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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C.  20549

FORM 10-K

Commission file number 0-8176 Southwest Water Company (Exact name of registrant as specified in its charter)

          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. 

          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).

          The aggregate market value of the voting common equity held by non-affiliates of the registrant was approximately $120,068,000 based upon the average high and low prices of such common equity as of June 28, 2002.  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 26, 2003, there were 9,770,832 common shares outstanding.

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SOUTHWEST WATER COMPANY AND SUBSIDIARIES

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SOUTHWEST WATER COMPANY AND SUBSIDIARIES

FORWARD-LOOKING STATEMENTS

          Certain written and oral statements made by our Company and subsidiaries or with the approval of an authorized executive officer of our Company may constitute “forward looking statements” as defined under the Private Securities Litigation Reform Act of 1995, including statements made in this report and other filings with the Securities and Exchange Commission. Generally, the words “believe,” “expect,” “intend,” “estimate,” “anticipate,” “project,” “will,” and similar expressions identify forward-looking statements, which generally are not historical in nature. All statements which address operating performance, events or developments that we expect or anticipate will occur in the future are forward-looking statements. Forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially from our historical experience and our present expectations or projections. When made, we believe that these forward-looking statements are reasonable. However, 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. We undertake no obligation to publicly update or revise any forward-looking statements.

PART I

Item 1. Description of Business

           A.     History

          Southwest Water Company (Southwest Water, the Company, “we,” “ us,” or “our”) was incorporated in California on December 10, 1954. We reincorporated in Delaware on June 30, 1988. We provide a broad range of services including water production and distribution, wastewater collection and treatment, public works services, customer billing and service, and utility submetering. We provide service for more than two million people in 31 states from coast to coast. Our business is operated by our subsidiaries and is segmented into two operating groups: our Utility Group, which owns and operates regulated water and wastewater utilities, and our Services Group, which manages our non-regulated businesses.

          Our Services Group consists of our contract service businesses through which we operate and maintain water supply and wastewater treatment facilities owned by cities, public agencies, municipal utility districts and private entities primarily in Texas, New Mexico, California, Colorado, Mississippi and Georgia. Nationwide, we provide utility submetering and billing and collection services. While state and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations, the pricing of our services within the Services Group is not subject to regulation. Operating margins within our Services Group are generally low because these are service businesses and competition exists within the industry.

          Within our Utility Group, we own and operate 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 operations, as well as establish the rates that we can charge for our water and wastewater services.

           B.     Acquisitions

          In November 2002, we acquired 100% ownership of certain contract operations of AquaSource, Inc., a provider of contract water and wastewater services in Texas and Colorado. The purchase price consisted of approximately $10,317,000 in cash.  Upon closing of the transaction on November 22, 2002, we began operating a part 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 Operations Technologies, Inc. (OpTech), a provider of contract water and wastewater and public works services in the southeastern United States, for a

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purchase price of $8,248,000. The purchase price consisted of cash payments of $3,530,000 in August 2001 and $418,000 in January 2002, in addition to 96,580 shares (restated for a 5% stock dividend on January 2, 2003) of our common stock with a market value of $1,300,000 at August 31, 2001 and promissory notes in the aggregate amount of $3,000,000. 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 prior owner has the option to sell the remaining 10% of OpTech to us using the same formula.

          In April 2000, we acquired 80% of the outstanding common stock of Master Tek International, Inc. (Master Tek) and entered the utility submetering, billing and collection services market. Master Tek was established in 1975, and incorporated in Colorado in 1985. The purchase price was $4,000,000, consisting of $2,000,000 in cash and a $2,000,000 10-year promissory note. Under the terms of the purchase agreement, the minority owner of Master Tek may require us to purchase his initial 20% minority interest in 5% increments at a price based on a formula but not less than $1,000,000 per year over a four–year period commencing in April 2002. In April 2002, we paid $1,000,000 to the minority owner for an additional 5% interest in Master Tek in accordance with the purchase agreement, thereby increasing our ownership to 85%.  In February 2003, the minority owner exercised his right to require us to purchase an additional 5% interest in Master Tek, which will increase our ownership to 90% in April 2003. We may be required to purchase the remaining 10% minority interest for $2,000,000 over the course of the next two years.  We also entered into an employment agreement, a consulting agreement and a non-compete agreement with the minority owner.

          In 2000, our California utility purchased the city of West Covina’s water distribution system and facilities for a price of approximately $8,500,000. 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 shareholder and purchased an additional 31% interest from the majority shareholder, thereby increasing our ownership in Windermere to 80%. The former majority shareholder retains a 20% ownership interest in Windermere. 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 $4,000,000 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 $6,000,000 payable in our common stock at any time when the market value of our common stock increases to $18.14 per share (as adjusted for stock splits and dividends). The minority owner of Windermere has the right to sell the remaining 20% after October 1, 2005, for $6,000,000 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 to provide certain services to Southwest Water.

           C.     Operating Segments

          Our operations are organized into two reportable business segments: Services Group and Utility Group. Our Services Group conducts our non-regulated segment operations, while our regulated segment operations are conducted by our Utility Group. Our reportable business segments are strategic business units that offer different services. They are managed separately because each business requires different operating and marketing strategies. A summary of the profit or loss and assets for our business segments is found in Note 13 to the accompanying consolidated financial statements in Item 8.

           1)     Services Group

           a.     Development of Business, Services and Regulation

          Our Services Group provides water and wastewater services primarily in Texas, Mississippi, California, Georgia, New Mexico, and Colorado. These services include 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. Typically, our Services Group does not own the water sources or utility facilities that we operate for our clients. Although not the owner, the Services Group is responsible

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for operating water and wastewater facilities in compliance with all federal, state and local environmental and health standards and regulations. 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.

          Additionally, our Services Group provides utility submetering for multiple family housing units such as apartment buildings. Submetering operations include installation of submeters, billing, collection and customer services.

          In some instances, the companies in our Services Group may be subject to regulatory oversight; however, the pricing of our services is not subject to regulation. See Note 13 to the accompanying consolidated financial statements.

          Our Services Group generally has three distinct types of contractual relationships: (1) time-and-material contracts, primarily with municipal utility districts in Texas, (2) fixed-fee operations and maintenance contracts and (3) hybrid contracts involving fixed fees for defined basic services with additional billings beyond the basic services.

          Most contracts with municipal utility districts are short-term contracts and do not generally include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis. Our operations and maintenance contracts are generally longer-term water and wastewater service contracts, primarily with cities, and many include inflation adjustments, as measured by a consumer price index. Most contracts with management companies and owners of apartment or condominium communities are short-term contracts and generally do not include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis.

           b.     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. Services typically include customer billing and collection, customer service, daily operation and maintenance of water and wastewater facilities and assets, and environmental monitoring and reporting. Our Services Group usually bills for any additional services provided beyond the basic contract on a time-and-materials basis as such services are rendered. 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 periods of 10 or more years.  Most MUD contracts provide for an increase in the monthly base fee as the number of customer connections increases.

           c.     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. Although in some cases there may be some variation due to weather or seasonality, 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. When our Services Group provides services beyond the scope of a contract, we bill for the additional services. If a major system failure or catastrophic event occurred as the result of flooding, earthquake, electrical strike or vandalism for example, the facility owner would likely call upon us to provide a variety of additional services on a time-and-materials basis. Such services could include running pumps, resealing manholes or replacing meters. 

          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 growth beyond a specified level. Under the O&M contracts, our Services Group may pay certain costs such as chemical or utility expenses. The O&M contracts provide that we are reimbursed for certain of these costs.

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          In most cases, O&M contracts are cancellable only upon a specific breach of the contract by either party.  O&M contracts have terms ranging from month-to-month up to 10 or more years, and our experience has been that approximately 90% of our O&M contracts are renewed upon expiration.

           d.     Construction Management Projects

          In 1999, we agreed to provide the design, building, financing and operation of a $6,500,000 reverse osmosis water treatment plant near El Paso, Texas, for the El Paso County Water Authority (EPCWA). 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, $22,000,000 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 2,600,000 gallons of water per day. Reverse osmosis technology is a process that removes microscopic particles such as minerals and salts from a solution to produce potable water.

          In September 2002, we agreed to facilitate the engineering and construction of a $25,000,000 reverse osmosis water treatment plant in the city of San Juan Capistrano, California, for the Capistrano Valley Water District (CVWD). The project will include the drilling of eight new wells and developing associated water lines. During construction of the treatment plant, we will receive payments upon completion of construction milestones until final completion of the construction. In addition, the CVWD awarded us a 20-year, $20,000,000 contract to operate the treatment plant after completion of construction. The construction of the plant commenced in December 2002, with completion expected in late 2004, at which time we will begin to operate the facility under the 20-year contract.  Upon completion, the plant will have a capacity to treat approximately 5,000,000 gallons of 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 for similar work performed by our Services Group for non-affiliated entities. 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 sales price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process. Accordingly, the intercompany profit on such projects has not been eliminated in the accompanying consolidated financial statements.

           e.     Utility Submetering

          Utility submetering involves the installation of electronic equipment in apartments, condominiums, mobile home parks and other multi-family dwellings to monitor each resident’s usage of utilities, allowing water, gas and electricity usage to be measured and charged to each individual residential unit. By making residents accountable for their own utility consumption, submetering tends to promote conservation of natural resources and allows for landlord utility cost recovery. Our Services Group has designed its own submetering equipment and also installs submetering equipment manufactured by others.

