeals for the State of California, First Appellate District.  A court date has not been set and, to date, liability insurance carriers have absorbed the costs of defense of the lawsuits.  Based upon information available at this time, the Company does not expect that this action will have a material adverse effect on its consolidated financial position, results of operations or cash flows.

In August 2006, the Company elected not to renew the employment contract of one of its operating company presidents.  Subsequently, the individual resigned and filed a complaint seeking, among other things, a declaration that the individual not be bound by a two-year post-employment non-compete agreement.  The Company has filed an answer and counterclaim to the complaint.  Subsequent to the individual’s resignation, some key employees from the operating company resigned and began competing with the Company.  The Company has filed litigation against the former operating company president and certain of the key employees.  Based upon information available at this time, the Company does not expect that these legal actions will have a material adverse effect on its consolidated financial position, results of operations or cash flows.

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

EPA Investigations

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 subsidiary has operated this facility since September 2004.  The facility was also served with search warrants executed by the EPA.  The Company is cooperating fully with the investigation.  The Company has provided the records requested and there have been no further developments since that date.

On May 18, 2005, the EPA executed a search warrant at the Company’s Texas-based testing laboratory and on July 20, 2006 the laboratory received a subpoena to provide additional records and information to a grand jury.  The Company is cooperating fully with the investigation and there have been no further developments since that date.

Eminent Domain Proceedings

The Albuquerque Bernalillo County Water Authority (the “Water Authority”) and the City of Rio Rancho, New Mexico gave notice on October 19, 2006 that they intend to condemn New Mexico Utilities Inc. (“NMUI”), one of the Company’s  wholly-owned regulated utilities, in accordance with the provisions of the New Mexico Eminent Domain Code.  The Company is exposed to the risk of losing its NMUI water and wastewater system if the eminent domain proceedings succeed.  However, under prevailing law, condemning agencies must pay fair market value for property they take through eminent domain.  While it is too early to predict the outcome of this matter, the Company believes that the fair market value of its NMUI system exceeds its recorded net book value as of September 30, 2006.

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Commitments Under Long-Term Service Contracts

In 2002, the Company was retained to facilitate the engineering and construction of a $23.0 million reverse osmosis water treatment plant in the city of San Juan Capistrano, California for the Capistrano Valley Water District (“CVWD”).  In 2003, the Company obtained a $3.4 million standby letter of credit as collateral to insure its performance during the design and construction of the water treatment plant.  Construction was completed during 2005.  Upon final acceptance of the completed project by the CVWD, the standby letter of credit will be terminated and the final $2.3 million of the total contract price, which is included in accounts receivable as of September 30, 2006, will be released to the Company from the construction financing escrow account.

The Company now operates the completed plant under a twenty-year operating agreement.  The CVWD service contract contains certain guarantees related to the performance of the Company and a subsidiary, including certain liquidated damages, in the event of failure on the part of the Company to perform other than by reason of uncontrollable circumstances as defined in the service contract.  Also, the Company has made other guarantees to CVWD, including guarantees with respect to the quality and quantity of the finished water and the production efficiency of the facility.

As part of the financing for this project, the CVWD sold insured municipal bonds.  The Company entered into an agreement with the bond insurer to guarantee the Company’s performance under the service contract, subject to certain liability caps to the bond insurer in the event of a default.  During the twenty-year operation of the facility, such liability caps will not exceed an amount equal to $4.0 million plus an amount no greater than the replacement cost of the actual reverse osmosis filtration unit within the facility, estimated to be approximately $1.5 million.

Minority Interest Put and Call Rights

Prior to March 20, 2006, the Company owned 90% of the outstanding common stock of Operations Technologies, Inc. (“OpTech”).  The minority stockholder had the right to require the Company to purchase the remaining 10% of OpTech for the greater of $1.0 million or a formula-determined amount based on the profitability of OpTech.  The Company had the right to purchase the remaining 10% of OpTech beginning in August 2006 at the same terms.  On March 20, 2006, the minority stockholder elected to exercise its right and the Company acquired the shares based on the formula determined amount which was slightly more than the $1.0 million minimum amount (Note 2).

Prior to December 2005, the Company had an 80% interest in Windermere Utility Company.  The stockholders rights agreement provided that the Company had the right to acquire the remaining 20% of Windermere at any time for $6.0 million payable in common stock of the Company provided certain market value thresholds were attained.  The minority stockholder of Windermere had the right to require the Company to purchase the shares beginning in October 2005 on essentially the same terms, depending on the prevailing market value of the common stock.  In December 2005, the minority stockholder elected to exercise its right and the Company issued 450,644 shares of its common stock in exchange for the remaining Windermere shares.

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Note 7.       Earnings Per Share

The following table is a reconciliation of the numerators (income) and denominators (shares) used in both the basic and diluted earnings per share calculations.

	Three Months Ended						Nine Months Ended
	September 30,						September 30,
(In thousands, except share data)	2006			2005			2006			2005
Numerators—Net income applicable to common stockholders:
Income from continuing operations	$	3,672		$	3,006		$	6,189		$	5,924
Less preferred stock dividends	(6		)	(6		)	(18		)	(18		)
Income from continuing operations applicable to common stockholders	3,666			3,000			6,171			5,906
Cumulative effect of change in accounting principle	—			—			71			—
Loss from discontinued operations	—			—			—			(4,902		)
Net income applicable to common stockholders	$	3,666		$	3,000		$	6,242		$	1,004
Denominators—Weighted average common shares outstanding:
Basic weighted average common shares outstanding	23,069			20,874			22,691			20,582
Plus shares issued on assumed exercise of stock options and warrants	353			840			493			700
Diluted weighted average common shares outstanding	23,422			21,714			23,184			21,282
Earnings per share applicable to common stockholders:
Basic:
Continuing operations	$	0.16		$	0.14		$	0.27		$	0.29
Cumulative effect of change in accounting principle	—			—			0.01			—
Discontinued operations	—			—			—			(0.24		)
Net income applicable to common stockholders	$	0.16		$	0.14	)	$	0.28		$	0.05
Diluted:
Continuing operations	$	0.16		$	0.14		$	0.27		$	0.28
Cumulative effect of change in accounting principle	—			—			—			—
Discontinued operations	—			—			—			(0.23		)
Net income applicable to common stockholders	$	0.16		$	0.14		$	0.27		$	0.05

The difference between basic and diluted earnings per share is the effect of stock options that, under the treasury share method, give rise to potentially dilutive common shares.  As described in Note 5, the Company has $13.1 million of 6.85% fixed-rate convertible subordinate debentures outstanding as of September 30, 2006.  The debentures are convertible into common stock at any time prior to maturity, unless previously redeemed, at a conversion price of $11.018 per share which totals 1.2 million shares as of September 30, 2006.  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.

Both basic and diluted earnings per common share and the related weighted average common shares outstanding for the three months and nine months ended September 30, 2005 have been retroactively adjusted to reflect a 5% stock distribution declared on January 2, 2006.

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Note 8.   Consolidated Statements of Cash Flows

The following information supplements the Company’s consolidated statements of cash flows.

	Nine Months Ended
	September 30,
(In thousands)	2006			2005
Cash paid during the year for:
Interest	$	6,420		$	5,193
Income taxes paid (refunded), net	(1,948		)	(1,345		)
Components of cash paid for acquisitions:
Fair value of assets acquired	$	1,859		$	12,336
Liabilities assumed	(50		)	(1,677		)
Cash paid for acquisitions	$	1,809		$	10,659
Components of proceeds from sale of discontinued operations:
Fair value of assets sold	$	—		$	12,748
Liabilities assumed by buyer	—			(598		)
Selling price	—			12,150
Transaction expenses	—			(1,228		)
Held in escrow and included in other receivables	—			(1,070		)
Net cash proceeds from sale of discontinued operations	$	—		$	9,852
Non-cash investing and financing activities:
Non-cash contributions in aid of construction and advances for construction conveyed to Company by developers	$	5,823		$	2,248
Debentures converted into common stock	3,027			408

Note 9.       Stock Based Incentive Compensation Plans

Prior to May 2006, the Company had three stock-based incentive compensation plans: a Stock Option Plan, a Director Stock Option Plan, and an Employee Stock Purchase Plan.  At the May 2006 annual meeting of stockholders, the stockholders approved a new Equity Incentive Plan which replaced the previously existing Stock Option Plan and Director Stock Option Plan.  The table below summarizes the number of shares authorized and available for issuance under the two stock-based plans as of September 30, 2006.

	Number of Shares
(In thousands)	Authorized	Available
Equity Incentive Plan	5,434	1,201
Employee Stock Purchase Plan	1,256	898
Total	6,690	2,099

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Effective January 1, 2006, the Company adopted the provisions of SFAS No. 123(R), “Share-Based Payment” (“SFAS 123(R)”), using the modified prospective method.  Generally, SFAS 123(R) is similar in approach to SFAS 123, which the Company adopted in 2002, and requires that compensation cost relating to share-based payments be recognized in the financial statements based on the fair value of the equity or liability instruments issued.  Because the Company has been recognizing compensation cost related to share-based payments since its 2002 adoption of SFAS 123, the adoption of SFAS 123(R) did not have a material effect on the consolidated financial statements.

The adoption of SFAS 123(R) required the Company to change from recognizing the effect of forfeitures as they occur to estimating the number of options for which the requisite service is not expected to be rendered and reducing the periodic compensation cost recorded accordingly.  As a result, the Company recorded a benefit of $0.1 million ($0.07 million, net of tax) on January 1, 2006, which is reported as the cumulative effect of a change in accounting principle, to reflect the amount of compensation cost previously recognized related to outstanding options as of December 31, 2005 that are not expected to vest based on an estimate of forfeitures derived from historical data.

The following table illustrates the pro forma effect if the Company had applied the provisions of SFAS 123(R) as of January 1, 2005:

	Period Ended
	September 30, 2005
	Three		Nine
(In thousands)	Months		Months
Compensation cost:
Recorded in 2005 recognizing forfeitures as they occur	$	236	$	702
Net change	10		43
Pro forma for 2005 estimating expected forfeitures	$	246	$	745

	Three Months Ended				Nine Months Ended
	September 30, 2005				September 30, 2005
(In thousands, except share data)	As Reported		Pro Forma		As Reported		Pro Forma
Income from continuing operations	$	3,006	$	2,996	$	5,924	$	5,881
Net income	3,006		2,996		1,022		979
Net income applicable to common stockholders	3,000		2,990		1,004		961
Basic income per common share: (1)
Income from continuing operations	0.14		0.14		0.29		0.28
Net income applicable to common	0.14		0.14		0.05		0.05
Diluted income per common share: (2)
Income from continuing operations	0.14		0.14		0.28		0.28
Net income (loss) applicable to common	0.14		0.14		0.05		0.05

(1)Based on approximately 20.9 million and 20.6 million weighted average common shares outstanding during the three months and nine months ended September 30, 2005, respectively (Note 7).

(2)Based on approximately 21.7 million and 21.3 million weighted average common shares outstanding during the three months and nine months ended September 30, 2005, respectively (Note 7).

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Stock Option Plans

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 2006 and 2005:

	Nine Months Ended
	September 30,
	2006		2005
Dividend yield	1.4	%	1.7	%
Expected volatility	33.5	%	24.3	%
Risk-free interest rate	4.8	%	4.1	%
Expected life in years	4.6		5.7

The weighted average grant date fair value of options granted during the three months ended September 30, 2005 was $3.41 (none granted during the same period in 2006), and $4.99 and $3.01 per share for the nine months ended September 30, 2006 and 2005, respectively.  Compensation expense arising from stock option grants was $0.2 million and $0.2 million during the three months ended September 30, 2006 and 2005, respectively, and $0.8 million and $0.7 million during the nine months ended September 30, 2006 and 2005, respectively.  As of September 30, 2006, aggregate unrecognized compensation costs, before estimated forfeitures, totals $1.8 million and is expected to be recognized over the next five years (2.2 years on a weighted average basis).

The following table summarizes all stock option plan activity during the nine months ended September 30, 2006:

			Weighted-
	Number		Average
	of		Exercise
(In thousands, except exercise prices)	Shares		Price
Outstanding at December 31, 2005	2,641		$	8.30
Granted	436		16.24
Exercised	(816	)	6.66
Forfeited	(281	)	10.86
Expired	(5	)	2.38
Outstanding at September 30, 2006	1,975		10.19

The total intrinsic value of options exercised during the three months ended September 30, 2006 and 2005 was $3.2 million and $2.6 million, respectively, and $6.0 million and $2.9 million for the nine months ended September 30, 2006 and 2005, respectively.

