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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-K

Commission file number 0-8176

(Exact name of registrant as specified in its charter)

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

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

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

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

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

        The aggregate market value of the voting common equity held by non-affiliates of the registrant was approximately $177.2 million based upon the average bid and asked price of such common equity as of June 30, 2004. 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 21, 2005, there were 19,414,317 common shares outstanding.

Documents Incorporated by Reference

        Portions of the registrant's definitive Proxy Statement to be filed with the Securities and Exchange Commission pursuant to Regulation 14A not later than 120 days after the close of the Registrant's fiscal year, are incorporated by reference in Part III of this Form 10-K.

SOUTHWEST WATER COMPANY AND SUBSIDIARIES


TABLE OF CONTENTS

SOUTHWEST WATER COMPANY AND SUBSIDIARIES

FORWARD-LOOKING STATEMENTS

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

PART I

ITEM 1. BUSINESS.

OVERVIEW

        Southwest Water Company and its subsidiaries ("Southwest Water," "the Company," "we," "us" or "our," except where the context requires otherwise) provide a broad range of services including water production, treatment and distribution; wastewater collection and treatment; utility billing and collection; utility infrastructure construction management; and public works services. We own regulated public utilities and also serve cities, utility districts and private companies under contract. We provide our services to more than two million people. Our subsidiaries are segmented into two operating groups: our Utility Group and our Services Group.

        Within our Utility Group, we own and manage the operations of rate-regulated public water and wastewater utilities in California, New Mexico, Oklahoma and Texas, through which we sell water to residential and commercial customers. State and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect these operations. The rates that we can charge for water and wastewater usage are established and approved by state government agencies.

        Our Services Group provides water and wastewater facility operations and maintenance services, equipment maintenance and repair, sewer pipeline cleaning, billing and collection services, and state-certified water and wastewater laboratory analysis on a contract basis. The facilities operated by the Services Group are owned by cities, public agencies, municipal utility districts and private entities primarily in Alabama, California, Colorado, Georgia, Mississippi, New Jersey, New Mexico, South Dakota and Texas. 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 billing and collection services for multiple-family housing units such as apartment buildings. While state and federal agencies issue regulations regarding standards of water quality, safety, environmental and other matters which affect our Services Group operations, the pricing of the services provided by our Services Group is not subject to government regulation.

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

OUR BUSINESS STRATEGY

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

We work to enhance organic revenue growth.

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

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Construction management of water and wastewater systems,



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Water and wastewater certified laboratory services,



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Public works management,



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Multiple-family utility billing and collection,



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Non-regulated wholesale water sales,



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Pipeline inspection,



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Water meter replacement, and



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Refurbishing of manholes and sewer lines.

        Utility Group organic revenue growth in 2003 and 2004 benefited from rate increases in our California and Texas utilities and from increased customer connections in our New Mexico and Texas utilities. New operations and maintenance contracts, and higher billing rates and expanded services under certain existing contracts fueled organic revenue growth for our Services Group in 2003 and 2004.

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

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

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In September 2004, we acquired the assets of ACE Technologies, Inc., a water and wastewater testing laboratory, and incorporated its business into an existing subsidiary. This acquisition allowed us to expand our capacity and expertise in the water and wastewater quality testing field.



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In July 2004, we acquired a Texas utility consisting of a collection of rural regulated water systems and wastewater systems serving approximately 21,000 water connections and 3,500 wastewater connections from Tecon Water Holdings, L.P., and renamed the utility Monarch Utilities, Inc. ("Monarch Utilities"). The acquisition expanded our regulated operations in the state of Texas. The proximity of these new systems to our existing operations will allow us to obtain certain operating efficiencies by sharing overhead costs and employee competency in this region.



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During 2004, we completed several acquisitions in the multiple-family utility billing and collection market. These acquisitions were structured as asset purchases, primarily of account

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contracts, account lists, software and other assets. Under the purchase agreements we acquired approximately 136,000 active billing and collection units.

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



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In December 2001, we acquired substantially all of the assets of CDC/Construction Design Company, LTD., a company with experience in underground water and wastewater utility maintenance and manhole rehabilitation.



