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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

SOUTHWEST WATER COMPANY
(Exact name of registrant as specified in its charter)

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)

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

        Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III in this Form 10-K or any amendment to this Form 10-K. o

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

        The aggregate market value of the voting common equity held by non-affiliates of the registrant was approximately $136.7 million based upon the average bid and asked price of such common equity as of June 30, 2003. The registrant is unable to estimate the aggregate market value of its preferred shares held by non-affiliates of the registrant because there is no public market for such shares. On March 12, 2004, there were 14,712,228 common shares outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

        Portions of the Proxy Statement to be filed with the Securities and Exchange Commission on or prior to April 8, 2004 and to be used in connection with the 2004 Annual Meeting of Stockholders to be held on May 13, 2004 are incorporated by reference in Part III of this Form 10-K.

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

TABLE OF CONTENTS

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

FORWARD-LOOKING STATEMENTS

        This Annual Report on 10-K contains "forward-looking statements" within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. All statements contained in this Form 10-K that are not clearly historical in nature are forward-looking, and the words "anticipate," "believe," "belief," "expect," "estimate," "plan," "intend," "continue," "predict," "may," "should" and similar expressions are generally intended to identify forward-looking statements. Forward-looking statements are subject to risks and uncertainties, including those set forth under "Risk Factors" below, that could cause actual results to differ materially from our historical experience and our present expectations or projections. Factors that could affect forward-looking statements relating to the resolution of the reportable condition with respect to internal controls discussed in Item 9A of this Form 10-K include, among other things: the Company's ability to fully resolve the deficiencies during the six to nine month period from the date of filing of this Form 10-K; the Company's ability to identify and retain qualified and experienced financial personnel at the Services Group; the Company's ability to design and maintain policies and procedures which enable the Company to avoid any reoccurrence of the matters which gave rise to the reportable condition; and the Company's ability to implement policies and procedures including documentation that meets the internal control over financial reporting requirements of the rules adopted by the Securities and Exchange Commission pursuant to Section 404 of the Sarbanes-Oxley Act of 2002. Caution should be taken not to place undue reliance on any such forward-looking statements since such statements speak only as of the date when made. Other than as required by applicable law, we undertake no obligation to publicly update or revise forward-looking statements.

PART I

ITEM 1.    DESCRIPTION OF BUSINESS.

OVERVIEW

        Southwest Water Company (Southwest Water, the "Company," "we," "us," or "our") was incorporated in California in December 1954. We reincorporated in Delaware in June 1988. We provide a broad range of services including water production and distribution, wastewater collection and treatment, public works services, utility billing and service, and infrastructure construction management. We provide our services to more than two million people in 36 states. Our business is operated by our subsidiaries and is segmented into two operating groups: our Services Group and our Utility Group.

        Our Services Group provides water and wastewater facility operations and maintenance services, equipment maintenance and repair, sewer pipeline cleaning, billing and collection services, and state-certified water and wastewater laboratory analysis on a contract basis. The facilities we operate are owned by cities, public agencies, municipal utility districts and private entities primarily in Texas, New Mexico, California, Colorado, Alabama, Mississippi, Georgia and New Jersey. Our Services Group also facilitates the design, construction, project management, and operating aspects of various water and wastewater projects. During the construction phase of such a project, our Services group may have an ownership interest in the project. This Group is headquartered in Sugar Land, Texas. Additionally, our Services Group provides utility billing services for multiple family housing units such as apartment buildings. These operations include installation of meters, billing, collection and customer services. While state and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect our Services Group operations, the pricing of our services within the Services Group is not subject to regulation.

        Within our Utility Group, we own and manage the operations of rate-regulated public water and wastewater utilities in California, New Mexico and Texas. State and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these

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operations. The rates that we can charge for water and wastewater usage are established and approved by government agencies.

OUR BUSINESS STRATEGY

        Our primary objectives are to provide an essential product or service, and to generate value for clients, customers, employees and stockholders. We apply two principal strategies in our efforts to continue growing our business and improving our financial performance:

We work to enhance organic revenue growth.

        Southwest Water Company is a leading full spectrum service provider in the water and wastewater industries. We have a broad footprint in high population-growth states. Our target market focus is on small to medium size cities. We offer our clients and customers services within our core competency of water and wastewater management. In addition we provide related peripheral services including:

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Refurbishing of manholes and sewer lines,



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Pipeline inspection,



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Water meter replacement,



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Water and waste water quality testing,



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Construction management,



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Utility billing and collection and



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Public works management.

        Successful application of our organic revenue growth strategy was evidenced in June 2003 when one of our subsidiaries was granted a 10-year, $30-million contract to operate the public works department of the City of Pascagoula, Mississippi. Included in this contract is management of water production and distribution, sewage collection and treatment, and other public works services for the Gulf Coast city's 30,000 residents.

        Organic revenue growth in 2003 benefited from rate increases in our California and Texas utilities and increased customer connections in our New Mexico and Texas utilities.

We pursue selected acquisitions that fit our long-term growth goals in both the Utility and Services Groups.

        In recent years we have made several key acquisitions to expand our business.

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In February 2000, our California utility purchased the City of West Covina's water distribution system and facilities adding approximately 7,000 connections to our customer base; (an increase of approximately 11%).



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In April 2000, we acquired 80% of Master Tek International, Inc. (Master Tek), a company with expertise in billing and collection services and utility submetering. We subsequently acquired the remaining 20% of Master Tek in 2003.



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In August 2001, we acquired Operations Technologies, Inc. (OpTech) which enhanced our contract operations in two ways. First, it extended our client base to the Southeast portion of the United States as OpTech serves clients in Georgia, and expanded our coverage of the Gulf Coast by adding operations in Alabama and Mississippi. Second, it expanded our range of contract services to include such public works functions as storm water drainage, system maintenance and street repair.

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In November 2002 we acquired certain contract operations of AquaSource, Inc., which we operate under the name Aqua Services, LP (Aqua Services). The acquisition introduced us to new markets in three states and strengthened our presence in the Houston, Texas area.

KEY BUSINESS SEGMENTS

        Group revenues for the three years ended December 31, 2003 were as follows:

SERVICES GROUP—DEVELOPMENT OF BUSINESS, SERVICES AND REGULATION

Contractual Relationships

        Our Services Group has three distinct types of contractual relationships:

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Time-and-material contracts, primarily with municipal utility districts in Texas,



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Operations and maintenance contracts for a fixed-fee and



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Construction management contracts.

Municipal Utility District (MUD) Contracts

        A MUD is created under the rules of the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission, to provide water supply, wastewater treatment and drainage services to areas where existing municipal services are not available. Our Services Group has MUD contracts in the suburbs of Houston, Austin and El Paso, Texas. Under a typical MUD contract, we bill a monthly base fee to provide a specified level of services. We typically provide water and wastewater facility operations and maintenance services, equipment maintenance and repair, billing and collection services, and state-certified water and wastewater laboratory analysis. We usually bill for any additional services provided beyond the basic contract on a time-and-materials basis as such services are rendered. Most contracts provide for an increase in the monthly base fee as the number of customer connections increases and do not generally include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis. Generally, MUD contracts are cancellable on 30 or 60-day notice by either party. Our experience indicates that, with high-quality service and strong focus on client satisfaction, MUD relationships can last for many years.

Operations and Maintenance (O&M) Contracts

        O&M contracts are agreements with cities and private entities that provide specific services such as facility operation and maintenance, meter reading, customer billing and collection, or management of the entire water or wastewater system. Under a standard O&M contract, our Services Group companies charge a fee that covers a specified level of services. Services are typically provided evenly throughout the contract period and are billed on a monthly basis. Our O&M contracts limit our liability in the event of a major system failure or catastrophic event. If we provide services beyond the scope of a contract, we bill for the additional services. For example, if a major system failure or catastrophic event occurred as the result of flooding, earthquake, electrical strike or vandalism, the facility owner usually asks us to provide additional services on a time-and-materials basis.

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        Most O&M contracts provide for annual increases based upon measures of inflation, and we typically have the right to increase our fixed operations fee if the system experiences customer connection growth beyond a specified level. We may pay certain costs such as chemical or power expenses. Usually, however, the contracts provide reimbursement for these costs.

        In most cases, O&M contracts are cancellable only upon a specific breach of contract by either party. O&M contracts have terms ranging from month-to-month up to 20 years. We have a strong focus on customer service and client satisfaction and our experience has been that over 95% of our O&M contracts are renewed upon expiration.

Construction Management Projects

        In 1999, we agreed to design, build, finance and operate a $6.5 million reverse osmosis water treatment plant near El Paso, Texas, for the El Paso County Water Authority (EPCWA). Reverse osmosis technology is a process that removes microscopic particles such as minerals and salts from a solution to produce potable water. The project included drilling five wells and developing associated water lines and settling ponds. During construction of the treatment plant, we received monthly payments from the EPCWA. In addition, the EPCWA awarded us a 20-year, $22.0 million extension of the existing operating contract. The construction of the plant was substantially completed in December 2000 and the facility began operating in February 2001, treating an average of 2.6 million gallons of water per day.

        In September 2002, we agreed to design, build, finance and operate a $25.0 million reverse osmosis water treatment plant in the city of San Juan Capistrano, California, for the Capistrano Valley Water District (CVWD). The project includes the drilling of eight new wells and the installation of associated water lines. During construction of the treatment plant, we have received payments upon completion of construction milestones and will continue to receive such payments until final completion of construction. In addition, the CVWD awarded us a 20-year $20.0 million contract to operate the treatment plant after completion of construction. The construction of the plant started in December 2002. As of December 31, 2003 the plant is approximately 50% complete. We expect to complete the plant during or before the fourth quarter of 2004 at which time we will begin to operate the facility under the 20-year contract. Upon completion, the plant will have the capacity to produce approximately 5.0 million gallons of potable water per day.

        Our Services Group has contracted with our Texas utilities and our New Mexico utility to perform operating services, normal maintenance and construction work and, in addition, to manage capital projects for these utilities. These contracts were established utilizing terms and conditions equivalent to prevailing industry rates and for similar work performed by our Services Group for non-affiliated customers. In accordance with Statement of Financial Accounting Standards (SFAS) No. 71, Accounting for the Effects of Certain Types of Regulation, we recognize a profit margin from contract work performed and do not eliminate the intercompany profit on the contract work performed when the contract price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process.

Growth and Backlog

        During the past three years, our Services Group has increased revenues and service area by adding new contracts, construction projects, pursuing renewal of existing contracts and by making acquisitions.

        Our Services Group's revenue backlog consists of new and existing contracts. We include new contracts in the backlog when we have a signed contract. Revenues included in the backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these contracts is reflected in the backlog. MUD and utility billing contracts are assumed to have a 36-month term, consistent with

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our experience, and are included in the backlog computation using an assumed 36-month term. The acquisition of Aqua Services in November 2002 accounted for most of the increase in MUD and O&M contracts during 2002.

        As of December 31, 2003 and 2002, our Services Group backlog was approximately $315.0 million and $275.0 million, respectively.

Seasonality

        Our Services Group operations can be affected by severe weather and rainfall. In general, heavy rainfall or storm conditions may limit our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions may also result in additional labor and material costs to us that may not necessarily be recoverable from our various firm price city contracts. However, such severe weather conditions are infrequent, and any additional costs that we incur that cannot be billed under our contracts are not material to our results of operations.

        Revenues and earnings of our billing and collection business are generally not subject to seasonal fluctuations.

Competition

        Competition in the O&M portion of our business includes a number of significantly larger companies that provide O&M services on a national and international basis, as well as regional and local competitors. New contracts are awarded based on a combination of customer relationships, service levels, competitive pricing, references and technical expertise. While our Services Group intends to expand its market share within the southwestern and southern United States, there is substantial competition in these markets. Cities themselves are also major competitors, since we must overcome reluctance on the part of city officials to outsource their water and wastewater services. Although industry renewal rates tend to be high, the contract water and wastewater management business is very competitive, and we cannot assure you that our Services Group will be able to increase or sustain its market share.

UTILITY GROUP—DEVELOPMENT OF BUSINESS, SERVICES AND REGULATION

California

        Our regulated public water utility in California produces and supplies water for residential, business, industrial and public authority use and for fire protection service under the jurisdiction of the California Public Utilities Commission (CPUC). Our California utility service area contains a population of approximately 311,000 people in an area of approximately 43 square miles within Los Angeles and Orange counties.