          In addition to the sale and installation of submetering devices, our submetering company provides billing, collection and customer relation services. The billing process for submetered facilities usually involves the transmission of utility usage data via radio frequency and telephone lines to our facility near Denver, Colorado. As of December 31, 2002, our Services Group was providing submetering services to approximately 127,000 dwelling units in 29 states.

           f.     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 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.

          The utility submetering, installation, billing and collection business is highly competitive. While industry contract renewal rates are high, management companies and owners of multifamily dwellings periodically change billing and collection companies. In addition, we compete with several larger competitors whose size, customer base and capital resources may restrict our ability to compete successfully for certain contracts. Submetering is a relatively new industry and may attract other large competitors.  We cannot assure you that our efforts in the submetering business will be successful in increasing or sustaining market share.

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           g.     Growth and Backlog

          During the past three years, our Services Group has increased revenues and service area by adding new MUD, O&M and submetering contracts, managing construction projects, aggressively pursuing renewal of its existing contracts and making acquisitions.

          As the major cities in Texas (such as Houston and Austin) expand their boundaries, they periodically acquire MUD-owned facilities through annexation to city-owned facilities; however, during 2002, none of the MUD facilities operated by our Services Group was annexed to city-owned facilities.

          As of December 31, 2002, our Services Group had 263 MUD contracts, an increase of 85 contracts compared to December 31, 2001. As of December 31, 2002, we had 196 O&M contracts compared to 66 contracts as of December 31, 2001.  The acquisition of Aqua Services in November 2002 accounted for most of the increase in MUD and O&M contracts during 2002. 

          The following table indicates the number of Services Group contracts in effect as of the end of each of the three most recent years:

Table 1
Services Group – Number of Contracts

          Our Services Group’s revenue backlog consists of new and existing contracts. We include new contracts in the backlog when both the client and we have signed the contracts. 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 existing contracts is reflected in the backlog. MUD and submetering contracts are assumed to have a 36-month term, consistent with our experience, and are included in the backlog computation using an assumed 36-month term. We believe our backlog figures are firm, subject only to the cancellation and modification provisions contained in the contracts.

          As of December 31, 2002 and 2001, our Services Group backlog was approximately $275,000,000 and $144,000,000, respectively. The increase in the backlog was primarily due to 1) the addition of several new O&M and MUD contracts resulting from the acquisition of Aqua Services and 2) the addition of a $25,000,000 construction project of a reverse osmosis water treatment plant in San Juan Capistrano, California.  Of the backlog as of December 31, 2002, we anticipate that approximately $100,000,000 will be realized in revenues during calendar year 2003.

           h.     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 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 utility submetering business are generally not subject to seasonal fluctuations.

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           2)     Utility Group

           a.     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 private and public 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, California.

          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. We have experienced only modest connection growth since the late 1960s, principally due to the population saturation of our service area. In February 2000, our California utility purchased the City of West Covina’s (West Covina) water distribution system and facilities, which added approximately 7,000 connections to our customer base, an increase of approximately 11%.

          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:

Table 2
California Utility – Number of Water Connections by Classification

          During 2002, our California utility’s annual revenues were approximately 72% from sales to residential connections, approximately 17% from sales to business and industrial connections, and approximately 11% from sales to other connections.

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, New Mexico, and contains a population of about 36,000 people in an area of approximately 34 square miles, of which an estimated 34% 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:

Table 3
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 over 11,000 connections. Most of this growth has resulted from the extension of water services and sewage

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collection services into new residential subdivisions and new commercial development. During 2002, we added 1,359 new water connections and 1,317 new wastewater connections in New Mexico. Because of the continuing real estate development in its service area, our New Mexico utility expects continued connection growth in 2003. During 2002 and 2001, our revenues in New Mexico were approximately 61% and 58%, respectively, from sales to residential connections and approximately 39% and 42%, respectively, from sales to commercial and industrial connections.

          Texas

          Our Texas utilities currently provide water supply and sewage collection and treatment services to approximately 5,800 connections for residential, commercial, irrigation and fire protection under the jurisdiction of the Texas Commission on Environmental Quality (TCEQ), formerly the Texas Natural Resource Conservation Commission. Our service areas in Texas are located near the City of Austin, and contain a population of approximately 19,000 people in an area of approximately eight square miles, of which an estimated 46% has been developed. These service areas are experiencing continued real estate development, and we expect the number of connections to continue growing in 2003.

Table 4
Texas Utilities – Number of Water Connections by Classification

           b.     Sources of Water

          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 San Gabriel Central Basin (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 without paying any additional charges. As discussed in Part D. Environmental Matters, in recent years, the availability of water from the Main Basin has decreased because of groundwater contamination issues. As a result, the amount of water that our California utility has pumped from the Main Basin has declined. During 2002, the Main and Central Basins were the source of approximately 28% of our California water supply, compared to approximately 54% and 60% in 2001 and 2000, respectively.  Generally, purchased water is more expensive than water pumped from our own wells. 

          Our water supply in California is supplemented by water purchased from external sources. We purchase water from the Metropolitan Water District (MWD) of Southern California through member agencies and other customers of member agencies. We also purchase water from two mutual water companies that produce their water from the Main Basin. Our California utility’s ownership of shares in each of these mutual water companies has allowed it to purchase water at a cost that is lower than many other sources. In addition, in the past we have leased Main Basin pumping rights from other parties, which has reduced our cost of water in California. However, we cannot assure you that these sources of water will remain unaffected by the Main Basin groundwater contamination issues or that our California utility will be able to use these water sources indefinitely. 

          In Part D. Environmental Matters, we discuss certain groundwater issues impacting the Main Basin. In 2001 we were required to shut down some of our wells. This resulted in our California utility purchasing approximately 46% of its water supply from the MWD and other sources in 2001, compared to approximately 40% in 2000. During 2002, our California utility shut down additional wells. As a consequence, the Main and Central Basins were the source of approximately

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28% of our California water supplies in 2002, and we were required to purchase approximately 72% of our water supply from the MWD and other water sources. 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.

          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 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.

          Our New Mexico utility owns five wells and four reservoirs, and we believe that we have adequate water capacity to serve our current customer base as well as new customers over the next decade, based upon the current growth rate. 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 to ensure an adequate supply of water. If an interruption were to occur in our New Mexico water supply, our New Mexico utility also has an emergency supply of water available through an interconnection with another water purveyor.

          Our Texas utilities own eight wells and 10 reservoirs in addition to distribution, collection and treatment facilities. Water is pumped out of the Edwards aquifer. We believe that we have adequate capacity to serve our existing customer base in Texas.

          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 a 20-year agreement to purchase water from the City of Austin.

           c.     Water Quality Regulation

          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 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.

          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. The water supplied by our Texas utilities is subject to regulation by the EPA and by the TCEQ.

          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

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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 (CRs).

          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 an option that includes 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 we anticipate that the change in standard may have an impact on our New Mexico water utility operations. 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 present a rate case to the NMPRC to recover these costs. We cannot assure you that funds will be made available to our 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, radio nuclides, pesticides 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 performed 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 established. The results of the sampling and testing are made available to DOHS and to all water purveyors that produce water from the Basins. The cost of such sampling and testing is covered by Board 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.

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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.

           d.     Competition

          Our Utility Group companies 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 these state laws, municipalities and certain other public agencies have the right to acquire private water 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.

           e.     Rate Establishment

          Under current CPUC practices, California customer water rates may be increased through general rate increases or by offsets for certain expense increases. Since September 30, 2002, the 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. Public participation hearings are also held. Historically, rate proceedings have required approximately 12 months from the time an application is filed to the CPUC’s authorization of new rates. 

          In addition to a general rate increase, the CPUC typically provides for a step increase in the second and third years after a general rate review.  The step increases are intended to compensate for projected expense increases. Prior to their approval, step increases are subject to verification that earnings levels have not exceeded the rate of return authorized at the general rate proceeding. In recent years, our California utility succeeded in achieving efficiencies and cost savings that resulted in the deferral of rate requests. However, in accordance with a change in the law, our California utility made a filing on April 2, 2002 to start a new general rate case, and the rate case proceedings are currently underway.  Both the Company and the CPUC staff have testified before an Administrative Law Judge and the judge has rendered a preliminary opinion. That opinion is pending with the CPUC. We anticipate a rate increase in the first half of 2003.

          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 periodic requests for rate increases.           

          Under prior CPUC procedures, rate increases to offset increases in certain expenses such as the cost of purchased water and energy costs to pump water 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 increases are no longer as readily available, have more restrictions and will no longer be considered by the CPUC unless they occur within a three-year general rate cycle.