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In August 2001, we acquired 90% of the outstanding shares of Operations Technologies, Inc. ("OpTech") which enhanced our contract operations by extending our client base to the southeast portion of the United States and expanding our range of contract services to include public works functions such as storm water drainage, system maintenance and street repair.



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In April 2000, we acquired 80% of Master Tek International, Inc. ("Master Tek"), a company with expertise in multiple-family billing and collection services. In 2004, we completed the acquisition of the remaining 20% of Master Tek.



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

        We continue to work to identify and evaluate potential acquisitions.

KEY BUSINESS SEGMENTS

        Group revenues for the three years ended December 31, 2004 were as follows:

UTILITY GROUP—DEVELOPMENT OF BUSINESS, SERVICES AND REGULATION

California

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

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

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

California Utility—Number of Water Connections by Classification

        During 2004, our California utility's annual revenues were approximately 73% from sales to residential connections, approximately 17% from sales to business and industrial connections, and approximately 10% from sales to other connections.

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

        In the "Environmental Matters" section below, we discuss certain groundwater issues impacting the Main Basin. In 2001, we were required to remove some of our wells from service due to these issues. This resulted in our California utility purchasing increasing amounts of water from the MWD and other sources. The percentage of water supply purchased from external sources at our California Utility is as follows:

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

        Our California utility owns 15 wells and 31 reservoirs. We believe that we are able to purchase or produce adequate water to serve our current customer base and manage reasonable growth from new customers.

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

        Although our utility service areas in California are not likely to experience significant connection growth, our California utility operations are capital intensive. Significant capital expenditures are necessary for the renovation and replacement of our facilities in California. Capital is generated from utility operations and periodic debt financing. Our California utility also receives contributions in aid of construction from developers, governmental agencies, municipalities or individuals to assist in the cost of facility development. For the years ended December 31, 2004, 2003 and 2002, capital expenditures in California approximated $9.3 million, $8.8 million and $10.0 million, respectively. Of these amounts, our California utility received capital contributions and advances from developers of approximately $5.6 million, $3.2 million and $2.5 million in 2004, 2003 and 2002, respectively, to assist in paying for the capital expenditures. Additions included payments received as part of a settlement agreement relating to Main Basin groundwater contamination totaling approximately $0.7 million, $2.5 million and $3.2 million in 2004, 2003 and 2002, respectively (see further discussion in "Environmental Matters" below).

        The CPUC regulates the rates and operations of our utility subsidiary in California. Under current CPUC practices, California customer water rates may be changed through general rate cases or by offsets for certain rate base and expense items. Since September 30, 2002, the California Public Utilities Code has required that CPUC-regulated water utilities file general rate cases every three years. General rate cases require formal proceedings with the CPUC in which overall rate structure, expenses and rate base are examined by CPUC staff. Historically, rate proceedings have required approximately 12 months from the time an application is filed to the CPUC's authorization of new rates. Our California utility made a general rate case filing on April 2, 2002 and was granted an average 17% increase in rates effective May 28, 2003. The next general rate case is scheduled to be filed in 2005.

        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 pro forma earnings levels have not exceeded the amounts authorized in the general rate proceeding.

        Under prior CPUC procedures, offsets were approved through an abbreviated proceeding that required approximately two months from the time a request was filed to the authorization of new rates. Under current CPUC guidelines, offset changes, particularly increases, generally have more restrictions and are reviewed more closely.

        The CPUC previously allowed water utilities to defer recognition of certain expense increases which were beyond our control through the use of balancing accounts. Those expenses included costs for purchased water, purchased power and pump taxes. Prior to November 29, 2001, the CPUC allowed balancing accounts in the income statements of water utilities, with a corresponding liability or asset on the balance sheet. However, the CPUC has changed this policy by eliminating the use of balancing accounts after November 29, 2001. In 2002 our California water utility recorded a balancing account receivable of approximately $2.3 million, representing the difference between actual water production costs incurred and CPUC-adopted water production costs. On July 8, 2004, the CPUC issued a decision that allows our water utility in California to collect the $2.3 million balancing account and an additional under-collection of approximately $0.7 million for a total of $3.0 million. The $0.7 million increase in the balancing account receivable was recorded in the third quarter of 2004. The CPUC decision provides for us to recover the settlement amount through a surcharge billed to customers. Currently, when actual water production costs exceed CPUC-adopted levels, the costs are expensed as incurred. Such costs are tracked in a memorandum account for potential future recovery.

