| SOUTHWEST WATER CO ITEM 1A RISK FACTORS We operate in two business segments: our Utility Group and our Services Group |
| There are separate risk factors associated with each |
| Rainfall and weather conditions affect the financial results of our Utility Group |
| • Most water use occurs during the second and third quarters of each year when weather tends to be hot and dry |
| Depending on the degree of heat and lack of rain, 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 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 |
| Regulatory Environment |
| Changes in the regulatory environment, including restrictions on the rates we are allowed to charge customers, may adversely affect our results of operations |
| • Our 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, in many instances we use electric pumps |
| 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 affect 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, construction and construction management services to our regulated utilities at fair market value, may adversely impact our operating results |
| Water Contamination |
| Contamination of our water sources by third parties may adversely affect our operations |
| • Our water sources are subject to contamination from sewage spills, hazardous materials leaks, or similar events |
| We may not be able to recover costs incurred or revenues lost due to such contamination |
| Additionally, these events could expose us to environmental liabilities, claims and litigation costs |
| Natural Disasters or Terrorist Activities |
| We own assets in areas that historically have experienced natural disasters or that may be disrupted by terrorist activities |
| • Some of our utility operations are located in areas that historically have experienced earthquakes and hurricanes as well as other natural disasters |
| While we maintain insurance policies to help reduce our financial exposure, a significant event could adversely impact our ability to deliver water |
| • Our utility assets could be targeted by terrorists seeking to disrupt services to our customers |
| 14 ______________________________________________________________________ Environmental Risks |
| We are subject to environmental risks and may not be able to provide an adequate supply of water to our customers |
| • 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 |
| • Even though 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 contaminants in our wells to acceptable levels at a commercially reasonable cost or at all |
| • 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 |
| To meet this new standard, we took actions that included constructing two arsenic removal treatment plants costing dlra2dtta6 million and we expect that the resulting treatment requirements will increase our cost of the water we provide |
| While we may request rate increases to recover these additional costs and the cost of complying with standards enacted in the future, if any, we cannot assure you that we will be successful in obtaining those rate increases |
| Water Sources |
| We have no assured access to water |
| 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 |
| • 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 |
| 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 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 |
| • 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 operate in a competitive market |
| • 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 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 companies |
| Our inability to achieve this balance could adversely impact our results of operations |
| Revenue Growth |
| Our revenue growth depends upon our ability to generate new as well as to renew operating contracts with 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 15 ______________________________________________________________________ Services Group’s marketing and sales efforts is spent demonstrating the benefits of contract operations to elected officials and municipal authorities |
| The existing political environment means that decisions are based on many factors, not just economic factors |
| Weather Conditions |
| 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 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 |
| Construction Contract Performance Risk |
| Services Group contracts for the design and construction of water and wastewater projects may expose us to certain completion and performance risks |
| Management’s Discussion and Analysis of Financial Condition and Results of Operation—Certain Contractual Commitments and Indemnities |
| ” • 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 |
| Environmental and Water Quality Risks |
| 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, such as chlorine gas and hydrogen sulfide |
| 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 |
| Escalating Costs |
| Our operating costs, construction costs and costs of providing services 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 |
| 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 16 ______________________________________________________________________ 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 |
| Contract Cancellations |
| 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 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 |
| Our capital resources may restrict our ability to operate and expand our business |
| Management’s Discussion and Analysis of Financial Condition and Results of Operation—Certain Contractual Commitments and Indemnities |
| ” • We anticipate that our available line of credit borrowing capacity, cash balances, cash flow generated from operations, and execution of additional financing alternatives will enable us to continue operating and expanding our business |
| We may be unable to renew our credit facilities when they expire |
| We may be unable to execute additional financing alternatives at terms that we find acceptable |
| If we were unable to renew our existing lines of credit, or if we were unable to execute additional financing alternatives, our capital spending would be reduced or delayed, and any future acquisitions would be delayed or eliminated |
| While we have the ability to take these actions, they could negatively impact our revenues, revenue growth and profitability |
| Debt Covenants |
| We are subject to debt covenants |
| • We are obligated to comply with specified debt covenants under certain of our loan and debt agreements |
| Failure to maintain compliance with these covenants could limit future borrowing, and we could face penalties, increased borrowing costs, litigation, acceleration of maturity schedules and cross default issues |
| Such actions by our creditors could have a material adverse effect on our results of operations |
| Geographic Diversity |
| Our operations are subject to certain risks due to their location |
| • We own or operate water and wastewater facilities in numerous locations in numerous states and, consequently, we are subject to widely differing 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 |
| Internal Control Weaknesses |
| Internal control weaknesses could have an adverse effect on us |
| • As reported under Item 9A of our 2004 Form 10-K, our management concluded that we had a material weakness in our internal control over financial reporting as of December 31, 2004 |
| Management took steps to remediate the material weakness which resulted in an assessment that management maintained effective internal control over financial reporting as of December 31, 2005 |
| Controls that function effectively today may become inadequate due to changes in conditions |
| • Insufficient internal controls could result in lack of compliance with contractual agreements, misstatements in our financial statements in amounts that could be material and could cause investors to lose confidence in our reported financial information, which could have a negative effect on the trading price of our stock |
| 17 ______________________________________________________________________ Information Technology |
| We rely on a number of complex business systems that could malfunction |
| • Our businesses are dependent on several complex business systems that must function reliably in order for us to operate effectively |
| Among other things, system malfunctions could prevent us from operating or monitoring our facilities, billing accurately and timely analyzing financial results |
| Our profitability and cash flow could be impacted negatively in the event these systems do not operate effectively |
| Uninsured Risks |
| We retain certain risks not covered by our insurance policies |
| • We evaluate our risks and insurance coverage annually |
| Our evaluation considers the costs, risks and benefits of retaining versus insuring various risks as well as the availability of certain types of insurance coverage |
| Retained risks are associated with deductible limits, partial self-insurance programs and insurance policy coverage ceilings |
| We cannot assure you that we will not face uninsured losses pertaining to the risks we have retained or that such uninsured losses will not affect our financial condition, liquidity and results of operations |