          Prior to November 29, 2001, the CPUC permitted California water utilities to record the difference between actual and CPUC-adopted water production costs in balancing accounts on the balance sheet, with a corresponding

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adjustment in the income statement. In 2001, our California utility recorded approximately $700,000 of balancing account benefits in its income statement, and had a total balance of approximately $2,300,000 in deferred costs recorded as an asset on its balance sheet at the end of November 2001.  As mentioned above, no such benefits were available in 2002.  The disposition of pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking.  On December 17, 2002, the CPUC issued a decision considered favorable to the water industry that should allow our California utility to recover approximately $2,300,000 that was in its balancing account on November 29, 2001.

          Subsequent to November 29, 2001, our California utility has accounted for the difference between actual and CPUC-adopted water production costs in current operations in the income statement. Such costs have been tracked on a memorandum basis, and the rules for the recovery, if any, of such costs are the subject of CPUC rulemaking. The changed CPUC rules resulted in a reduction in revenue and earnings before taxes of approximately $700,000 in 2002 compared to 2001, and we believe that the changed CPUC rules will result in fluctuations in revenues and earnings in future periods.

          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.

          Requests for rate increases for our New Mexico utility are submitted to the NMPRC with the test year typically being the previous year’s actual results. Because of the continued growth in its service area, our New Mexico utility has not found it necessary to request a general water rate increase during the past several years. The most recent general water rate increase granted to our New Mexico utility was in 1984, while the last general sewer rate increase granted to our New Mexico utility was in 1995.

          In Texas, requests for rate increases are submitted to the TCEQ with the test year typically being the previous year’s actual results.  One of our Texas utility companies filed for a rate increase in April 2001 and received approval from the TCEQ for a 48% increase in December 2001. In addition, we received annual step increases for 2002 through 2004.

           f.     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 any significant increase in the number of connections in our current service area.

          In February 2000, our California utility purchased West Covina’s water distribution system and facilities for a price of approximately $8,500,000. 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%.

          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 our California utility operations, periodic debt financing and lines of credit that we maintain with banks. To a lesser extent, our California utility 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, 2002, 2001 and 2000, capital expenditures in California approximated $10,000,000, $4,700,000 and $5,600,000, respectively. Of these amounts, our California utility received capital contributions and advances from developers of approximately $2,535,000, $339,000 and $1,110,000 in 2002, 2001 and 2000, respectively. Additions for 2002 included approximately $4,278,000 of expenditures reimbursed to our California utility under a settlement agreement relating to Main Basin groundwater contamination (see Part D. Environmental Matters below).

          Because our New Mexico utility service area continues to experience rapid 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

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December 31, 2002, 2001 and 2000, capital expenditures approximated $7,500,000, $3,700,000 and $3,500,000, respectively. Of these amounts, our New Mexico utility received capital contributions from developers of approximately $6,740,000, $3,103,000 and $2,847,000 in 2002, 2001 and 2000, respectively.

          Because our Texas utility service areas are also in locations of rapid growth, these operations are capital intensive as well. Capital is generated from Texas operations, a bank term loan to the larger of our Texas utilities, and Living Unit Equivalent connection fees (LUEs) received from developers. For the years ended December 31, 2002 and 2001, capital expenditures were approximately $13,700,000 and $5,019,000, respectively. Of these amounts, our Texas utilities received contributions and LUEs from developers of approximately $4,800,000 in 2002 and $1,026,000 in 2001.

          In recent years, the City of Albuquerque has annexed a significant portion of our service area in New Mexico; however, we have continued to serve the customers located in the annexed areas. Currently, 80% of our utility customers in New Mexico are located within Albuquerque’s city limits. In 1998, Albuquerque initiated an action in eminent domain to acquire our New Mexico utility operations. In September 2000, the Albuquerque City Council voted to withdraw the condemnation proceeding. We received a formal withdrawal of the condemnation in 2001 and Albuquerque reimbursed us for approximately $115,000 in legal fees incurred as a result of the condemnation proceeding. We are not aware of any impending proceedings for the condemnation of any portion of our facilities in New Mexico.

           g.     Seasonality

          Our Utility Group water operations 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 operations are generally not affected by seasonality.

           D.     Environmental Matters

          The water supply of our California water utility has been affected by the presence of certain groundwater contaminants. These contaminants consist mainly of chemicals (including NDMA and perchlorates) 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 in California (see Item 1. Description of Business - Part C. 2) c. Water Quality Regulation above).

          In May 2002, a settlement was reached among some of the alleged polluters (the Cooperating Respondents or CRs) and a number of water companies, including our California water utility. As part of the settlement, in the second quarter of 2002, we recorded income of approximately $1,649,000 and received payments, primarily representing reimbursement of certain water and energy costs incurred in 2000 and 2001. Additionally, as part of the settlement, we have received payments in 2002 and expect to continue to receive payments in future periods from this settlement until completion of remediation. The payments represent the incremental cost of purchasing water over the cost that would have been incurred by us to pump our wells had they not been shut down as a result of the contamination. We bill and collect this reimbursement each month, and the amounts are recorded as a reduction of water costs included in direct operating expenses.

          For our California utility, the settlement also provides capital contributions to construct two new wells, pipelines and additional interconnections with other water sources. In accordance with the terms of the settlement agreement, the CRs were required to provide financial assurances in the form of either irrevocable standby letters of credit or cash into an escrow account equal to the total amount of capital funds required to complete the clean-up process for all water companies impacted by the contamination, estimated at approximately $250,000,000.  Funds from the settlement will also be used to develop long-term solutions that will potentially enable us to use our own less costly groundwater supplies in the future. During 2002, we received approximately $4,278,000 from the CRs to pay for capital expenditures related to these long-term solutions.

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           E.     Service Areas

          Our Services Group provides water and wastewater operations and maintenance services primarily in California, New Mexico, Texas, Colorado, Georgia, and Mississippi.  This group is headquartered in Sugar Land, Texas.  Our submetering efforts are headquartered near Denver, Colorado, where we support clients in 29 states.  Our Utility Group owns and operates regulated water and wastewater facilities in California, New Mexico, and Texas.  This group is headquartered in West Covina, California.

           F.     Credit Concentration

          We have no individual customers who accounted for 10% or more of our consolidated revenues in 2002, or whose loss would have a material adverse effect on our consolidated or operating segment revenues.

           G.     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 submetering equipment. Except for certain logos, trademarks and artwork used in marketing, we have no other patents, licenses or trademarks.

           H.     Regulatory Matters

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

          Under current CPUC practices, California customer water rates may be increased through general rate increases or by offsets for certain expense increases. An amendment to the California Public Utilities Code effective September 30, 2002 requires CPUC-regulated water utilities to 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. Public participation hearings are also held. Historically, rate proceedings have required approximately 12 months from the time an application is filed to the CPUC’s authorization of new rates.  The previously mentioned change in the law requires the CPUC to render rate decisions in accordance with its rate case plan.  It also provides that, if the CPUC does not issue its decision in accordance with the plan, utilities may implement interim rates subject to refund.

          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 earnings levels have not exceeded the rate of return authorized at the general rate proceeding. In recent years, our California utility succeeded in achieving efficiencies and cost savings that resulted in the deferral of rate requests. However, in accordance with a change in the law, our California utility made a filing on April 2, 2002 to start a new general rate case, and the rate case proceedings are currently underway.  Both the company and the CPUC staff have testified before an Administrative Law Judge and the judge has rendered a preliminary opinion.  That opinion is pending with the CPUC.  We anticipate a rate increase in the first half of 2003.

          Under prior CPUC procedures, rate increases to offset increases in certain expenses such as the cost of purchased water and energy costs to pump water were approved through an abbreviated offset proceeding that required approximately two months from the time a request was filed to the authorization of new rates. Under current CPUC guidelines, offset increases are no longer as readily available as they have been in the past. Offset increases have more restrictions and will no longer be considered by the CPUC unless they occur within a three-year general rate cycle.

          Prior to November 29, 2001, the CPUC permitted California water utilities to record the difference between actual and CPUC-adopted water production costs in balancing accounts on the balance sheet, with a corresponding adjustment in the income statement. In 2001, our California utility recorded approximately $700,000 of balancing account benefits in its income statement, and had a total balance of approximately $2,300,000 in deferred costs

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recorded as an asset on its balance sheet at the end of November 2001.  As mentioned above, no such benefits were available in 2002.  The disposition of pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking.  On December 17, 2002, the CPUC issued a decision considered favorable to the water industry that should allow our California utility to recover approximately $2,300,000 that was in its balancing account on November 29, 2001.

          For water production costs incurred on or after November 29, 2001, the CPUC eliminated the use of balancing accounts. In place of the balancing account, our California utility has accounted for the difference between actual and CPUC-adopted water production costs in current operations in the income statement. Such costs have been tracked on a memorandum basis, and the rules for the recovery of such costs are currently the subject of the previously mentioned CPUC rulemaking. The changed CPUC rules resulted in an increase in expense and a decrease in earnings before taxes of approximately $700,000 in 2002 compared to 2001, and we believe that the changed CPUC rules will result in fluctuations in revenues and earnings in future periods.