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New Mexico

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

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

New Mexico Utility—Number of Water Connections by Classification

        Our New Mexico utility has grown from approximately 800 connections at the time of its acquisition in 1969 to over 14,000 connections. Most of this growth has resulted from the extension of water services and sewage collection services into new residential subdivisions and new commercial development. During 2004, we added 1,362 new water connections and 1,315 new wastewater connections in New Mexico. Because of the continuing real estate development in our service area, we expect continued connection growth in 2005. During 2004 and 2003, our revenues in New Mexico were approximately 64% and 63%, respectively, from sales to residential connections and approximately 36% and 37%, respectively, from sales to commercial and industrial connections.

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

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

        Because our New Mexico utility service area has continued to experience customer growth, our operations are capital intensive. Capital is generated from New Mexico operations, periodic debt financing, bank lines of credit extended to our New Mexico utility and to Southwest Water, contributions in aid of construction received from developers, and from advances received from developers, which must be repaid under rules of the NMPRC. For the years ended December 31, 2004, 2003 and 2002, our capital expenditures in New Mexico approximated $9.2 million, $9.6 million and $7.5 million, respectively. Of these amounts, our New Mexico utility received capital contributions from developers of approximately $6.3 million, $8.6 million and $6.7 million in 2004, 2003 and 2002, respectively.

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        The NMPRC regulates the rates and operations of our utility subsidiary in New Mexico. Requests for rate increases, typically based on historical costs, must be submitted to the NMPRC. We have not requested a general water rate increase during the past several years.

Texas

        Our regulated public water utilities in Texas provide water supply and sewage collection and treatment services to approximately 28,000 connections for residential, commercial and irrigation use and for fire protection service under the jurisdiction of the Texas Commission on Environmental Quality ("TCEQ"). Our service areas in Texas are broadly dispersed throughout the state, including the Dallas, Fort Worth, Houston and Austin areas. Our service areas contain a population of approximately 94,000 people in an area of approximately 35 square miles, which is largely undeveloped. These service areas are experiencing continued real estate development, and we expect the number of connections to continue growing in 2005.

        In July 2004, we acquired 86 water systems in Texas which we operate as Monarch Utilities. As of the date of acquisition, Monarch Utilities served approximately 21,000 water connections and 3,500 wastewater connections.

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

Texas Utilities—Number of Water Connections by Classification

        Our Texas utilities own or have rights to 216 wells and 189 reservoirs in addition to distribution, collection and treatment facilities. We believe that we have adequate capacity to serve our existing customer base in Texas as well as reasonable growth from new customers.

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

        Because our Texas utility service areas are also in locations of customer growth, these operations are capital intensive. Capital is generated from Texas operations, bank term loans, and contributions and advances received from developers. For the years ended December 31, 2004, 2003 and 2002, our capital expenditures in Texas were approximately $12.4 million, $11.1 million and $13.7 million, respectively. Of these amounts, our Texas utilities received contributions from developers of approximately $1.8 million, $0.6 million and $4.8 million in 2004, 2003 and 2002, respectively.

        The TCEQ regulates the rates and operations of our Texas utility subsidiaries. One of our Texas utilities filed for a general rate increase in June 2001, and new rates became effective in January 2002. Monarch Utilities received authorization for a rate increase in October 2004 and will benefit from a step increase in October 2005. Our other utilities are not currently seeking increased rates; however, regulatory changes concerning water quality, future construction expenditures and increased operating expenses may result in future requests for rate increases.

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Seasonality

        Our Utility Group water revenues are seasonal because rainfall and weather conditions affect water sales. 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. Utility Group wastewater revenues are generally not affected by seasonality.

        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.