The following tables summarize information about stock options outstanding and exercisable as of September 30, 2006.

			Expected
(In thousands, except as indicated)	Outstanding		to Vest		Exercisable
Number of shares	1,975		1,847		1,101
Weighted average remaining contractual life in years	4.07		3.97		2.57
Weighted average exercise price per share	$	10.19	$	9.97	$	7.67
Aggregate intrinsic value (at closing stock price of $12.23 per share)	$	5,725	$	5,621	$	5,034

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	Outstanding				Exercisable
	Number	Weighted-			Number
	Outstanding	Average	Weighted-		Exercisable	Weighted-
	as of	Remaining	Average		as of	Average
	September 30,	Contractual	Exercise		September 30,	Exercise
(In thousands, except per share data)	2006	Life	Price		2006	Price
Range of per share exercise prices:
$  1.69 to $  3.99	17	0.81 years	$	3.34	16	$	3.34
$  4.00 to $  7.99	603	2.65 years	6.25		603	6.25
$  8.00 to $11.99	771	3.84 years	9.68		458	9.44
$12.00 to $17.75	584	5.92 years	15.13		24	12.79
$  1.69 to $17.75	1,975	4.07 years	10.19		1,101	7.67

Employee Stock Purchase Plan (“ESPP”)

The Company has a stockholder-approved employee stock purchase plan (“ESPP”) that allows eligible employees to purchase 1.3 million shares of 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 three-day average share price calculated at the beginning and end of each three-month offering period.  Under the ESPP, the Company issued 5,895 and 15,048 shares to employees during the three months and nine months ended September 30, 2006, respectively.  Compensation expense recognized by the Company resulting from employee stock purchases pursuant to this plan was nominal for the three months and nine months ended September 30, 2006 and 2005.  As of September 30, 2006, 0.9 million shares remain available for future purchases.

Note 10.     Stock Purchase Plan

Dividend Reinvestment and Direct Stock Purchase Plan (“DRIP / DSPP”)

The Company has a dividend reinvestment and stock purchase plan that gives common stockholders the option of receiving their dividends in cash or in common stock at a discount from prevailing market prices (“DRIP”).  The plan also permits existing stockholders to purchase additional common stock, up to a maximum of $10,000 per month, at a discount (“DSPP”); new investors may participate in the plan, subject to a $250 minimum initial investment.  The Company may, at its sole discretion, permit purchases above the $10,000 stated maximum.  The discounts may range from 0% to 5%, as determined from time to time by the Company.  The DRIP and DSPP discounts offered by the Company are 3% for the DRIP and 3% for the DSPP as of September 30, 2006.  During 2006, the Company registered an additional 1,200,000 shares of common stock that were authorized to be issued under the plan.  As of September 30, 2006, there are 3.7 million shares authorized for issuance under the plan of which 1.3 million shares remain available for issuance.

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Note 11. Employee Retirement Plan

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

	Three Months Ended				Nine Months Ended
	September 30,				September 30,
(In thousands)	2006		2005		2006		2005
Service cost	$	16	$	16	$	49	$	48
Interest cost	19		20		57		60
Recognized actuarial loss	13		22		39		66
Total	$	48	$	58	$	145	$	174

Note 12.     Segment Information

The Company’s businesses are segmented into two operating groups: the Utility Group and the Services Group.  Each segment is a strategic business unit that offers different services.  They are managed separately since each business requires different operating and growth strategies.  The accounting policies of the segments are described in the summary of significant accounting policies in Note 1 to the audited financial statements included in the Company’s 2005 Form 10-K.

The Utility Group owns and operates public water and wastewater utilities in Alabama, California, New Mexico, Oklahoma and Texas.  State and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations.  In the regulated utility subsidiaries, the rates that they charge for water and wastewater services are established by state or local regulatory authorities.  The service areas in which the Utility Group operates constitute monopolies with allowable rates determined by state or local regulatory agencies.

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 some of the companies in the Utility Group.  The Services Group also provides construction and construction management services, certified water and wastewater laboratory testing services, and public works services.  The Services Group, while subject to certain environmental standards, is not regulated in its pricing, marketing or rates of return.

The following table presents information about the operations of each segment for the three months and nine months ended September 30, 2006 and 2005.

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							Total			Corporate
	Utility			Services			Operating			and			Consolidated
(In thousands)	Group			Group (1)			Segments			Other (2)			Total
Three months ended September 30, 2006:
Revenues (1)	$	25,839		$	34,302		$	60,141		$	—		$	60,141
Operating income (loss)	$	9,513		$	922		$	10,435		$	(2,678	)	$	7,757
Interest expense	(1,564		)	(464		)	(2,028		)	(53		)	(2,081		)
Interest income	8			83			91			17			108
Other income (expense)	(12		)	—			(12		)	23			11
Income (loss) from continuing operations before income taxes	$	7,945		$	541		$	8,486		$	(2,691	)	$	5,795
Three months ended September 30, 2005:
Revenues (1)	$	23,300		$	31,368		$	54,668		$	—		$	54,668
Operating income (loss)	$	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
Nine months ended September 30, 2006:
Revenues (1)	$	64,602		$	101,701		$	166,303		$	—		$	166,303
Operating income (loss)	$	23,290		$	2,590		$	25,880		$	(10,146	)	$	15,734
Interest expense	(4,637		)	(1,442		)	(6,079		)	(254		)	(6,333		)
Interest income	37			247			284			79			363
Other income (expense)	(37		)	—			(37		)	37			—
Income (loss) from continuing operations before income taxes	$	18,653		$	1,395		$	20,048		$	(10,284	)	$	9,764
Nine months ended September 30, 2005:
Revenues (1)	$	59,054		$	92,127		$	151,181		$	—		$	151,181
Operating income (loss)	$	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

(1)In addition to services provided to external customers, some companies in the Services Group provide construction, operations and maintenance services to companies in the 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 revenues were $9.2 million and $7.9 million for three months ended September 30, 2006 and 2005, respectively, and $26.2 million and $22.4 million for nine months ended September 30, 2006 and 2005, respectively.  Intersegment profit was $2.6 million and $2.4 million for three months ended September 30, 2006 and 2005, respectively, and $7.9 million and $6.7 million for nine months ended September 30, 2006 and 2005, respectively.

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(2)Consists of costs that include headquarters expenses and any corporate functional departments whose costs are not allocated to the reportable segments.

The following table presents information about identifiable assets by segment as of September 30, 2006 and December 31, 2005.

	September 30,			December 31,
(In thousands)	2006			2005
Utility Group	$	403,210		$	371,714
Services Group	74,641			68,546
Corporate and other	6,079			13,321
Inter-group elimination	(11,784		)	(8,856		)
Total assets	$	472,146		$	444,725

Corporate and other assets reflect corporate headquarters assets, excluding investments in and receivables from subsidiaries.  The inter-group elimination reflects the elimination of inter-group receivables as of the period end date.

Note 13.     Subsequent Event

On October 20, 2006, the Company’s California utility sold $10.0 million of first mortgage bonds and used $8.0 million of the proceeds to repay maturing first mortgage bonds and the remainder of the proceeds for working capital purposes, including the funding of capital expenditure programs (Note 5).

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ITEM 2.    MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SPECIAL NOTE ABOUT FORWARD-LOOKING STATEMENTS

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

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

OVERVIEW

Southwest Water Company provides 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.  We own regulated public utilities and also serve cities, utility districts and private companies under contract.  Our subsidiaries are segmented into two operating groups: our Utility Group and our Services Group.

We grow our Utility Group by:

·increasing the number of customers we serve;

·increasing the rate customers pay for our services through rate case filings with state regulatory commissions;

·creating new utilities by partnering with the development community in high growth markets; and

·acquiring utilities from cities, municipalities and private owners in high growth markets.

Our most recent significant Utility Group acquisition, which affects the comparability of the historical financial condition and results of operations described in the MD&A, is an Alabama-based wastewater collection and treatment system, which we operate as Southwest Water Alabama, which we acquired in September 2005.  During 2006, we also acquired two small water utilities and the rights to provide water and wastewater utility service in developing areas located near Austin, Texas.  While these acquisitions are insignificant to our financial results, both individually and in the aggregate, they are strategically important as they expand our utility ownership in an area that is currently experiencing significant population growth.

We grow our Services Group by:

·increasing the number of clients we have contracts with;

·increasing the customer base for our existing contracts;

·providing additional services to clients to enhance the value of our contracts; and

·acquiring strategically located, well-established service contract businesses in high growth markets.

Our most recent significant Services Group acquisition, which affects the comparability of the historical financial condition and results of operations described in the MD&A, is Novus Utilities; an Alabama based contract operations company, which we acquired in March 2005.

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Disposition

In June 2005 we sold Master Tek International, Inc., our submetering business that provided multi-family residential utility metering, billing and collection services for residential properties.  We elected to sell Master Tek because of changes in the submetering market which would have required significant capital investments in future years.  We believe growth opportunities involving our core competencies of operating and managing water and wastewater facilities exceed those of the submetering business.  The sale of this business, which was part of our Services Group, is not expected to affect the operations of our remaining businesses in the Services Group or our Utility Group.  As a result of the sale, the business we sold is reflected as a discontinued operation in our consolidated financial statements and the discussion below is focused on continuing operations for all periods.

RESULTS OF OPERATIONS

Three Months Ended September 30, 2006 Compared to 2005

Revenues.  Revenues increased $5.5 million, or 10.0%, to $60.1 million for the three months ended September 30, 2006 from $54.7 million for the same period during the prior year.  By segment, revenues increased as follows:

	Three Months Ended
	September 30,				Increase		Percent of Revenues
(In thousands, except percentage data)	2006		2005		(Decrease)		2006		2005
Utility Group	$	25,839	$	23,300	$	2,539	43.0	%	42.6	%
Services Group	34,302		31,368		2,934		57.0		57.4
Total	$	60,141	$	54,668	$	5,473	100.0	%	100.0	%

Utility Group.  Revenues increased $2.5 million, or 10.9%, to $25.8 million for the three months ended September 30, 2006, from $23.3 million for the same period during the prior year.  The increase was primarily due to the following:

·a $1.1 million increase at our California utility due to higher consumption as a result of warmer temperatures in Southern California during the summer months versus the prior year and an increase in rates that went into effect on July 1, 2006;

·a $0.8 million increase at our New Mexico and Texas utilities primarily resulting from an increase in the number of connections, a fourth quarter 2005 rate increase at our Texas utilities and, to a lesser extent, increased consumption; and

·a $0.6 million increase related to our acquisition of a wastewater treatment facility in Alabama at the end of the third quarter of 2005.

Services Group.  Revenues increased $2.9 million, or 9.4%, to $34.3 million for the three months ended September 30, 2006 from $31.4 million for the same period during the prior year.  The increase in revenues was primarily due to the following:

·a $1.7 million increase in contract operations, maintenance, public works and construction due to new contracts and increased demand for services; and

·a $1.2 million increase related to growth in the customer base under existing contracts as a result of increased housing starts.

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Expenses.  Expenses increased $3.8 million, or 7.9%, to $52.4 million for the three months ended September 30, 2006 from $48.5 million for the same period during the prior year as follows:

	Three Months Ended
	September 30,				Increase		Percent of Revenues*
(In thousands, except percentage data)	2006		2005		(Decrease)		2006		2005
Utility Group operating expenses	$	14,539	$	12,835	$	1,704	56.3	%	55.1	%
Services Group operating expenses	29,801		28,038		1,763		86.9		89.4
Selling, general and administrative expenses	7,783		7,665		118		12.9		14.0
Impairment of goodwill	261		—		261		0.4		—
Total	$	52,384	$	48,538	$	3,846	87.1		88.8

*Utility Group and Services Group operating expenses are computed as a percent of their respective revenues.  Selling general and administrative expenses, impairment of goodwill and total expenses are computed as a percent of total revenues.

Utility Group Operating Expenses.  Operating expenses increased $1.7 million, or 13.3%, to $14.5 million for the three months ended September 30, 2006, from $12.8 million for the same period during the prior year.  The increase in operating expenses was primarily due to the following:

·a $1.0 million increase in expenses at our New Mexico and Texas utilities related to higher production costs as a result of higher revenues and increased costs for chemicals, lab fees and sludge hauling;

·a $0.4 million increase related to our acquisition of a wastewater treatment facility in Alabama at the end of the third quarter of 2005; and

·a $0.9 million increase at our California utility resulting from an increase in other operating expenses, including property taxes and depreciation; offset by

·a $0.6 million decrease resulting from our California utility recording a balancing account receivable pursuant to a CPUC decision which eliminated a required earnings test.