        Our California utility or its predecessor entities have supplied water since approximately 1907. From the mid-1950s to the late 1960s, our operations expanded rapidly as most of our service area was converted from agricultural use to residential, business and industrial use.

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        The following table indicates by classification the number of water connections that our California utility served as of the end of each of the past three years:

California Utility—Number of Water Connections by Classification

        During 2003, our California utility's annual revenues were approximately 74% from sales to residential connections, approximately 17% from sales to business and industrial connections, and approximately 9% from sales to other connections.

        Our California Utility provides water by either pumping water from wells we own or by purchasing water from the Metropolitan Water District of Southern California (MWD), a governmental agency, and other sources. The wells owned and operated by our California utility pump water from two of the major groundwater basins in the Southern California coastal watershed: the Main San Gabriel Basin (the Main Basin) and the Central Basin. Our rights to pump water from the Main and Central Basins are fully adjudicated under California law, and these adjudications establish our right to produce water at levels and at a cost prescribed each year by the Watermaster Boards (the Boards) that manage the Main and Central Basins. Our California utility is also allowed to produce water from the Main and Central Basins in excess of the amount prescribed by the Boards, but when such excess production occurs, an additional payment from our utility is required to provide for the replenishment of the water supply. As the water levels in the Main and Central Basins increase or decrease, the Boards may adjust the amount of water that we are allowed to pump.

        In the Environmental Matters section below, we discuss certain groundwater issues impacting the Main Basin. In 2001 we were required to shut down some of our wells due to these issues. This resulted in our California utility purchasing increasing amounts of water from the MWD and other sources in 2001. During 2002, our California utility shut down additional wells which necessitated the purchase of an additional amount of water. The percentage of water supply purchased form external sources is as follows:

        Under an agreement made in early 2002, we have been reimbursed for certain costs of purchasing water needed to replace lost production as a result of the Main Basin contamination issues. We expect such reimbursement to continue until completion of remediation.

        Our California utility owns 15 wells and 30 reservoirs. We believe that we are able to purchase or produce adequate water to serve our current customer base and manage reasonable growth from new customers.

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New Mexico

        Our regulated public water utility in New Mexico provides water supply and sewage collection services for residential, commercial and irrigation use and for fire protection service under jurisdiction of the New Mexico Public Regulation Commission (NMPRC). Our New Mexico utility service area is located in the northwest part of the City of Albuquerque and in the northern portion of Bernalillo County, and contains a population of about 41,000 people in an area of approximately 34 square miles. Approximately 35% of the area has been developed.

        The following table indicates by classification the number of water connections served by our New Mexico utility as of the end of each of the most recent three years:

New Mexico Utility—Number of Water Connections by Classification

        Our New Mexico utility has grown from approximately 800 connections at the time of its acquisition in 1969 to almost 13,000 connections. Most of this growth has resulted from the extension of water services and sewage collection services into new residential subdivisions and new commercial development. During 2003, we added 1,584 new water connections and 1,564 new wastewater connections in New Mexico. Because of the continuing real estate development in our service area, we expect continued connection growth in 2004. During 2003 and 2002, our revenues in New Mexico were approximately 63% and 61%, respectively, from sales to residential connections and approximately 37% and 39%, respectively, from sales to commercial and industrial connections.

        Our New Mexico utility owns six wells and five reservoirs, and we believe that we have adequate water capacity to serve our current customer base as well as reasonable growth from new customers. The wells that we own and operate in New Mexico produce water from the Rio Grande Underground Basin.

        As customer growth continues in our New Mexico service area, we may have to increase our water supply capacity through additional well construction. Our New Mexico utility has established an emergency supply of water available through an interconnection with another water purveyor, for use in the case of a temporary interruption in our New Mexico water supply.

Texas

        Our regulated public water utilities in Texas provide water supply and sewage collection and treatment services to approximately 6,100 connections for residential, commercial, irrigation and fire protection under the jurisdiction of the Texas Commission on Environmental Quality (TCEQ). Our service areas in Texas are located near the City of Austin, and contain a population of approximately 20,000 people in an area of approximately eight square miles, of which an estimated 50% has been developed. These service areas are experiencing continued real estate development, and we expect the number of connections to continue growing in 2004.

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Texas Utilities—Number of Water Connections by Classification

        Our Texas utilities own or have rights to 17 wells and 11 reservoirs in addition to distribution, collection and treatment facilities. Water is pumped from the Edwards aquifer. We believe that we have adequate capacity to serve our existing customer base in Texas as well as reasonable growth from new customers.

        As customer growth continues in our Texas service areas, we may have to increase the water supply capacity of our Texas utilities through a combination of outside water purchases and the construction of additional wells. One of our Texas utilities has long-term agreements to purchase water from the cities of Austin and Pflugerville in Texas.

Growth

        In recent years, the growth of our California utility has been limited to extensions into new subdivisions along the periphery of its service area. There is little undeveloped land available for new business, industrial construction or residential growth in the California service area. As a result, we do not anticipate significant increase in the number of connections in our current service area.

        Although our utility service areas in California are mature, our California utility operations are capital intensive. Significant capital expenditures are necessary for the renovation and replacement of our facilities in California. Capital is generated from utility operations and periodic debt financing. Our California utility also receives contributions in aid of construction from developers, governmental agencies, municipalities or individuals to assist in the cost of facility replacement. For the years ended December 31, 2003, 2002 and 2001, capital expenditures in California approximated $7.8 million, $10.0 million and $4.7 million, respectively. Of these amounts, our California utility received capital contributions and advances from developers of approximately $3.6 million, $2.5 million and $0.3 million in 2003, 2002 and 2001, respectively. Additions for 2003 included approximately $2.5 million of payments received as part of a settlement agreement relating to Main Basin groundwater contamination (see Environmental Matters below).

        Because our New Mexico utility service area continues to experience customer growth, our operations are capital intensive. Capital is generated from New Mexico operations, periodic debt financing, bank lines of credit extended to our New Mexico utility and to Southwest Water, contributions in aid of construction received from developers, and from advances received from developers, which must be repaid under rules of the NMPRC. For the years ended December 31, 2003, 2002 and 2001, capital expenditures approximated $9.6 million, $7.5 million and $3.7 million, respectively. Of these amounts, our New Mexico utility received capital contributions from developers of approximately $8.6 million, $6.7 million and $3.1 million in 2003, 2002 and 2001, respectively.

        Because our Texas utility service areas are also in locations of customer growth, these operations are capital intensive as well. Capital is generated from Texas operations, a bank term loan and Living Unit Equivalent (LUEs) connection fees received from developers. For the years ended December 31, 2003 and 2002, capital expenditures were approximately $11.1 million, $13.7 million and $5.0 million, respectively. Of these amounts, our Texas utilities received contributions and LUEs from developers of approximately $0.6 million in 2003, $4.8 million and $1.0 million in 2003, 2002 and 2001, respectively.

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Seasonality

        Our Utility Group water revenues are seasonal because rainfall and weather conditions affect water consumption. The second and third quarters of each year typically account for the highest volume of water consumption when weather tends to be hot and dry. The results of operations for one quarter do not indicate results to be expected in another quarter. Drought conditions may result in consumer conservation efforts or water shortages, which can reduce consumption. Drought conditions may also result in increased water costs to us, which could adversely affect our profitability. Conversely, unusually wet conditions may result in decreased customer demand, lower revenues and lower profit in our utility operations. Utility Group wastewater revenues are generally not affected by seasonality.

Environmental Matters

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

        The incremental and unreimbursed costs of purchasing replacement water and related energy costs in 1999, 2000 and 2001 related to this contamination were approximately $84,000, $756,000 and $809,000, respectively. Prior to May 2002, these costs were recorded as operating expenses and reduced our operating income.

        In May 2002, a settlement agreement was reached between some of the parties allegedly responsible for the contamination (Cooperating Respondents) and a number of affected water companies, including our California water utility. As a result of this agreement, we recorded income in 2002 of approximately $1.7 million, for reimbursement of certain water and energy costs, incurred from the contamination. This settlement was an unusual event and we recorded the $1.7 million in Other income (expense), in accordance with the provisions of Accounting Principles Board (APB) Opinion No. 30, Reporting the Results of Operations.

        Since our groundwater contamination related costs incurred prior to the agreement were not included in our water rate calculations, the reimbursement offset costs that our utility had previously incurred, resulting in no effect on ratepayers.

        As a result of this contamination, we have received payments during the last three years, and we expect to continue to receive payments until completion of remediation. These payments represent the incremental cost of purchasing water over the cost that would have been incurred by us to pump water from our wells had they not been shut down as a result of contamination and excluded costs covered in the $1.7 million settlement discussed above. The settlement agreement provided for ongoing reimbursement of our excess water costs and we bill and collect this reimbursement monthly. These monthly reimbursements are recorded as a reduction to operating expenses. The reimbursements were approximately $4.0 million, $4.4 million during 2003 and 2002.

        The settlement agreement also provides for contributions by the Cooperating Respondents for construction of new wells and interconnections with nearby water sources. These contributions were approximately $2.5 million and approximately $4.4 million for 2003 and 2002, respectively, and were recorded as contributions in aid of construction.

Water Quality Regulations

        The water supplies available to our utilities in California, New Mexico and Texas are subject to regulation by the United States Environmental Protection Agency (EPA) under the 1996 Federal Safe Drinking Water Act (US Act). The US Act establishes uniform minimum national water quality

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standards, as well as specification of the types of treatment processes to be used for public drinking water. The EPA, as mandated under the US Act, issues regulations that require, among other things, disinfection of drinking water, specification of maximum contaminant levels (MCLs) and filtration of surface water supplies.

        Our California water supplies are also subject to regulation by the Office of Drinking Water of the California Department of Health Services (DOHS) under the California Safe Drinking Water Act (Cal Act). The Cal Act and the rules of the DOHS are similar to the US Act and the mandates of the EPA, except that in many instances the requirements of the DOHS are more stringent than those of the EPA.

        In addition to the EPA and the DOHS water quality regulations, our California water utility is also subject to water quality standards that may be set by the CPUC. The California Supreme Court has ruled that the CPUC has the authority to set standards that are more stringent than those set by the EPA and the DOHS.

        In June 1998, we detected the substance N-nitrosodimethylamine (NDMA) in one of our California utility's wells at a level in excess of the EPA reference dosage for health risks. Upon detection, the well was immediately removed from service. In 1999, our California utility completed construction of a treatment facility that is intended to reduce NDMA in this well to non-detectable levels. In February 2001, we received final regulatory approval of the facility and in May 2001, our California utility began producing water from this well.

        In January 2002, the DOHS set a more stringent recommended standard for the substance perchlorate, which was subsequently detected in this California well at levels in excess of the revised standard. We immediately removed this well from service. In 2000, in another of our California utility's well fields, we detected amounts of contaminants in excess of the EPA reference dosage for health risks. All wells in that well field were immediately removed from service. The water production from these wells was replaced with purchased water, the excess costs of which were substantially funded by the Cooperating Respondents.

        The water supplied by our New Mexico utility is subject to regulation by the EPA and by the State of New Mexico Environmental Improvement Division (EID). The water supplied by our Texas utilities is subject to regulation by the EPA and by the TCEQ.

        In February 2002, the EPA set a more stringent arsenic standard in drinking water from 50 parts per billion to 10 parts per billion, which must be fully met by 2006. At the present time, our water sources in California and Texas are in compliance with the new standards. The DOHS is holding discussions that could result in a more stringent arsenic standard effective in June 2004. We cannot predict the impact that such changes in the arsenic standard would have on our California and Texas water utility operations. If the arsenic standard remains at 10 parts per billion, we do not expect it to have a material adverse impact on our financial position or results of operations in California and Texas.

        Although our New Mexico utility meets the current arsenic standard of 50 parts per billion, it does not meet the newly adopted arsenic standard of 10 parts per billion. To meet this new standard by the required 2006 implementation date, we are considering options that include the construction of an arsenic removal treatment plant. We anticipate that significant capital expenditures at our New Mexico facility may be required to comply with the new arsenic standard and that the cost of water will increase as a result of treatment requirements. However, we cannot determine the impact at this time. We believe that there may be funds available from state or federal agencies that could defray all or a part of the capital expenditures that we believe will be necessary to meet the new arsenic standards. If this new standard has an impact on our New Mexico operations, we will likely make a request to the NMPRC for recovery of these costs. We cannot assure you that funds will be made available to our

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New Mexico utility or that costs incurred or capital spent will ultimately be recoverable from the ratepayers.