Environmental Matters

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

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

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

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

        As a result of this settlement agreement, we have received payments during the last three years, and we expect to continue to receive payments until completion of remediation. These payments represent the incremental cost of purchasing water over the cost that would have been incurred by us to pump water from our wells had they not been shut down as a result of contamination and excluded costs covered in the $1.7 million settlement discussed above. The settlement agreement provided for ongoing reimbursement of our excess water costs and we bill and collect this reimbursement monthly. These monthly reimbursements are recorded as a reduction to operating expenses. The reimbursements were approximately $3.3 million, $4.0 million and $4.4 million during 2004, 2003 and 2002, respectively.

        The settlement agreement also provides for contributions by the Cooperating Respondents for construction of new wells and interconnections with nearby water sources. These contributions were approximately $0.7 million, $2.5 million and $4.4 million for 2004, 2003 and 2002, respectively, and were recorded as contributions in aid of construction.

Water Quality Regulations

        The water supplies available to our utilities in California, New Mexico, and Texas are subject to regulation by the United States Environmental Protection Agency ("EPA") under the 1996 Federal

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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.

        In June 1998, we detected the substance N-nitrosodimethylamine ("NDMA") in one of our California utility's wells at a level in excess of the EPA reference dosage for health risks. Upon detection, the well was immediately removed from service. In 1999, our California utility completed construction of a treatment facility that is intended to reduce NDMA in this well to non-detectable levels. In February 2001, we received final regulatory approval of the facility and in May 2001, our California utility began producing water from this well. However, in January 2002, the DOHS set a more stringent recommended standard for the substance perchlorate, which was subsequently detected in this California well at levels in excess of the revised standard. We immediately removed this well from service.

        In 2000, in another of our California utility's well fields, we detected amounts of contaminants in excess of the EPA reference dosage for health risks. All wells in that well field were immediately removed from service. The water production from these wells was replaced with purchased water, the excess costs of which were substantially funded by the Cooperating Respondents.

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

        In February 2002, the EPA set a more stringent arsenic standard in drinking water from 50 parts per billion to 10 parts per billion, which must be fully met by 2006. At the present time, our water sources in California and Texas are in compliance with the new standards. The DOHS is holding discussions that could result in a more stringent arsenic standard. 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 EPA 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 taking actions that include the construction of arsenic removal treatment plants. We anticipate that capital expenditures of approximately $4 million will be required at our New Mexico facilities in order to comply with the new arsenic standard and that the cost of water will increase as a result of treatment requirements. 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 consider making a request to the NMPRC for recovery of these costs. While the NMPRC has previously allowed the recovery of similar costs through higher rates, we cannot assure you that costs incurred or capital spent will ultimately be recoverable from the ratepayers.

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        Costs associated with testing of our water supplies in California, Texas and New Mexico 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 supplies will be recoverable from ratepayers through future rate increases. However, we cannot assure you that water sources currently available to our utilities will meet future EPA, or state regulatory requirements, that recovery of additional costs will be allowed, or that new or revised monitoring requirements will not necessitate additional capital expenditures 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 state regulatory agencies have put into effect regulations and other pronouncements that require periodic testing and sampling of water to ensure that only permissible levels of organic and volatile and semi-volatile organic compounds ("VOCs"), herbicides, pesticides, radionuclides, and inorganic substances are present in water supplied to the public. Our water utilities operators regularly sample and monitor the quality of water being distributed throughout the system. Our utility personnel conduct sampling, testing and inspections at the intervals, locations and frequencies required by EPA and state regulations. Water samples from throughout our water systems are tested regularly by state-certified laboratories for bacterial contamination, chemical contaminant content and for the presence of pollutants and contaminants for which MCLs have been put into effect. The test results are sent to the respective state regulatory agencies. Disinfection and other types of treatment are applied to water supplies as required or needed to safeguard against bacteriological, chemical and other water contaminants. In addition, each of our utilities 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.

        In addition to water sampling and testing performed by our California utility personnel, independent engineers retained by the Boards conduct sampling and testing for certain pollutants such as VOCs. The results of the sampling and testing are made available to the DOHS and all water purveyors that produce water from the Main Basin. The cost of such sampling and testing is covered by assessments to the producers in this basin.

        Several water and wastewater systems at one of our Texas utilities are in violation of MCLs and other state regulatory requirements. The TCEQ and customers in affected areas have been advised of the violations. We are currently evaluating these issues and working with the TCEQ and outside consultants to bring the systems into full compliance.