Operating expenses were 56.3% and 55.1% of related revenues for the three months ended September 30, 2006 and 2005, respectively.  This increase was primarily due to higher operating costs at our Texas utilities.

Services Group Operating Expenses.  Operating expenses increased $1.8 million, or 6.3%, to $29.8 million for the three months ended September 30, 2006 from $28.0 million for the same period during the prior year.  The increase in operating expenses was due to the following:

·a $2.1 million increase related to the cost of serving new contracts and growth in existing contracts, including the impact of rising fuel and fleet related expenses; offset by

·a $0.3 million decrease in our testing laboratory’s 2006 operating expenses as a result of increased focus on bottom line performance.

Operating expenses as a percentage of the related revenues decreased to 86.9% for the three months ended September 30, 2006 compared to 89.4% for the same period during the prior year.

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $0.1 million, or 1.5%, to $7.8 million for the three months ended September 30, 2006 and are comparable to $7.7 million for the same period during the prior year.

Selling, general and administrative expenses, as a percent of total revenues, were 12.9% and 14.0% for the three months ended September 30, 2006 and 2005, respectively.

Impairment of Goodwill.  During the three months ended September 30, 2006, a $0.3 million charge was recorded to reflect the impairment of goodwill in accordance with the impairment testing provision of SFAS No. 142, Goodwill and Other Intangible Assets (“SFAS 142”).  As required by SFAS 142, we test goodwill annually for impairment at the reporting unit level, as of October 31st of each year, or when events or circumstances indicate the carrying values may not be recoverable.  We evaluate goodwill for impairment using discounted cash flow

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methodologies, transaction values for comparable companies, and other valuation techniques for reporting units with goodwill balances.  The realizability of the Company’s long-lived assets, including goodwill, is dependent on expected future cash flows from the underlying operations.

During the third quarter of 2006, a significant contract at our water and wastewater testing laboratory was not renewed.  The carrying value of the entity was tested for impairment using the revised cash flow projections and it was determined that carrying values were not recoverable.  As a result, $0.3 million of goodwill associated with the laboratory reporting unit was deemed to be impaired and was charged to expense in the third quarter of 2006.  See the discussion of goodwill impairment charges for the nine months ended September 30, 2006 for additional information.

Other Income (Expense).  Other expense increased $0.5 million, or 30.4%, to $2.0 million for the three months ended September 30, 2006 from $1.5 million for the same period during the prior year as follows:

	Three Months Ended
	September 30,
(In thousands)	2006			2005			Change
Interest expense	$	(2,081	)	$	(1,651	)	$	(430	)
Interest income	108			119			(11		)
Other	11			27			(16		)
Total	$	(1,962	)	$	(1,505	)	$	(457	)

Interest Expense.  Interest expense increased $0.4 million, or 26.0%, for the three months ended September 30, 2006 compared to the same period during the prior year.  The major components of interest expense were as follows:

	Three Months Ended
	September 30,						Increase
(In thousands)	2006			2005			(Decrease)
Interest expense:
Revolving lines of credit	$	647		$	496		$	151
Mortgage bonds and bank term loans	1,215			906			309
Convertible subordinated debentures	221			289			(68		)
Other indebtedness	202			387			(185		)
Total interest incurred	2,285			2,078			207
Less capitalized interest	(204		)	(427		)	223
Total interest expense	$	2,081		$	1,651		$	430

The increase in total interest incurred is primarily due to an increase in borrowings levels on our mortgage bonds and bank term loans and an increase in interest rates related to our revolving line of credit, which was partially offset by lower borrowing levels on the revolving line of credit.  Average borrowings on the line of credit decreased to $37.9 million for the three months ended September 30, 2006 from $40.0 million for the same period during the prior year.  The weighted average interest rate on those borrowings increased to 6.8% for the three months ended September 30, 2006 from 5.0% for the same period during the prior year.  Interest related to our mortgage bonds and bank term loans increased as a result of a net increase in average borrowings between the periods; average borrowings increased to $94.6 million for the three months ended September 30, 2006 from $92.6 million for the same period during the prior year.

Our average balances of interest bearing debt outstanding were approximately $130.4 million and $127.1 million for the three months ended September 30, 2006 and 2005, respectively.  Our effective weighted average interest rate increased to 6.4% for the three months ended September 30, 2006 from 5.2% for the same period during the prior year.

Provision for Income Taxes.  Our effective consolidated income tax rate was 36.6% for the three months ended September 30, 2006 and is comparable to 35.0% for the same period during the prior year.

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Nine Months Ended September 30, 2006 Compared to 2005

Revenues.  Revenues increased $15.1 million, or 10.0%, to $166.3 million for the nine months ended September 30, 2006 from $151.2 million for the same period during the prior year.  By segment, revenues increased as follows:

	Nine Months Ended
	September 30,				Increase		Percent of Revenues
(In thousands, except percentage data)	2006		2005		(Decrease)		2006		2005
Utility Group	$	64,602	$	59,054	$	5,548	38.8	%	39.1	%
Services Group	101,701		92,127		9,574		61.2		60.9
Total	$	166,303	$	151,181	$	15,122	100.0	%	100.0	%

Utility Group.  Revenues increased $5.5 million, or 9.4%, to $64.6 million for the nine months ended September 30, 2006, from $59.1 million for the same period during the prior year.  The increase was primarily due to the following:

·a $2.3 million increase at our New Mexico and Texas utilities primarily resulting from an increase in the number of connections, a fourth quarter 2005 rate increase at our Texas utilities and, to a lesser extent, increased consumption;

·a $1.9 million increase related to our acquisition of a wastewater treatment facility in Alabama at the end of the third quarter of 2005; and

·a $1.3 million increase at our California utility related to increased consumption and an increase in rates that went into effect on July 1st of this year.

Services Group.  Revenues increased $9.6 million, or 10.4%, to $101.7 million for the nine months ended September 30, 2006 from $92.1 million for the same period during the prior year.  The increase in revenues was primarily due to the following:

·a $4.7 million increase in contract operations, maintenance, public works and construction due to new contracts;

·a $4.2 million increase related to growth in the customer base under existing contracts as a result of increased housing starts; and

·a $1.4 million increase resulting from the acquisition of an Alabama-based contract operations company in March 2005; offset by

·a $0.7 million decrease in revenues at our testing laboratory operation.

Expenses.  Expenses increased $13.5 million, or 9.8%, to $150.6 million for the nine months ended September 30, 2006 from $137.1 million for the same period during the prior year as follows:

	Nine Months Ended
	September 30,				Increase		Percent of Revenues *
(In thousands, except percentage data)	2006		2005		(Decrease)		2006		2005
Utility Group operating expenses	$	35,442	$	33,492	$	1,950	54.9	%	56.7	%
Services Group operating expenses	88,822		80,611		8,211		87.3		87.5
Selling, general and administrative expenses	25,376		22,974		2,402		15.3		15.2
Impairment of goodwill	929		—		929		0.6		—
Total	$	150,569	$	137,077	$	13,492	90.5		90.7

*Utility Group and Services Group operating expenses are computed as a percent of their respective revenues.  Selling general and administrative expenses, impairment of goodwill and total expenses are computed as a percent of total revenues.

Utility Group Operating Expenses.  Operating expenses increased $1.9 million, or 5.8%, to $35.4 million for the nine months ended September 30, 2006, from $33.5 million for the same period during the prior year.  The increase in operating expenses was primarily due to the following:

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·a $1.6 million increase in expenses at our New Mexico and Texas utilities resulting from an increase in the number of connections we serve which caused higher costs related to water productions, chemicals, lab fees and sludge hauling;

·a $1.7 million increase in operating expenses at our California utility resulting from higher water production costs; and

·a $1.0 million increase related to our acquisition of a wastewater treatment facility in Alabama at the end of the third quarter of 2005; offset by

·a $2.0 million decrease resulting from our California utility recording a balancing account receivable pursuant to a CPUC decision which eliminated a required earnings test; and

·a $0.4 million reduction in expenses at our California utility resulting from a gain on the sale of land that was no longer used or useful to its operations.

Operating expenses were 54.9% and 56.7% of related revenues for the nine months ended September 30, 2006 and 2005, respectively.  Operating expenses as a percent of related revenues for 2006 were 58.6% excluding the effect of the gain on the sale of land and the favorable CPUC decision.  The adjusted increase is primarily due to higher operating costs in our California and Texas utilities.

Services Group Operating Expenses.  Operating expenses increased $8.2 million, or 10.2%, to $88.8 million for the nine months ended September 30, 2006 from $80.6 million for the same period during the prior year.  The increase in operating expenses was due to the following:

·a $7.5 million increase related to the cost of serving new contracts and the growth in existing contracts, including the impact of rising fuel and fleet related expenses; and

·a $1.1 million increase from our acquisition of an Alabama-based contract operations company in March 2005; offset by

·a $0.4 million decrease in our testing laboratory’s 2006 operating expenses as a result of increased focus on bottom line performance.

Operating expenses as a percentage of the related revenues of 87.3% for the nine months ended September 30, 2006 is comparable to 87.5% for the same period during the prior year.

Selling, General and Administrative Expenses.  Selling, general and administrative expenses increased $2.4 million, or 10.5%, to $25.4 million for the nine months ended September 30, 2006 compared to $23.0 million for the same period during the prior year.  The increase in selling, general and administrative expenses was primarily due to the following:

·a $1.1 million increase in salaries, wages and related benefits resulting from workforce increases to support our business growth;

·a $0.8 million increase related to one-time charges for relocation assistance extended to our new CEO;

·a $0.5 million increase attributable to acquisitions which occurred in 2005; and

·a $0.2 million increase in legal fees, most of which is attributable to routine legal and administrative proceedings incident to the normal conduct of business; offset by

·a $0.2 million decrease in Sarbanes-Oxley compliance-related costs.

Selling, general and administrative expenses, as a percent of total revenues, were 15.3% and 15.2% for the nine months ended September 30, 2006 and 2005, respectively.  Selling, general and administrative expenses as a percent of revenue excluding the one-time CEO relocation assistance costs were 14.5% for the nine months ended September 30, 2006.

Impairment of Goodwill.  During the nine months ended September 30, 2006, charges totaling $0.9 million have been recorded to reflect the impairment of goodwill in accordance with the impairment testing provision of

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SFAS No. 142.  As required by SFAS 142, we test goodwill annually for impairment at the reporting unit level, as of October 31st of each year, or when events or circumstances indicate the carrying values may not be recoverable.  We evaluate goodwill for impairment using discounted cash flow methodologies, transaction values for comparable companies, and other valuation techniques for reporting units with goodwill balances.  The realizability of the Company’s long-lived assets, including goodwill, is dependent on expected future cash flows from the underlying operations.

During the second quarter of 2006, we reviewed the business strategy for our water and wastewater testing laboratory reporting unit.  This review resulted in our decision to realign the operations by reducing the size and scope of its business activities and focusing on its core operations and customers.  This realignment is intended to create a strong foundation for providing high-quality laboratory testing and reporting services to municipal utility districts and targeted commercial customers, enhancing future growth and performance.  The carrying value of the entity was tested for impairment using the revised cash flow projections and it was determined that carrying values were not fully recoverable.  As a result, $0.5 million of goodwill associated with the laboratory reporting unit was deemed to be impaired and was charged to expense in the second quarter of 2006.

Additionally, in the second quarter we determined that the renewal of a primary contract for another reporting unit was not likely to occur, significantly reducing future estimated cash flows of the reporting unit.  As a result, $0.1 million of goodwill associated with this reporting unit was deemed to be impaired and was charged to expense during that period.

During the third quarter of 2006, a significant contract at the testing laboratory was not renewed.  The carrying value of the entity was tested again for impairment using the revised cash flow projections and it was determined that carrying values were not recoverable.  As a result, the remaining $0.3 million of goodwill associated with the laboratory reporting unit was deemed to be impaired and was charged to expense in the third quarter of 2006.