        Costs associated with testing of our water supplies in California have increased and are expected to further increase as regulatory agencies adopt additional monitoring requirements. We believe that costs associated with the additional monitoring and testing of our water supply in California will be recoverable from ratepayers through future rate increases. However, we cannot assure you that water sources currently available to our California utility will meet future EPA or DOHS requirements, that recovery of additional costs will be allowed, or that new or revised monitoring requirements will not necessitate additional capital expenditures by our California utility in the future. We believe that future incremental costs of complying with governmental regulations, including capital expenditures, will be recoverable through increased rates. However, we cannot assure you that recovery of such costs will be allowed.

        Both the EPA and the DOHS have put into effect regulations and other pronouncements that require periodic testing and sampling of water to ensure that only permissible levels of organic and volatile and semi-volatile organic compounds (VOCs), herbicides, pesticides, radionuclides, and inorganic substances are present in water supplied to the public. Our California water quality personnel regularly sample and monitor the quality of water being distributed throughout the system. Our California utility conducts sampling, testing and inspections at the intervals, locations and frequencies required by EPA and DOHS regulations. Chlorination is currently performed to provide chlorine residuals required by the DOHS as a safeguard against bacteriological contamination. In addition to water sampling and testing performed by our personnel, independent engineers retained by the Boards conduct sampling and testing for certain pollutants such as VOCs. Water samples from throughout our California water system are tested regularly by independent, state-certified laboratories for bacterial contamination, chemical contaminant content and for the presence of pollutants and contaminants for which MCLs have been put into effect. The results of the sampling and testing are made available to DOHS and all water purveyors that produce water from the Basins. The cost of such sampling and testing is covered by assessments to the producers.

        Samples of water from throughout our water systems in California, New Mexico and Texas, as well as treated wastewater, are regularly tested by independent, state-certified laboratories, and the test results are sent to the respective state regulatory agencies. Chlorination is performed as a safeguard against bacteriological contamination. Each of the companies in our Utility Group provides its customers with an annual water quality report that, among other matters, informs them of the sources and quality of the water being provided.

        We believe that water supplied by our California utility meets all current requirements of the US Act, the Cal Act and the regulations put into effect under the related legislation and CPUC standards. We also believe that water supplied by our New Mexico utility and our Texas utilities complies with all current requirements of the EPA and the respective state regulatory agencies. However, we cannot assure you that water sources currently available to our water utilities will meet future EPA or state regulatory requirements, or that such future requirements will not necessitate future capital expenditures by our water utilities.

Rate Establishment

        The CPUC, the NMPRC and the TCEQ regulate the rates and operations of our regulated utility subsidiaries in California, New Mexico and Texas, respectively. The rates established by these agencies are intended to provide utilities an opportunity to recover costs and earn a reasonable return on capital.

        Under current CPUC practices, California customer water rates may be changed through general rate cases or by offsets for certain rate base and expense items. Since September 30, 2002, the

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California Public Utilities Code has required that CPUC-regulated water utilities file general rate cases every three years. General rate cases require formal proceedings with the CPUC in which overall rate structure, expenses and rate base are examined by CPUC staff. Historically, rate proceedings have required approximately 12 months from the time an application is filed to the CPUC's authorization of new rates. Our California utility made a general rate case filing on April 2, 2002 and was granted an average 17% increase in rates effective May 28, 2003.

        In addition to a general rate increase, the CPUC typically provides for step increases in the second and third years. The step increases are intended to compensate for projected expense increases. Prior to their approval, step increases are subject to verification that proforma earnings levels have not exceeded the rate of return authorized in the general rate proceeding.

        Under prior CPUC procedures, offsets were approved through an abbreviated proceeding that required approximately two months from the time a request was filed to the authorization of new rates. Under current CPUC guidelines, offset changes, particularly increases, have more restrictions and will no longer be considered outside of general rate cases unless they occur within the three-year general rate cycle.

        The CPUC allows water utilities to pass unforseen expenses through to rate payers through balancing accounts. In the water industry those costs have been determined to consist of costs for purchased water, purchased power and pump taxes. Prior to November 29, 2001, the CPUC allowed balancing accounts in the income statements of water utilities, with a corresponding liability or asset on the balance sheet. However, the CPUC has changed this policy by eliminating the use of balancing accounts after November 29, 2001. Our California water utility has recorded a balancing account receivable of approximately $2.3 million, representing the difference between actual water production costs incurred and California Public Utilities Commission (CPUC)-adopted water production costs. In December 2002, the CPUC issued a decision that we anticipate will allow our water utility in California to recover the $2.3 million balancing account. Currently, when actual water production costs exceed CPUC-adopted levels the costs are expensed as incurred. Costs are tracked in a memorandum account for potential future recovery.

        One of our Texas utilities filed for a general rate increase in June 2001, and new rates became effective in January 2002. Our other utilities are not currently seeking any rate increase; however, regulatory changes concerning water quality, future construction expenditures and increased operating expenses may result in future requests for rate increases.

        Historically, our utilities have been permitted to increase rates as necessary to achieve a reasonable rate of return, and we believe that this practice will continue in the future. However, the inability to increase rates in the event that certain costs increase could adversely affect the results of operations of our Utility Group.

Competition

        Our regulated utility subsidiaries in California, New Mexico and Texas each operate under a Certificate of Public Convenience and Necessity granted by the CPUC, NMPRC and TCEQ, respectively. These companies are also regulated by other state and local governmental authorities having jurisdiction over water and wastewater service and other aspects of our water utility businesses. Our Utility Group water businesses are dependent upon maintaining these certificates and upon various governmental and court decisions affecting our water rights and service areas.

        California, Texas and New Mexico state laws provide that no public or private agency can install facilities within the service area of a public utility in order to compete with it, except upon payment of just compensation for all damages incurred by the public utility. Under the state laws of California and New Mexico, municipalities and certain other public agencies have the right to acquire private water

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utility plants and systems within their territorial limits by condemnation but must pay fair value for the condemned system. We are not aware of any impending proceeding for the condemnation of any portion of their facilities.

CREDIT CONCENTRATION

        We have no individual customers who accounted for 10% or more of our consolidated revenues in 2003, or whose loss would have a material adverse effect on our consolidated or operating segment revenues.

INTELLECTUAL PROPERTY

        The primary focus of the water and wastewater management industry is customer service, and the industry does not rely heavily on technological or proprietary manufacturing processes. We do not conduct significant research and development activities, although we have several patents pending for certain metering equipment. Except for certain logos, trademarks and artwork used in marketing, we have no other patents, licenses or trademarks.

SIGNIFICANT ACQUISITIONS

        In November 2002, we acquired certain contract operations of Aqua Source Inc., a provider of contract water and wastewater services in Texas, Colorado and South Dakota. The purchase price consisted of approximately $10.3 million in cash. Upon closing of the transaction on November 22, 2002, we began operating the majority of this business under the name Aqua Services, LP (Aqua Services) while the remaining part was incorporated into one of our existing subsidiaries, ECO Resources, Inc. (ECO).

        In August 2001, we purchased 90% of the outstanding shares of OpTech, a provider of contract water and wastewater and public works services in the southeastern United States, for a purchase price of $8.2 million. The purchase price consisted of cash payments of $3.5 million in August 2001 and $0.4 million in January 2002, promissory notes in the aggregate amount of $3.0 million and shares our common stock with a market value of $1.3 million at August 31, 2001. We also entered into an employment agreement and a non-compete agreement with the owner of the remaining 10% of OpTech. Under the terms of our purchase agreement, we have the right to acquire the remaining 10% of OpTech after a period of five years based upon a formula relating to the profitability of OpTech. After two years, the minority owner has the option to sell the remaining 10% of OpTech to us using the same formula, subject to a minimum of $1.0 million.

        In April 2000, we acquired 80% of the outstanding common stock of Master Tek. The Company entered into a separate employment agreement, a consulting agreement and a non-compete agreement with the minority owner. Under the terms of the purchase agreement, the minority owner had the right to require the Company to purchase his initial 20% minority interest in 5% increments at a price based on a formula but not less than $1.0 million per year over a four-year period commencing in April 2002. In April 2002, the Company paid $1.0 million to the minority owner for an additional 5% interest in Master Tek in accordance with the purchase agreement. In February 2003, the minority owner exercised his right to require us to purchase an additional 5% interest in Master Tek, which increased the Company's ownership to 90% in April 2003.

        After the April 2000 purchase of Master Tek, the minority owner and the Company had several disagreements, which ultimately led us to initiate legal action against the minority owner. During 2003, we placed payments due to the minority owner in escrow.

        In December 2003, we came to a final resolution of the litigation against the minority owner. The agreement called for a payout of approximately $2.7 million to the minority owner as final payoff of the remaining $1.5 million note payable due the minority owner, and in exchange for the remaining 10% interest in Master Tek stock. All other future obligations to the minority owner were terminated. The final agreement provided for indemnifications from the minority owner to cover certain unasserted claims. The settlement payout of approximately $2.7 million was made in January 2004.

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        In February 2000, our California utility purchased the city of West Covina's water distribution system and facilities for a price of approximately $8.5 million. The sale closed February 25, 2000, and we assumed ownership and operation of the water system on that date. The transaction added approximately 7,000 connections to our California utility customer base, an increase of about 11%.

        In 1996, we acquired a 49% interest in Windermere Utility Company (Windermere), a regulated water and wastewater utility located in the Austin, Texas area. In October 2000, we reached an agreement with the majority stockholder and purchased an additional 31% interest from the majority stockholder, increasing our ownership in Windermere to 80%. As part of this transaction, we also purchased 100% of Hornsby Bend Utility Company (Hornsby), a nearby water and wastewater utility. The purchase price for these two transactions consisted of Southwest Water common stock with a market value of $4.0 million at October 1, 2000. The purchase agreement provides that we have the right to acquire the remaining 20% ownership in Windermere for a purchase price of $6.0 million payable in our common stock at any time when the market value of our common stock increases to $13.61 per share (after adjustment for stock splits and dividends through January 2004). The minority owner of Windermere has the right to sell the remaining 20% after October 1, 2005, for $6.0 million payable in our common stock, subject to a limitation on the maximum and minimum number of issuable shares. We also entered into a consulting agreement with the minority owner.

EMPLOYEES

        At December 31, 2003, we employed approximately 1,400 people. Approximately 1,200 people were employed in our Services Group and 200 were employed in our Utility Group. Approximately 1% of our employees are represented by an employee-union. We believe relations with our employees are positive.

DIVIDEND HISTORY

        During the past twenty years, Southwest Water has paid a quarterly cash dividend. For specific information relative to dividends paid during 2003 and 2002, see Item 5. Market for the Registrant's Common Equity and Related Stockholder Matters. In addition, we have also declared stock splits, paid in the form of stock dividends, annually over the last five years.

RISK FACTORS

        The following factors could cause our actual results to differ materially from our historical results and/or forward-looking statements:

Risks Related to our Common Stock

•

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

We have significant levels of long term debt including, first mortgage bond indentures, term loans, convertible debentures and revolving credit facilities. If we were unable to make scheduled principal or interest payments on our debt, we could face actions by our creditors including penalties, litigation, increased interest charges, acceleration of maturity schedules, and cross default issues. Such actions by our creditors could have a material adverse effect on our results of operations.

We are obligated to maintain specified debt covenants under certain of our loan and debt agreements. If we were unable to maintain compliance with these covenants we could face penalties, increased interest charges, litigation, acceleration of maturity schedules, and cross default

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issues. Such actions by our creditors could have a material adverse effect on our results of operations.

•

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

As a holding company, we conduct all of our operations exclusively through our subsidiaries and our only significant assets are our investment in those subsidiaries. This means that we are dependent on distributions of funds from our subsidiaries to meet our debt service and other obligations. Our subsidiaries are separate and distinct legal entities and have no obligation to pay any amounts due on our debt. Furthermore, our right to receive cash or other assets of one of our subsidiaries upon the liquidation or reorganization of that subsidiary is generally subject to the prior claims of creditors, including trade creditors, of that subsidiary. Even if we were recognized as a creditor of that subsidiary, our claims would still be subject to any security interest of that subsidiary's other creditors. Therefore, our debt would be structurally subordinated to creditors, including trade creditors, of our subsidiaries. If we were unable to collect funds from our wholly owned subsidiaries in a timely manner we could be unable to meet our obligations, which could have a material adverse effect on our results of operations.