          Southwest Water and its Utility Group closely monitor legislative, EPA, CPUC, NMPRC and TCEQ developments. The various water industry associations in which we participate also monitor these developments. We do not know the possible legislative, EPA, CPUC, NMPRC or TCEQ changes that will be enacted or the terms of such changes if enacted. Therefore, we cannot predict the impact, if any, of future legislative changes, EPA, CPUC, NMPRC or TCEQ developments or changes on our financial position, results of operations or cash flows.   However, as discussed in Part D. Environmental Matters, future capital investments may be needed to meet new EPA arsenic requirements.

          Our Services Group pricing is not subject to regulation by any public regulatory commissions.

           I.     Employees

          At December 31, 2002, we employed approximately 1,200 people, none of whom is represented by an employee union. We believe that our labor relations are positive.

           J.     Dividend History

          During the past five years, Southwest Water has paid a cash dividend in each quarter.  For specific information relative to dividends paid during 2002 and 2001, 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.

           K.     Risk Factors

          1) Risk Factors that impact our Utility Group operations

          a) Weather conditions can impact the financial results of our Utility Group.

          Rainfall and weather conditions affect our utility operations, with most water consumption occurring during the third quarter 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 higher-cost purchased water to meet customer demand.  Therefore, while our revenues may increase, we may experience lower profit margin ratios 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.

          b) Rates that we are allowed to charge customers are set by regulatory agencies.

          The water and wastewater utilities owned by our Utility Group 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

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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 in recent years.  While we are using energy-efficient techniques and new and better equipment, we are also seeking 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.  For example as discussed in Part C. 2) e., the California Public Utility Commission’s changes to the balancing account procedures in late 2001 impacted our earnings in 2002.

          c) 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.

          d) We 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.  The first factor is our ability to find water that meets all state, federal, state regulatory water quality standards.  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.  As discussed in Part C. 2) c., 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.

          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, these alternative sources of supply 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 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. 

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

          To meet both 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 shareholder equity, contributions by developers 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 the regulators, our financial performance could be adversely affected.

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          2) Risk factors that impact our Services Group operations

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

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

          Our utility submetering, installation, billing and collection business is also highly competitive. We strive to develop an expertise in managing each property we serve.  However, the submetering industry does not typically use long-term contracts and management companies and owners of multi-family dwellings periodically change billing and collection companies. In addition, our utility submetering company competes with several larger competitors whose size, customer base and capital resources may restrict our ability to compete successfully for certain contracts. Submetering is a relatively new industry and may attract other large competitors.

          Due to the nature of our contract operations business which provides utility services, primarily operations and operations management, to municipalities and municipal utility districts, and to the very competitive environment 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.

          b) We market our services in a political environment.

          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.

          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. 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. 

          c) Our business depends on trained, qualified employees.

          State regulations set the 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 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.

          d) Risk of events such as hurricanes, tornadoes and floods may impact our profitability.

          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.

          e) 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

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follow other best practice activities, should we fail in providing these services properly, it may adversely impact our revenues and profitability.

          Additionally, in certain circumstances our submetering 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 believe that estimates used in our submetering business are reasonable and reflect common practices in the industry.  However, we cannot assure you that we will not face claims regarding the use of such estimates, which may impact our profitability.

          f) 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 may involve risks, including shortages of materials and labor, work stoppages, labor relations disputes, weather interference, engineering, 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 procure maximum price contracts for 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, contract prices are 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 be held responsible 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 very 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.

          g) 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 you that such guarantees completely protect us from the risk of quality failure in the design,

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manufacture, and installation of submetering equipment.  We cannot assure you that we will not face claims regarding product and installation quality for equipment placed in service either before our after our acquisition of our submetering business. Such claims could have an adverse impact on our profitability.

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

          Our client, the municipality or public agency, is the owner of the facilities that we operate under contract.  We operate each facility in accordance with various Federal and state water quality standards.  We also handle certain hazardous materials at these facilities, primarily chlorine gas.  Certain environmental issues could be attributed to any failures of our operation of the facilities, including sewage spills, noncompliance with water quality standards, hazardous material leaks and spills, etc.  Should we fail to properly meet our contractual responsibilities relative to these issues, we could be subject to various claims and litigation costs.

          Though we attempt to operate using best practices, proper training, maintain close management oversight and utilizing insurance policies to reduce risks, we cannot assure you that we will successfully manage these issues, and failure to do so could have a material adverse effect on our future results of operations.

          i) We have risks associated with a large fleet of vehicles.

          The Services Group has a fleet in excess of 500 vehicles.  Our employees drive over 8,000,000 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, if we are not successful in managing this large fleet, it could have a material adverse impact on our profitability.

          j) 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 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.

          k) Our operating contracts may be cancelled by a municipality, impacting our backlog.

          Our Service Group revenue backlog consists of new and existing contracts. We include new contracts in the backlog when both the client and we have signed the contracts. 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, 2002, our backlog was approximately $275,000,000. 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.

          3) Other risk factors

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

          Of the $24,000,000 total capacity under our lines of credit, we have approximately $3,842,000 in available borrowing capacity as of December 31, 2002 as a result of using approximately $10,317,000 in borrowings on our

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lines of credit to fund the acquisition of Aqua Services in November 2002.  In addition to this borrowing capacity we had cash and cash-equivalent balances totaling approximately $1,606,000 as of December 31, 2002.

          As indicated in Note 17 to the accompanying consolidated financial statements, in March 2003, we entered into an agreement to amend one of our lines of credit under which the bank increased our line of credit capacity by $4,000,000 through December 31, 2003.

          We are currently evaluating our capital structure and potential financing alternatives available to us to provide additional liquidity.  These alternatives include increasing the size of our lines of credit, long-term asset backed financing capacity in our regulated utilities, sale and leaseback of certain fleet assets and administrative office space, and issuing debt or equity in either a public or private placement offering.  We anticipate that these financing alternatives will enable us to substantially reduce the amounts currently outstanding on our lines of credit during 2003.  While we believe that there will be lender and investor interest in these financing alternatives, there can be no assurance that we will be able to obtain such funding in 2003.  Also we cannot assure you that any financing completed will not increase our interest expense, dilute the percentage ownership of our existing shareholders, or dilute our earnings per share.

          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 during 2003, these actions could negatively impact our revenues, revenue growth, and profitability.

          b) We may fail to effectively manage growth.

          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 new business ventures. We cannot assure you that we will successfully manage our growth, and failure to do so could have a material adverse effect on our future results of operations.

          c) Our business may be impacted 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.

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

          We own and/or operate water and wastewater facilities in numerous locations in eight or more 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.

          We make available free of charge on or 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 address is “www.southwestwater.com”.

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           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 70,700 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.

          Water Production and Distribution Facilities

          Our California utility owns and operates water production and distribution systems consisting of well pumping plants, booster pumping stations, water treatment facilities, reservoir storage facilities, transmission and distribution mains, and service connections to individual customers. Our utility has rights-of-way and easements in its service area necessary to provide water services. As of December 31, 2002, our California utility owned approximately 858 miles of transmission and distribution mains and 30 storage reservoirs with a total capacity of approximately 71,000,000 gallons. As of December 31, 2002, this utility also owned five active wells with a total pumping capacity of approximately 9,600 gallons per minute, compared to eight active wells with a total pumping capacity of approximately 15,600 gallons per minute at December 31, 2001. In the first two months of 2002, we removed three wells from service. In 2002, our California utility constructed two new wells, which we expect to activate in early 2003. 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 CPUC. Our utility employees perform normal maintenance and construction work on these facilities while major construction projects are performed by outside contractors chosen through competitive bidding. Ongoing maintenance and repairs performed by our utility in California were approximately $1,900,000, $1,700,000 and $1,700,000 in 2002, 2001 and 2000, respectively, and approximated 6% of its operating expenses in each of the three years ended December 31, 2002, 2001 and 2000. As previously discussed, in 2000 our California utility acquired the West Covina water distribution system, which added 87 miles of transmission and distribution mains and four storage reservoirs with a total capacity of 15,000,000 gallons to our California production and distribution systems.

          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, 2002, our utility in California was in compliance with dividend limitations mandated by the California Indenture.

          Our New Mexico utility owns and operates a water production and distribution system consisting of well pumping plants, reservoir storage facilities, booster pumping stations, transmission and distribution mains, and service connections to individual customers. We have rights-of-way and easements in our New Mexico service area necessary to provide water and sewer services. At December 31, 2002, our utility in New Mexico owned five wells, approximately 172 miles of transmission and distribution mains and four storage reservoirs with a total capacity of approximately 10,000,000 gallons, and our wells have a total pumping capacity of approximately 9,525 gallons per minute. While facilities we own in New Mexico vary as to age and quality, we believe these facilities are in good condition and are adequate for current and foreseeable operations.