Other Income (Expense).  Other expense increased $1.1 million, or 21.7%, to $6.0 million for the nine months ended September 30, 2006 from $4.9 million for the same period during the prior year as follows:

	Nine Months Ended
	September 30,
(In thousands)	2006			2005			Change
Interest expense	$	(6,333	)	$	(5,251	)	$	(1,082	)
Interest income	363			332			31
Other	—			13			(13		)
Total	$	(5,970	)	$	(4,906	)	$	(1,064	)

Interest Expense.  Interest expense increased $1.1 million, or 20.6%, for the nine months ended September 30, 2006 compared to the same period during the prior year.  The major components of interest expense were as follows:

	Nine Months Ended
	September 30,						Increase
(In thousands)	2006			2005			(Decrease)
Interest expense:
Revolving lines of credit	$	1,776		$	1,372		$	404
Mortgage bonds and bank term loans	3,648			2,985			663
Convertible subordinated debentures	727			880			(153		)
Other indebtedness	609			523			86
Total interest incurred	6,760			5,760			1,000
Less capitalized interest	(427		)	(509		)	82
Total interest expense	$	6,333		$	5,251		$	1,082

The increase in total interest incurred is primarily due to an increase in borrowings levels on our mortgage bonds and bank term loans and an increase in interest rates related to our revolving line of credit.  Average borrowings on the line of credit decreased to $36.6 million for the nine months ended September 30, 2006 from

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$38.8 million for the same period during the prior year.  The weighted average interest rate on those borrowings increased to 6.5% for the nine months ended September 30, 2006 from 4.7% for the same period during the prior year.  Interest related to our mortgage bonds and bank term loans increased as a result of a net increase in average borrowings between the periods; average borrowings increased to $93.1 million for the nine months ended September 30, 2006 from $89.6 million for the same period during the prior year.

Our average balances of interest bearing debt outstanding were approximately $130.0 million and $125.7 million for the nine months ended September 30, 2006 and 2005, respectively.  Our effective weighted average interest rate increased to 6.5% for the nine months ended September 30, 2006 from 5.6% for the same period during the prior year.

Provision for Income Taxes.  Our effective consolidated income tax rate was 36.6% for the nine months ended September 30, 2006 and is comparable to 35.8% for the same period during the prior year (based on combined pre-tax income and related income taxes for both continuing and discontinued operations).

Cumulative Effect of Change in Accounting Principle.  Effective January 1, 2006, we adopted the provisions of SFAS No. 123(R), Share-Based Payment (“SFAS 123(R)”).  The adoption of SFAS 123(R) required us to change from recognizing the effect of forfeitures as they occur to estimating the number of outstanding instruments for which the requisite service is not expected to be rendered.  As required by SFAS 123(R) we recorded a $0.07 million (net of tax) benefit on January 1, 2006 to reflect the reduction in compensation expense that would have resulted had we been estimating the effect of forfeitures in prior periods.

Loss from Discontinued Operations.  Loss from discontinued operations, which pertains to our submetering business we sold during the second quarter of 2005, was $4.9 million for the nine months ended September 30, 2005.  The loss is comprised of a $1.3 million operating loss and a $3.6 million loss on the sale of the business.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

FIN No. 48.  In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of FASB Statement No. 109 (“FIN 48”).  This interpretation clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes.  FIN 48 prescribes a recognition threshold and measurement model for tax positions taken or expected to be taken in tax returns.  FIN 48 requires a company to recognize in its financial statements the impact of a tax position if it is “more-likely-than-not” (more than 50%) the position will be sustained upon examination, based on the technical merits of the position.  The interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition.  The provisions of FIN 48 are effective as of the beginning of our 2007 fiscal year, with the cumulative effect of the change in accounting principle, if any, recorded as an adjustment to opening retained earnings.  We do not expect the adoption of FIN 48 will have a material effect on our consolidated financial statements.

SFAS No. 157.  In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements (“SFAS 157”).  This statement establishes a single authoritative definition of fair value, sets out framework for establishing fair value, and requires additional disclosures about fair value measurements.  This statement applies only to fair value measurements that are already required or permitted by other accounting standards and is expected to increase the consistency of those measurements.  Adoption of SFAS 157 is required for our fiscal year beginning January 1, 2008 and is applied prospectively; we not meet the criteria for earlier adoption.  While we still are evaluating the impact this statement will have on our consolidated financial statements, we do not currently believe the impact will be material.

SFAS No. 158.  In September 2006, the FASB also issued SFAS No. 158, Employers’ Accounting for Defined Benefit Pension and Other Postretirement Plans (“SFAS 158”).  The new statement amends SFAS No. 87, 88, 106, 132(R) and other related accounting literature, but retains most of their measurement and disclosure requirements and will not change the amount of net periodic benefit cost recognized in the income statement.  SFAS 158 will require employers to recognize as an asset or liability on their balance sheets the over-funded or under-funded status of a defined benefit postretirement plan.  SFAS 158 will also require employers to measure defined benefit plan assets and obligations as of the dates of the employers’ fiscal year-end balance sheet.  The provisions of

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SFAS 158 require the Company to: i) initially recognize the funded status of the defined benefit postretirement plan as of the end of its fiscal year on December 31, 2006; and ii) measure defined benefit plan assets and obligations as of the dates of its year-end balance sheets starting December 31, 2008.  We do not expect the adoption of SFAS 158 will have a material effect on our consolidated financial statements.

SAB No. 108.  In September 2006, the Securities and Exchange Commission (“SEC”) issued Staff Accounting Bulletin (“SAB”) No. 108 (Topic 1N), Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”).  SAB 108 addresses how the effects of prior year uncorrected misstatements should be considered when quantifying misstatements in the current year financial statements.  SAB 108 requires companies to quantify misstatements using both the balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relevant quantitative and qualitative factors.  This SAB does not change the SEC staff’s previous guidance in SAB No. 99 (Topic 1M), Materiality, on evaluating the materiality of misstatements.  When applying the new guidance for the first time, if companies identify material errors that were in existence at the beginning of their current fiscal year, they may correct those errors through a one-time cumulative-effect adjustment to beginning-of-year retained earnings.  Our fiscal year ending December 31, 2006 will be the initial year of applying the new guidance.  We are still evaluating the effect this new guidance will have on our consolidated financial statements.

LIQUIDITY AND CAPITAL RESOURCES

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

·generate sufficient operating cash flows to service our debt and tax obligations, fund capital improvements and organic growth, and pay dividends to our stockholders;

·utilize our credit facility for major capital improvements and to manage seasonal cash needs;

·obtain external financing for major acquisitions; and

·maintain approximately equal levels of debt and equity consistent with the investor-owned water utility industry.

Our statements of cash flows are summarized as follows:

	Nine Months Ended
	September 30,						Increase
(In thousands)	2006			2005			(Decrease)
Net cash provided by (used in):
Continuing operations:
Operating activities	$	17,861		$	19,339		$	(1,478	)
Investing activities	(32,094		)	(26,862		)	(5,232		)
Financing activities	14,695			14,279			416
Total continuing operations	462			6,756			(6,294		)
Discontinued operations:
Operating activities	—			(788		)	788
Investing activities	—			(73		)	73
Financing activities	—			(532		)	532
Total discontinued operations	—			(1,393		)	1,393
Increase in cash and cash equivalents	$	462		$	5,363		$	(4,901	)

Cash Flows From Operating Activities.  Net cash provided by operating activities decreased by $1.5 million during the nine months ended September 30, 2006 compared to the same period during the prior year.  In 2006, $2.0 million of balancing account under-collections (receivables) were recorded as a result of a favorable California Public Utilities Commission decision regarding recovery of under-collections.  Operating cash flows in future periods will reflect the collection of the balance account.  Excluding the effect of recording the balancing account in 2006, cash flows from operations are comparable with the prior year period.

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Cash Flows From Investing Activities.  Cash used in investing activities totaled $32.1 million for the nine months ended September 30, 2006 compared to $26.9 million for the same period during 2005 as follows:

	Nine Months Ended
	September 30,						Increase
(In thousands)	2006			2005			(Decrease)
Cash flows used in (provided by) investing activities:
Additions to property, plant and equipment	$	29,699		$	26,055		$	3,644
Acquisition of businesses, net of cash acquired	1,809			10,659			(8,850		)
Purchase of minority interest	1,013			—			1,013
Proceeds from sale of discontinued operations	—			(9,852		)	9,852
Proceeds from sales of land	(427		)	—			(427		)
Net cash used for investing activities	$	32,094		$	26,862		$	5,232

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

	Nine Months Ended
	September 30,
(In thousands)	2006		2005
Company-financed additions	$	24,100	$	23,069
Capital improvement reimbursements	2,630		144
Cash contributions received in aid of construction	2,969		2,842
Total cash additions to property, plant and equipment	29,699		26,055
Non-cash contributions in aid of construction	5,823		2,248
Total additions to property, plant and equipment	$	35,522	$	28,303

Capital projects primarily relate to the expansion, replacement and renovation of our water and wastewater systems, particularly at our Texas and New Mexico utilities.  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 and is not refundable.  In 2006, we expect to spend approximately $30.0 million on company-financed additions, principally within our Utility Group, and expect to receive $11.0 million of CIAC resulting in total expected additions to property, plant and equipment of about $41.0 million.

In March 2006, we acquired the remaining 10% interest in Operations Technology, Inc. (“OpTech”) that we did not already own for $1.0 million in cash.  We also made substantial investments in acquisitions during 2006 and 2005 and expect we will continue to do so in the future.

Cash Flows From Financing Activities.  During first nine months of 2006, we financed our growth through a broad range of capital initiatives:

·received $7.1 million of proceeds from our direct stock purchase plan, our employee stock purchase and option plans and our director option plan;

·borrowed $6.0 million under our revolving line of credit; and

·received $5.6 million of capital improvement reimbursements and contributions in aid of construction.

Aggregate borrowings under our revolving line of credit increased by a net $6.0 million during the nine months ended September 30, 2006 and were primarily used to fund our investing activities.  Additional borrowing availability under our revolving credit facility was $59.9 million as of September 30, 2006.

During the nine months ended September 30, 2006, we have paid dividends totaling $3.6 million and our quarterly dividend rate is currently $0.0524 per common share.

Cash Flows From Discontinued Operations.  Net cash used in discontinued operations was $1.4 million and reflects the cash flows of the discontinued operation prior to June 30, 2005, the date it was sold.

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Fourth Quarter 2006 Debt Refinancing.  On October 20, 2006, our California utility sold $10.0 million of Series E first mortgage bonds and used $8.0 million of the proceeds to repay its maturing Series C first mortgage bonds and the remainder of the proceeds for working capital purposes, including the funding of capital expenditure programs.  The Series E bonds bear interest at a fixed 6.295% annual rate, payable semiannually, and are due in 2026.  The $8.0 million of Series C first mortgage bonds were classified as current obligations as of December 31, 2005.  As a result of the successful refinancing of these obligations on a long-term basis, the obligations have been classified as long-term (due in 2026) as of September 30, 2006.

CONTRACTUAL OBLIGATIONS

The following table summarizes our known contractual obligations to make future cash payments as of September 30, 2006, as well as an estimate of the periods during which these payments are expected to be made.

			Years Ended December 31,
			Remainder		2007		2009		2011
			of		and		and		and
(In thousands)	Total		2006		2008		2010		Beyond
Long-term debt (1):
Bank line of credit (2)	$	36,000	$	—	$	—	$	36,000	$	—
Mortgage bonds (3)	43,000		—		—		—		43,000
Bank term loans (4)	32,823		205		1,645		1,646		29,327
Convertible subordinated debentures (5)	13,081		—		—		—		13,081
Economic development revenue bonds (6)	2,130		100		220		245		1,565
Notes payable (7)	912		86		826		—		—
Total long-term debt	127,946		391		2,691		37,891		86,973
Repayment of advances for construction (8)	9,076		550		1,196		720		6,610
Lease assignment obligations (9)	2,531		73		2,458		—		—
Operating lease obligations	31,532		1,681		10,569		5,729		13,553
Total obligations as of September 30, 2006	$	171,085	$	2,695	$	16,914	$	44,340	$	107,136

(1)Excludes interest payment obligations, which are described in the following notes.  The terms of the long-term debt are more fully described in the notes to the consolidated financial statements included in this report and our 2005 Annual Report on Form 10-K.

(2)The bank lines of credit bear interest at variable rates and therefore the amount of future interest payments are uncertain.  Borrowings bear interest, at our option, based on a margin either: a) over the LIBOR rate; or b) under the prime rate.  The margins vary based on our consolidated debt to equity ratio.  The weighted-average interest rate on our bank line of credit borrowings was 6.24% as of September 30, 2006.