•

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

Our share price could become volatile due in part to the high volatility in the securities markets generally as well as developments from quarter to quarter which impact our financial results. Factors other than our financial results that may affect our share price include, but are not limited to:

(i) market expectations of the performance and capital spending plans of our customers; (ii) the level of business activity or perceived growth in the market for water services in general; (iii) investor perception of, as well as the actual performance of, other utilities or water services companies; (iv) a change in interest rates; (v) announcements by our customers or announcements concerning financial difficulties for customers for whom we have provided financing or with whom we have entered into material contracts; (vi) announcements by our key competitors concerning the award of large agreements or contracts for water services; (vii) potential litigation involving ourselves or the industries in which we operate; and (viii) announcements concerning the bankruptcy or other similar reorganization proceedings involving, or any investigations into the accounting practices of, other water services companies.

Risks Related to Our Business

Risk factors that affect our Services Group operations

•

We operate in a competitive market with low operating margins.

Our Services Group competes with several larger companies whose size, financial resources, customer base and technical expertise may restrict our ability to compete successfully for certain operations and maintenance contracts.

Due to the nature of our contract operations business, and to the very competitive nature of the market, we operate in a low margin environment. We must accurately estimate the cost and profitability of each project while, at the same time, maintaining prices at a level low enough to compete with other large companies. Our inability to do so could adversely impact our future revenue growth and profitability.

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•

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

Our revenue growth depends upon our ability to generate new as well as renew operating contracts with smaller cities, other agencies and municipal utility districts. Because we are selling in a political environment, we are subject to changing trends and municipal preferences. Recent terrorist acts have affected some political viewpoints relative to outsourcing of water or wastewater utility services. In the United States, municipalities own and municipal employees operate the majority of water and wastewater systems. A significant portion of our Services Group's marketing and sales efforts is spent demonstrating the benefits of contract operations to elected officials and municipal authorities. Employee unions and certain "public interest" groups generally oppose the principle of outsourcing and are active opponents in this process. The political environment means that decisions are made based on many factors, not just economic factors.

•

Our business depends on trained, qualified employees.

State regulations set the employee training, experience and qualifications standards required to operate specific water and wastewater facilities. We must recruit, retain and develop qualified employees, maintain training programs and support employee advancement. We must also obtain the proper management and operational people, finding state-certified and qualified employees to support the operation of water and wastewater facilities. Failure to do so could put us at risk, among other things, for operational errors at the facilities, for improper billing and collection processes, and for loss of contracts and revenues.

•

Events such as hurricanes, tornadoes and floods may affect our results of operations.

Our Services Group contract operations can be impacted by heavy rainfall which may limit our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions, such as hurricanes, tornadoes and floods, may result in additional labor and material costs that may not necessarily be recoverable under our firm, fixed-price O&M contracts, and may adversely impact our revenues and profitability. However, for our non-fixed-priced contracts, these events may provide additional billable opportunities to provide cleanup and repair work.

•

Our Services Group contracts have certain performance risks.

Our Services Group operating contracts require high levels of service to our clients. If we are unable to provide such services, the client may refuse payment, terminate the contract and may initiate a claim against us. Though we provide training programs, maintain close management oversight, provide performance bonds to our clients and follow other best practice activities, should we fail to properly provide these services. Such a failure may adversely impact our revenues and profitability.

Additionally, in certain circumstances our billing and collection business may use estimates in calculating invoices sent to tenants on behalf of our landlord clients. These estimates may involve allocations of common area space, extrapolation of usage data, allocation of usage between billing periods, correction of incorrect meter readings, and usage allocation based upon facility size, tenant load, occupancy term and other factors. We cannot assure you that we will not face claims regarding the use of such estimates, which may impact our profitability.

•

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

We have entered into, and may continue to enter into, design and construction contracts for water and wastewater facilities. These construction activities involve potential risks, including shortages of materials and labor, work stoppages, labor relations disputes, weather interference, engineering,

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environmental, permitting or geological problems and unanticipated cost increases for reasons beyond our control. These issues could give rise to delays, cost overruns or performance deficiencies, or otherwise adversely affect the design, construction or operation of the project. To minimize our exposure to the risks associated with construction projects, we attempt to procure maximum price contracts from significant subcontractors, and secure performance and completion bonds from those subcontractors.

Certain of our contracts are fixed-price contracts, where we may bear all, or a significant portion of, the risk for cost overruns. Under these fixed-price contracts, our contract pricing is established in part based on fixed, firm subcontractor quotes or contracts and on cost and scheduling estimates. These estimates may be based on a number of assumptions, including assumptions about prices and availability of labor, equipment and materials, and other issues. If these subcontractor quotations or cost estimates prove inaccurate, or if circumstances change, cost overruns may occur, and we could experience reduced profits or, in some cases, a loss for that project. There can be no assurance that we can avoid additional costs under these types of contracts.

We may have contracts where we guarantee project completion by a scheduled date. At times, we may guarantee that the project, when completed, will achieve certain performance standards. If we subsequently fail to complete the project as scheduled, or if the project subsequently fails to meet guaranteed performance standards, we may face claims for cost impacts and/or penalties to the client resulting from any delay or for the costs to cause the project to achieve the performance standards. To the extent that these events occur, and are not due to circumstances for which the customer accepts responsibility, and cannot be mitigated against performance bonds or our subcontractor contracts, the total costs of the project would exceed our original estimates and we could experience reduced profits or, in some cases, a loss for the project.

Our customers may require us to secure performance and completion bonds for certain contracts and projects. Since September 2001, the market environment for surety companies has become risk averse. We secure performance and completion bonds for our contracts from these surety companies. To the extent we are unable to obtain bonds, new contracts would not be awarded to us and as a result, we could experience reduced revenues and profits. There can be no assurance that we can secure performance and completion bonds on new future projects, or obtain bond renewals on existing contracts or projects.

We may manage engineering and construction activities for water and wastewater facilities where design, construction or systems failures can result in injury or damage to third parties. Any liability in excess of claims against our subcontractors, the performance bonds and our insurance limits at facilities so managed could result in liability claims against us, which may adversely impact our profits. In addition, if there is a customer dispute regarding our performance of project management services, the customer may decide to delay or withhold payment to us. If we were ultimately unable to collect these payments, our profits would be reduced.

•

We use third party equipment and subcontractors.

Our submetering business relies on third parties for certain product design, product manufacture and assembly, and product installation and service. In selecting these third party service providers we attempt to ensure that they will provide a service that meets high quality standards. We receive guarantees from certain of these vendors, but we cannot guarantee that such guarantees completely protect us from the risk of quality failure in the design, manufacture, and installation of submetering equipment. We cannot assure that we will not face claims regarding product and installation quality for equipment placed in service either before after our acquisition of our submetering business. Such claims could have an adverse impact on our profitability.

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•

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

Our clients, municipalities or public agencies, are the owners of the facilities that we operate under contract. These facilities must be operated in accordance with various Federal and state water quality standards. We also handle certain hazardous materials at these facilities, primarily chlorine gas. Any failures of our operation of the facilities, including sewage spills, noncompliance with water quality standards, hazardous material leaks and spills, and similar events, could expose us to environmental liabilities, claims and litigation costs. We cannot assure you that we will successfully manage these issues, and failure to do so could have a material adverse effect on future results of operations.

•

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

The Services Group has a fleet in excess of 500 vehicles. Our employees drive over 8 million miles per year. We are subject to normal vehicle risks associated with operating a fleet this large, including automobile accidents causing damage or injury to our own leased vehicles or employees, as well as third party damage to other property, vehicles or possible injury to others. Although we have vehicle insurance that covers material third party damage and liability, inability to manage this large fleet could have a material adverse impact on our profitability.

•

Our operating costs may rise faster than our revenues.

Many of our contracts with municipalities include contractual price increases tied to national consumer price indices. However, our costs are subject to market conditions and other factors, which may increase significantly higher than a generalized price index. The largest component of our operating costs is made up of salaries and wages. These costs are impacted by the local supply and demand for qualified labor. Other large components of our costs are general insurance, workers compensation insurance, employee benefits and health insurance costs. These costs may increase at rates higher than a price index and may have a material adverse effect on our future results of operations.

•

Our operating contracts may be canceled, reducing our revenues and backlog.

Our Service Group revenue backlog consists of new and existing contracts. We include new contracts in the backlog when we have a signed contract. Revenues included in our backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these existing contracts is reflected in the backlog. Although our Services Group tends to experience high renewal rates, municipalities and cities periodically change operators or terminate outsourcing at the end of a contract. The inability to renew existing contracts could have a material adverse impact on our Services Group. In addition, a municipality could cancel a long-term contract without notice. This would result in loss of revenues and operating profits and could involve us in litigation if a breach of contract occurs.

As of December 31, 2003, our backlog was approximately $320 million. We believe that this backlog is firm. However, we cannot guarantee that the revenues projected in our backlog will be realized or, if realized, will result in profits.

Risk Factors that affect our Utility Group operations

•

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

Rainfall and weather conditions affect our utility operations, with most water consumption occurring during the second and third quarters of each year when weather tends to be hot and dry. During this period, our marginal costs of water may exceed our marginal revenues as we use

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higher-cost purchased water to meet customer demand. Therefore, while our revenues may increase, we may experience lower profit margins during periods of peak demand.

Drought or unusually wet conditions may also adversely impact our revenues and profitability. During a drought, we may experience both lower revenues due to consumer conservation efforts and higher water costs due to supply shortages. Since a fairly high percentage of our water is used outside of our customers' homes to water yards and fill pools, unusually wet conditions could result in decreased customer demand, lower revenues and lower profit. Consequently, the results of operations for one quarter should not be used to predict the results of future quarters.

•

Changes in the regulatory environment, including restrictions on the rates we are allowed to charge customers, may adversely affect our results of operations.

The regulated utility subsidiaries are subject to regulation by governmental agencies which establish the rates that we may charge our customers. These rates are intended, in concept, to permit our utilities to recover operating costs and earn a rate of return on our investment in utility plant and equipment. Each state regulatory agency sets the rules and policies that allow our utilities to file applications to increase rates as expenses or investment needs increase. These rules and policies may require that we estimate future expenses or may require that we incur specific expenses before there can be a change in rates. As a result, our revenues and earnings may fluctuate depending on the accuracy of our estimates, timing of our investments or expenses, or other factors. For example, electric power costs in California have been volatile. While we intend to use energy-efficient techniques and appropriate equipment, we may seek an increase in rates. If we were unable to obtain a rate increase that completely offsets the effect of higher power costs, we would realize a decrease in our profitability.

The regulatory agencies may change their rules and policies which may adversely impact our profitability. In some states regulators are elected by popular vote, and the results of elections may change the rules and policies of the agency. Changes in rules and policies may adversely impact our profitability.

•

We own assets in areas subject to natural disasters.

Some of our utility operations are located in an area of southern California that is subject to earthquakes and other natural disasters. While we maintain insurance policies to help reduce our financial exposure, a significant seismic event could adversely impact our ability to deliver water.

•

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

Several factors impact our ability to provide water to our customers. We face contamination and pollution issues regarding our water supplies. Improved detection technology, increasingly stringent regulatory requirements, and heightened consumer awareness of water quality issues contribute to an environment of increased focus on water quality. While we continuously treat and test our water supplies to ensure that the water we distribute complies with water quality standards, we cannot assure you that we will be able in the future to reduce the amounts of contaminants in our wells to acceptable levels. In addition, the standards that we must meet are constantly changing and becoming more stringent. For example, in February 2002, the EPA lowered the arsenic standard in drinking water from 50 parts per billion to 10 parts per billion. If we cannot find an adequate treatment method to reduce arsenic in our New Mexico utility's well water, we would have to find alternative sources of supply. Our success in finding such alternative sources of supply at reasonable prices cannot be guaranteed.

To date, we have been able to produce and purchase enough water to meet our current customer requirements in California. However, we cannot assure you that we will be able to produce or

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purchase enough water to fully satisfy future customer demand in our California service area. We are currently examining various options to increase our available water supply in California. These options include drilling new wells, adding connections to our existing MWD supply lines and constructing water treatment facilities. We cannot assure you that the results of drilling the wells will be successful, that we will be able to obtain necessary permits to add new supply lines and connections, or that we will be able to obtain regulatory or legislative approval to operate new water treatment facilities. During 2003, we drilled two new wells that are now producing water at approximately 5,500 gallons per minute. Additionally, we added four new pipelines that provide us access to additional sources of supply.