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          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, 2002, our New Mexico utility was in compliance with dividend limitations mandated by the New Mexico Indenture.

          Our Texas utilities own and operate water production and distribution systems consisting of well pumping plants, booster pumping stations, transmission and distribution mains, and service connections to individual customers. We have rights-of-way and easements in our Texas service areas necessary to provide water and wastewater services. At December 31, 2002, the larger of our Texas utilities owned six wells, eight reservoirs and approximately 30 miles of transmission and distribution mains, and its wells have a total pumping capacity of approximately 2,500 gallons per minute. At December 31, 2002, the smaller of our Texas utilities owned two wells, two reservoirs and approximately 14 miles of transmission and distribution mains. The wells owned by this smaller Texas utility have a total pumping capacity of approximately 1,000 gallons per minute.

Wastewater Facilities

          Our New Mexico utility owns and operates a sewer collection system consisting of one lift station and approximately 130 miles of interceptor and collector lines. Wastewater is treated at a city-owned facility.

          Our Texas utilities own and operate two sewer collection systems, including five lift stations and approximately 44 miles of interceptor and collector lines. In 2002, one of these wastewater treatment facilities was expanded to increase our combined processing capacity from approximately 1,900,000 gallons per day of sewage to over 3,500,000 gallons per day. 

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Item 3. Legal Proceedings

          In September 2002, we were named as a defendant in a lawsuit alleging wrongful death as the result of a chlorine gas leak that occurred in July 2000 at one of the facilities in Mississippi that we operate under an O&M contract.  The decedent who was exposed to the gas leak was treated and released from the hospital on the day following the gas leak.  He subsequently died eleven months later of causes that we believe are unrelated to the chlorine gas exposure.  We deny any wrongdoing and are vigorously defending against the claim. Our umbrella liability insurance carrier is currently absorbing the costs of defense of the lawsuit; however, we cannot predict the outcome of this lawsuit. Based upon information available at this time, however, we do not expect that this action will have a material adverse effect on our financial position, results of operations or cash flows.

          We were named as a defendant in three lawsuits filed in 1998 alleging injury and damages as the result of a sewage spill which occurred at an Austin, Texas sewage pumping station operated by us. A cross-complaint was subsequently filed and served on us by the City of Brushy Creek, Texas. In 2001, a settlement was reached with two of the plaintiffs and a third suit was settled in 2002. We expect the cross-complaint to be settled in 2003. Our subsidiary has been defended and indemnified by our insurance carrier and will be required to pay a $10,000 deductible on settlement of each of the claims.  We do not believe these actions will have a material adverse effect on our financial position, results of operations or cash flows.

          We were named as a defendant in several lawsuits alleging water contamination in the Main Basin. The California Supreme Court (the Court) ruled in February 2002 that the plaintiffs cannot challenge the adequacy of the water quality standards established by the CPUC. However, the plaintiffs may sue and collect damages from our California utility and other regulated water companies if they prove that water delivered did not meet CPUC water quality standards. The Court directed that the cases be sent to the trial court for further proceedings. We believe that our California utility has complied with CPUC water quality standards and are vigorously defending these claims. We 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. All lawsuits have been consolidated before a single California Superior Court judge. Discovery is underway and we expect, upon completion of that discovery, to obtain orders determining whether the plaintiffs are legally entitled to proceed against us, which plaintiffs may proceed against us and which claims may be prosecuted. 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.

          Southwest Water and its subsidiaries are the subjects of certain 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.

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Item 4. Submission of Matters to a Vote of Security Holders

          None.

Item 4a. Executive Officers of the Registrant

          Our Board of Directors elects the 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, 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 are as follows:

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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 5% stock dividend on January 1, 2003, a 5% stock dividend on October 1, 2001 and a 5-for-4 stock split in the form of a stock dividend on January 1, 2001. Our common stock is traded on the Nasdaq Stock Market under the symbol SWWC. At December 31, 2002, there were 2,305 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 $0.058 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 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, a 3-for-2 stock split in the form of a stock dividend on October 1, 1999, a 5-for-4 stock split in the form of a stock dividend on October 1, 1998 and a 5% stock dividend on January 1, 1998.

          See notes (a) – (e) on following page.

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Notes to Item 6. Selected Financial Data (in thousands except per share data)

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Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations

ADJUSTMENTS RELATED TO STOCK OPTION ACCOUNTING

          Effective in 2002, we retroactively adopted the fair value based method of accounting for stock options as outlined in SFAS No. 123.  Accordingly, all prior periods presented have been restated to reflect compensation cost that would have been recognized under the fair value based accounting method for all options granted, modified or settled in fiscal years beginning after December 15, 1994. 

          The amounts we previously reported in our Annual Reports on Form 10-K included the tax benefit from stock options exercised as a credit to the provision for income taxes.  This benefit for options exercised should have been recorded as an increase to paid-in capital.  Accordingly, the amounts previously reported have been adjusted to properly account for this tax benefit. These adjustments had the effect of reducing net income by $301,000, $167,000 and $162,000 for 2001, 2000 and 1999, respectively, and reducing both basic and diluted EPS by $0.03, $0.02 and $0.02 for each of these respective years compared to the amounts previously reported in our Annual Reports on Form 10-K.  These non-cash tax adjustments to net income have no effect upon our cash flows, ability to pay dividends, current income tax liability or total stockholders’ equity.

          See Note (e) to Item 6. Selected Financial Data, and Notes 2, 11 and 16 to the accompanying consolidated financial statements for more complete disclosure.

RESULTS OF OPERATIONS

Year Ended December 31, 2002 Compared to the Year Ended December 31, 2001

Net Revenues and Operating Income

          Services Group

          Services Group revenues for 2002 were $78,833,000, an increase of 19% from $66,476,000 in 2001. This increase was due primarily to a) the acquisition of OpTech in August 2001, b) increased construction and O&M revenues and c) the acquisition of Aqua Services in November 2002, offset in part by decreased submetering revenues of 23% primarily as a result of a large construction project completed during 2001 with no similar project in 2002.

          Services Group operating income decreased 16% to $1,868,000 in 2002 compared to $2,215,000 in 2001.  As a percentage of this group’s revenues, Services Group operating income was 2% and 3% in 2002 and 2001, respectively. Services Group operating income for 2002 reflects decreased operating income from submetering, acquisition integration issues and higher medical and general insurance costs.

          Utility Group

          Utility Group revenues for 2002 increased to $51,967,000, an increase of $2,896,000, or 6%, from $49,071,000 in 2001. In 2002, water usage increased 6% at our California utility because of hot, dry weather in the third quarter and drought-like conditions throughout much of the year. Water usage increased 3% overall in New Mexico, primarily reflecting a 14% increase in the number of customers, offset in part by reduced water usage per customer during 2002. The effects of a rate increase and an increase in the number of customers at one of our Texas utilities also contributed to the increase in revenues.

          For 2002, our Utility Group operating income decreased 4% to $14,137,000 from $14,756,000 in 2001. As a percentage of this group’s revenues, operating income was 27% and 30% in 2002 and 2001, respectively. The decrease in 2002 operating income resulted primarily from the effect of higher water-volume-related expenses incurred at our California utility.  In addition, in 2001, our California utility was able to defer recognizing certain costs in the approximate amount of $700,000 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 negatively impacted our California utility’s 2002 operating income. This decrease was partially offset by a rate increase at one of our Texas utilities, which positively impacted operating income. 

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Selling, General and Administrative Expenses

          Selling, general and administrative expenses increased 5% to $18,398,000 during 2002, compared to $17,492,000 for 2001. As a percentage of consolidated revenues, selling, general and administrative expenses were 14% and 15% in 2002 and 2001, respectively. The 2002 increase in selling, general and administrative expenses was primarily attributable to a) the acquisition of OpTech in August 2001, b) the acquisition of Aqua Services in November 2002, c) increases in medical and general insurance costs, d) marketing and new business development expenses and e) an increase in stock-based compensation expense recorded under SFAS No. 123 due to higher fair value for  options issued in 2002. 

Other Income and Expense

          Interest Expense

          Total interest expense increased 22% to $4,494,000 during 2002, compared to $3,694,000 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 the years ended December 31, 2002 and 2001 are as follows:

          Water-Related Cost Reimbursement

          In the second quarter of 2002, we accrued income for a reimbursement of approximately $1,649,000 for water-quality-related expenses incurred in 2001 and 2000. Additionally, in 2002 we received and will continue to receive reimbursement for a portion of the incremental cost of purchasing water rather than pumping from our closed wells. We bill and collect this reimbursement each month and the amounts are recorded as a reduction against water costs included in direct operating expenses.

          Other

          In the first quarter of 2002, we recorded a one-time gain on termination of a pension plan of approximately $980,000. This increase in other income was partially offset by amortization of contracts related to the purchase of OpTech in August 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.