(3)Interest on the mortgage bonds is fixed at a weighted-average annual interest rate of 6.53% and is payable semiannually.

(4)Interest on the bank term loans is fixed at a weighted-average annual interest rate of 6.56% and is payable semiannually.

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

(6)Interest on the economic development bonds is fixed at a weighted-average annual interest rate of 5.92% and is payable semiannually.

(7)Interest is payable either monthly or quarterly at rates ranging from 5.0% to 7.5% per year.

(8)Advances for construction are non-interest bearing.

(9)Interest on the lease assignment obligations is fixed at a weighted-average interest rate of 8.39% and is payable monthly.

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FINANCIAL CONDITION AND LIQUIDITY

As of September 30, 2006, we had working capital of approximately $12.2 million and $59.9 million of additional borrowings available under our line of credit facility which expires on April 1, 2010.  In addition to our line of credit, our California and New Mexico mortgage bond indentures permit the issuance of an additional $80.8 million of first mortgage bonds as of September 30, 2006.  However, the terms of our credit facility do not permit additional first mortgage bond indebtedness without prior consent from the credit facility lenders.  The mortgage bond indentures also limit the amount of cash and property dividends our California and New Mexico utilities may pay to the parent company to fund its payment obligations.  Dividends have averaged $3.0 to $4.0 million per year and are less than the aggregate cumulative dividend restriction threshold by $44.2 million as of September 30, 2006.

We also have on file a registration statement with the Securities and Exchange Commission, which is effective for the issuance of up to $50.0 million aggregate principal amount of common stock, debt securities and warrants.  To date we have issued approximately $43.6 million of common stock under the shelf registration, and about $6.4 million remains available for issuance as of September 30, 2006.  We may offer any of these securities for sale at any time and from time to time.

As of September 30, 2006, we have contractual obligations totaling $171.1 million (excluding interest), $2.7 million of which is due during the remainder of 2006.  We were in compliance with all loan agreement covenants during the nine months ended September 30, 2006.

We believe that our expected operating cash flows, together with borrowings under our revolving credit facility ($59.9 million of which was available as of September 30, 2006 and expires on April 1, 2010) will be sufficient to meet our operating expenses, working capital and capital expenditure requirements as well as our debt service obligations for the next twelve months.  However, our ability to comply with debt financial covenants, pay principal or interest and refinance our debt obligations will depend on our future operating performance as well as competitive, legislative, regulatory, business and other factors beyond our control.

CERTAIN CONTRACTUAL COMMITMENTS AND INDEMNITIES

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

We now operate the completed plant under a twenty-year operating agreement.  The CVWD service contract contains certain guarantees related to our performance, including certain liquidated damages, in the event of failure on our part to perform other than by reason of uncontrollable circumstances as defined in the service contract.  Also, we have made other guarantees to CVWD, including guarantees with respect to the quality and quantity of the finished water and the production efficiency of the facility.

As part of the financing for this project, the CVWD sold insured municipal bonds.  We entered into an agreement with the bond insurer to guarantee our performance under the service contract, subject to certain liability caps to the bond insurer in the event of a default.  During the twenty-year operation of the facility, such liability caps will not exceed an amount equal to $4.0 million plus an amount no greater than the replacement cost of the actual reverse osmosis filtration unit within the facility, estimated to be approximately $1.5 million.

We had irrevocable standby letters of credit in the amount of $4.1 million issued and outstanding under our credit facility, including the CVWD letter of credit described above, as of September 30, 2006.

During our normal course of business, we have entered into agreements containing indemnities pursuant to which we may be required to make payments in the future.  These indemnities are in connection with facility leases and liabilities and operations and maintenance and construction contracts entered into by our Services Group.  The duration of these indemnities, commitments and guarantees varies, and in certain cases, is indefinite.  Substantially

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all of these indemnities provide no limitation on the maximum potential future payments we could be obligated to make and is not quantifiable.  We have not recorded any liability for these indemnities.

In connection with the sale of Master Tek, we indemnified the buyer with respect to representations and warranties.  Our indemnities with respect to these matters are limited in terms of duration to periods ranging from one year to the expiration of the applicable statue of limitations.

OFF-BALANCE SHEET ARRANGEMENTS

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

We lease some of our equipment and office facilities under operating leases which are deemed to be off-balance sheet arrangements.  Our future operating lease payment obligations are more fully described under the caption “—Contractual Obligations” above.

ITEM 3.QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

As of September 30, 2006, we had $128.9 million of long-term variable and fixed-rate debt.  We are exposed to market risk based on changes in prevailing interest rates.

Market risk related to our variable-rate debt is estimated as the potential decrease in pre-tax earnings resulting from an increase in interest rates.  We have $36.0 million of long-term debt that bears interest at variable rates based on either the prime rate or LIBOR.  Our variable-rate debt had a weighted average interest rate of 6.24% as of September 30, 2006.  A hypothetical one percent (100 basis points) increase in the average interest rates charged on our variable-rate debt would reduce our pre-tax earnings by approximately $0.4 million per year.

Our fixed-rate debt, which had a carrying value of $92.9 million as of September 30, 2006, had a fair value of $89.2 million as of that date.  Market risk related to our fixed-rate debt is deemed to be the potential increase in fair value resulting from a decrease in prevailing interest rates.  Our fixed-rate debt had a weighted average interest rate of 6.7% as of September 30, 2006.  A hypothetical ten percent decrease in interest rates, from 6.7% to 6.0%, would increase the fair value of our fixed-rate debt by approximately $5.6 million.

We do not use derivative financial instruments to manage or reduce these risks although we may elect do so in the future.  We do not enter into derivatives or other financial instruments for trading or speculative purposes.

ITEM 4.CONTROLS AND PROCEDURES

Under the supervision and with the participation of our management, including the Chief Executive Officer and Chief Financial Officer, we have evaluated the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15(b) as of the end of the period covered by this report.  Based on that evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that these disclosure controls and procedures are effective.  There were no changes in our internal control over financial reporting during the quarter ended September 30, 2006 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II — OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

Information required by this Item 1 is contained in Note 6 to the consolidated financial statements, Part I, Item 1 of this report, under the captions “Legal Proceedings,” “EPA Investigations” and “Eminent Domain Proceedings.”  The text under those captions is incorporated by reference into this Item 1.

ITEMS 1A, 2, 3, 4 AND 5 ARE NOT APPLICABLE AND HAVE BEEN OMITTED.

ITEM 6.EXHIBITS

Exhibit Number		Exhibit Description
3.2		Amendment No. 3 to Amended and Restated Bylaws of Southwest Water Company effective May 16, 2006 (incorporated by reference to Exhibit 3.2 to the Company’s Form 8-K filed with the Commission on May 19, 2006)
4.1.6	*	Fifth Amendment and Supplement to Indenture of Mortgage and Deed of Trust between Suburban Water Systems and U.S. Bank National Association, dated October 20, 2006
4.13.1		Southwest Water Company 2006 Equity Incentive Plan (incorporated by reference as Exhibit 4.13.1 to the Company’s Registration Statement on Form S-8, File No. 33-134575, filed with the Commission on May 31, 2006)
4.13.2		Southwest Water Company 2006 Equity Incentive Plan Notice of Restricted Stock Award and Restricted Stock Agreement (incorporated by reference as Exhibit 4.13.2 to the Company’s Registration Statement on Form S-8, File No. 33-134575, filed with the Commission on May 31, 2006)
4.13.3		Southwest Water Company 2006 Equity Incentive Plan Notice of Restricted Stock Unit Award and Restricted Stock Unit Agreement (incorporated by reference as Exhibit 4.13.3 to the Company’s Registration Statement on Form S-8, File No. 33-134575, filed with the Commission on May 31, 2006)
4.13.4		Southwest Water Company 2006 Equity Incentive Plan Stock Option Agreement (incorporated by reference as Exhibit 4.13.4 to the Company’s Registration Statement on Form S-8, File No. 33-134575, filed with the Commission on May 31, 2006)
4.13.5		Southwest Water Company 2006 Equity Incentive Plan SAR Agreement (incorporated by reference as Exhibit 4.13.5 to the Company’s Registration Statement on Form S-8, File No. 33-134575, filed with the Commission on May 31, 2006)
10.1		Executive Employment Agreement dated April 28, 2006, between Cheryl L. Clary and Southwest Water Company (incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed with the Commission on May 3, 2006)
10.2		Executive Employment Agreement dated April 28, 2006, between Michael O. Quinn and Southwest Water Company (incorporated by reference to Exhibit 10.2 to the Company’s Form 8-K filed with the Commission on May 3, 2006)
10.3		Change of Control Agreement dated April 28, 2006, between Cheryl L. Clary and Southwest Water Company (incorporated by reference to Exhibit 10.3 to the Company’s Form 8-K filed with the Commission on May 3, 2006)
10.4		Change of Control Agreement dated April 28, 2006, between Michael O. Quinn and Southwest Water Company (incorporated by reference to Exhibit 10.4 to the Company’s Form 8-K filed with the Commission on May 3, 2006)

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Exhibit Number		Exhibit Description
10.5		Change of Control Agreement dated as of May 15, 2006, between Southwest Water Company, a Delaware corporation, and Mark A. Swatek, the Company’s Chairman of the Board and Chief Executive Officer (incorporated by reference to Exhibit 10.1 to the Company’s Form 8-K filed with the Commission on May 19, 2006)
10.17.1.1	*	First Amendment to Amended and Restated Master Loan Agreement (MLA No. RX 0936) dated November 6, 2006 between Monarch Utilities I L.P. and CoBank, ACB
15	*	Letter regarding unaudited interim financial information from Independent Registered Public Accounting Firm
21.1	*	Subsidiaries of the Registrant
31.1	*	Certification of Principal Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2	*	Certification of Principal Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1	*	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2	*	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

*Filed herewith

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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, thereto duly authorized.

	SOUTHWEST WATER COMPANY (REGISTRANT)
Date: November 9, 2006	By:	/s/ CHERYL L. CLARY
		Cheryl L. Clary
		Chief Financial Officer

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EX-4.1.6

Exhibit 4.1.6

SUBURBAN WATER SYSTEMS

TO

U.S. BANK NATIONAL ASSOCIATION,
TRUSTEE

FIFTH AMENDMENT AND SUPPLEMENT TO

INDENTURE OF MORTGAGE AND DEED OF TRUST
DATED OCTOBER 1, 1986

[This instrument is an amendment to an Indenture which is a mortgage of both real and personal property, including chattels, and also constitutes, among other things, a security agreement creating a security interest in personal property.  Such Indenture contains after-acquired property provisions.]

THIS FIFTH AMENDMENT AND SUPPLEMENT TO INDENTURE OF MORTGAGE AND DEED OF TRUST DATED OCTOBER 1, 1986 (the “Fifth Amendment”), is made and entered into as of October 20, 2006, by and between SUBURBAN WATER SYSTEMS, a California corporation formerly known as Southwest Suburban Water (herein, the “Company”), and U.S. BANK NATIONAL ASSOCIATION, a national banking association, as trustee (herein, the “Trustee”), with respect to the following:

A.The Company executed and delivered that certain Indenture of Mortgage and Deed of Trust dated October 1, 1986 ( the “Original Indenture”) to Security Pacific National Bank, a national banking association, predecessor to Bank of America NT & SA, predecessor trustee to U.S. Bank Trust National Association (originally named First Trust of California, National Association), predecessor to the Trustee.  The Original Indenture was recorded on November 17, 1986, as Instrument No. 86-1574184 in the Official Records of the County of Los Angeles, State of California, and was recorded on November 17, 1986, as Instrument No. 86-563570 in the Official Records of the County of Orange, State of California.