Each of our utilities obtains its water from various sources. The preferred source is pumping water from aquifers within our service areas. In the event that our wells cannot meet the customer demand, we have the ability to purchase water from surrounding municipalities, agencies and other utilities. However, it usually costs us more to purchase water than to produce it. Furthermore, these alternative sources may not always have an adequate supply to sell us. For example, our California utility purchases water from the Metropolitan Water District of California, which receives water from the Colorado River. In 2003, the US Department of the Interior restricted the amount of water that California may receive from the Colorado River. This restriction may impact the amount of water that the Metropolitan Water District can sell to our California utility in the future. We can make no guarantee that we will always have access to an adequate supply of water that will meet all quality standards, or that the cost of our water will not adversely affect our revenues and profits.

•

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

To meet the regulatory requirements for rates, increases in customer connections, and environmental challenges we need to continue our investment in utility plant and property. Currently we obtain the funds for our capital projects from the acceptance of contributions from developers, the issuance of our equity securities to the public and the use of both short and long-term debt. In the event that the capital markets for any of these sources were not available, or if we could not raise the capital in a manner acceptable to our regulators, our financial performance could be adversely affected.

Other Risk Factors

•

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

We anticipate that our available line of credit borrowing capacity, cash balances, cash flow generated from operations, and execution of additional financing alternatives will enable us to continue operating and expanding our business. We may be unable to renew our credit facilities when they expire. We may be unable to execute additional financing alternatives at terms that we find acceptable. If we were unable to renew our existing lines of credit, or if we were unable to execute additional financing alternatives, our capital spending would be reduced or delayed, and any future acquisitions would be delayed or eliminated. While we have the ability to take these actions they could negatively impact our revenues, revenue growth, and profitability.

•

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

During the past few years, we have expanded our business both through internal growth and through acquisitions. We may actively seek acquisitions and joint ventures in each of our business lines. The success of our future business development and growth opportunities depends on our ability to attract and retain experienced and qualified persons to operate and manage our business ventures. In addition, our future success depends, in part, upon our ability to prudently manage

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past and future acquisitions, if any. We cannot assure you that we will successfully manage our growth, or acquisitions, and failure to do so could have a material adverse effect on our future results of operations.

•

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

Both our Services Group and our Utility Group operations are impacted by the general economic conditions for real estate, the pace and location of real estate development activities within the United States. Increases in the number of water and wastewater connections, connection fees and billing and collection accounts are the result of expanded real estate development in areas we serve. We have little or no ability to control the pace and location of real estate development activities which affect our business. We cannot assure you that we will be able to continue to increase the number of customer connections and accounts, which may adversely affect our revenue growth.

•

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

The cost of water (whether produced from our own wells or purchased from outside sources), electric power and natural gas represents a substantial portion of the combined operating costs of our water utilities. Purchased water is significantly more expensive than water produced by our utilities. As a result, each utility attempts to produce as much as possible of the water it delivers and to use water purchases only to supplement its own production. Factors such as drought, water contamination issues and customer demand can increase water purchases and the overall cost of water for our utilities. Such factors are not within our control and may decrease our profitability if we are unable to obtain rate increases from a regulatory agency.

Electric power costs in California have been volatile. The cost of natural gas has increased significantly in the United States in recent years. Our response to these increases is to utilize energy-efficient techniques, new and better equipment and seek rate relief from the regulating agencies. We may not, however, have the ability to completely offset the effect of these cost increases. Continued increases in the costs of these services may decrease our profitability. Such factors are not within our control and may decrease our profitability if we are unable to obtain rate increases from regulatory agencies.

•

Our operations are subject to certain risks due to their location.

We own and/or operate water and wastewater facilities in numerous locations in numerous states and, consequently, we are subject to weather, political, water supply, labor supply, utility cost, regulatory, economic and other risks in the areas we service. We cannot control these risks. However, we believe that our broad geographic service area, while exposing us to these risks in numerous local markets, provides us a certain amount of geographical diversification against these risks at a consolidated company level.

COMPANY INFORMATION

        We make available free of charge through our Internet website our press releases, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after they are electronically filed with, or furnished to, the Securities and Exchange Commission. Our Internet website also contains our Code of Ethical Conduct for all employees and our Code of Ethics for Directors and Executive Officers. The Code of Ethics for Directors and Executive Officers applies to our Chief Executive Officer and senior financial officers. We will provide without charge to any person, on the written or oral request of said person, a copy of our Ethics Code. Requests should be directed to the Director of Corporate Communications,

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Southwest Water Company, 624 South Grand Avenue, Suite 2900, Los Angeles, California 90017-3782 (telephone number (213) 929-1800). Our Internet website address is "www.swwc.com".

ITEM 2.    PROPERTIES

Facilities

Administrative Offices

        We lease administrative office and warehouse space at 13 locations in California, Texas, New Mexico, Colorado, Georgia, and Mississippi. In aggregate, these office and warehouse facilities total approximately 78,000 square feet. In addition we own administrative and warehouse space at four locations in California, Texas and New Mexico. In the aggregate, the facilities we own total approximately 19,300 square feet of office space and approximately 10 acres of land. We believe that these facilities are adequate to meet the needs of our existing operations and provide reasonable space for growth. Our operations do not require uniquely specialized facilities, and we believe that additional or alternative office space is available, if required, at reasonable prices. We may relocate some of our offices as leases terminate to improve the location or size of the facility, or to provide better coordination among our operating units.

        The majority of our property plant and equipment is held in the Utility Group. Net holdings as of December 31, 2003 are as follows:

Water Production and Distribution Facilities

        Our utilities subsidiaries own and operate water production and distribution systems including well pumping plants, booster pumping stations, water treatment facilities, reservoir storage facilities, transmission and distribution mains, and service connections to individual customers. Our utilities have rights-of-way and easements in their service areas necessary to provide water services. Water production and distribution facilities held by our utilities as of December 31, 2003 were as follows:

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Wastewater Facilities

        Our New Mexico utility owns and operates a sewer collection system consisting of one lift station and approximately 147 miles of interceptor and collector lines. Wastewater is treated at a city-owned facility.

        Our Texas utilities own and operate three sewer collection systems, including seven lift stations and approximately 85 miles of interceptor and collector lines. In 2002, one of these wastewater treatment facilities was expanded to increase our combined processing capacity from approximately 1.9 million gallons per day of sewage to over 3.7 million gallons per day.

Capital Expenditures, Repairs and Maintenance

        We believe that our properties are maintained in good condition and in accordance with current standards of good industry practice. We believe that the facilities used in the operation of our business are in good condition in terms of suitability, adequacy and utilization. We intend to continue our capital expenditure program, constructing and replacing reservoirs, wells and transmission and distribution lines in future years as needed and as approved by the regulating authorities. Our employees perform normal maintenance and construction work on these facilities while major construction projects are performed by general contractors. Ongoing maintenance and repairs expenses in our Utility Group for the three years ended December 31, 2003 were as follows:

Mortgages and Liens

        Virtually all of our California utility's property is subject to the lien of an Indenture of Mortgage and Deed of Trust dated October 1, 1986, as amended, (the California Indenture), securing our California utility's First Mortgage Bonds. The California Indenture contains certain restrictions common to such types of instruments regarding the disposition of property and includes various covenants and restrictions, including limitations on the amount of cash dividends that our California utility may pay to Southwest Water. Our California utility pays regular quarterly dividends to Southwest Water. As of December 31, 2003, our utility in California was in compliance with dividend limitations mandated by the California Indenture.

        Virtually all of our utility property in New Mexico is subject to the lien of an Indenture of Mortgage and Deed of Trust dated February 14, 1992, as amended (the New Mexico Indenture), securing our New Mexico utility's First Mortgage Bonds. The New Mexico Indenture contains certain restrictions common to such types of instruments regarding the disposition of such property and includes various covenants and other restrictions, including limitations on the amount of cash dividends that our New Mexico utility may pay to Southwest Water. Our utility in New Mexico pays regular quarterly dividends to Southwest Water. At December 31, 2003, our New Mexico utility was in compliance with dividend limitations mandated by the New Mexico Indenture.

        Substantially all of the assets of the Company's Windermere subsidiary in Texas have been identified as security for Windermere's 10-year $10.0 million secured bank term loan.

ITEM 3.    LEGAL PROCEEDINGS

        Southwest Water and a subsidiary have been named as defendants in twelve lawsuits alleging various injuries as a result of water contamination in the San Gabriel Valley Main Basin. The

23

California Supreme Court (the Court) ruled in February 2002 that the plaintiffs cannot challenge the adequacy of the water quality standards established by California Department of Health Services (DOHS). The plaintiffs may sue and collect damages from CPUC-regulated water companies only by proving that water delivered did not meet these water quality standards. Our subsidiary believes that it has complied with DOHS water quality standards. The Court directed that the cases be sent to a trial court for further proceedings. At this time a number of cases, including the twelve involving Southwest and its subsidiary, have been consolidated before a single judge. The parties are now engaged in initial discovery and motions to determine whether, in light of the ruling by the Court, the plaintiffs can plead and prove any violation of water quality standards by the CPUC regulated water companies. Southwest Water and this subsidiary have requested defense and indemnification from our liability insurance carriers for these lawsuits. Several of the liability insurance carriers are currently absorbing the costs of defense of the lawsuits. We cannot predict the outcome of these lawsuits. Based upon information available at this time, we do not expect that these actions will have a material adverse effect on our financial position, results of operations or cash flows.

        In April 2003, Southwest Water filed a lawsuit in the United States District Court for the District of Colorado against the minority owner of Master Tek for certain issues associated with both our initial acquisition of 80% of the stock of Master Tek and subsequent costs we incurred. In December 2003, the Company came to a final resolution of the litigation against the minority owner. The agreement called for a payment of approximately $2.7 million to the minority owner as final payoff of the remaining $1.5 million note payable and acquisition of the remaining 10% interest in Master Tek stock. All other future obligations to the minority owner were terminated. The final agreement provided for indemnifications from the minority owner to cover certain unasserted claims. The settlement payout of approximately $2.7 million was made in January 2004.

        Southwest Water and its subsidiaries are the subjects of litigation arising from the ordinary course of operations. We believe the ultimate resolution of such matters will not materially affect our financial position, results of operations or cash flows.

ITEM 4.    SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

        None.

ITEM 4A.    EXECUTIVE OFFICERS

        Our Board of Directors elects executive officers each year at the first meeting following the Annual Meeting of Stockholders. There are no family relationships among any of the executive officers of Southwest Water Company, and there are no agreements or understandings between any such officer and another person pursuant to which he or she was elected as an officer. There are no legal proceedings that involve any executive officer of the type requiring disclosure pursuant to the instructions to this item. The executive officers of Southwest Water Company are as follows:

Anton C. Garnier—Chief Executive Officer

Age: 63

        Mr. Garnier has served as President and Chief Executive Officer of the Company since 1968. He is a past president of the National Association of Water Companies and served on the board of the San Gabriel Valley Watermaster, and he has been actively involved in the American Water Works Association and California Water Association. Mr. Garnier also serves as the president and a director of East Pasadena Water Company, California-Michigan Land and Water Company, and is a board member of California Domestic Water Company. Mr. Garnier's other current and past affiliations include the World Business Council, Chief Executives Organization, Cal Tech Executive Forum, Fellows

24

of the Huntington Library, Young Presidents Organization, 1984 U.S. Olympics, Whittier College Business Department Advisory Board, and the Boy Scouts of America.

Peter J. Moerbeek—President and Chief Operating Officer, Southwest Water and President, Southwest Water Company Services Group

Age: 56

        Mr. Moerbeek began his career at Southwest Water Company in 1995 as vice president finance and chief financial officer. In 1997 he was appointed to the additional position of chief operating officer of ECO Resources Inc., (ECO) a wholly owned subsidiary of Southwest Water. He was appointed to the position, President, Southwest Water Company Services Group when that position was created in 2002. In February 2004, Mr. Moerbeek assumed his current position as President and Chief Operating Officer of Southwest Water. He continues as the President of the Services Group. In 2001, Mr. Moerbeek was appointed to the Board of Directors of Southwest Water Company. From 1989 to 1995 Mr. Moerbeek served as Executive Vice President—Finance and Operations for Pico Products, a publicly held manufacturer and importer of cable television equipment and parts. From 1986 to 1989 Mr. Moerbeek served as Vice President and Controller for Ortel Corporation, a high-tech laser manufacturing start-up. From 1982 to 1985 he served as Vice President, Finance and Administration for Eisenman Chemical Company, a provider of products and services to the oil industry. Mr. Moerbeek has an MBA and a Bachelor of Science in Electrical Engineering from the University of Washington.