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Earnings Per Share

          Diluted Earnings Per Share (EPS) was $0.58 in 2002, an increase of 5% compared to diluted EPS of $0.55 in 2001 (after adjustment for a 5% stock dividend on January 1, 2003).  The water-quality-related cost reimbursement described above contributed $0.11 per share, net of taxes, to diluted EPS in 2002, while the one-time gain on termination of a pension plan in the first quarter of 2002 contributed $0.06, net of taxes, to diluted EPS in 2002.

Year Ended December 31, 2001 Compared to the Year Ended December 31, 2000

Net Revenues and Operating Income

          Services Group

          Services Group revenues for 2001 were $66,476,000, an increase of 10% from $60,425,000 in 2000. This increase was due primarily to the acquisition of OpTech in August 2001 and increased construction revenues at our submetering company, primarily as a result of a large construction project completed during 2001 with no similar project in 2000.  These increases were partially offset by a decrease in revenues due to the benefit in 2000 of a large construction project.  There was no comparable project in 2001. 

          Services Group operating income decreased to $2,215,000 in 2001, a decrease of $648,000, or 23%, compared to 2000.  As a percentage of this group’s revenues, Services Group operating income was 3% and 5% in 2001 and 2000, respectively.  During 2000, the Services Group had the benefit of a large construction project consisting of a reverse osmosis water treatment plant in El Paso, Texas, and recognized the related revenue and operating income.  There was no comparable project in 2001.  The decrease in operating income was partially offset because of the acquisition of Master Tek in April 2000 and OpTech in August 2001.

Utility Group

          Utility Group revenues for 2001 increased $4,755,000, or 11%, to $49,071,000 from $44,316,000 in 2000.  This increase was primarily the result of the acquisition of our Texas utilities in October 2000, coupled with increased water usage at our California utility because of hot, dry weather in the third quarter and drought-like conditions during 2001. Water usage increased 3% overall in New Mexico, primarily reflecting a 14% increase in customers. The effects of a rate increase at one of our Texas utilities also contributed to the increase in revenues.

          For 2001, our Utility Group operating income increased 14% to $14,756,000 from $12,938,000 in 2000. As a percentage of this group’s revenues, Utility Group operating income was 30% and 29% in 2001 and 2000, respectively. The increase in 2001 operating income resulted primarily from the acquisition of our Texas utilities in October 2000.         

Selling, General and Administrative Expenses

          Selling, general and administrative expenses increased 11% to $17,492,000 during 2001, compared to $15,694,000 for 2000. As a percentage of consolidated revenues, selling, general and administrative expenses were 15% in both 2001 and 2000. Our Services Group selling, general and administrative expenses increased by approximately $909,000 due primarily to the acquisition of our submetering business in April 2000. General and administrative expenses in our Utility Group increased by approximately $411,000, primarily as the result of the acquisition of our Texas utilities in October 2000.  General and administrative expenses of the parent company increased by approximately $478,000.

Other Income and Expense

          Interest Expense

          Total interest expense increased 1% to $3,694,000 during 2001, compared to $3,652,000 in 2000. 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 significant 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 2001, compared to 2000. The effective

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interest rates on our indebtedness were approximately 7.4% and 8.7% in 2001 and 2000, respectively. During 2001, we capitalized approximately $790,000 of interest relating to various construction projects at one of our Texas utilities and at our largest Services Group company.

          The major components of interest expense for the years ended December 31, 2001 and 2000 are as follows:

Income Taxes

          Our effective tax rate  was approximately 39% for both years ended December 31, 2001 and 2000.

Earnings Per Share

          Diluted EPS was $0.55 in 2001, an increase of 6% compared to diluted EPS of $0.52 in 2000 (after adjustment for a 5% stock dividend on January 1, 2003).

FINANCIAL CONDITION

Liquidity and Financial Position

          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, funding of projects and acquisition of contracts.

          As of December 31, 2002, we had a working capital deficit of approximately $1,787,000 with cash and cash-equivalent balances totaling approximately $1,606,000, as well as aggregate lines of credit totaling $24,000,000 consisting of three separate unsecured lines of credit from three commercial banks. One of the lines of credit expires in March 2004, another expires in April 2004 and the remaining line expires in September 2004. As of December 31, 2002, we had approximately $20,158,000 outstanding and approximately $3,842,000 available on these three lines of credit.  During 2002, our outstanding line of credit borrowings increased by approximately $4,166,000. We paid for the acquisition of the AquaSource business with approximately $10,317,000 in cash.  We paid in full our New Mexico utility Series A First Mortgage Bonds in the amount of $2,000,000, and we purchased certain utility property.  These borrowings were offset in part by repayments on our lines of credit with the net proceeds of approximately $9,750,000 from a new bank term loan secured by our Texas utility, the cash received as payment for the El Paso, Texas reverse osmosis plant and from payments received for water-quality-related reimbursements.

          On January 8, 2003, we obtained an additional unsecured line of credit facility in the amount of $3,430,000 from one of our commercial banks.  This facility was used to issue a $3,430,000 standby letter of credit as collateral for performance under the service contract for the CVWD 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 by the CVWD, the standby letter of 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 $65,000,000 as of December 31, 2002.  However, the additional borrowing available under our current commercial lines of credit is limited by financial covenants that restrict additional borrowing at December

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31, 2002 to an amount no greater than the remaining unused credit line amount.  Accordingly, borrowings were limited to our unused lines of credit of approximately $3,842,000 at December 31, 2002.

          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. As of December 31, 2002, we were in compliance with all applicable covenants of each of the line of credit agreements.

          We periodically use our lines of credit to fund large construction projects and/or acquisitions.  Upon completion of these larger transactions, we have historically obtained a permanent funding source and used the proceeds to restore availability under the lines of credit. Of the $24,000,000 total capacity under our lines of credit, we had approximately $3,842,000 in borrowing capacity as of December 31, 2002 as a result of using approximately $10,317,000 in borrowings on our lines of credit to fund the acquisition of Aqua Services in November 2002. 

          As indicated in Note 17 to the accompanying consolidated financial statements, in March 2003, we entered into an agreement to amend one of our lines of credit under which the bank increased our line of credit capacity by $4,000,000 through December 31, 2003.

          We are currently evaluating our capital structure and potential financing alternatives available to us to provide additional liquidity.  These alternatives include increasing the size of our lines of credit, long-term asset-backed financing capacity in our regulated utilities, sale and leaseback of certain fleet assets and administrative office space, and issuance of debt or equity in either public or private offerings.  We anticipate that these financing alternatives will enable us to substantially reduce the amounts currently outstanding on our lines of credit.  While we believe that there will be investor and lender interest in these financing alternatives, there can be no assurance that we will be able to obtain such funding in 2003.

          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.  While we have the ability to take such actions during 2003, these actions could negatively impact our revenues, revenue growth, and profitability.

          During 2002, net cash provided by operations totaled $22,086,000 compared to $4,038,000 in 2001. Increased cash flows from operations were primarily the result of the collection of significant receivables in connection with the completion of a reverse-osmosis water treatment plant constructed by our Services Group and an increase in accounts payable, primarily for construction-related activities. In addition, we recorded approximately $1,649,000  for certain water-quality-related expenses incurred in prior years.

          Our investing activities include company-funded acquisitions of plant and equipment as well as acquisitions of operating entities.

Property, Plant and Equipment

          During 2002, our additions to property, plant and equipment were $34,602,000 consisting of $13,344,000 in Company-financed additions, $4,278,000 in contributions by CRs, $7,965,000 in developer-paid additions and $9,015,000 in non-cash property contributed by developers. Company-financed capital additions were funded primarily by cash flow from operations and by borrowings on our bank lines of credit. Total additions to property, plant and equipment represented an increase of $18,013,000 compared to 2001.

          Additions to property, plant and equipment were primarily utility assets for our Utility Group, including new wells and transmission lines at our New Mexico utility and the construction of a lift station, force main and an elevated storage tank at one of our Texas utilities. In addition, we completed expansion of an office building in Austin, Texas.

          Developers made Contributions in Aid of Construction (CIAC), Living Unit Equivalent (LUE) fees and Advances totaling $16,980,000 during 2002, of which $7,965,000 was received in cash and $9,015,000 was received as non-cash contributions of property. We estimate that our total Company-financed capital additions in 2003 will be approximately $14,000,000, primarily for utility plant, and that our cash flows from operations, borrowings on our lines of credit, CIAC, LUE fees and Advances will fund these additions.

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Acquisitions

          In November 2002, we acquired 100% ownership of certain contract operations of AquaSource, Inc., a provider of contract water and wastewater services in Texas and Colorado. The purchase price consisted of approximately $10,317,000 in cash, which was funded primarily by borrowings under our bank lines of credit.

          Under the terms of our purchase agreement for Master Tek, the minority owner of Master Tek has the option to require us to purchase his initial 20% minority interest in 5% increments at a price not to exceed $1,000,000 per year over four years. The minority owner exercised this option to sell us 5% of Master Tek stock for which we paid $1,000,000 in cash in April 2002. In February 2003, the minority owner exercised his option to sell us an additional 5% of Master Tek stock for $1,000,000, which we expect to pay in April 2003.