B.The Original Indenture was amended pursuant to that certain First Amendment and Supplement to Indenture of Mortgage and Deed of Trust Dated October 1, 1986 (the “First Amendment”), dated as of February 7, 1990, and recorded on April 12, 1990, as Instrument No. 90-694089 in the Official Records of the County of Los Angeles, State of California, and was recorded on May 8, 1990, as Instrument No. 90-241742 in the Official Records of the County of Orange, State of California, and further amended pursuant to that certain Second Amendment and Supplement to Indenture of Mortgage and Deed of Trust Dated October 1, 1986 (the “Second Amendment”), dated as of January 24, 1992, and recorded on February 14, 1992, as Instrument No. 92-260829 in the Official Records of the County of Los Angeles, State of California, and was recorded on February 14, 1992, as Instrument No. 92-091620 in the official records of the County of Orange, State of California, and further amended pursuant to that certain Third Amendment and Supplement to Indenture of Mortgage and Deed of Trust Dated October 1, 1986 (the “Third Amendment”), dated as of October 9, 1996, and recorded on October 18, 1996, as Instrument No. 96-1696870 in the Official Records of the County of Los Angeles, State of California, and was recorded on October 18, 1996, as Instrument No. 199650531190 in the official records of the County of Orange, State of California, and further amended pursuant to that certain Fourth Amendment and Supplement to Indenture of Mortgage and Deed of Trust Dated October 1, 1986 (the “Fourth Amendment”), dated as of October 19, 2004, and recorded on October 19, 2004, as Instrument No. 04-2682597 in the Official Records of the County of Los Angeles, State of California, and recorded on October 19, 2004, as Instrument No. 2004000939642 in the Official Records of the County of Orange, State of California.  The Original Indenture, as amended and supplemented by the First Amendment, the Second Amendment, the Third Amendment, and the Fourth Amendment, is hereinafter referred to as the “Existing Indenture,” and the Existing Indenture, as amended and supplemented by this Fifth Amendment, is hereinafter referred to as the “Indenture.”

C.The Company has requested that the Trustee enter into this Fifth Amendment setting forth the terms and conditions of the issuance of certain Bonds in the aggregate principal amount of $10,000,000, which Bonds shall be issued as “Series E” under and pursuant to the Indenture.  Proceeds from the Series “E” Bonds will be used to repay the maturing Series “C” Bonds in the entire $8 million amount outstanding on October 20, 2006, the date of the Series “E” Bond closing.  The remaining $2 million proceeds will be used for general corporate purposes.

D.The Company has duly authorized the creation, execution and delivery of the Series E Bonds, and all things have been done which are necessary to make the Series E Bonds, when executed by the Company and authenticated and delivered by the Trustee under the Indenture and duly issued by the Company, the valid and binding obligations of the Company, and to constitute the Indenture a valid

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mortgage and deed of trust and a security agreement and contract for the security of the Bonds (including, without limitation, the Series E Bonds), in accordance with the terms of the Bonds and the Indenture.  In addition, all other instruments and actions required pursuant to law and pursuant to the requirements of the Existing Indenture for the Trustee to execute and deliver this Fifth Amendment have been duly delivered or taken.

E.The Company redeemed 100% of the issued and outstanding Series A Bonds.

F.The Company will pay all principal and accrued interest payable on 100% of the issued and outstanding Series C Bonds concurrently with and out of the proceeds of sale of the Series E Bonds pursuant to this Fifth Amendment.

AMENDMENT

IN CONSIDERATION of the foregoing recitals and pursuant to the authority granted under Section 13.01 of the Indenture [Supplemental Indentures Without Consent of Bondholders], the Company and the Trustee agree that the Existing Indenture shall be amended in the following respects.

1.DEFINITIONS.

All terms used in this Fifth Amendment with initial capital letters and not defined herein shall have the meanings given in the Existing Indenture.

2.ORIGINAL ISSUANCE OF SERIES E BONDS.

There is hereby added to the Existing Indenture a new Article, to be entitled Article XIX, and which shall read in its entirety as follows:

“ARTICLE XIX
TERM AND ISSUE OF SERIES E BONDS

Section 19.01.  Specific Title, Terms and Forms.  There shall be a fifth series of Bonds entitled “First Mortgage Bonds, Series E 6.295%, Due October 20, 2026” (herein called the “Series E Bonds”).  The forms thereof shall be substantially as set forth in Article II with such insertions, omissions, substitutions and variations as may be determined by the officers executing the same as evidenced by their execution thereof to reflect the applicable terms of the Series E Bonds established by this Article.  The precise form of Series E Bonds shall be as set forth in an exhibit to the Bond Purchase Agreement (the “Purchase Agreement”) dated as of October 20, 2006, between the Company and the Purchaser named therein pursuant to which the Series E Bonds are sold, and the Trustee is authorized to refer to such Purchase Agreement when any Series E Bonds are presented to the Trustee for authentication.

The Maturity of the Series E Bonds shall be October 20, 2026, and the aggregate principal amount thereof which may be authenticated and delivered and Outstanding is limited to $10,000,000.

The Series E Bonds may be issued only as registered Bonds in denominations of $1,000 and any multiple thereof.  The Series E Bonds shall bear interest from the later of the initial issuance of the Series E Bonds or the most recent Interest Payment Date to which interest has been paid or duly provided for.  The Series E Bonds shall bear interest payable semi-annually on April 1 and October 1 of each year (the Interest Payment Dates of the Series E Bonds), at the rate of 6.295% per annum, until the principal

3

thereof shall be paid or duly provided for; provided that interest on any overdue principal, overdue Redemption Price, and (to the extent permitted by applicable law) overdue interest, shall accrue at a rate equal to the lesser of (a) the highest rate allowed by applicable law or (b) 7.295% per annum.  Interest shall be computed on the basis of a 360-day year of twelve 30-day months.

Notwithstanding the provisions of Section 5.05 [Deposit of Redemption Price] or other provisions in the Indenture to the contrary, the principal or the Redemption Price of, and any applicable accrued and unpaid interest on, the Series E Bonds shall be payable by depositing such amounts, before 12:00 noon, New York time, on the Redemption Date or Maturity date, as the case may be, by federal funds bank wire transfer, in the account of each Bondholder of the Series E Bonds in any bank in the United States as may be designated in a written notice to the Company by such Bondholder, or in such other manner as may be directed, or to such other address in the United States as may be designated, in writing by such Bondholder.  The address on Annex 1 to the Purchase Agreement with respect to the initial purchaser of the Series E Bonds shall be deemed to constitute notice, direction or designation (as appropriate) to the Company with respect to direct payments to such purchaser as aforesaid.  With regard to any Series E Bond, the bank designated pursuant to this paragraph with respect to such Series E Bond shall be the Place of Payment in respect of such Series E Bond.

The Regular Record Date referred to in Section 2.10 [Payment of Interest on Bonds, Interest Rights Preserved] for the payment of the interest payable on the Series E Bonds, and punctually paid or duly provided for, on any Interest Payment Date shall be the 20th day (whether or not a Business Day) of the calendar month next preceding such Interest Payment Date.

If any payment due on, or with respect to, any Series E Bonds shall fall due on a day other than a Business Day, then such payment shall be made on the First Business Day following the day on which such payment shall have so fallen due; provided that if all or any portion of such payment shall consist of a payment of interest, for purposes of calculating such interest, such payment shall not be deemed to have been originally due on such first following Business Day, and such interest shall accrue and be payable only to the Interest Payment Date.

Section 19.02.  Exchangeability.  Subject to Section 2.08 [Registration, Transfer and Exchange], all Series E Bonds shall be fully interchangeable, and, upon surrender at the office or agency of the Company which the Company maintains pursuant to Section 6.02 [Maintenance of Office or Agency], shall be exchangeable for other Series E Bonds of a different authorized denomination or denominations, as requested by the Holder surrendering the same.  The Company will execute, and the Trustee shall authenticate and deliver, Series E Bonds whenever the same are required for any such exchange.

Section 19.03.  Redemption.

A.The Series E Bonds are subject to redemption, in whole or in part, before their Maturity in the following events and in the manner provided in Article V [Redemption of Bonds] (unless a different manner is set forth in this Section 19.03, in which case the provisions of this Section shall control):

(1)at any time after issuance, at the option of the Company evidenced by a Board Resolution, in an amount not less than 5% of the aggregate principal amount of the Series E Bonds Outstanding in the case of a partial redemption, at a Redemption Price equal to 100% of the principal amount of the Series E Bonds to be redeemed, together with the Make Whole Surcharge at such time (as shall be calculated by Purchaser which calculations shall be set forth in an Officers’ Certificate delivered to each Holder of Series E Bonds and to the Trustee two (2) Business Days prior to the Redemption Date) and interest accrued and unpaid to the Redemption Date, on a Redemption Date specified by the

4

Company in compliance with Section 5.02 [Election to Redeem; Notice to Trustee], except that notice of the Redemption Date and other matters specified in Section 5.02 [Election to Redeem; Notice to Trustee] shall be given not less than 30 nor more than 60 days prior to the Redemption Date specified by the Company.  The Company shall obtain from Purchaser a calculation of the estimated Make Whole Surcharge and interest due three (3) business days prior to the Redemption Date.  A final determination of the Make Whole Surcharge will be recalculated in agreement with Purchaser on the Redemption Date; and

(2)from moneys received by the Trustee as a result of a major casualty or condemnation as provided in Articles VII [Possession and Release of Property] and VIII [Application of Trust Moneys], at a Redemption Price equal to 100% of the principal amount of Bonds to be redeemed, together with the Make Whole Surcharge at such time (provided that in the case of any redemption resulting from a major casualty event, such Make Whole Surcharge shall be calculated without the additional amount required by paragraph B of the definition of such term) and together with interest accrued and unpaid to the Redemption Date, and on a Redemption Date that is the first date for which notice of redemption can be given by the Trustee as provided in Article V [Redemption of Bonds].  For purposes of this Section 19.03, a “major” casualty or condemnation is one in which either or both of (i) the compensation for, or proceeds of sale of, any part of the Trust Estate Taken by Eminent Domain, or (ii) the proceeds of insurance upon any part of the Trust Estate, is equal to or greater than $10,000,000.

B.Notwithstanding the last sentence of the first paragraph of Section 5.04 [Notice of Redemption] and the first sentence of the second paragraph of Section 1.04 [Notices to Bondholders, Waiver], the giving of notice of redemption to each Holder of a Series E Bond, as provided in Section 5.04, shall be a condition precedent to the Company’s right to redeem Series E Bonds in accordance with the foregoing clauses A(1) and A(2) of this Section 19.03.  Any notice of redemption to any Holder of Series E Bonds for a redemption pursuant to clause A(1) of this Section 19.03 shall be accompanied by an Officers’ Certificate as to the estimated Make Whole Surcharge due in connection with such redemption (calculated as if the date of such notice were the date of such redemption) setting forth the details of such computation.

C.Notwithstanding the provisions of Section 5.03 [Selection by Trustee of Bonds to Be Redeemed], if there is more than one Holder of the Series E Bonds, the aggregate principal amount of each required or optional partial redemption of the Series E Bonds shall be allocated in units of $1,000 or multiples thereof among the Holders of the Series E Bonds at the time Outstanding in proportion, as nearly as practicable, to the respective unpaid principal amounts of the Series E Bonds then Outstanding held by each such Holder of Series E Bonds, with adjustments, to the extent practicable, to equalize for any prior redemptions not in such proportion.

D.Notwithstanding the second sentence of Section 5.06 [Bonds Payable on Redemption Date] or the provisions of Section 5.07 [Bonds Redeemed in Part], no Holder of any Series E Bond shall be required to surrender such Bond to any Person, or to file, or cause to be filed, with the Trustee any agreement or certificate required by Section 5.07, prior to receiving any payment thereon or in respect thereof; provided, however, that upon payment of the principal or Redemption Price in full, and accrued and unpaid interest on and all other amounts in respect of such Series E Bond, the Holder thereof shall promptly thereafter surrender such Series E Bond to the Company.  Any such Series E Bond so surrendered shall be cancelled and shall not be reissued, and no new Series E Bond shall be issued in lieu of such surrendered Series E Bond.

E.The Series E Bonds may be redeemed from Trust Moneys, as provided in Section 8.04 [Retirement of Bonds], including from moneys received by the Trustee as a result of casualty or condemnation, as provided in Articles VII [Possession and Release of Property] and VIII [Application of

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Trust Moneys], but only at the time, in the manner and at the Redemption Price specified in clauses (A)(1) and (A)(2) of this Section 19.03.  If the Series E Bonds shall be redeemed under Section  19.03.A(2), then said Series E Bonds shall be redeemed pro rata with the Series B Bonds, the Series D Bonds, and any other Bonds having the benefit of a redemption provision substantially identical to that contained in 19.03.A(2), in proportion, as nearly as practicable, to the respective unpaid principal amounts of all such Bonds Outstanding on the Redemption Date.

Section 19.04.  Payment of Optional Redemption Price.  If the giving of notice of optional redemption shall have been completed as required in Article V [Redemption of Bonds], the Series E Bonds or portions of such Series E Bonds specified in such notice shall become due and payable on the Redemption Date at the applicable Redemption Price set forth in Section 19.03.  On and after the Redemption Date (unless the Company shall default in the payment of such Bonds on the Redemption Date) interest on the Series E Bonds or the portions of the Series E Bonds so called for redemption shall cease to accrue.