        Since the terrorist attacks on September 11, 2001, there has been heightened concern regarding the vulnerability of drinking water systems. Drinking water systems were identified as critical infrastructures and potential terrorist targets. In compliance with the Public Health Security and Bioterrorism Response Act of 2002, PL 107-88, our Utility Group assessed the vulnerability of our water systems to terrorist attack. This vulnerability assessment was used to determine the risks posed to the water supply system operations, treatment, and distribution systems; identify the water systems' vulnerabilities; provide a prioritized plan for security upgrades, modifications of operational procedures, and/or policy changes to mitigate identified risks to critical assets; and provide a basis for comparing the cost of protection against the risks posed. While it is impossible to protect or eliminate the vulnerability of all of our drinking water systems, our utilities considered and are implementing improvements in security that can make it more difficult for attacks to succeed and can lessen the impact of attacks that may occur.

        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

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current requirements of the EPA and the respective state regulatory agencies, except as noted above. 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.

Competition

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

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

SERVICES GROUP—DEVELOPMENT OF BUSINESS, SERVICES AND REGULATION

Contractual Relationships

        Our Services Group has over 450 contracts. The majority of these contracts fall into three categories:

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Municipal Utility District contracts



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Operations and maintenance contracts



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Construction management contracts

Municipal Utility District (MUD) Contracts

        A MUD is created under the rules of the TCEQ 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 the MUD to provide a specified level of services. We typically provide water and wastewater facility operations and maintenance services, equipment maintenance and repair, billing and collection services, and state-certified water and wastewater laboratory analysis. We usually bill for any additional services provided beyond the basic contract on a time-and-materials basis as such services are rendered. Most contracts provide for an increase in the monthly base fee as the number of customer connections increases and do not generally include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis. Generally, MUD contracts are cancelable with 30 to 60 day prior notice by either party. Our experience indicates that, with high-quality service and strong focus on client satisfaction, MUD relationships can last for many years.

Operations and Maintenance (O&M) Contracts

        O&M contracts are agreements with cities, private entities and investor-owned utilities (including Utility Group affiliates) that provide specific services such as facility operation and maintenance, meter reading, customer billing and collection, public works services, or management of entire water or

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wastewater systems. Under a typical O&M contract, our Services Group subsidiaries charge a fee that covers a specified level of services. Services are typically provided evenly throughout the contract period and are billed on a monthly basis. Our O&M contracts limit our liability in the event of a major system failure or catastrophic event. If we provide services beyond the scope of a contract, we bill for the additional services. For example, if a major system failure or catastrophic event occurred as the result of flooding, earthquake, electrical strike or vandalism, the facility owner usually asks us to provide additional services on a time-and-materials basis.

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

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

Construction and Construction Management Projects

        Our Services Group enters into contracts pursuant to which we provide construction and construction management services for water and wastewater facility development, improvement and expansion projects. Under the terms of certain of these contracts, we may bear all or a significant portion of the risk of cost overruns, or incur additional costs or penalties for failing to meet project completion deadlines or minimum performance standards.

        In September 2002, we successfully bid a project to design, build, finance and operate a $23.0 million reverse osmosis water treatment plant in the city of San Juan Capistrano, California, for the Capistrano Valley Water District ("CVWD"). The project included the drilling of several new wells and the installation of associated water lines. During construction of the treatment plant, we received payments upon completion of construction milestones and will continue to receive such payments until final completion of construction. In addition, the CVWD awarded us a 20-year $20.0 million contract to operate the treatment plant after completion of construction. The construction of the plant started in December 2002 and was substantially complete as of December 31, 2004. The plant is operational and we have met a contractual requirement to produce a specified volume of treated water from this facility as of December 4, 2004. We are currently operating and maintaining the facility under the 20-year contract. The plant has the capacity to produce approximately 5.0 million gallons of potable water per day.

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

Growth and Backlog

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

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        Revenues included in backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these contracts is reflected in the backlog. MUD and multiple-family utility billing contracts are assumed to have a 36-month remaining term, consistent with our experience, and are included in the backlog computation using an assumed 36-month term. As of December 31, 2004 and 2003, our Services Group backlog was approximately $324 million and $315 million, respectively.