          Under the terms of the OpTech purchase agreement, we have the right to acquire the remaining 10% of OpTech after five years based on a formula relating to the profitability of OpTech.  In addition, in August 2004 (two years after the effective date of the purchase), the minority owner of OpTech has the option to sell the remaining 10% of OpTech to us using the same profitability formula, which has a minimum purchase price of $1,000,000.

Financing Activities

          Our financing activities include net proceeds from the issuance of long-term debt, CIAC, LUE fees, advances and net borrowings on our lines of credit, dividend payments, payments on long-term debt and stock transactions among other items.

          On August 9, 2002, we obtained a 10-year $10,000,000 secured bank term loan. The net proceeds of approximately $9,750,000 were used to pay down our bank lines of credit. The term loan bears interest at a rate equal to LIBOR plus 1.75%, with principal payments of $125,000 due quarterly, beginning in November 2002. The note is secured by substantially all of the assets of one of our Texas utilities.  We are subject to certain financial covenants under the term loan agreement.  As of December 31, 2002, we were in compliance with all applicable covenants under this agreement.

          On July 20, 2001, Southwest Water issued $20,000,000 of 6.85% fixed rate convertible subordinate debentures, due July 1, 2021, and received net proceeds of approximately $18,890,000 from the sale after underwriting discounts, commissions and other expenses of the offering.  The net proceeds from the sale of these debentures were used to reduce borrowings on our revolving bank lines of credit. 

          The debentures are convertible into shares of our common stock at a conversion price of $16.197 per share, and are convertible at any time prior to maturity unless previously redeemed.  We may redeem the debentures in whole or in part at any time, at a redemption price of 105% at July 1, 2003 and declining 1% annually to par (100% of face value) after June 30, 2008.  The issuance costs of the convertible subordinate debentures in the amount of approximately $1,110,000 are being amortized over 20 years. We are subject to certain financial covenants under the terms of the indenture agreement for the convertible subordinate debentures.  As of December 31, 2002, we were in compliance with all applicable restrictions.

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Contractual Obligations

          As of December 31, 2002, the Company’s contractual obligations were due as follows:

          On January 8, 2003, we obtained an unsecured line of credit facility from a commercial bank used to issue a $3,430,000 standby letter of credit as collateral for performance under a service contract for the CVWD 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 by the CVWD, the standby letter of credit facility will be terminated.

          Under this service contract, we will manage both the design and construction of this facility. Upon acceptance by the CVWD, we will also operate the facility for a 20-year period. Subcontractor agreements with an engineering firm and a large construction firm are being used to fulfill significant obligations of this service contract.

          This service contract contains certain guarantees to the CVWD related to our performance, including certain liquidated damages in the event of our failure to perform, other than due to uncontrollable circumstances.  As part of the financing of this project, the CVWD was successful in the sale of insured municipal bonds.  We entered into an agreement with the bond insurer to guarantee our performance under the service contract, subject to certain liability caps in the event of a default.  Such liability caps will not exceed an amount equal to $6,000,000 during the two-year construction period of the project, and afterwards, during the 20-year operation of the facility, the liability cap will not exceed an amount equal to $4,000,000 plus an amount equal to the replacement of the actual reverse osmosis unit within the facility.

Critical Accounting Policies

          The accounting policies described below are those we consider critical in preparing our consolidated financial statements.  Certain of these policies require management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of certain contingent assets and liabilities at the date of the consolidated financial statements, as well as amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.  See Note 1 to the accompanying consolidated financial statements for a detailed description of our significant accounting policies.

          Recognition of Revenues: 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 usually 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.

          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.

          Water utility revenues are recognized when amounts are billed to customers. An estimated amount for unbilled revenues is also recognized for water used towards the end of the accounting period. 

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          Impairment of Goodwill:  We have made acquisitions in the past that resulted in recording goodwill and intangible assets.  The balance sheets presented in the consolidated financial statements include the goodwill and intangible customer contracts related to the 2002 acquisition of the contract services business of AquaSource, the goodwill and intangible contract value related to the 2001 acquisition of OpTech, and the goodwill and non-compete agreement related to the 2000 acquisition of Master Tek.  In June 2001, the Financial Accounting Standards Board (FASB) issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 requires that goodwill and intangible assets with indefinite useful lives are not amortized, but instead are tested for impairment at least annually. For intangible assets with definite useful lives, SFAS No. 142 requires amortization over their estimated useful lives to their estimated residual values. SFAS No. 142 became effective for fiscal years beginning after December 15, 2001. At December 31, 2002, other assets include approximately $20,172,000 of net goodwill, which was no longer subject to amortization beginning in 2002.  There was no impairment of goodwill as of December 31, 2002.

          Prior to implementation of SFAS No. 142, we recognized approximately $218,000 and $163,000 of goodwill amortization for the years ended December 31, 2001 and 2000, respectively. Beginning in 2002, we no longer recognized such amortization. In addition, under the provisions of SFAS No. 141, Business Combinations, we identified approximately $204,000 of intangible contract costs in connection with our acquisition of AquaSource and approximately $1,100,000 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. We do not expect the implementation of SFAS Nos. 141 and 142 to have a material impact on our financial position or results of operations.

          Utility Accounting:  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, which specifies certain revenue, expense and balance sheet treatment as required by each state regulatory agency.  Each state agency 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. 

          Our Texas and New Mexico utilities have contracted with one of the companies in our Services Group to perform operating services, normal maintenance and construction work, and, in addition, manage capital projects.  We believe that these contracts were established utilizing terms and conditions equivalent to prevailing industry rates for similar work performed by our Services Group for non-affiliated entities.  In accordance with SFAS No. 71, our Services Group recognizes a profit margin from contract work performed and does not eliminate the intercompany profit on the construction contract work performed when the contract sales price is reasonable and it is probable that the costs and capital will be recoverable through the rate making process.  Accordingly, the intercompany profit on such projects has not been eliminated in the accompanying consolidated financial statements.

          Balancing Account:    Prior to November 29, 2001, the CPUC permitted California water utilities to record the difference between actual and CPUC-adopted water production costs in balancing accounts on the balance sheet, with a corresponding adjustment in the income statement. In 2001, our California utility recorded approximately $700,000 of balancing account benefits in its income statement, and had a total balance of approximately $2,300,000 in deferred costs held on its balance sheet at the end of November 2001.  As mentioned above, no such benefits were available in 2002.  The disposition of pre-November 29, 2001 balancing accounts became the subject of a CPUC rulemaking.  On December 17, 2002, the CPUC issued a decision considered favorable to the water industry that should allow our California utility to recover approximately $2,300,000 that was in its balancing account as of November 29, 2001.

          Collectibility of Customer Receivables:  We periodically evaluate the collectibility of our customer receivables, and provide an allowance for uncollectible receivables based upon an estimate by management of the amount of receivables that might not be collectible.  This estimate is predicated upon a number of factors, including historical receivable write-off experience, a review of customer accounts with past due uncollected balances, probable costs of collection and the general credit worthiness of our customers.  During 2002, we provided for an additional $372,000 of bad debt expense and we wrote off approximately $320,000 of uncollectible accounts receivable relating to our Services Group submetering accounts.  We believe that our allowance for doubtful accounts is adequate as of December 31, 2002.

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          Stock-Based Compensation:  In 2002, we voluntarily adopted the fair value recognition provisions of SFAS No. 123. SFAS No. 123 requires that we value stock options issued based upon an option pricing model and recognize this value as an expense over the period in which the options vest. In accordance with the provisions of SFAS No. 148, we have elected to recognize stock-based compensation using the retroactive restatement method.  Under this change in accounting method, we have restated our consolidated financial statements for all years presented in this Annual Report on Form 10-K and the accompanying consolidated financial statements 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.

          The Black-Scholes 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.  In addition, option valuation models require us to make subjective assumptions including 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 value of an estimate, in management’s opinion, the existing option valuation models, including Black-Scholes, do not necessarily provide a reliable single measure of the fair value of our employee stock options.

Recent Accounting Pronouncements

          In June 2001, the FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires us to record the fair value of an asset retirement obligation as a liability in the period in which we incur a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the assets. We will also record a corresponding asset that is depreciated over the life of the asset. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. We were required to and did adopt SFAS No. 143 on January 1, 2003. The adoption of SFAS No. 143 is not expected to have a material effect on our consolidated financial statements.

          In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 amends existing guidance on reporting gains and losses on the extinguishment of debt to prohibit the classification of the gain or loss as extraordinary, as the use of such extinguishments have become part of the risk management strategy of many companies. SFAS No. 145 also amends SFAS No. 13 to require sale-leaseback accounting for certain lease modifications that have economic effects similar to sale-leaseback transactions. The provision of the Statement related to the rescission of Statement No. 4 is applied in fiscal years beginning after May 15, 2002. Earlier application of these provisions is encouraged. The provisions of the Statement related to Statement No. 13 were effective for transactions occurring after May 15, 2002, with early application encouraged. The adoption of SFAS No. 145 is not expected to have a material effect on our consolidated financial statements.