If any Holder of any Series E Bond which is redeemed in part only shall present such Bonds to the Company, the Company shall execute and the Trustee shall authenticate and deliver to such Holder, at the expense of the Company, a new Series E Bond or Bonds in aggregate principal amount equal to the unredeemed portion of the Series E Bond so presented.

Section 19.05.  Authentication and Delivery.  Upon the execution and delivery of this Fifth Amendment, the Company shall execute and deliver to the Trustee, and the Trustee shall authenticate, the Series E Bonds and deliver them to the purchasers thereof as instructed by the Company.

Prior to the delivery by the Trustee of the Series E Bonds there shall be filed with the Trustee original executed counterparts of this Fifth Amendment, the Purchase Agreement, the Title Policies or commitments for issuance thereof and evidence of recording of this Fifth Amendment in the land records of Los Angeles and Orange Counties, California.

3.CERTAIN AMENDMENTS TO DEFINITIONS.

(a)Make Whole Surcharge Definitions.  Section 1.01 [Definitions] of the Existing Indenture is hereby amended by adding the following definition of Make Whole Surcharge for the Series E Bonds and the following related definitions:

“Make Whole Surcharge” means, with respect to any Series E Bond, an amount determined as follows:

To determine the surcharge designed to compensate CoBank for any actual or imputed funding losses incurred by CoBank as a result of the repayment, CoBank will:

(A)Determine the difference between:  (1) the rate estimated by CoBank on the date the rate was fixed to be its cost to fund the loan on that day in the manner set forth in its then current methodology; minus (2) the rate estimated by CoBank on the date the surcharge is calculated to be its cost, less dealer concessions and other issuance costs, to fund a new fixed rate loan in accordance with its then current methodology having the same fixed rate period and repayment characteristics as the balance being repaid.  If such difference is negative,

6

then for purposes of the remaining calculations, such difference shall be deemed to be zero.

(B)Add ½ of 1% to such difference (such that the minimum result shall at all times be ½ of 1%).

(C)Divide the result determined in (B) above by the number of times interest is payable during the year.

(D)For each interest period (or portion thereof) during which interest was scheduled to accrue at the fixed rate, multiply the amount determined in (C) above by the principal balance scheduled to have been outstanding during such period (such that there is a calculation for each interest period during which the amount repaid was scheduled to have been outstanding at the fixed rate).

(E)Determine the present value of each calculation made under (D) above based upon the scheduled time that interest on the amount repaid would have been payable and a discount rate equal to the rate set forth in (A)(2) above.

(F) Add all of the calculations made under (E) above.  The result shall be the Make Whole Surcharge.

Nothing contained herein shall prevent CoBank from funding its loans in any manner as CoBank may, in its sole discretion, elect, and the surcharges provided for herein shall not be increased or decreased based on the actual methods chosen by CoBank to fund or hedge the loan being repaid.”

(b)Definition of Place of Payment.  The definition of “Place of Payment” in Section 1.01 [Definitions] of the Existing Indenture is hereby amended to read, in its entirety, as follows:

“Place of Payment” means, (a) when used with respect to the Series B Bonds (except as provided in clause (d) below), the place for payment of the principal, Make Whole Amount, if any, and interest upon the Series B Bonds designated in Section 16.01; (b) when used with respect to the Series D Bonds (except as provided in clause (d) below), the place for payment of the principal, Make Whole Amount, if any, and interest upon the Series D Bonds designated in Section 18.01; (c) when used with respect to the Series E Bonds (except as provided in clause (d) below), the place for payment of the principal, Make Whole Surcharge, if any, and interest upon the Series E Bonds designated in Section 19.01; and (d) with respect to any exchange of Series B Bonds pursuant to Section 16.02 [Exchangeability]; with respect to any exchange of Series D Bonds pursuant to Section 18.02 [Exchangeability]; with respect to any exchange of Series E Bonds pursuant to Section 19.02 [Exchangeability]; and with respect to Bonds of any other series, means a city or any political subdivision thereof in which the Company is by this Indenture required to maintain an office or agency pursuant to Section 6.02 [Maintenance of Office or Agency].”

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4.REPLACEMENT OF MUTILATED, DESTROYED, LOST AND STOLEN BONDS.

The proviso in lines 5 through 7 of the first paragraph of Section 2.09 [Mutilated, Destroyed, Lost and Stolen Bonds] of the Existing Indenture is hereby amended to add thereto the words “or Series E Bond” immediately after the words “Series D Bond.”

5.COVENANTS.

In consideration of and in connection with the issuance of the Series E Bonds, the Company makes the following additional covenants in favor of the Series E Bondholders (but not the Series A Bondholders, the Series B Bondholders, the Series C Bondholders, the Series D Bondholders, or the Bondholders of any subsequent series of Bonds, if any).

(a)Redemption of Series E Bonds.  If Bonds having the benefit of a redemption provision substantially identical to that contained in Section 3.03A(3) shall be redeemed under Section 3.03A(3), then Series E Bonds shall be redeemed pro rata with the Bonds having the benefit of a redemption provision substantially identical to that contained in Section 3.03A(3) in proportion, as nearly as practicable, to the respective unpaid principal amount of all such Bonds outstanding on the Redemption Date.

(b)Financial Reports to Series E Bondholders.  Article VI [Covenants] of the Existing Indenture is hereby amended by adding thereto a new Section, to be entitled Section 6.18 and to read in its entirety as follows:

“Section 6.18.  Financial Reports to Series E Bondholders.  For so long as any of the Series E Bonds are Outstanding, the Company shall furnish to each of the Series E Bondholders at their addresses for notices pursuant to Section 1.04 [Notices to Bondholders; Waiver] all financial statements and information, notices, reports and other information required pursuant to, and otherwise comply with each of, the provisions of Section 4.1 (together with any successor provision, and as such provision or successor provision may be amended from time to time), of the Purchase Agreement pursuant to which the Series E Bonds were originally sold, which provisions are incorporated by reference herein, mutatis mutandis, with the same effect as if set forth therein.”

(c)Dividend Covenant.  Section 6.14 [Payment of Dividends] of the Existing Indenture is hereby amended by adding the following to the end of the first paragraph thereof:

“In addition to the foregoing, for so long as any of the Series E Bonds are Outstanding the Company will not declare or make or incur any liability to make any Distribution in respect of the common stock of the Company if, immediately after giving effect to the proposed Distribution, the aggregate amount of Distributions in respect of its common stock made during the period subsequent to December 31, 2003 would exceed:  the sum of (a) $24,077,000.00, plus (b) 95% of the aggregate Net Income (or 100% of Net Income if Net Income shall be a deficit) accrued subsequent to December 31, 2003.”

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(d)No Change in Business.  Article VI [Covenants] of the Existing Indenture is hereby amended by adding thereto a new Section 6.19, reading in its entirety as follows:

“Section 6.19.  No Change in Business.

The Company shall not cease to conduct its principal business as a regulated water/wastewater public utility under the laws of one or more states of the United States of America.  In the event that the Company shall engage in a consolidation, merger, conveyance, transfer or lease transaction pursuant to the provisions of Section 12.01 and 12.02 of the Indenture, the Company agrees that any surviving or successor entity will be a regulated water/wastewater public utility under the laws of one or more states of the United States of America.”

6.POWERS EXERCISABLE NOTWITHSTANDING DEFAULT.

(a)Section 7.04.  Section 7.04 [Powers Exercisable Notwithstanding Default] of the Existing Indenture, as previously amended and restated by the Fourth Amendment, is hereby amended to read, in its entirety, as follows:

“While in possession of all or substantially all of the Trust Estate (other than any cash and securities constituting part of the Trust Estate and deposited with the Trustee), the Company may exercise the powers conferred upon it in the Sections of this Article even though it is prohibited from doing so while a Default exists as provided therein, if (i) the Holders of not less than 66-2/3% in principal amount of each of the following series of Bonds then Outstanding, the Series B Bonds, the Series D Bonds, and the Series E Bonds, and (ii) the Holders of not less than 66-2/3% in principal amount of all other Bonds then Outstanding (as a group), in each case by Act of such Bondholders, shall consent to such action, in which event none of the instruments required to be furnished to the Trustee under any of such Sections as a condition to the exercise of such powers need state that no Default exists as provided therein.”

(b)Section 8.07.  Section 8.07 [Powers Exercisable Notwithstanding Default] of the Existing Indenture, is hereby amended to read, in its entirety, as follows:

“While in possession of all or substantially all of the Trust Estate (other than any cash and securities constituting part of the Trust Estate and deposited with the Trustee), the Company may do any of the things enumerated in Sections 8.02 [Withdrawal on Basis of Bondable Capacity] to 8.06 [Amounts under $100,000], inclusive, which it is prohibited from doing while a Default exists as provided therein, if (i) the Holders of not less than 66-2/3% in principal amount of each of the following series of Bonds then Outstanding: the Series B Bonds, the Series D Bonds, and the Series E Bonds, and (ii) the Holders of not less than 66-2/3% in principal amount of all other Bonds then Outstanding (as a group), in each case by Act of such Bondholders, shall consent to such action, in which event any Certificate filed under any of said

9

Sections shall omit any statement to the effect that no Default exists as provided thereunder.”

7.EVENTS OF DEFAULT.

Section 9.01 [Events of Default] of the Existing Indenture is hereby amended by adding thereto a new subsection 9.01.F, to read in its entirety as follows:

“F.“Event of Default” with respect to the Series E Bonds only means any one of the events specified in clause A of this Section 9.01 or any one of the following events (whatever the reason for such event and whether it shall be voluntary or involuntary or be effected by operation of law or pursuant to any judgment, decree or order of any court or any order, rule or regulation of any administrative or governmental body):

(1)Principal or Premium Payments – the Company fails to make any payment of principal or Make Whole Surcharge on any Series E Bond when such payment is due,

(2)Interest Payments – the Company fails to make any payment of interest on any Series E Bond within 5 days after the date such payment is due,

(3)Particular Covenant Defaults – the Company fails to perform or observe any covenant contained in Section 6.06, Section 6.09, Section 6.14, the last sentence of Section 6.12, or Article XII,

(4)Other Defaults – the Company fails to comply with any other provision of this Indenture or the Purchase Agreement pursuant to which the Series E Bonds were sold, and such failure continues for more than 30 days after such failure shall first become known to any officer of the Company;

(5)Warranties or Representations – any warranty or representation by the Company or by Southwest Water Company, a Delaware corporation, contained in this Indenture, the Purchase Agreement pursuant to which the Series E Bonds were sold or in any instrument or certificate furnished by the Company in compliance with this Indenture or the Purchase Agreement pursuant to which the Series E Bonds were sold is false or incorrect in any material respect on the date as of which made,

(6)Default on Indebtedness – the Company fails to make any payment due on any indebtedness for borrowed money (including, without limitation, Bonds of any other series) in an amount aggregating in excess of $1,000,000, or any event shall occur or any conditions shall exist in respect of any such indebtedness of the Company, or under any agreement securing or relating to such indebtedness, the effect of which is (i) to cause (or permit any Holder of such indebtedness or a trustee to cause) such indebtedness, or a portion thereof, to become due prior to its

10

stated maturity or prior to its regularly scheduled date or dates of payment or (ii) to permit a trustee to elect a majority of the directors on the Board of Directors of the Company, and

(7)Undischarged Final Judgments – a final judgment or judgments for the payment of money aggregating in excess of $100,000 is or are outstanding against the Company and any one of such judgments has been outstanding for more than thirty (30) days from the date of its entry and has not been discharged in full or stayed.”

8.CONDEMNATION OF ENTIRE TRUST ESTATE.

The parenthetical phrase in lines 5 and 6 of Section 8.10 [Condemnation of Entire Trust Estate] of the Existing Indenture is hereby amended in its entirety to read as follows:

“(other than the Series B Bonds, which shall only be redeemable pursuant to Section 16.03 [Redemption], the Series D Bonds, which shall only be redeemable pursuant to Section 18.03 [Redemption]), and the Series E Bonds, which shall only be redeemable pursuant to Section 19.03 [Redemption]).”

9.INCIDENTS OF SALE.

Section 9.05.A [Incidents of Sale] of the Existing Indenture is hereby amended to read, in its entirety, as follows:

“A.  the principal, the Make Whole Amount, the Make Whole Surcharge or other premium, if any, and accrued interest on all Outstanding Secured Bonds, if not previously due, shall at once become and be immediately due and payable,”

10.NOTICE OF DEFAULTS.