Seasonality

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

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

Competition

        Competition in the MUD, O&M and construction management portions of our business includes a number of significantly larger companies that provide services on a national and international basis, as well as regional and local competitors. New contracts are awarded based on a combination of customer relationships, service levels, competitive pricing, references and technical expertise.

        Cities themselves are also competitors in O&M operations, 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.

Regulation

        Our Services Group prices are not subject to regulation. However, because we provide contract services which include the operation and maintenance of water supply and wastewater facilities owned by cities, public agencies, municipal utility districts and private entities, we are subject to state and federal regulations regarding standards of water quality, safety, environmental and other matters.

CREDIT CONCENTRATION

        We have no individual customers who accounted for 10% or more of our consolidated revenues in 2004, or whose loss would have a material adverse effect on our consolidated or operating segment revenues.

INTELLECTUAL PROPERTY

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

SIGNIFICANT ACQUISITIONS

        In September 2004, we acquired the assets of ACE Technologies, Inc., a water and wastewater testing laboratory, and incorporated its business into an existing subsidiary. This acquisition allowed us to expand our capacity and expertise in the water and wastewater quality testing field. The purchase price was approximately $1.2 million, consisting entirely of a note payable.

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        In July 2004, we acquired a Texas utility consisting of a collection of rural regulated water systems and wastewater systems serving approximately 21,000 water connections and 3,500 wastewater connections from Tecon Water Holdings, L.P., and renamed the utility Monarch Utilities, Inc. ("Monarch Utilities"). The aggregate purchase price was approximately $66 million, comprised of approximately $48 million in cash payments and the assumption of approximately $18 million in debt.

        During 2004, we completed several acquisitions in the multiple-family utility billing and collection market. These acquisitions were structured as asset purchases, primarily of account contracts, account lists, software and other assets. Under the purchase agreements we acquired approximately 136,000 active billing and collection units at a cost of approximately $3.8 million in cash and approximately $1.5 million in notes payable.

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

        In December 2001, we acquired substantially all of the assets of CDC/Construction Design Company, LTD., a company with experience in underground water and wastewater utility maintenance and manhole rehabilitation. The aggregate purchase price was approximately $3.2 million, which consisted of approximately $0.2 million in cash payments and notes payable of approximately $3.0 million.

        In August 2001, we purchased 90% of the outstanding shares of OpTech, a provider of contract water and wastewater and public works services in the southeastern United States, for a purchase price of $8.2 million. The purchase price consisted of cash payments of $3.5 million in August 2001 and $0.4 million in January 2002, promissory notes in the aggregate amount of $3.0 million and shares of our common stock with a market value of $1.3 million at August 31, 2001. We also entered into an employment agreement and a non-compete agreement with the owner of the remaining 10% of OpTech. Under the terms of our purchase agreement, we have the right to acquire the remaining 10% of OpTech after a period of five years based upon a formula relating to the profitability of OpTech. Beginning in 2004, the minority owner has the option to sell the remaining 10% of OpTech to us using the same formula, subject to a minimum of $1.0 million.

        In April 2000, the Company purchased 80% of the outstanding common stock of Master Tek for $4.0 million. The purchase price consisted of $2.0 million in cash and a $2.0 million ten-year promissory note. The purchase agreement provided that the Company had the right to acquire the remaining 20% ownership for a price based on a formula related to the future financial performance of Master Tek over the following seven years. Under the terms of the purchase agreement, the minority owner of Master Tek had the right to require the Company to purchase his remaining 20% minority interest in 5% increments at a price based on a formula, but not less than $1.0 million per year, over a four-year period commencing in April 2002. The acquisition was accounted for using the purchase method of accounting, and the results of Master Tek's operations have been consolidated with those of Southwest Water since April 3, 2000, the effective date of the transaction. The purchase price was allocated to the assets acquired and the liabilities assumed based on their estimated fair value at the date of acquisition. In April 2002, we paid $1.0 million 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, we filed a lawsuit against the minority stockholder of Master Tek. In April 2003, the minority stockholder exercised his right to require the Company to purchase an additional 5% interest in Master Tek, which increased the Company's ownership to 90%. The lawsuit was settled in October 2003 with the following resolutions: (i) we took ownership of the remaining 10% of shares of Master Tek stock, (ii) a final payment of $2.7 million to the minority owner made in January 2004,

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(iii) elimination of the Company's $1.5 million note payable to the minority stockholder, (iv) release of the Company from any claims made by the minority stockholder and (v) certain indemnifications from the minority stockholder to cover certain potential or unasserted claims from third parties.