Richard J. Shields—Chief Financial Officer

Age: 46

        Mr. Shields has served as our Chief Financial Officer since October 2002. From 2001 to 2002, Mr. Shields served as Vice President and Chief Financial Officer of Day Software, Inc. From 1999 to 2001 he served as Chief Financial Officer of Winfire, Inc. From 1996 to 1999 Mr. Shields served as Chief Financial Officer of Frame-n-lens Optical, Inc. From 1988 through 1996 Mr. Shields held various finance management positions at AST Research, Inc., including Director of the Americas Region Finance. From 1985 to 1988 Mr. Shields served in various management positions at Taco Bell Corporation. Mr. Shields began his career in 1982 with Price Waterhouse. Mr. Shields has a Bachelor of Arts in accounting from Eastern Washington University and an MBA from the University of Notre Dame.

Shelley A. Farnham—Vice President Human Resources and Secretary

Age: 48

        Ms. Farnham has been Vice President of Human Resources since July 1998. She oversees organizational planning and development, employee relations, training, compensation and benefits administration for the company and its subsidiaries. She provided human resources leadership to the marketing organization of Atlantic Richfield's Products Company from 1995 to 1998. From 1988 to 1995 Ms. Farnham held numerous positions in human resources, ranging from recruiter to training manager to interstate personnel manager with the Federal Reserve Bank of New York and Northrop Corporation. She has a Bachelor of Science degree in Management/Finance from Simmons College in Boston, Massachusetts, and she has earned certificates in training and human resources and organizational development from UCLA.

25

Maurice W. Gallarda—Vice President New Business Development

Age: 50

        Mr. Gallarda has been with the Company since 1998. As vice president of new business development he manages strategic growth planning as well as internal growth and opportunities for expansion into new markets and services. From 1995 to 1998 Mr. Gallarda was chief executive officer of Watershed Holdings, Inc., a company he founded to provide engineering, analytical and manufacturing services to the environmental industry. From 1987 through 1995 Mr. Gallarda served as President of Thorne Environmental, Inc., and Park Environmental Corporation where his responsibilities included the integration of existing business into the expanding environmental industry. He is also active in several professional organizations including the American Society of Civil Engineers, the Water Environment Federation, the California Environmental Bar Association and the National Society of Professional Engineers. An appointee of former California Governor Pete Wilson, Mr. Gallarda served on the California Regional Water Quality Control Board. Mr. Gallarda has a Bachelor of Science degree in Civil Engineering from California State University, Sacramento. He is licensed as a professional civil engineer in multiple states.

Michael Miller—Corporate Controller

Age: 39

        Mr. Miller was appointed Corporate Controller in September 2003. Prior to that, Mr. Miller served as the finance executive responsible for SEC Compliance and Public Reporting at Artemis International Solutions Corporation. From 1996 to 2002 Mr. Miller was a finance executive with EarthLink Inc., and served as Director of Finance and Public Reporting from 1996 to 2002. Mr. Miller served in the audit practice of Ernst & Young LLP from 1988 to 1990 and PricewaterhouseCoopers LLP, from 1990 to 1996. Mr. Miller has a Bachelor of Science in Business Administration-Accounting from California State University, Northridge.

Michael O. Quinn—President, Southwest Water Company Utility Group

Age: 57

        Mr. Quinn has held a variety of positions with Southwest Water Company and its subsidiaries since 1970. He is president of the Utility Group of Southwest Water Company and has been President of Suburban Water Systems since 1996. From 1992 to 1996 he was chief operating officer for Suburban Water Systems. From 1985 to 1992 he was president of ECO Resources, Inc. Prior to that he was controller/treasurer at Suburban Water Systems. Mr. Quinn holds a Bachelor of Arts in Business Management from California State University at Fullerton. Among his water industry affiliations, Mr. Quinn is immediate past president of the California Water Association, is president elect of the National Association of Water Companies and serves on the board of the Citrus Valley Health Foundation board.

Thomas C. Tekulve—Vice President and Treasurer

Age: 52

        Mr. Tekulve joined Southwest Water Company in 1999 as Vice President, Finance and became Vice President, Treasurer in 2002. He oversees finance and treasury and provides guidance in strategic planning for the corporation and its subsidiaries. From 1995 to 1999 Mr. Tekulve served as vice president and chief financial officer of Safeguard Health Enterprises, Inc. From 1984 to 1994 he served in a variety of executive positions at Beckman Instruments, Inc., including Director of Finance for International Operations and Corporate Controller. He began his career with Arthur Andersen & Co. Mr. Tekulve has a Bachelor of Science in Business Administration-Accounting from California State University, Northridge and an MBA from Portland State University in Oregon.

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PART II

ITEM 5.    MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

Market Information

        The following table shows the range of market prices of Southwest Water's common shares. The prices shown reflect the intra-day high and low bid prices for our common stock without retail markup, markdown or commissions and may not necessarily represent actual transactions. The price ranges shown in the table, as well as cash dividends declared in each quarter, reflect a 4-for-3 stock split in the form of a stock dividend on January 1, 2004 and a 5% stock dividend on January 1, 2003. Our common stock is traded on the NASDAQ Stock Market under the symbol SWWC. At December 31, 2003, there were 2,457 stockholders of record.

Dividend Policy

        Since 1960, our practice has been to pay common stock dividends quarterly in January, April, July and October. The amount and timing of future dividends depends on our growth, results of operations, profitability and financial condition, as well as other factors deemed relevant by our board of directors. Our current quarterly dividend rate is $0.0475 per share of common stock.

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ITEM 6.    SELECTED FINANCIAL DATA

        Earnings per common share, cash dividends per common share and basic and diluted weighted average outstanding common shares reflect the following:

•

a 4-for-3 stock split in the form of a stock dividend on January 1, 2004,

•

a 5% stock dividend on January 1, 2003,

•

a 5% stock dividend on October 1, 2001,

•

a 5-for-4 stock split in the form of a stock dividend on January 1, 2001, and

•

a 3-for-2 stock split in the form of a stock dividend on October 1, 1999.

(a)

In 2001 we were required to shut down some of our wells due to chemical contamination. This resulted in our California utility purchasing a significant portion of its water supply from the MWD and other sources since 2001. In May 2002, an agreement was reached among some of the parties responsible for the contamination and a number of affected water companies, including our California water utility. As a result of the agreement we recorded income of approximately $1.7 million, which covered certain water and energy costs, incurred in 1999, 2000 and 2001 arising from the contamination that were prior to the commencement of monthly payments. This agreement was an unusual event and we recorded the $1.7 million in other income rather than as an increase to Operating Income, in accordance with the provisions of APB No. 30, Reporting the Results of Operations. See Summary of Significant Accounting Policies in the footnotes of our financial statements.

As a result of this contamination, we have received payments, and we expect to continue to receive payments until completion of remediation, for the incremental cost of purchasing water over the cost that would have been incurred by us to pump water from our wells had they not been shut down as a result of contamination. For 2003 the amount of reimbursed expenses was approximately $4.0 million. This reimbursement pertains to our agreement with the parties responsible for the contamination. It is ongoing and is no longer considered an unusual event. As such, the reimbursement is recorded as a reduction to "Operating Expenses—Utility Group" for 2003. The reimbursement, net of tax, for 2003 was $0.17 per share.

(b)

Results of operations for 2002 include other income of $1.7 million of income from an agreement with cooperating respondents, as well as a $1.0 million gain on termination of a pension plan. The effect those items, net of taxes was $0.08 per share of income, from an agreement with cooperating respondents, as well as $0.05 per share gain on termination of a pension plan.

(c)

Results of operations for 1999 include a $0.15 per share gain, net of taxes, in 1999 on the sale of surplus land formerly used in water utility operations.

(d)

Excludes amortization of goodwill beginning in 2002. The expense for amortization of goodwill was $104,000 and $63,000, net of taxes, in 2001 and 2000, respectively. There was no amortization of goodwill in prior years.

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ITEM 7.    MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        The information in this discussion contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended. See "Forward-looking Statements" above for additional information.

        The following discusses the financial condition and results of operations of Southwest Water Company and subsidiaries and should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this report.

Overview

        Southwest Water Company and Subsidiaries ("Southwest Water", "we" "us," "our" or the "Company"), provide a broad range of services including water production and distribution, wastewater collection and treatment, public works services, utility customer billing services and construction management. We provide services to more than two million people in 36 states. Our business is segmented into two operating groups; our Services Group and our Utility Group.

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

        Our Utility Group owns and operates public water and wastewater utilities in California, New Mexico and Texas. State and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations. The rates that our regulated utility subsidiaries charge for water and wastewater services are established by state authorities.

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Results of Operations

        The following table sets forth the percentage of total revenues represented by certain items in our consolidated statements of operations for the periods indicated:

2003 Compared to 2002

Revenues

Services Group

        Services Group revenue represents fees earned for water and wastewater facility operations and maintenance services, equipment maintenance and repair, sewer pipeline cleaning, billing and collection services, public works and state-certified water and wastewater laboratory analysis. Our Services Group also facilitates the design, construction, project management, and operating aspects of various water and wastewater projects. Services Group revenues for 2003 increased approximately $37.2 million, or 47%, to $116.0 million from $78.8 million during the prior year. The increase is due to the following:

•

The acquisition of Aqua Services in November 2002. In November 2002, we acquired certain contract operations of Aqua Source, Inc., a provider of contract water and wastewater services in Texas, Colorado and South Dakota. Upon closing of the transaction we began operating the majority of this business under the name Aqua Services, LP (Aqua Services) while the remaining part was incorporated into one of our existing subsidiaries, ECO Resources, Inc. (ECO). Revenues from Aqua Services were approximately $19.2 million and $1.3 million during 2003 and 2002, respectively.

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•

An increase in revenues of approximately $12.9 million from the construction of a reverse osmosis water treatment facility in California to $13.6 million during 2003 from $0.7 million in 2002.



•

An increase in revenues from our Texas service operations of approximately $4.3 million to $64.2 million during 2003 from $59.9 million during the prior year. The revenue increase is largely attributable to increased tapping and inspection revenue driven by real estate development activity in Texas.

Utility Group

        Utility Group revenue represents fees earned for the production and distribution of water and the collection and treatment of sewage for residential, business, industrial and public authority use. Revenues in the Utility Group increased approximately $4.9 million, or 9%, to $56.9 million during 2003 from $52.0 million during the prior year. The increase is primarily due to the favorable effect of rate increases in our California and Texas utilities and increased customer connections in our New Mexico and Texas utilities. The effect of increases in rates was partially offset by decreases in water consumption due to variations in weather in our California Utility. The changes are represented as follows:

Operating Expenses

Services Group

        Operating expenses—services group represent salaries, wages and employee benefits, facilities costs, supplies and equipment, repairs and maintenance, professional fees and other costs. Operating expenses—services group represented approximately 87% and 86% of the Services Group revenues for 2003 and 2002, respectively. Operating expenses increased approximately $33.5 million, or 49%, to $101.4 million during 2003 from $67.9 million during 2002. The increase was due to the following:

•

the acquisition of Aqua Services in November 2002, which generated operating costs of approximately $19.0 million and $1.3 million during 2003 and 2002, respectively, and



•

costs related to the construction of a reverse osmosis water treatment facility for the city of San Juan Capistrano, California which accounted for approximately $12.9 million of the increase in operating expenses.

        The remaining increase of approximately $2.9 million for 2003, compared to the prior year, resulted from increased operations and construction activity in the Services Group's operations.

        The increase in operating expenses as a percentage of operating revenues in 2003 was primarily due to the Company's project to construct and operate the reverse osmosis water treatment facility. We are accounting for the project under the percentage of completion method during the construction phase. The construction phase is expected to be completed in 2004.

Utility Group

        Operating expenses—utility group represent the costs of purchasing and producing water, treating wastewater, salaries, wages and employee benefits, facilities costs, supplies and equipment, repairs and

31

maintenance, professional fees and other costs. Operating expenses—utility group represented approximately 60% and 65% of revenues from utility operations for 2003 and 2002, respectively. Operating expenses were substantially unchanged from 2002 to 2003. The decrease in operating expenses as a percentage of revenue was due to the aforementioned increase in Utility Group revenues, which was primarily due to an increase in rates at our California utility. Operating expenses for our Utility Group increased $0.2 million, or 1%, to $33.9 million during 2003, from $33.7 million during 2002.