          In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposable activities and nullifies Emerging Issues Task Force (EITF) Issue 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity. The provisions of this Statement are effective for exit or disposal activities that are initiated after December 31, 2002, with early application encouraged. The adoption of SFAS No. 146 is not expected to have a material effect on our consolidated financial statements.

          In November 2002, the FASB issued Interpretation No. 45, Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness to Others, an interpretation of FASB Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.  This Interpretation elaborates on the disclosures to be made by a guarantor in its interim and annual financial statements about its obligations under guarantees issued.  The Interpretation also clarifies that a guarantor is required to recognize, at inception of a guarantee, a liability for the fair value of the obligation undertaken.  The initial recognition and measurement provisions of the Interpretation are applicable to guarantees issued or modified after December 31, 2002 and are not expected to have a material effect on our consolidated financial statements.  The disclosure requirements are effective for financial statements of interim and annual periods ending after December 15, 2002.

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          In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, an amendment of FASB Statement No. 123.  SFAS No. 148 amends FASB No. 123 to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based compensation.  In addition, SFAS No. 148 amends the disclosure requirements of Statement No. 123 to require prominent disclosures in both annual and interim financial statements.  In 2002, we adopted SFAS No. 123 and the related provisions of SFAS No. 148 using the retroactive restatement method. Certain of the disclosure modifications are required for fiscal years ending after December 15, 2002 and are included in Note 11 to the accompanying 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 is not expected to have 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.

          In November 2002, the EITF finalized EITF No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. EITF No. 00-21 is required to be adopted for all new revenue arrangements entered into in fiscal years beginning after June 15, 2003 but alternatively would allow us to apply EITF No. 00-21 to existing contracts and record the effect of adoption as the cumulative effect of a change in accounting principle. The adoption of EITF No. 00-21 is not expected to have a material effect on our consolidated financial statements.

Adoption of New Accounting Policy – Stock-Based Compensation

          We currently sponsor two stock option plans and, prior to 2002, we accounted for those plans under the recognition and measurement provisions of the Accounting Principles Board (APB) Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost was reflected in previously reported results, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. Effective January 1, 2002, we adopted the preferable fair value recognition provisions of SFAS No. 123. Under the retroactive restatement transition method as described in SFAS No. 148, we have recorded compensation costs of $963,000, $765,000, and $598,000 for the years ended December 31, 2002, 2001 and 2000, respectively. The cost recognized is the same as that which would have been recognized had the fair value method of SFAS No. 123 been applied from its original effective date. The expense for each of the three years ended December 31, 2002, 2001 and 2000 was recorded in the caption selling, general and administrative expenses in the accompanying consolidated financial statements. In accordance with the retroactive restatement transition method of adoption, all periods presented have been restated.

          We use the Black-Scholes option-pricing model to determine the fair value of each option grant. The Black-Scholes model includes assumptions regarding dividend yields, expected volatility, expected lives and risk-free interest rates. These assumptions reflect management’s best estimates, but these items involve inherent uncertainties based on market conditions generally outside of our control. As a result, if other assumptions had been used in the current period, stock-based compensation could have been materially impacted. Furthermore, if management uses different assumptions in future periods, stock-based compensation expense could be materially impacted in future years. Refer to Notes 2 and 11 to the accompanying consolidated financial statements.

Selected Risk Factors

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

          Of the $24,000,000 total capacity under our lines of credit, we had approximately $3,842,000 in available borrowing capacity as of December 31, 2002 as a result of using approximately $10,317,000 in borrowings on our lines of credit to fund the acquisition of Aqua Services in November 2002.  In addition to this borrowing capacity we had cash and cash-equivalent balances totaling approximately $1,606,000 as of December 31, 2002.

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          As indicated in Note 17 to the accompanying consolidated financial statements, in March 2003, we entered into an agreement to amend one of our lines of credit under which the bank increased our line of credit capacity by $4,000,000 through December 31, 2003.

          We are currently evaluating our capital structure and potential financing alternatives available to us to provide additional liquidity.  These alternatives include increasing the size of our lines of credit, long-term asset backed financing capacity in our regulated utilities, sale and leaseback of certain fleet assets and administrative office space, and issuing debt or equity in either a public or private placement offering.  We anticipate that these financing alternatives will enable us to substantially reduce the amounts currently outstanding on our lines of credit during 2003.  While we believe that there will be lender and investor interest in these financing alternatives, there can be no assurance that we will be able to obtain such funding in 2003.  Also we cannot assure you that any financing completed will not increase our interest expense, dilute the percentage ownership of our existing shareholders, or dilute our earnings per share.

          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 during 2003, these actions could negatively impact our revenues, revenue growth, and profitability.

          Our regulated and non-regulated operations are subject to seasonality and weather considerations

          Our regulated water utility operations are seasonal. Therefore, the results of operations for one quarter do not indicate results to be expected in another quarter. Rainfall and weather conditions affect our utility operations, with most water consumption occurring during the third quarter of each year when weather tends to be hot and dry. Drought conditions may result in lower revenue due to consumer conservation efforts and a shortage of water supply. Drought conditions may also result in increased water costs to us and adversely affect our profitability. Conversely, unusually wet conditions may result in decreased customer demand, lower revenues and lower profit to our utility operations.

          The contract operations business conducted by the subsidiaries in our Services Group can also be seasonal in nature. For example, heavy rainfall limits our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions can result in additional labor and material costs that may not necessarily be recoverable from the various cities under O&M contracts.

          Environmental matters

          Operations of our utilities in California, New Mexico and Texas fall under the regulatory jurisdiction of the CPUC, the NMPRC and the TCEQ, respectively. The primary responsibility of these regulatory agencies is to ensure an adequate supply of affordable, healthful, potable water to residents of their respective states. Our operations are also subject to water and wastewater pollution standards and water and wastewater quality regulations of the EPA and various state health regulatory agencies. Both the EPA and state health regulatory agencies require periodic testing and sampling of water. Costs associated with the testing of water supplies have increased and are expected to increase further as the regulatory agencies adopt additional monitoring requirements. In November 2001, the EPA announced a decision to lower the arsenic standard in drinking water from 50 parts per billion to 10 parts per billion. Although our utilities meet the current 50 parts per billion standard, our utility in New Mexico does not meet the newly adopted arsenic standard which must be completely met by 2006.  Our New Mexico utility anticipates significant capital expenditures will be required in order to comply with the new standard. As discussed in Item 1. Description of Business – Part C. 2) c. Water Quality Regulation, we cannot predict the impact that the change in this standard will have on our water utility operations; however, we do not expect it to have a material adverse impact on our consolidated financial position or operations. We believe that future incremental costs of complying with government regulations, including any capital expenditures, will be recoverable through increased rates and contract operations revenues. However, we cannot assure you that recovery of such costs will be allowed. To date, we have not experienced any material adverse effects upon our financial position, results of operations or cash flows resulting from compliance with government regulations.

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          As contract operators, the companies in our Services Group do not own any of the water sources or utility facilities that they operate for their clients. Although not the owners, our subsidiaries are responsible for operating these water and wastewater facilities in compliance with all federal, state and local health standards and regulations. Our utility submetering, billing and collection services company does not own or operate any water or other production or treatment facilities.

          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 (approximately 49%, 45% and 47% in 2002, 2001 and 2000, respectively) 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 increased dramatically in the last two years and may continue to increase in the near term. 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.

          Other Risk Factors

          For a discussion of other risk factors, see Item 1. Description of Business – Part K. Risk Factors.

Item 7a. Quantitative and Qualitative Disclosures About Market Risk

          We have certain indebtedness that is subject to variable interest rates. As a result, Southwest Water’s interest expense is affected by changes in the general level of interest rates. Changes in interest rates affect the interest expense paid on the line of credit borrowings, which is determined based upon an agreed rate formula with the banks. Contractually, the highest interest rates charged on the lines of credit cannot exceed the banks’ prime rate plus one-quarter percent.

          Southwest Water is utilizing the favorable low interest rates in the current market. In part to mitigate future market interest rate risk, we completed a $20,000,000, 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 our 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 a certain market price, our debentures will become dilutive in our computation of earnings per share. 

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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, 2002 and 2001, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2002, 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.

The Company’s consolidated financial statements for 2001 and 2000 were previously prepared using Accounting Principles Board (APB) Opinion No. 25, “Accounting for Stock Issued to Employees,” to record stock-based compensation.  As more fully described in Note 2 to the consolidated financial statements, the Company adopted SFAS No. 123, “Accounting for Stock-Based Compensation,” to record stock-based compensation.  Consequently, the Company’s consolidated financial statements for 2001 and 2000 have been restated in accordance with the retroactive restatement method under SFAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure,” an amendment of SFAS No. 123.

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Southwest Water Company and Subsidiaries

CONSOLIDATED STATEMENTS OF INCOME