        In 1996, we acquired a 49% interest in Windermere Utility Company ("Windermere"), a regulated water and wastewater utility located in the Austin, Texas, area. In October 2000, we reached an agreement with the majority stockholder and purchased an additional 31% interest from the majority stockholder, increasing our ownership in Windermere to 80%. As part of this transaction, we also purchased 100% of Hornsby Bend Utility Company ("Hornsby"), a nearby water and wastewater utility. The purchase price for these two transactions consisted of Southwest Water common stock with a market value of $4.0 million at October 1, 2000. The purchase agreement provides that we have the right to acquire the remaining 20% ownership in Windermere for a purchase price of $6.0 million payable in our common stock at any time when the market value of our common stock increases to $12.96 per share (after adjustment for stock splits and dividends through January 2005). The minority owner of Windermere has the right to put the remaining 20% to us after October 1, 2005, for up to 450,000 shares of our common stock, but no less than 240,000 shares, depending on the prevailing stock price. We also entered into a consulting agreement with the minority owner.

EMPLOYEES

        At December 31, 2004, we employed approximately 1,500 people. Approximately 1,400 people were employed in our Services Group and 100 were employed in our Utility Group. Approximately 1% of our employees are represented under a collective bargaining agreement. We believe relations with our employees are positive.

DIVIDEND HISTORY

        During the past 20 years, Southwest Water has paid quarterly a cash dividend. For specific information relative to dividends paid during 2004 and 2003, see "Item 5. Market for the Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities." In addition, we have also declared stock dividends or stock splits, paid in the form of stock dividends, annually over the last ten years.

SUBSEQUENT EVENTS

        We received an unsolicited proposal, from a prospective buyer, to negotiate terms and conditions for the sale of our multiple-family utility billing and collection subsidiary. We are evaluating this and other alternatives. Based upon our evaluation we may consider the divestiture or restructuring of this subsidiary, which generated revenues of approximately $8 million in 2004.

        In March 2005, we completed the acquisition of Novus Utility Services, Inc. ("Novus"), a Birmingham, Alabama, contract operations company. The aggregate purchase price was approximately $2.5 million in cash and notes payable. Novus generated 2004 revenues of approximately $4 million.

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RISK FACTORS

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

Risks Related to Our Business

Risk Factors that affect our Utility Group operations

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

Rainfall and weather conditions affect our utility operations, with most water consumption occurring during the second and third quarters of each year when weather tends to be hot and dry. During this period, our marginal costs of water may exceed our marginal revenues as we use higher-cost purchased water to meet customer demand. Therefore, while our revenues may increase, we may experience lower profit margins during periods of peak demand.

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

•

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

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

The regulatory agencies may change their rules and policies which may adversely impact our profitability. In some states regulators are elected by popular vote, and the results of elections may change the rules and policies of the agency. Changes in rules and policies, including policies allowing our Services Group to provide operations and maintenance, and construction and construction management services to our regulated utilities at fair market value, may adversely impact our operating results.

•

We may discover additional contamination of our water sources which may adversely affect our operations.

Our water sources are subject to contamination from sewage spills, hazardous materials leaks, or similar events. We may not recover costs incurred or revenues lost due to such contamination from responsible parties or from rate payers. Additionally, these events could expose us to environmental liabilities, claims and litigation costs. We cannot assure you that we will successfully manage these issues, and failure to do so could have a material adverse effect on future results of operations.

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•

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

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. Additionally, our utility assets could be targeted by terrorists seeking to disrupt services to our customers.