        Operating expenses incurred by our New Mexico utility increased $409,000, or 10%, during 2003 as compared to 2002. The City of Albuquerque has increased sewage treatment rates approximately 9%. In addition, our New Mexico utility has incurred additional fuel costs due to increased volume.

        As expected, operating expenses at our California and Texas Utilities did not change in a significant amount.

Selling, general and administrative expenses

        Selling, general and administrative expenses consist mainly of costs related to personnel, facilities, insurance and professional services, which support our sales, marketing, human resources, finance and administration functions. Selling general and administrative expenses increased approximately $4.4 million, or 24%, to $22.8 million for 2003 from $18.4 million during the prior year. The increase was largely due to the inclusion of approximately $1.3 million from Aqua Services and the increased costs company-wide for employee health benefits, insurance and compensation expenses. As a percentage of revenues, selling, general and administrative expenses decreased from 14% in 2002 to 13% in 2003.

Other income (expense)

Interest Expense

        The major components of interest expense for 2003 and 2002 are as follows:

        We increased borrowings during the first six months of 2003 to finance capital improvements in our Utility Group. Our benefit from lower interest rates and higher capitalized interest from increased construction activity in our Utility Group was offset by higher borrowings on our bank lines of credit and increased interest expense related to our Texas utility bank term loan. In August 2002, one of our Texas utilities obtained a 10-year; $10.0 million secured bank term loan which increased our long-term debt outstanding and consequently, our interest expense. Our effective interest rates for 2003 and 2002 were 6.6% and 6.8%, respectively.

32

Gains on Sales of Land

        In the second quarter of 2003, we recognized a $0.7 million pretax gain on the sale of surplus land, and in the second quarter of 2002 we recognized a $0.1 million pretax gain on the sale of surplus land.

Other

        We report material events that are unusual in nature or occur infrequently, but not both, in Other Income (Expense) rather than in Operating Income, in accordance with the provisions of APB No. 30 Reporting the Results of Operations. Included in Other Income for 2002 is the effect of a one-time, non-taxable gain in 2002 of approximately $1.0 million resulting from the termination of the Company's defined benefit plan (as more fully disclosed in Note 12 to the consolidated financial statements). There were no similar pension related gains in 2003. Included in Other Income for 2002 is a $1.7 million agreement reached among parties responsible for the contamination, the ("Cooperating Respondents"), and our California utility regarding water-quality-related expenses incurred in 1999, 2000 and 2001 (see Note 1 in the accompanying consolidated financial statements). In 2003 and subsequent years, such reimbursements will be recorded as a reduction to Operating Expenses—Utilities.

Income Taxes

        Our effective tax rate for 2003 was approximately 36% compared to approximately 35% for 2002. Our effective tax rate for 2002 reflected the benefit of a one-time gain on the termination of a pension plan, which was excluded from ordinary taxable income.

2002 Compared to 2001

Revenues

Services Group

        Services Group revenues increased $12.3 million, or 18%, to $78.8 million during 2002 from $66.5 million during 2001. The increase is due to the following:

•

We acquired OpTech in August 2001 and had the benefit of revenues earned by OpTech for a full year during 2002 versus a partial year in 2001. Revenues recorded by OpTech during the period August 1, 2001 through December 31, 2001 and during the year ended December 31, 2002 were $3.7 million and $11.7 million, respectively,



•

Approximately $1.3 million in revenues from the acquisition of Aqua Services in November of 2002, and



•

An increase of approximately $6.5 million of O&M revenues due to the origination of contracts with new customers and expansion of services with existing customers.

Utility Group

        Utility Group revenues increased $2.9 million, or 6%, to $52.0 million during 2002 from $49.1 million during 2001. Revenues at our California utility increased $2.0 million or 5% to $39.7 million in 2002 from $37.7 million in 2001. The number of water connections served by our California Utility remained relatively stable at 74,846 and 74,665 at December 31, 2002 and 2001, respectively. The increase in revenue recorded by our California utility was due to increased consumption driven by hot, dry weather in 2002, which was one of the driest years in recent history.    Revenues at our New Mexico utility increased $0.5 million or 7% to $7.3 million in 2002 from $6.8 million in 2001. Connections served by our New Mexico utility increased to 11,365 at

33

December 31, 2002 from 10,006 at December 31, 2001, an increase of approximately 13%. However, the increase was partially offset by a reduction in per customer volume due to changes in weather.

        Revenues at our Texas utilities increased approximately $0.2 million or 7% to $2.8 million during 2002 from $2.6 million during 2001. The increase is primarily due to an increase in volume and consistent with the increase in connections to 5,754 at December 31, 2002 from 5,316 at December 31, 2001.

Operating Expenses

Services Group

        Operating expenses—services group represented approximately 86% of the Services Group revenues for 2002 and 2001, respectively. Operating expenses increased approximately $10.9 million, or 19%, to $67.9 million during 2002 from $57.0 million during 2001. The increase was due to the following:

•

The acquisition of Aqua Services. in November 2002, which generated operating costs of approximately $1.3 million during 2002.



•

Operating costs related to the OpTech acquisition during the period August 1, 2001 through December 31, 2001 were $3.5 million compared to costs of $12.7 million incurred during the year ended December 31, 2002.



•

An increase of approximately $6.3 million of operating expense due to the origination of contracts with new customers and expansion of services with existing customers.

Utility Group

        Operating expenses—utility group represented approximately 65% and 60% of revenues from utility operations for 2002 and 2001, respectively. Operating expenses for our Utility Group increased $4.4 million, or 15%, to $33.7 million during 2002, from $29.3 million during 2001. The increase in operating expenses incurred by our California utility was $3.3 million to $26.9 million during 2002 from $23.6 million during 2001. The increase in operating expenses for our California utility was due to increased water production driven by hot, dry weather in 2002. Volume-related costs were $5.5 million greater in 2002 than 2001. We had to purchase additional water from higher priced sources in order to address the overall increase in demand. However, the increased water costs were partially offset by the recoveries from Cooperating Respondents. In addition, in 2001, our California utility was able to defer recognizing certain costs of approximately $0.7 million until future rate cases through the use of a balancing account. As of November 29, 2001, the CPUC eliminated the use of balancing accounts, which had the effect of increasing operating expense for 2002.

        Operating expenses incurred by our New Mexico utility increased $1.0, or 33%, to $4.1 million during 2002 from $3.1 million during 2001. The increase was primarily due to an increase in the number of connections served by our New Mexico utility. In addition, the City of Albuquerque allowed our New Mexico utility to increase sewage treatment rates it charged in 2002.

        Operating expenses for our Texas utilities increased approximately 4% to $2.8 million during 2002 from $2.7 million during 2001. The increase is primarily due to an increase in volume and is consistent with the increase in connections to 5,754 at December 31, 2002 from 5,316 at December 31, 2001.

Selling, General and Administrative Expenses

        Selling, general and administrative expenses increased 5% to $18.4 million during 2002, compared to $17.5 million for 2001. As a percentage of consolidated revenues, selling, general and administrative expenses were 14% and 15% in 2002 and 2001, respectively. The increase in selling, general and

34

administrative expenses was primarily attributable to i) the acquisition of OpTech in August 2001, ii) the acquisition of Aqua Services in November 2002, iii) increases in medical and general insurance costs, iv) marketing and new business development expenses and v) an increase in stock-based compensation expense, of $0.2 million to $1.0 million in 2002. In addition, due to changes in the Company's stock price, options issued in 2002 were calculated to have a higher per option value than the options issued in 2001.

Other Income (Expense)

Interest Expense

        Total interest expense increased 22% to $4.5 million during 2002, compared to $3.6 million in 2001. The increase reflects interest expense on our 20-year convertible subordinate debentures that were issued in July 2001. This increase was partially offset by decreases in the interest expense on our bank lines of credit because we paid down a portion of our line of credit borrowing with the proceeds from the debentures. The interest expense on the bank lines of credit also decreased due to generally lower interest rates in 2002 compared to 2001. The effective interest rates on our indebtedness were approximately 6.8% and 7.4% in 2002 and 2001, respectively. The reduction in capitalized interest during 2002, compared to the prior year, was due primarily to a reduction in company-financed utility projects.

        The major components of interest expense for 2002 and 2001 were as follows:

Other

        We report material events that are unusual in nature or occur infrequently, but not both, in Other Income (Expense) rather than in Operating Income, in accordance with the provisions of APB No. 30 Reporting the Results of Operations. Included in Other Income on the Company's Consolidated Statements of Income is the effect of a one-time, non-taxable gain in 2002 of approximately $1.0 million resulting from the termination of the Company's defined benefit pension plan (as more fully disclosed in Note 11 to the consolidated financial statements). Also included in Other Income for 2002 is a $1.7 million settlement reached between parties responsible for the contamination and our California utility regarding water-quality-related expenses incurred in 1999, 2000 and 2001.

Income Taxes

        Our effective tax rate for 2002 was approximately 35% compared to approximately 39% for 2001. Our effective tax rate for 2002 was reduced when we recorded a one-time gain on termination of a pension plan, which is excluded from ordinary taxable income.

35

Liquidity and Capital Resources

        Our operating activities provided approximately $8.8 million in cash during 2003 consisting of net income of $7.2 million, adjusted for certain non-cash items including depreciation and amortization of $7.5 million, deferred income taxes of $3.5 million and stock-based compensation of $0.9 million. Operating cash flow was further increased by a net increase in liabilities of $3.0 million. Operating cash flow was reduced by (i) an increase in accounts receivable of $3.1 million, (ii) an increase in other assets of $5.7 million, (iii) a gain of $0.7 million from the sale of land, and (iv) an increase in restricted cash of $2.8 million and (v) approximately $1.0 million in other items. The $3.1 million increase in trade accounts receivable was due to the following:

•

Approximately $2.1 million represents the excess of amounts earned over the amounts collected in connection with the Company's $25.0 million project to design and build a reverse osmosis water treatment plant for the city of San Juan Capistrano, California.



•

Our California utility made a general rate case filing on April 2, 2002 and was granted an average 17% increase in rates. Approximately $1.2 million of the accounts receivable increase was due to the increase in monthly revenue as a result of the rate increase.

        Our investing activities used cash of $17.6 million during 2003. Capital expenditures of $18.4 million were primarily for the acquisition of property, plant and equipment for regulated water system assets used by our Utility Group, including new wells and transmission lines and the construction of a lift station and water line in Texas. The effect of these expenditures was partially offset by proceeds from sales of land of approximately $0.8 million.

        The following table summarizes our activity for additions to property, plant and equipment during 2003 and 2002:

        Financing activities provided cash of approximately $9.8 million. Net proceeds from our private placement of equity in May 2003 were approximately $10.9 million. We collected approximately $1.3 million in net proceeds from our dividend reinvestment and employee stock purchase plans. Proceeds from asset sale-leaseback arrangements were approximately $1.7 million. Reimbursements to our California utility under an expense reimbursement agreement were approximately $2.5 million. Contributions in Aid of Construction (CIAC) represent contributions in the form of cash, services or property received from developers, governmental agencies, municipalities or individuals for the purpose of constructing utility plant. CIAC and advances for construction were approximately $1.4 million. Cash used to reduce debt and to pay dividends was approximately $5.8 million and $2.6 million, respectively.

        Our liquidity is influenced primarily by cash flows from operations and by capital expenditures at our Utility Group for the addition, replacement and renovation of water and wastewater utility facilities. Our capital resources are used for debt service on our bonds and debentures and are also influenced by investments in new business opportunities, including the acquisition of companies and acquisition of contract operations.

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Off-Balance Sheet Arrangements

        The Company does not have any material off-balance sheet arrangements that have, or are reasonably likely to have, a current or future effect on our financial condition, changes in financial conditions, revenue or expenses, results of operations, liquidity, capital expenditures or capital resources.

Contractual Obligations

        A summary of our future contractual obligations and commercial commitments as of December 31, 2003 is as follows:

(1)

The convertible subordinate debentures are due in 2021. There are no intermediate put rights attached to the debentures.

        We anticipate that mortgage bonds that come due in 2006 will be refinanced through the sale of new mortgage bonds or may be funded through the additional issuance of our equity capital. If we were unable to refinance these bonds, or to raise capital to provide for these funds, the Company would expect to utilize cash flows generated from operations and a portion of our line of credit borrowing capacity from our commercial banks.