Section 10.02.  [Notice of Defaults] of the Existing Indenture is hereby amended and restated to read in its entirety as follows:

“Within 90 days after the Trustee shall have actual knowledge of any Default hereunder, the Trustee shall transmit by mail to all Bondholders entitled to receive reports pursuant to Section 11.03.C [Reports by Trustee], if operative, and if Section 11.03.C is not operative, to all Registered Holders of Bonds as their names and addresses appear in the Bond Register, notice of such Default hereunder known to the Trustee, unless such Default shall have been cured or waived; PROVIDED, HOWEVER, that, except in the case of a Default in the payment of the principal of (or premium, if any) or interest on any Bond or in the payment of any sinking or purchase fund installment, and except for notice to the Holders of Series B Bonds, Series D Bonds, or Series E Bonds, which shall not be withheld in any event, the Trustee shall be protected in withholding such notice if and so long as the board of directors, the executive committee or a trust committee of directors and/or Responsible Officers of the Trustee in good faith determine that

11

the withholding of such notice is in the interests of the Bondholders; PROVIDED, FURTHER, that in the case of any Default of the character specified in Section 9.01.A(3) [Events of Default], except as specified in the next succeeding provision, no such notice to Bondholders shall be given until at least 30 days after the occurrence thereof; and, PROVIDED, FURTHER, that in the case of any Default with respect to the Series B Bonds, Series D Bonds, or Series E Bonds, the Trustee shall give written notice thereof to the Holders of, respectively, Series B Bonds, Series D Bonds, or Series E Bonds, as their names and addresses appear in the Bond Register, promptly after the Trustee has actual knowledge of such Default.

11.SUPPLEMENTAL INDENTURES WITH CONSENT OF BONDHOLDERS.

The proviso in lines 4 through 7 of the second to last paragraph of Section 13.02 [Supplemental Indentures with the Consent of Bondholders] of the Existing Indenture is hereby amended and restated in its entirety to read as follows:

“, PROVIDED, HOWEVER, that the Trustee shall not at any time make any such determination with respect to the Series B Bonds, Series D Bonds, or Series E Bonds, respectively, without the prior written consent of the Holders of a majority in principal amount of, respectively, the Series B Bonds, Series D Bonds, or Series E Bonds, as the case may be, Outstanding at such time.”

12.EFFECTIVE DATE.

As used herein, the Effective Date of this Fifth Amendment shall be that date upon which an executed and acknowledged counterpart of this Fifth Amendment is recorded in the Offices of the County Recorders of Los Angeles and Orange Counties, California.

13.INDENTURE IN EFFECT.

The Company and the Trustee agree and acknowledge that the Existing Indenture, as amended and supplemented by this Fifth Amendment, remains in full force and effect in accordance with its terms.

14.COMPANY COVENANT TO PAY TRUSTEE FEES.

By its signature hereto, the Company covenants and agrees to pay the reasonable fees and costs of the Trustee incurred or charged in connection with the review and execution of this Fifth Amendment and all other instruments described in Recital D to this Fifth Amendment.

15.COUNTERPARTS AND INCLUSIONS IN INDENTURE.

This Fifth Amendment may be executed in two or more counterparts, each of which shall be deemed an original, but all of which together shall constitute a single instrument.  Upon recordation of this Fifth Amendment in the Offices of the County Recorders of Los Angeles and Orange Counties, California, this Fifth Amendment shall be and become a part of the Indenture and shall be construed as a part thereof.  By its signature hereto, the Trustee authorizes the Company to record executed and acknowledged counterparts of this Fifth Amendment in the Offices of the County Recorders of Los Angeles and Orange Counties, California.

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16.SEPARABILITY CLAUSE.

In case any provision in this Fifth Amendment shall be invalid, illegal or unenforceable, the validity, legality and enforceability of the remaining provisions, and of the other provisions of the Indenture, shall not in any way be affected or impaired thereby.

17.GOVERNING LAW.

THIS FIFTH AMENDMENT SHALL BE CONSTRUED IN ACCORDANCE WITH AND GOVERNED BY THE LAWS OF THE STATE OF CALIFORNIA.

IN WITNESS WHEREOF, the parties hereto have caused this Fifth Amendment and Supplement to Indenture of Mortgage and Deed of Trust Dated October 1, 1986, to be duly executed, with the Company’s corporate seal to be hereunto affixed and attested, all as of the day and year first above written.

SUBURBAN WATER SYSTEMS,
Mortgagor
By	/s/ Michael O. Quinn
	Michael O. Quinn
	President
By	/s/ John A. Brettl
	John A. Brettl
	Chief Financial Officer
U.S. BANK NATIONAL ASSOCIATION,
As Trustee,
Mortgagee
By	/s/ Julia Hommel
	Authorized Officer

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EX-10.17.1.1

Exhibit 10.17.1.1

FIRST AMENDMENT TO
MASTER LOAN AGREEMENT

THIS FIRST AMENDMENT TO MASTER LOAN AGREEMENT (this “Amendment”) is entered into as of November 6, 2006, between MONARCH UTILITIES I 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 an Amended and Restated Master Loan Agreement dated as of September 12, 2005 (the “MLA”). The parties now desire to amend the MLA.

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

SECTION 1.         Definitions.  All capitalized terms used in this Amendment and not otherwise defined herein shall have the meanings given to those terms in the MLA.

SECTION 2.         Amendments.

(A)          Debt. Section 6.02 of the MLA is hereby amended to add the following sentence at the end thereof:  “For purposes hereof, accounts payable to ECO Resources, Inc. for services rendered to the Company in the ordinary course of the Company’s business and which are paid by the Company on a regular basis (“ECO Accounts”) shall be considered to be accounts payable and not debt.

(B)          Payments of Debt to Southwest. Section 6.08(B) is hereby amended and restated to read as follows: “(B) make any payments on any debt owing to Southwest or any subsidiary of Southwest.”

(C)          Financial Covenants.  Article 7 of the MLA is hereby amended and restated in its entirety to read as follows:

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 1.20 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 to EBITDA for each fiscal year of the Company of not greater than 10 to 1.

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 .65 to 1.00.

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

(B)          Definitions.

(1)           Debt Service Coverage Ratio. The definition of “Debt Service Coverage Ratio” is hereby amended to add the following sentence at the end thereof: “Notwithstanding the foregoing: (1) in calculating net income, management fees shall be excluded as long as such fees are not paid by the Company; and (2) ECO Accounts shall not be considered to be Long-Term Debt.”

(2)           EBITDA.  The definition of “EBITDA” is hereby amended to add the following sentence at the end thereof: “Notwithstanding the foregoing, in calculating EBITDA management fees shall be excluded from operating expenses as long as such fees are not paid by the Company.”

(3)           ECO Accounts. There is hereby added in alphabetical order, a definition of ECO Accounts reading as follows: “ECO Accounts shall have the meaning set forth in Section 6.02 of the Agreement.

(4)           Total Debt. The definition of “Total Debt” is hereby amended to add the following sentence at the end thereof: “In calculating Total Debt: (1) all long-term debt and other loans and advances from Southwest (other than loans and advances for construction) shall be included; and (2) ECO Accounts shall be excluded.”

SECTION 3.         Representations and Warranties.  The Company represents and warrants that: (A) no consent, permission, authorization, order or license of any governmental authority or of any party to any agreement to which the Company is a party or by which it or any of its property may be bound or affected, is necessary in connection with the execution, delivery, performance or enforcement of this Amendment; (B) the Company is in compliance with all of the terms of the Loan Documents and no Default or Event of Default exists; and (C) this Amendment has been duly authorized, executed and delivered by the Company, and creates legal, valid, and binding obligations of the Company which are enforceable in accordance with their terms, except to the extent that enforceability may be limited by applicable bankruptcy, insolvency or similar Laws affecting the rights of creditors generally.

SECTION 4.         Confirmation.  Except as amended hereby, the MLA shall remain in full force and effect as written.

IN WITNESS WHEREOF, the parties have caused this Amendment 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:	By:
Title:	Title:

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EX-15

Exhibit 15

(KPMG LLP Letterhead)

November 9, 2006

Southwest Water Company
Los Angeles, California

Re: Registration Statements (Nos. 333-18513, 333-38935, 333-39506, 333-39508, 333-109444, 333-117713, and 333 134575) on Form S-8 and the Registration Statements (Nos. 333-77881, 333-35252, 333-63196, 333-69662, 333 70194, 333-106506, 333-111586, 333-121426, and 333-133399) on Form S-3

With respect to the subject registration statements, we acknowledge our awareness of the use therein of our report dated November 9, 2006 related to our review of interim financial information.

Pursuant to Rule 436 under the Securities Act of 1933 (the Act), such report is not considered part of a registration statement prepared or certified by an independent registered public accounting firm, or a report prepared or certified by an independent registered public accounting firm within the meaning of Sections 7 and 11 of the Act.

/s/ KPMG LLP

Los Angeles, California

                                                                                                                                                       & #160;                                                       

EX-21.1

Exhibit 21.1

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

Subsidiaries of the Registrant

	Jurisdiction of
Name of Subsidiary / Affiliate	Incorporation
Aqua Services, LP	Texas
AquaSource Services I, LLC	Delaware
AquaSource Services II, LLC	Delaware
CDC Maintenance, Inc.	Texas
CHA Utilities, LLC.	Texas
CHA Utility Company, LTD.	Texas
ECO Capistrano Valley, Inc.	Delaware
ECO Resources, Inc.	Texas
ECO Southern California, Inc. *	California
Hornsby Bend Utility Company	Texas
Inland Pacific Development Company, LLC *	Delaware
Inland Pacific Water Company *	California
Inverness Utility Company, Inc.	Texas
Lab-tech Corporation *	Texas
METRO-H2O Utilities, Inc.	Texas
Mid-Tex Utility Company, Inc.	Texas
Midway Water Utilities, Inc.	Texas
Monarch Utilities I, LP	Texas
Monarch Utilities, Inc.	Texas
Monarch Utilities, LLC	Texas
New Mexico Utilities, Inc.	New Mexico
Novus Utilities, Inc.	Delaware
Operations Technologies, Inc.	Georgia
Southwest Environmental Laboratories, Inc.	Texas
Southwest Water Alabama, Inc.	Alabama
Southwest Water Florida, Inc. *	Florida
Southwest Water Government Services Company	Delaware
Southwest Water Services Group Houston, Inc.	Delaware
Southwest Water Mississippi, Inc.	Mississippi
Suburban Water Systems	California
SW Resource Management Company	Delaware
SW Utility Company	Texas
Tenkiller Utility Company	Oklahoma
TWC Utility Company, LLC	Texas
Wastewater Rehabilitation Inspections, Inc.	Texas
Water Quality Management Corporation	Colorado
Water Suppliers Mobile Communication Service	California
Windermere Utility Company	Texas

* - Inactive

EX-31.1

Exhibit 31.1

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

I, Mark A. Swatek, certify that:

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

2.Based on my knowledge, this quarterly 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 quarterly 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 we 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, 2006	/s/ MARK A. SWATEK
	Mark A. Swatek
	Chief Executive Officer

EX-31.2

Exhibit 31.2

Certification of Principal 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 quarterly 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 quarterly 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 we 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, 2006	/s/ CHERYL L. CLARY
	Cheryl L. Clary
	Chief Financial Officer

EX-32.1

Exhibit 32.1

Certification of Chief Executive Officer
Pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002
(18 U.S.C. § 1350)

In connection with the quarterly report of Southwest Water Company (the “Company”) on Form 10-Q for the period ended September 30, 2006 (the “Report”), I, Mark A. Swatek, Chief Executive Officer of the Company, certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350), that:

1)to my knowledge, 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.

Date: November 9, 2006	/s/ MARK A. SWATEK
	Mark A. Swatek
	Chief Executive Officer

EX-32.2

Exhibit 32.2

Certification of Chief Financial Officer
Pursuant to Section 906 of the Sarbanes-Oxley Act Of 2002
(18 U.S.C. § 1350)

In connection with the quarterly report of Southwest Water Company (the “Company”) on Form 10-Q for the period ended September 30, 2006 (the “Report”), I, Cheryl L. Clary, Chief Financial Officer of the Company, certify, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (18 U.S.C. §1350), that:

1)to my knowledge, 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.

Date: November 9, 2006	/s/ CHERYL L. CLARY
	Cheryl L. Clary
	Chief Financial Officer