•

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

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

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

Each of our utilities obtains its water from various sources. The preferred source is pumping water from aquifers within our service areas. In the event that our wells cannot meet the customer demand, we have the ability to purchase water from surrounding municipalities, agencies and other utilities. However, it usually costs us more to purchase water than to produce it. Furthermore, these alternative sources may not always have an adequate supply to sell us. For example, our California utility purchases water from the MWD, 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 MWD can sell to our California utility in the future. We can make no guarantee that we will always have access to an adequate supply of water that will meet all quality standards, or that the cost of our water will not adversely affect our operating results.

•

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

To meet the regulatory requirements for rates, increases in customer connections, and environmental challenges, we need to continue our investment in utility plant and property. Currently we obtain the funds for our capital projects from our operations, the acceptance of contributions from developers, the issuance of our equity securities in public or private transactions and the use of both short- and long-term debt. In the event that any of these sources were not

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available, or if we could not raise the capital in a manner acceptable to our regulators, our financial performance could be adversely affected.

•

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

Under most circumstances, we discontinue service to non-paying customers. However, there may be situations where the discontinuation of water service could cause potentially significant environmental exposures. In such cases, we may continue to incur costs to procure and distribute water to non-paying customers.

Risk factors that affect our Services Group operations

•

We operate in a competitive market with low operating margins.

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

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

•

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

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

•

Our business depends on trained, qualified employees.

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

•

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

Our Services Group contract operations can be impacted by heavy rainfall which may limit our ability to perform certain billable work such as pipeline maintenance, manhole rehabilitation and other outdoor services. Severe weather conditions, such as hurricanes, tornadoes and floods, may

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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 results of operations.

•

Our Services Group contracts have certain performance risks.

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

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

•

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

We have entered into, and may continue to enter into, design and construction contracts for water and wastewater facilities. These construction activities involve potential risks, including shortages of materials and labor, work stoppages, labor relations disputes, weather interference, engineering, environmental, permitting or geological problems and unanticipated cost increases for reasons beyond our control. These issues could give rise to delays, cost overruns or performance deficiencies, or otherwise adversely affect the design, construction or operation of the project. To minimize our exposure to the risks associated with construction projects, we attempt to procure maximum price contracts from significant subcontractors, and secure performance and completion bonds from those subcontractors.

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

We may have contracts where we guarantee project completion by a scheduled date. At times, we may guarantee that the project, when completed, will achieve certain performance standards. If we subsequently fail to complete the project as scheduled, or if the project subsequently fails to meet guaranteed performance standards, we may face claims for cost impacts and/or penalties to the client resulting from any delay or as reimbursement for costs incurred to meet project 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 could exceed our original estimates and we could experience reduced profits or, in some cases, a loss for the project.

Our customers may require us to secure performance and completion bonds for certain contracts and projects. Since September 2001, the market environment for surety companies has become risk averse. We secure performance and completion bonds for our contracts from these surety companies. To the extent we are unable to obtain bonds, new contracts would not be awarded to

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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 future projects, or obtain bond renewals on existing contracts or projects.

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

•

We use third party equipment and subcontractors.

Our multiple-family utility billing and collection 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 be certain that such guarantees completely protect us from the risk of quality failure in the design, 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 or after our acquisition of our submetering business. Such claims could have an adverse impact on our results of operations.

•

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

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

•

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

The Services Group has a fleet in excess of 700 vehicles. Our employees drive over 15 million miles per year. We are subject to normal vehicle risks associated with operating a fleet this large, including automobile accidents causing injury to our employees or damage to our leased vehicles, as well as third party damage to other property, vehicles or possible injury to others. Although we have vehicle insurance that covers material third party damage and liability, inability to manage this large fleet could have a material adverse impact on our results of operations.

•

Our operating costs may rise faster than our revenues.

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

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•

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

Our Service Group revenue backlog consists of new and existing contracts. We include new contracts in the backlog when we have a signed contract. Revenues included in our backlog may be realized over a multi-year period. The O&M contracts signed by our Services Group typically have durations of three to five years, and the uncompleted remaining portion of these existing contracts is reflected in the backlog. Although our Services Group tends to experience high renewal rates, municipalities and cities periodically change operators or terminate out