        We anticipate that our available line of credit borrowing capacity and cash flows generated from operations will be sufficient to fund our activities during the next 12 months. If we were unable to renew our existing lines of credit or if we were unable to execute additional financing alternatives, our capital spending and any future acquisitions would be reduced, eliminated or delayed.

        We have filed with the Securities and Exchange Commission a registration statement, which is effective for the issuance of up to $50 million aggregate principal amount of common stock, debt securities and warrants. We may offer any of these securities for sale at any time and from time to time.

        On December 31, 2003, we had working capital of approximately $4.0 million with available cash and cash-equivalent balances of approximately $2.6 million (excluding restricted cash balances), as well as aggregate lines of credit totaling $30.0 million consisting of three separate unsecured lines of credit from three commercial banks. Our total borrowing availability under lines of credit was approximately $13.6 million on December 31, 2003. One line of credit expires in April 2005; the other two expire in September 2005.

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        For 2003 and 2002, we had weighted average borrowing rates on our bank lines of credit of 2.79% and 3.40%, respectively.

        In January 2003, we expanded one of our lines of credit from one of our commercial banks by $3.4 million. This facility was utilized to issue a standby letter of credit in that amount as collateral for performance under a service contract to design and construct a reverse osmosis water treatment facility and associated wells. This standby letter of credit is in force for the estimated two-year construction period of the project. Upon acceptance of the completed project, expected in 2004, the standby letter of credit and the related credit facility will be terminated.

        In addition to our lines of credit, we have excess borrowing capacity under our first mortgage bond indentures of approximately $72.8 million as of December 31, 2003. However, the additional borrowing available under our current commercial lines of credit is limited by financial covenants that restrict additional borrowing to an amount no greater than the remaining unused credit line amount.

        We expect to maintain our lines of credit in the normal course of business. Each of the line of credit agreements contains certain financial covenants. During 2003, we were in compliance with all applicable covenants under each of the line of credit agreements.

Critical Accounting Policies

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

•

Revenue recognition,



•

Valuation of long-lived and intangible assets,



•

Accounting for regulated business in accordance with SFAS 71,



•

Stock-based compensation,



•

Deferred costs, and



•

Unusual events.

        In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP and does not require management's judgment in its application. There are also areas in which management's judgment in selecting among available GAAP alternatives would not produce a materially different result. Our senior management has reviewed these critical accounting policies and related disclosures with our Audit Committee.

Revenue recognition

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

        Revenues for construction projects are recorded using the percentage-of-completion method of accounting. The percentage of completion method recognizes revenue and income as work progresses

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on a project based on the expected total project costs and the expected total project revenues. This method is based on an estimate of the revenue and income earned to date, less the revenue and income recognized in earlier periods. If management determines the Company will ultimately suffer a loss on a construction project, the entire estimated loss is recorded in the period such a determination is made.

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

        The Company has adopted the provisions of Emerging Issues Task Force (EITF) 00-21, Accounting for Revenue Arrangements with Multiple Deliverables, on a prospective basis as of July 1, 2003. EITF 00-21 modified the application of existing contract accounting literature followed by the Company. EITF 00-21 governs how to identify whether goods or services, or both, that are to be delivered separately in a bundled sales arrangement should be accounted for separately. In most circumstances, EITF 00-21 also limits the recognition of revenue in excess of amounts billed (e.g. unbilled revenue) to the amount that would be received if the client contract were terminated for any reason.

        The Company provides design, build, finance and operation services under time-and-material, unit-price and fixed-price contracts, which may extend up to 20 or more years.

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

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

        Revenues for submetering billing and collection services are recognized and billed at the end of the month in which services are performed. Revenues for installation of submetering equipment are accounted for using the percentage-of-completion method.

Valuation of long-lived and intangible assets

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

        We have made acquisitions in the past that resulted in recording goodwill and intangible assets. In June 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires

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that goodwill and intangible assets with indefinite useful lives are not amortized, but instead are tested for impairment at least annually. For intangible assets with definite useful lives, SFAS No. 142 requires amortization over their estimated useful lives. SFAS No. 142 became effective for fiscal years beginning after December 15, 2001. At December 31, 2003, other assets include approximately $21.4 million of goodwill, which was no longer subject to amortization beginning in 2002. There were no impairment charges to goodwill as of December 31, 2003 and no events have occurred that indicated diminution in the value of recorded goodwill.

        Under the provisions of SFAS No. 141, Business Combinations, we identified approximately $0.2 million of intangible contract costs in connection with our acquisition of Aqua Services and approximately $1.1 million of intangible contract costs in connection with our acquisition of OpTech. We are amortizing the intangible contract costs over a period of four years, which is the average estimated life of the contracts.

Accounting for regulated businesses

        Our regulated businesses, which include our utilities in California, New Mexico and Texas, are required to be accounted for under the provisions of SFAS No. 71, Accounting for the Effects of Certain Types of Regulation, which specifies certain revenue, expense and balance sheet treatment as required by each state regulatory authority. Each state authority establishes rates which are intended to permit each utility to recover its costs and earn a reasonable rate of return. Each utility may file and process general rate applications on a periodic basis. Since the established rates may be in effect for several years, our utilities attempt to anticipate cost increases and apply for rates sufficient to permit recovery of those cost increases when incurred, where permitted by state law.

        One of our Services Group subsidiaries has contracted with our utilities in Texas and New Mexico to perform operating services, maintenance, and construction work, and to manage capital projects. These contracts were established utilizing terms and conditions equivalent to prevailing industry rates for similar work performed by our Services Group for non-affiliated customers. In accordance with SFAS No. 71, our Services Group recognizes profit from work performed and does not eliminate the intercompany profit when the contract sales price is reasonable and it is probable that the costs and capital will be recoverable by the utility through the rate-making process. Accordingly, the intercompany profit, for construction as well as O&M services, and the related receivables and payables, on such work have not been eliminated in the accompanying condensed consolidated financial statements. However, all revenue in excess of profits has been eliminated in consolidation, consisting of approximately $8.3 million, $9.5 million and $5.9 million for the years ended December 31, 2003, 2002 and 2001, respectively.

        Our California water utility has recorded a balancing account receivable in the amount of approximately $2.3 million, representing the difference between actual water production costs incurred and CPUC-adopted water production costs. Historically, the CPUC allowed such balancing accounts in the income statements of water utilities, with a corresponding liability or asset on the balance sheet. However, the CPUC changed this policy by eliminating the use of balancing accounts as of November 29, 2001. In December 2002, the CPUC issued a decision that we believe will allow our water utility in California to recover the $2.3 million that was held in the balancing account as of November 29, 2001.

        Beginning in December 2001, our water utility has recognized all water costs as incurred. Currently the differences between actual and CPUC-adopted water production costs are expensed as incurred. These differences are tracked in a memorandum account and we will attempt to recover these expenses in future rate hearings.

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Stock-Based Compensation

        In 2002, we adopted the fair value recognition provisions of SFAS No. 123, which requires valuation of stock options issued based upon an option pricing model and recognition of this value as an expense over the period in which the options vest. In accordance with the provisions of SFAS No. 148, we elected to recognize stock-based compensation using the retroactive restatement method. Under this change in accounting method, we restated our accompanying condensed consolidated financial statements for periods prior to 2002 to reflect stock-based compensation expense under a fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994.

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

Deferred Costs

        The Company defers and subsequently amortizes certain direct contract acquisition costs related to activities to enable the provision of contracted services to the client. Deferred contract acquisition costs are amortized on a straight-line basis over the remaining original contract term unless revenue patterns indicate a more accelerated method is appropriate. Deferred contract costs of $1.5 million are shown net of accumulated amortization at December 31, 2003. Amortization expense related to deferred contract costs was $372,530, $280,636 and $281,520 for 2003, 2002 and 2001, respectively. The recoverability of all long-lived assets associated with a particular contract, including deferred contract costs, is analyzed on a periodic basis. If long-lived assets are determined to be impaired, an impairment is recognized for the amount by which the carrying value of the long-lived assets exceeds the fair value of those assets.

Unusual Events

        Southwest Water reports material events that are unusual in nature or occur infrequently, but not both, in other income (expense) rather than in operating income, in accordance with the provisions of APB No. 30 Reporting the Results of Operations. APB No. 30 provides that unusual or infrequent events are separately disclosed and excluded from operating income, and that the nature and financial effects of each event or transaction should be disclosed on the face of the income statement. Included in other income on our consolidated statements of income is the effect of a one-time, non-taxable gain in 2002 of approximately $1.0 million resulting from the termination of our defined benefit plan (as more fully disclosed in Note 11 to the consolidated financial statements). Also included in other income for 2002 is a $1.7 million agreement reached among parties responsible for the contamination and our California utility regarding water-quality-related expenses incurred in 1999, 2000 and 2001.

Recent Accounting Pronouncements

        In April 2003, the FASB issued SFAS No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. SFAS No. 149 amends and clarifies financial accounting and reporting for derivative instruments. This statement is effective for contracts entered into or modified after June 30, 2003. We adopted this statement in the third quarter of 2003 and it did not have a material effect on our consolidated financial statements.

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        In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity. This statement establishes accounting standards with respect for how a company classifies and measures financial instruments that have characteristics of both liabilities and equity. This statement is effective for all financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. We adopted this statement in the third quarter of 2003, and it did not have a material effect on our consolidated financial statements.

        In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of Accounting Research Bulletin No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interest in variable interest entities created or obtained after January 31, 2003. For public companies, such as ours, the Interpretation is applied to the enterprise no later than the end of the first annual reporting period beginning after June 15, 2003. The application of this Interpretation has not had a material effect on our Consolidated Financial Statements. The Interpretation requires certain disclosures in financial statements issued after January 31, 2003 if it is reasonably possible that an entity will consolidate or disclose information about variable interest entities when the Interpretation becomes effective.

        FASB Staff Position No. FIN 46-R, Effective Date of FASB Interpretation No. 46, Consolidation of Variable Interest Entities deferred the effective date for applying the provisions of FIN 46 for interests held by public entities in variable interest entities or potential variable interest entities created before February 1, 2003. A public entity need not apply the provisions of FIN 46 to an interest held in a variable interest entity or potential variable interest entity until the end of the first interim or annual period ending after December 15, 2003 if both of the following apply:

1.

The variable interest entity was created before February 1, 2003, and



2.

The public entity has not issued financial statements reporting interests in variable interest entities in accordance with FIN 46, other than certain required disclosures.

        We will adopt the provisions of FIN 46 for our financial statements for the periods ending after January 31, 2004 for any variable interest entities created before February 1, 2003. We do not expect the adoption of FIN 46 to have a material impact on our financial statements.

ITEM 7A.    QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

        We have certain indebtedness that is subject to variable rate interest. As a result, Southwest Water's interest expense is affected by changes in the general level of interest rates. The interest expense paid on our line of credit borrowings and certain term loans is determined based upon a rate formula that fluctuates with short-term LIBOR rates and cannot exceed the banks' prime rate minus one-quarter percent.

        We completed a $20.0 million, 20-year convertible subordinate debenture offering in July 2001, which bears a fixed interest rate of 6.85% per annum. The proceeds were used to pay down certain variable rate indebtedness. Our long-term debentures were sold with a fixed interest rate, and are not subject to market fluctuation of interest rates. Our debentures are convertible into Southwest Water common stock and at such time as our diluted earnings exceed $0.53 per share, the debentures will be considered to be common stock equivalents and 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.

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ITEM 8.    FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

Index to Financial Statements and Financial Statement Schedules

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INDEPENDENT AUDITORS' REPORT

To the Board of Directors and Stockholders of Southwest Water Company:

        We have audited the consolidated financial statements of Southwest Water Company and subsidiaries (the Company) as listed in the accompanying index. In connection with our audits of the consolidated financial statements, we also have audited the financial statement schedules as listed in the accompanying index. These consolidated financial statements and financial statement schedules are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements and financial statement schedules based on our audits.

        We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

        In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of Southwest Water Company and subsidiaries as of December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2003, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the related financial statement schedules, when considered in relation to the basic consolidated financial statements taken as a whole, present fairly, in all material respects, the information set forth therein.

        As discussed in Note 1 to the consolidated financial statements, in 2002, the Company changed its method for accounting for the amortization of goodwill.

/s/ KPMG LLP

Los Angeles, California
March 12, 2004

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SOUTHWEST WATER COMPANY AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF INCOME

See accompanying notes to consolidated financial statements.

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SOUTHWEST WATER COMPANY AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS