10-K 1 a10-5591_110k.htm 10-K

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549


 

FORM 10-K

 

(Mark One)

 

       x

Annual Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the fiscal year ended December 31, 2009

or

       o

Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

 

For the transition period from           to

 

Commission File Number 0-8176

 

 

(Exact name of registrant as specified in its charter)

 

Delaware
(State or other jurisdiction of
incorporation or organization)

95-1840947
(I.R.S. Employer
Identification Number)

 

One Wilshire Building

624 South Grand Avenue, Suite 2900

Los Angeles, California 90017-3782

(Address of principal executive offices, including zip code)

 

(213) 929-1800

(Registrant’s telephone, including area code)

 

Securities registered pursuant to Section 12(b) of the Act:

Common Stock, $.01 par value

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o  No x

 

Indicate by a check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o  No x

 

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

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o  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 of this Form 10-K or any amendment to this Form 10-K. o

 

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

 

Large accelerated filer o

Accelerated filer x

Non-Accelerated filer o

Smaller reporting company o

 

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

 

The aggregate market value of the voting common equity held by non-affiliates of the registrant was $137.1 million based on the closing sale price of such common equity at June 30, 2009 as reported by The NASDAQ Stock Market LLC. 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 February 28, 2010 there were 24,794,218 common shares outstanding.

 

 

 



Table of Contents

 

TABLE OF CONTENTS

 

 

 

Page

Part I

Item 1.

Business

1

Item 1A.

Risk Factors

18

Item 1B.

Unresolved Staff Comments

27

Item 2.

Properties

27

Item 3.

Legal Proceedings

30

Item 4.

Removed and Reserved

30

Part II

Item 5.

Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

30

Item 6.

Selected Financial Data

33

Item 7.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

34

Item 7A.

Quantitative and Qualitative Disclosures about Market Risk

61

Item 8.

Financial Statements and Supplementary Data

61

Item 9.

Changes In and Disagreements With Accountants on Accounting and Financial Disclosure

62

Item 9A.

Controls and Procedures

62

Item 9B.

Other Information

68

Part III

Item 10.

Directors, Executive Officers and Corporate Governance

69

Item 11.

Executive Compensation

69

Item 12.

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

69

Item 13.

Certain Relationships and Related Transactions, and Director Independence

69

Item 14.

Principal Accountant Fees and Services

69

Part IV

Item 15.

Exhibits, Financial Statement Schedules

70

Signatures

74

Index to Consolidated Financial Statements and Financial Statement Schedules

F-1

 



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FORWARD-LOOKING STATEMENTS

 

This Annual Report contains “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995, Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. All statements contained in this Annual Report on Form 10-K that are not clearly historical in nature are forward-looking, and the words “anticipate,” “believe,” “belief,” “expect,” “estimate,” “project,” “plan,” “intend,” “continue,” “predict,” “may,” “will,” “should,” “strategy,” “will likely result,” “will likely continue,” 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 “Item 1A. Risk Factors” below, that could cause actual results to differ materially from our historical experience and our present expectations or projections. A detailed discussion of these and other risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section entitled “Item 1A. Risk Factors” of this report. 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.

 

 

ITEM 1.  BUSINESS

 

COMPANY OVERVIEW

 

SouthWest Water’s principal business activity is to operate and maintain water and wastewater infrastructure. Through our operating subsidiaries, we own 144 systems and operate hundreds more under contract to cities, utility districts and private companies. SouthWest Water was incorporated in California in 1954 and reincorporated in Delaware in 1988. We maintain our corporate offices in Los Angeles, California.

 

In the past ten years, we have completed 19 acquisitions of both utility and contract service businesses. These businesses operated largely independent of each other, resulting in a complex business structure with inconsistent business practices. Beginning in 2007, we implemented changes to better integrate the acquisitions and our various business operations. Our operations were divided into four major operating segments in 2008 to focus on the distinct strategies of each of our operating businesses. Each operating segment is led by a Managing Director and a Financial Director and has embedded in it the direct operating cost and infrastructure to deliver its plan. Common support functions such as environmental health and safety, finance and accounting, information technology and some of our customer call centers are centralized. The costs of these centralized departments are allocated to each operating segment.

 

We now have four reporting segments. We separate our segments first by whether we own the utility or we provide contract services to others. Our owned water and wastewater utilities are referred to as our Utilities operations (“Utilities”). In our financial statements we report our Texas Utilities operations (“Texas Utilities”) as a separate segment because of different economic characteristics. This is principally because the Texas Utilities predominantly under-recovered their current cost of service, which includes a reasonable return on equity. We have made large investments in these operations since their acquisition which have not yet been recovered through the rates we charge. Our contract operations are generally segmented by contract type into those that are larger, stand alone operations (“O&M Services”) and those that are small, full service contracts operated by a common team of personnel resulting in a model that apportions a fractional cost to each client (“Texas MUD Services”).

 

Utilities consist of our owned water and wastewater utilities located in California, Alabama and Mississippi. In previous periods, the utilities segment included the business activities of our New Mexico Utility (“NMUI”) which was sold on

 

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May 8, 2009. The NMUI activities are now included in discontinued operations for all periods presented. See “Note 2 - Acquisitions, Assets Held for Sale and Dispositions” included in Part II Item 8 – “Financial Statements and Supplementary Data” for the summary of the historical results of discontinued operations. Residential customers make up the largest component of our Utilities customer base, with these customers representing approximately 94% of our water and wastewater connections. Substantially all of our Utilities customers are metered which allows us to measure and bill for our customers’ water consumption. Each of the operations in this segment has a unique service territory that is subject to state and federal regulations regarding standards of water quality, safety, environmental and other matters. The rates that we can charge for water and wastewater service include the opportunity to earn a reasonable rate of return on investments in these utilities as approved by state regulatory agencies except for some of our Alabama wastewater rates which are governed by our service agreements. Some of these governmental agencies approve recovery of costs based on a projected test year (“forward looking”) and some approve recovery of costs based on a historical test year (“backward looking”). Our Utilities operations require ongoing capital investments to maintain and enhance the reliability and quality of the service we provide, as well as the opportunity for revenue growth from rate increases and new connections.

 

Texas Utilities consists of 123 small, mostly rural systems that are grouped into nine jurisdictional utilities across Texas. Residential customers make up the largest component of our Texas Utilities customer base, with these customers representing approximately 98% of our water and wastewater connections. Substantially all of our Texas Utilities customers are metered which allows us to measure and bill for our customers’ water consumption. These systems are broadly dispersed geographically. The majority of the systems are organized as one utility with a single tariff, known as Monarch Utilities. The Monarch systems, as well as two smaller systems acquired in 2007, were at various stages of disrepair at the time of acquisition and we continue to spend significant capital to maintain regulatory compliance and to improve the quality of service. We are not yet recovering all of these costs in our rates and as a result, the Texas Utilities have a lower rate of return than typically expected from a utility. We are actively pursuing recovery of these costs in the rate setting process. All other aspects of operations for these utilities are the same as our Utilities operations; therefore, as soon as we are recovering our costs, including a reasonable return on investment, we expect to aggregate this segment with our Utilities segment.

 

O&M Services generally consists of operations that are project-specific contracts with cities, public agencies and private owners. Most contracts are stand alone operations staffed with project-specific personnel, with an average contract life of two to three years. Under a typical O&M contract, we charge a fee that covers a specified level of services that include facility operations and maintenance and may include other water or wastewater related services. Services are typically provided evenly throughout the contract period and are billed on a monthly basis. If we provide services beyond the scope of a contract, we bill for the additional services on a time-and-materials basis or negotiate a unique price. These operations are largely located in Alabama, California, Colorado, Georgia and Mississippi. We have one contract that represents approximately 22% of the revenue of this segment, which we are currently re-negotiating, and one that represents approximately 14%, which is due for renewal in November 2010. None of the remaining contracts represent more than 7% of this segment’s revenue and the majority represent less than 1%.

 

Texas MUD Services is a full service provider of utility services to a large number of small utilities in Texas that are mostly owned by municipal utility districts (“MUD”). A MUD is created to provide water supply, wastewater treatment and drainage service to areas where municipal services are not available. We service more than 270 MUD clients with a common team of client managers, operators, customer service and billing personnel. Therefore, these contracts are allocated a proportional amount of each cost center creating a business model that is significantly different from that of O&M Services. Under a typical MUD contract, we bill a monthly base fee to provide a specified level of service; usually water and/or wastewater facility inspections, routine operations, equipment maintenance, and utility customer service including meter reading, call center, dispatch, billing and collection services. We bill for any additional services provided beyond the basic contract

 

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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 generally include inflation adjustments. The majority of our MUD contracts are cancelable with 30 to 60 day prior notice by either party, but tend to last for longer periods due to the close working relationships between the operators and the clients. No one district represents more than 4% of the overall revenue of this segment.

 

DEFINITIVE MERGER AGREEMENT

 

We have entered into an Agreement and Plan of Merger, dated as of March 2, 2010 (the “Merger Agreement”) with SW Merger Acquisition Corp. (“Parent”) and SW Merger Sub Corp., a direct wholly-owned subsidiary of Parent (“Merger Sub”). Parent and Merger Sub are entities controlled by institutional investors advised by J.P. Morgan Asset Management (“IIF”) and Water Asset Management, L.L.C. (“WAM”).

 

The Merger Agreement contemplates that Merger Sub will be merged with and into SouthWest Water, with SouthWest Water continuing as the surviving corporation in such merger as a direct wholly-owned subsidiary of Parent (the “Merger”), and each outstanding share of our common stock, would be converted in the Merger into the right to receive $11.00 per share in cash (the “Merger Consideration”).

 

We have made various representations and warranties and covenants in the Merger Agreement, including, among others, not to (a) solicit proposals relating to alternative business combination transactions or (b) subject to certain exceptions that permit our board of directors to comply with its fiduciary duties, enter into discussions concerning, or provide confidential information in connection with, alternative business combination transactions. Subject to certain exceptions that permit our board of directors to comply with its fiduciary duties, our board of directors has resolved to recommend that our stockholders vote in favor of and adopt and approve the Merger and the Merger Agreement. The Merger Agreement also includes covenants pertaining to the operation of our business between execution of the Merger Agreement and the closing of the Merger.

 

Consummation of the Merger is subject to various conditions, including, among others, the approval and adoption of the Merger Agreement by our stockholders, the absence of certain legal impediments to consummation of the Merger, and the receipt of certain regulatory approvals. The Merger is not conditioned on the receipt of financing by the Parent, and each of IIF and WAM have executed equity commitment letters with the Parent under which they have committed to provide Parent with the funding necessary to pay the full Merger Consideration due under the Merger Agreement. The Merger Agreement contains certain termination rights and provides that upon the termination of the Merger Agreement under specified circumstances, we may be required to pay Parent a termination fee equal to 3% of the aggregate Merger Consideration, or the Parent may be required to pay us a termination fee equal to 5% of the aggregate Merger Consideration. In addition, in certain circumstances where the Merger Agreement is terminated, we are required to reimburse Parent, or the Parent is required to reimburse us, for fees and expenses incurred in connection with the Merger Agreement, up to a maximum in either case of $3.0 million (provided that any such fee and expense reimbursement will be credited against any termination fee that is payable).

 

In connection with the execution of the Merger Agreement, we also executed a binding letter of intent (the “Binding Letter”) with Parent, IIF and WAM (collectively, the “Investor”) under which the Investor is to purchase 2.7 million shares of our common stock at a purchase price of $6.00 per share, for an aggregate purchase price of $16.2 million (the “PIPE Investment”). The board of directors approved the terms of the agreement for the PIPE Investment on March 12, 2010. The PIPE Investment is subject to the final execution of mutually acceptable definitive agreements on terms consistent with those set forth in the Binding Letter. The Investor will be entitled to certain rights in connection with the PIPE Investment, including the appointment of a designee to serve on our board of directors.

 

Following the Merger, we will cease to be a reporting company under the Securities Exchange Act

 

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of 1934, as amended, and our common stock will cease to be traded on the NASDAQ Global Select Market.

 

In connection with the proposed transaction, we will file a proxy statement with the Securities and Exchange Commission (“SEC”). Before making any voting or investment decision, investors and security holders are urged to carefully read the entire proxy statement and any other relevant documents filed with the SEC, as well as any amendments or supplements to those documents, because they will contain important information about the proposed transaction.

 

See Part I, Item 1A – Risk Factors in this Form 10-K, for a description of the conditions of the Merger that could adversely affect our results of operations.

 

INDUSTRY OVERVIEW

 

The water and wastewater industry generates annual revenue in excess of $70 billion in the United States according to Environmental Business International, Inc. The United States Environmental Protection Agency (“EPA”) estimates that government-owned systems make up approximately 43% of all water systems and approximately 98% of all wastewater systems. Ownership is highly fragmented, with approximately 54,000 community water systems and approximately 16,000 community wastewater facilities, according to the EPA. The majority of the systems are very small, serving a population of 500 or less.

 

Utility ownership has high barriers to entry, including high capital requirements and multifaceted regulatory approval processes. The market is characterized by growing regulatory complexity and an aging and deteriorating municipal infrastructure. The EPA estimates that approximately $274 billion of capital spending will be necessary on water systems between 2000 and 2019 to replace aging infrastructure and to comply with quality standards and that approximately $388 billion of capital spending will be necessary on wastewater systems between 2000 and 2019 to replace aging infrastructure and comply with quality standards.

 

The contract services segment is characterized by aggressive competition and market-driven growth and profit margins. Industry participants, which include engineering and consulting companies and numerous other fee-for-service businesses, offer contract services such as the building and operating of water and wastewater utility systems, system repair services, lab services, sale of water infrastructure and distribution products (such as pipes) and other specialized services.

 

We are uniquely positioned in the industry as we are both an active acquirer of utilities and a leading provider of contract operations to other owners of utilities. This enables us to both service the needs of the municipalities and when appropriate convert those assets to private ownership.

 

OUR BUSINESS STRATEGY

 

Our primary objective is to own and operate water and wastewater infrastructure that provides a reliable, cost effective service to our clients and customers, while generating industry standard or better operating margins for our stockholders. We have targeted operating margins of 30% to 35% for our owned utility businesses and 5% to 10% for our contract service businesses. We apply two principal strategies, outlined below, in our efforts to continue growing our business and improving our financial performance. In the fourth quarter of 2008 we determined that it was necessary to restate our historical financial statements. This restatement was concluded in July 2009 and we became a timely filer with the Securities and Exchange Commission (“SEC”) in November 2009. As a result, progress on our business strategy was impacted during this timeframe. However, the

 

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information below continues to reflect our long-term business strategy.

 

1.             Optimize the business model.  In 2007 we began an organizational restructuring to drive efficiencies by reducing divisional management layers and streamlining business processes. These activities have taken time and investment, but we feel they are the foundation of our long-term strategy to drive sustainable efficiency improvements. These activities are focused in three categories:

 

a.             Focus on core business.  Our core business is to provide water and wastewater service to consumers either through our owned utility systems or for other utility owners under contract. In order to provide clear focus on these core business activities, we have divested non-core, outlying or underperforming assets, and we have exited service businesses that are non-core or that do not support our operating margin objectives. In 2009 we divested a non-strategic environmental testing lab. Since 2007, we have exited an electrical contracting business, pipe rehabilitation business, an under-performing wholesale wastewater facility and a bookkeeping business. We continue to assess our assets and services businesses to determine if further divestiture is warranted.

 

b.             Disciplined approach to cost recovery and margins.  In our owned utilities, we work to recover our cost of service, including a reasonable return on investment, as soon as practical by filing rate cases on a regular basis. Each of our utilities has a long-term strategy to address capital investment, growth and timing of rate filings. In our contract service businesses, we perform systematic price reviews on all of our contracts to ensure we are receiving a fair return and strive to achieve operating margin targets. We intend to continue to renegotiate or exit service contracts that are not achieving these targets. We also seek out projects and scope enhancements that will improve our operating margin profile across the services businesses.

 

c.             Reduced fixed cost structure.  We strive for cost containment across the Company. We have an opportunity to continue to drive down fixed costs over time to benefit both our customers and our shareholders. We began the process of consolidating support functions in 2007 to reduce costs and continued these efforts through 2008 and 2009. As a result, we have made large investments in our consolidated customer service, financial and information technology systems that have driven general and administrative costs higher as we build a foundation upon which to drive sustainable continuous improvement into the organization. As the efficiencies of these investments take hold, we have targeted objectives to reduce the fixed costs of supporting our operations. However, we anticipate that in the near term we will continue to experience higher costs due to these consolidation efforts as well as the remediation of our material internal control weaknesses (see “Item 9a – Controls and Procedures” for a detailed discussion of our material internal control weaknesses).

 

2.             Accelerate growth.  We generate growth in each of our business segments by expanding the number of water and wastewater utilities that we own and/or operate. We focus on a geographic radius around our current operations to utilize our contract operations personnel as local management in the region and gain economies of scale. We will evaluate opportunities outside of this radius, but generally only if the opportunity has the scale and economic potential to ensure that we can generate industry standard margins or better by moving into the region.

 

a.             Acquisition of utility assets.  Our primary targeted growth mechanism is to acquire additional utility assets that are rapidly accretive to the Company. We look to continue acquiring utilities in population growth markets, which are principally in the southern and western United States. As a population grows, utility connection count grows, making these assets strategic long-term growth engines. We look to consolidate in regions where our local expertise and knowledge of the region’s water and wastewater issues gives us a competitive advantage when bidding for assets. We will look at outlying opportunities as long as they are in a growth market and the utility has an adequate number of connections for the

 

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economics to be sufficient.

 

Our contract operations segments have been a good source of utility acquisitions over the last five years. Our local relationships and community involvement often lead to SouthWest Water being a natural consideration if or when a utility owner decides to divest. For example, in 2005, we acquired a wastewater collection and treatment system in the Birmingham, Alabama area that we were operating through our O&M Services segment. This utility was immediately accretive to operations. In January 2008, this team was also instrumental in the purchase of the wastewater collection and treatment system located directly adjacent to the system purchased in 2005. We expect a favorable return on invested capital from both of these acquisitions.

 

For additional information about our acquisition activities, see “Acquisitions and Dispositions” in this section.

 

b.            Attain new contracts.  We intend to continue to grow our contract service businesses, which includes both our O&M and MUD segments, by bidding for and winning additional service contracts. The mounting regulatory complexity and an aging and deteriorating infrastructure are increasingly becoming challenges for municipalities. Raising large amounts of funds can be difficult, especially for small and medium size cities. In order to meet their capital spending challenges, some municipalities are examining partnerships with the private sector. We have strategically grown our contract operations in small to medium size cities that are experiencing population growth. We look to expand our operations in geographic regions where we are currently operating to enhance our economies of scale, but will look at opportunities in other markets if they have the scale and economic potential to ensure we can generate industry standard margins or better. We also look to attain contract operations near our owned utilities to enable us to build a larger presence in the region.

 

 

BUSINESS SEGMENT PERFORMANCE

 

Revenue and operating income, which we define as revenue less the related direct operating expenses and allocated centralized costs, for the three years ended December 31, 2009 were as follows:

 

Revenue and Operating Income (Loss) by Business Segment

 

 

 

Years Ended December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2009

 

2008

 

2007

 

(In thousands, except percentage data)

 

Amount

 

Percent

 

Amount

 

Percent

 

Amount

 

Percent

 

Operating revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

Utilities

 

$

65,168

 

31

%

 

$

60,927

 

29

%

 

$

56,653

 

28

%

 

Texas Utilities

 

36,525

 

17

%

 

34,784

 

17

%

 

27,911

 

13

%

 

O&M Services

 

36,976

 

18

%

 

40,493

 

19

%

 

40,922

 

20

%

 

Texas MUD Services

 

72,424

 

34

%

 

74,453

 

35

%

 

79,321

 

39

%

 

Total revenue

 

$

211,093

 

100

%

 

$

210,657

 

100

%

 

$

204,807

 

100

%

 

Operating income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

Utilities

 

$

19,288

 

 

 

$

19,725

 

 

 

$

22,655

 

 

 

Texas Utilities

 

7,457

 

 

 

(19,037)

 

 

 

(1,230)

 

 

 

O&M Services

 

299

 

 

 

(2,881)

 

 

 

(1,369)

 

 

 

Texas MUD Services

 

(1,421)

 

 

 

(3,115)

 

 

 

2,841

 

 

 

Corporate

 

(37,459)

 

 

 

(21,822)

 

 

 

(15,358)

 

 

 

Total operating income (loss)

 

$

(11,836)

 

 

 

$

(27,130)

 

 

 

$

7,539 

 

 

 

 

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Additional information about our business segments can be found in Note 15, “Segment Information,” included in Part II, Item 8, “Financial Statements and Supplementary Data.”

 

UTILITIES—DEVELOPMENT OF BUSINESS, SERVICES AND REGULATION

 

Our owned water and wastewater utilities, which are the combination of Utilities and Texas Utilities operations, serve a population of more than 460,000 in five states. At December 31, 2009 we had approximately 109,000 active water connections and 21,000 active wastewater connections. Approximately 95% of our connections are to residential customers. The table below shows the revenue for the year ended December 31, 2009 and connection counts by state as of December 31, 2009.

 

 

 

Revenue

 

Percent

 

Water
Connections

 

Percent

 

Wastewater
Connections

 

Percent

 

(In thousands, except percentage data)

 

 

 

 

 

 

 

 

 

 

 

 

 

California

 

$

55,043

 

54

%

 

75,392

 

69

%

 

 

0

%

 

Texas(1)

 

36,525

 

36

%

 

33,418

 

31

%

 

11,209

 

54

%

 

Southeast(2)

 

10,125

 

10

%

 

285

 

0

%

 

9,652

 

46

%

 

Total

 

$

101,693

 

100

%

 

109,095

 

100

%

 

20,861

 

100

%

 

 


(1)                                 Includes a small system in Oklahoma

 

(2)                                 Includes utilities in Alabama and Mississippi

 

In this section we discuss the major drivers our utilities must effectively manage. Each region presents unique opportunities and challenges ranging from the local regulatory environment to weather. These drivers present both the opportunity and challenge of managing these utilities. As part of our long-term strategy, we have integrated rate making, operations, capital planning and community involvement to meet the demands of these dynamic market opportunities.

 

Seasonality and Conservation

 

Our utilities operate entirely in the South and West of the United States. Typically, the second and third quarters of each year account for the highest volume of water consumption when weather tends to be hot and dry. However, drought conditions may result in consumer conservation efforts or water shortages, which can reduce consumption. Conversely, unusually wet conditions may result in decreased customer demand, lower revenue and lower profit. Wastewater revenue is typically linked to consumer water use and is therefore also impacted by usage rates.

 

Weather patterns also impact costs. Drought conditions may result in our having to purchase water from costly sources. Rainy seasons can result in inflows into sewer collection systems which increases the amount of wastewater we treat which increases costs.

 

Water Sources

 

Our water utilities are dependent upon a defined source of water supply. In our long-term planning we are always evaluating quality, quantity, growth needs and alternate sources to ensure good stewardship of our utilities as well as achieving optimal costs in our operations.

 

We generally own the land and physical assets used to store, extract and treat source water. Typically, we do not own the water itself, which is held in public trust, but rather hold title to rights granted by federal and state agencies for the allocation of water pursuant to federal, state and local law. Sources of supply are seasonal in nature and weather conditions can have a pronounced effect on supply.

 

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Our supplies by principal service area are:

 

·                  California—obtains between 60% - 80% of its delivered water by pumping water from 19 owned wells and the balance from purchasing water from adjacent municipal and private water purveyors, and from two regional water wholesalers. Our wells pump water from two of the major groundwater basins in the Southern California coastal watershed: the Main San Gabriel Basin and the Central Basin. We own the rights to pump 13% of the water in the Main San Gabriel Basin and 2% in the Central Basin. Source water is stored for use in 32 storage reservoirs prior to distribution.

 

·                  Texas—obtains more than 80% of its delivered water by pumping from its 208 active wells across the state that draw from several aquifers, primarily the Edwards, Trinity, Gulf Coast and Carrizo Aquifers. Additionally, seven of our systems derive water from surface water sources that supply approximately 10% of our delivered water. Source water is stored for use in 249 storage reservoirs prior to distribution. We have several long-term agreements to purchase water from the cities of Austin and Pflugerville, Texas, and other water producers in the Austin, Dallas-Fort Worth and San Antonio areas.

 

Water Regulation

 

The water supplies available to all of our utilities are subject to regulation by the EPA under the 1996 Federal Safe Drinking Water Act (“US Act”). The US Act establishes uniform minimum national water quality standards, as well as specification of the types of treatment processes to be used for public drinking water. The EPA, as mandated under the US Act, issues regulations that require, among other things, disinfection of drinking water, specification of maximum contaminant levels (“MCLs”) and filtration of surface water supplies. Our water supplies are also subject to regulation by the following:

 

·                  In California, the California Department of Public Health (“CDPH”) under the California Safe Drinking Water Act (“Cal Act”);

 

·                  In Mississippi, the Mississippi Department of Health Services—Water Supply Division;

 

·                  In Oklahoma, the Department of Environmental Quality (“DEQ”); and

 

·                  In Texas, the Texas Commission on Environmental Quality (“TCEQ”).

 

The Cal Act and the rules of the CDPH are similar to the US Act and the mandates of the EPA, except that in many instances the requirements of the CDPH are more stringent than those of the EPA. In addition to the EPA and the CDPH water quality regulations, our California water utility is also subject to water quality standards that may be set by the California Public Utilities Commission (“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 CDPH.

 

Costs associated with testing our water supplies 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 and incremental costs of complying with governmental regulations will be recoverable from ratepayers through future rate increases.

 

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 below the prescribed MCLs 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

 

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

 

A few surface water systems at our Texas utilities have been in violation of MCLs for Disinfection By-Products (“DBPs”) which has resulted, in years prior to 2008, in citations and fines from the TCEQ. Several systems are not in compliance with secondary standards such as chlorides, total dissolved solids, and fluoride. Some of our Texas utilities are older systems and therefore require infrastructure upgrades to maintain regulatory compliance. We have entered into Compliance Agreements and Agreed Orders with the TCEQ under which we have committed to make certain improvements to achieve compliance by a pre-determined deadline. These agreements are intended to provide the TCEQ with assurance that problems covered by these agreements will be addressed, and the agreements generally provide protection to us from fines, penalties and other actions while corrective measures are being implemented. The customers in affected areas have been advised of the DBP MCL violations and the corrective actions taken by public notice, direct mail, or the annual Consumer Confidence Report, as required by the TCEQ. We have constructed new treatment facilities, drilled new groundwater wells, interconnected nearby systems, and taken other steps to address these compliance issues. We are actively working with the TCEQ and outside consultants to address the remaining issues and bring the affected systems into full compliance.

 

Drinking water systems have been identified as critical infrastructure and potential terrorist targets. In compliance with the Public Health Security and Bioterrorism Response Act of 2002, PL 107-88, we 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, and provide a prioritized plan for security upgrades, modifications of operational procedures, and/or policy changes to mitigate identified risks to critical assets.

 

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 Mississippi, Oklahoma and Texas utilities complies with all current requirements of the US Act and the respective state regulatory agencies, except as noted above.

 

Wastewater Regulation

 

The provision of wastewater services involves the collection of wastewater from customers’ premises through sewer lines. The wastewater is then transported through a sewer network to a treatment facility where it is treated to meet required effluent standards. The treated wastewater is finally returned to the environment as effluent, and the solid waste byproduct of the treatment process is disposed of in accordance with state and federal standards. Because each discharge point is different, the requirements for treatment can vary greatly from state to state, site to site. In response to this, our wastewater systems deploy a variety of different technologies and require varying levels of operator certification and training.

 

The water discharged from our wastewater facilities is subject to regulations imposed by the EPA under the Clean Water Act of 1972, as amended. We currently have wastewater treatment

 

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operations in Alabama, Mississippi, Oklahoma and Texas. The water discharged from our treatment facilities is also regulated by the Alabama Department of Environmental Management, the Mississippi Department of Environmental Quality and the Oklahoma Department of Environmental Quality.

 

In Alabama, new phased discharge limits have been set for our facilities on the Cahaba River that will require us to reduce the amount of phosphorus discharged over the next 15 years. These new limits will require significant upgrades to these facilities over the next several years.

 

In Texas, discharge water is also subject to regulation under the TCEQ and the Texas Clean Water Act, as amended. These regulations establish permit limitations for discharging contaminates into natural water bodies. We hold discharge permits as required by the TCEQ and are complying with all monitoring and reporting requirements related to the quality of the discharged water.

 

When we acquired our Texas-based Monarch Utilities in 2004, several of its wastewater facilities were not in compliance with TCEQ regulations and, as a result, some discharge violations have occurred that resulted in citations and fines. We have been working cooperatively with the TCEQ and have entered into Compliance Agreements and Agreed Orders with them under which we have committed to make certain improvements to achieve compliance by a pre-determined deadline. These agreements are intended to provide the TCEQ with assurance that problems covered by these agreements will be addressed, and the agreements generally provide protection to us from fines, penalties and other actions while corrective measures are being implemented. We are addressing these violations by constructing new treatment facilities, changing existing treatment procedures and/or modifying operations. We are continuing to work with the TCEQ and outside consultants to address the remaining issues and bring the affected systems into full compliance.

 

Water and Wastewater Rates

 

Our regulated investor-owned water and wastewater utilities in Alabama, California, Mississippi, Oklahoma and Texas generate operating revenue from customers based on tariffs that are established and updated by state regulators through a rate-setting process, except for some of our Alabama wastewater rates which are governed by service agreements. In states where we are regulated by state agencies, the rate-setting process may include public hearings, evidentiary hearings and the submission of evidence and testimony by the utility and intervenors. Some state regulators are more restrictive than others with regard to the types of expenses and investments that may be recovered in rates as well as with regard to the complexity of their rate-making processes and how they reach their final rate determinations. In evaluating a rate case, state regulators typically focus on five areas: (i) the amount and prudence of investment in facilities considered “used and useful” in providing service (typically by making reference to a representative 12-month period of time, known as a test year); (ii) the operating and maintenance costs and taxes associated with providing the service (again based on a representative test year); (iii) the appropriate rate of return; (iv) the rate design used to allocate revenue requirements equitably across the customer base; and (v) the quality of service the utility provides, including issues raised by customers.

 

State regulators have broad authority, derived from state laws and state constitutions under which they operate, to regulate many of the economic aspects of the utilities that fall within their jurisdiction. For example, they must approve the rates and conditions under which service is provided to customers and have extensive authority to establish rules and regulations under which the utilities operate. Although specific authority might differ from state to state, in most states regulators must approve rates, accounting treatments, long-term financing programs, significant capital expenditures and plant additions (in many instances prior to their completion), transactions between the regulated subsidiary and affiliated entities, reorganizations and mergers and acquisitions. The jurisdiction exercised by each regulator is prescribed by state laws and regulations and therefore varies from state to state. Regulatory policies not only vary from state to state, they may also change over time. These policies will affect the timing as well as the extent of

 

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recovery of expenses and the realized return on invested capital.

 

Economic regulation of utilities deals with many competing, and occasionally conflicting, public interests and policy goals. The primary responsibility of state regulators is to achieve the overall public interest by balancing the interests of customers and the utility and its owners. Although the specific approach to economic regulation varies, certain general principles are consistent across the states in which our utilities operate. Based on the United States Constitution and state constitutions that prohibit confiscation of property without due process of law and just compensation, as well as state statutory provisions and court precedent, utilities are entitled to recover, through rates charged to customers, prudent and reasonable operating costs, the cost of infrastructure or capital investment associated with such operating cost as well as an opportunity to earn a reasonable return on capital investment necessary to attract capital. State regulators also accord a utility the exclusive right to serve specific areas, the boundaries of which are delineated in the utility’s certificate of public convenience and necessity (“CPCN”). These CPCNs provide investor-owned utilities with protection from competition because they preclude others from providing service in the area approved by the CPCN. In return, the utility undertakes to provide reliable service on a nondiscriminatory basis to all customers within the authorized area.

 

Our operating revenue when controlled by state rate-making processes is typically based on each utility’s unique cost of service. Certain states utilize full or partial consolidated rate policies, under which all customers within a district, region or area are charged under one rate structure, regardless of how many individual systems are within the district, region or area. The single tariff structure is based on costs that are determined on a district, region or area wide basis, thereby moderating the impact of periodic fluctuations in specific system costs while lowering administrative costs for us and our customers. This is the case with our Monarch Utilities in Texas.

 

The process to obtain approval for a change in rates, or rate case, involves filing an application with the state regulator. Rate cases are normally initiated by the utility when necessary to ensure recovery of costs. In California rate applications are filed on a predetermined schedule established by the regulator. Elsewhere a rate case will typically not be filed unless the current or forecasted future return is below the allowed rate of return currently authorized by the regulator. A state regulator may also initiate a rate proceeding or investigation if it believes a utility may be earning in excess of its authorized rate of return. Rate cases often involve a lengthy and costly administrative process.

 

The decisions of regulators and the timing of those decisions can have a significant impact on the operations and earnings of our utilities. Rate cases and other rate-related proceedings can take from several months to more than a year to complete. Therefore, there is frequently a delay, or regulatory lag, between the time one of our regulated subsidiaries makes a capital investment or incurs an operating expense increase and when those costs are reflected in rates. For instance, new capital investment that is not reflected in the most recently completed rate case will generally not be recovered by the regulated subsidiary until the next rate case is filed and approved by the regulator. Our rate case management program is guided by the goals of obtaining efficient recovery of costs of capital and utility operating and maintenance costs, including costs incurred for compliance with environmental regulations. The corporate rate strategy and regulatory affairs team works closely with the management team at each of our utilities to anticipate the time required for the regulatory process and files a rate case with the goal of obtaining rates that reflect as closely as possible the cost of providing service at the time the rates become effective. Even if rates are sufficient, we face the risk that we will not achieve the authorized rate of return on our invested capital that is permitted by the state regulator.

 

Our utilities also pursue methods to minimize the adverse impact of regulatory lag and have worked with state regulators and legislatures to implement a number of approaches to achieve this result. A number of states in which we operate have adopted efficient rate policies, including some form of single tariff pricing, forward-looking test years and pass-through provisions. The forward-looking test year mechanism provides for rates that are contemporaneous with costs and allows us a greater opportunity to earn a fair return on our invested capital. California is a state

 

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that has adopted the forward-looking test year mechanism. Also, some of the states in which we operate permit pass-through provisions that allow for changes in certain non-controllable operating costs, such as purchased power and property taxes, to be passed through to customers outside of a general rate case proceeding.

 

Two of our Alabama wastewater utilities have rates established by long-term contracts with local governments and are not regulated by state regulators. These contracts were established with the local governmental agencies at the time the utilities were purchased and provide annual cost escalation rate increases as well as rate increases required to comply with new regulations or specific capital needs.

 

Capital Expenditures

 

Capital expenditures related to water supply, treatment and distribution and wastewater collection and treatment facilities are typically funded by water and wastewater rates. However, in some of our Texas Utilities, we have made large capital expenditures in the systems, primarily to correct compliance and operating issues the systems had prior to our ownership, that are significantly greater than is provided for in their current rates. In 2010, we estimate that Company-wide funding of capital investment is expected to be between $18 to $22 million. Our capital investment includes infrastructure renewal programs, where we replace existing infrastructure, as needed, and the construction of facilities to meet new customer growth.

 

Supply Cost Balancing Accounts

 

As permitted by the CPUC, our California utility maintains water supply cost balancing accounts. Balancing accounts track differences between non-controllable costs authorized in rates and recorded costs, and defers those amounts for future surcharge or surcredit to customers. Deferred amounts are charged or credited to customers over a 12 to 36 month period.  The supply cost balancing accounts track differences between the cost per unit charged by providers of supply items (purchased water, purchased power, and pump taxes) and the cost per unit for those items provided for in our rates. Under-collections (recorded as regulatory assets) occur when the recorded cost per unit exceeds costs per unit in rates and, conversely, over-collections (recorded as regulatory liabilities) occur when the recorded cost per unit is less than the cost per unit in rates.  Typically, under-collections or over-collections, when they occur, are tracked in the supply cost balancing accounts for future recovery or refund through a surcharge (in the event of an under-collection) or through a surcredit (in the event of an over-collection) on customers’ bills.  We accrue interest on our supply cost balancing accounts at the rate prevailing for 90-day commercial paper established by the CPUC.

 

Monterey-style Water Revenue Adjustment Mechanism

 

Effective August, 2008 with the adoption of the Monterey-style Water Revenue Adjustment Mechanism (“WRAM”), we began recording the difference between inclining block quantity rates, which are the tariff rates approved by the CPUC, and equivalent uniform rates, also established by the CPUC. Differences are recorded as an adjustment to revenue with an offsetting entry in the WRAM balancing account, which is either a regulatory asset or liability and represents amounts that will be billed or refunded to customers in the future.

 

The balances in the WRAM asset and liability accounts, which fluctuate on a monthly basis depending upon the mix of customer usage among the inclining rate blocks, represent the variance between adopted and actual results.  We accrue interest on the WRAM at the rate prevailing for 90-day commercial paper.  When the WRAM amount reaches two percent of the approved revenue requirement, whether positive or negative, the CPUC allows us to file an advice letter to request the recovery or amortization of the balance in the account. Account balances less than those levels may be refunded or collected in our general rate case proceedings or appended to future requests for recovery or refund.

 

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The low income ratepayer assistance (“LIRA”) memorandum account captures the net cost of this program which provides monthly credits to qualifying low income customers, and also related monthly charges to non-qualifying residential customers. Also, all revenue net of expenses associated with the non-tariff LifeLine houseline maintenance program is deferred in a memorandum account pending resolution of the CPUC’s current affiliated transactions rulemaking.

 

Competition

 

Our utilities generally do not face direct or indirect competition in providing utility service in our existing markets because (i) we operate within those markets pursuant to CPCNs (or similar authorizations) issued by regulators that preclude others from providing service in the authorized area and (ii) the high cost of constructing a new water and wastewater system in an existing market creates a barrier to market entry. We do face competition from governmental agencies, other investor-owned utilities and strategic buyers in connection with entering new markets and making strategic acquisitions. Consolidation is changing the competitive landscape as small local utilities struggle to meet their capital spending requirements and look to partner with investor-owned utilities. We also face competition in offering utility service to new real estate developers, where we compete with others on the basis of the financial terms we offer for our services, the availability of water and our ability to commence providing services on a timely basis. Our largest investor-owned competitors in entering new markets and making strategic acquisitions, based on a comparison of operating revenue and population served, are American Water Works, Aqua America Inc., United Water (owned by Suez Environment Company S.A.), American States Water Co., California Water Services Group and SJW Corp.

 

The CPCNs (or similar authorizations) pursuant to which we operate prevent or limit municipalities from competing with us to provide water and wastewater utility services to our existing customers. However, the potential exists that portions of our utility assets could be acquired by municipalities or other local government entities through one or more of the following methods:

 

·                  eminent domain (also known as condemnation);

 

·                  the right of purchase given or reserved by a municipality or political subdivision when the original certificate was granted;

 

·                  the right of purchase given or reserved under the law of the state in which the utility subsidiary was incorporated or from which it received its certificate; and

 

·                  legislative or regulatory changes to the certificate or its powers.

 

The sale price for such a transaction initiated by a local government may be determined consistent with applicable eminent domain law, or the price may be negotiated or fixed by appraisers as prescribed by the law of the state or in the particular franchise or charter.

 

We are occasionally subject to condemnation proceedings in the ordinary course of business. In January 2007, the Albuquerque Bernalillo County Water Authority and the City of Rio Rancho, New Mexico filed a petition in New Mexico District Court seeking to acquire, by condemnation, our New Mexico utility through the alleged power of eminent domain. In January 2009 we reached a settlement in these proceedings. See “Item 3. Legal Proceedings” for additional information.

 

CONTRACT SERVICES—DEVELOPMENT OF BUSINESS, SERVICES AND REGULATION

 

Our contract services businesses, which include both O&M Services and Texas MUD Services segments, are described below. Many of the overall drivers for these two operations are similar, although there are some differences. Although we are operating these utilities on behalf of a governmental agency or industry, the day to day issues are much the same as in our owned utilities operations. However, in contract services, some of these drivers can present an

 

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opportunity for us to provide additional services for our clients.

 

Seasonality

 

Contract service 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. Extreme heat can cause cracking and leaks in our client’s infrastructure, which increases the amount of time-and-materials service order work performed. Severe weather conditions may also result in additional labor and material costs to us that may not necessarily be recoverable through our various fixed price contracts.

 

Revenue from our billing and collection services business is generally not subject to seasonal fluctuations.

 

Regulation

 

Contract service revenue is not subject to regulation. However, 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. The systems we operate are subject to state and federal regulations regarding standards of water quality, safety, environmental and other matters, and our operators must comply with requisite standards.

 

In our contracts we typically do not take responsibility for compliance matters that would generally fall on the owner or owner engineer, such as size of plant, appropriate technology or effluent water or wastewater conditions. However, in our contracts we generally do accept risk as it specifically relates to operator error or practices and have experienced fines from time to time as a result. For example, in early 2010 we reached a preliminary settlement, requiring that we implement an acceptable compliance program and pay fines and penalties of $0.8 million. See Note 10 “Commitments and Contingencies – Legal Proceedings” included in Part II Item 8 – “Financial Statements and Supplementary Data” for more information. In response to this risk, we implemented standard operating procedures and internal compliance reviews. Also, because we are the operator on site, when a compliance issue occurs, regardless of who is at fault, our operators are trained to respond to both the operational situation and associated communication efforts.

 

Competition

 

Contract service operations are characterized by aggressive competition and market-driven growth and profit margins. Competition includes a number of significantly larger companies that provide services on a national and international basis, such as Veolia Environmental, Suez Environment, Severn Trent, CH2MHill (“OMI”) and American Water Works, as well as regional and local competitors. New contracts are awarded based on a combination of customer relationships, service levels, competitive pricing, references and technical expertise.

 

While cities themselves are not competitors, we must overcome reluctance on the part of some city officials to outsource their water and wastewater services. However, we are seeing increased interest as the growing regulatory complexity and an aging and deteriorating municipal infrastructure are increasingly becoming a challenge for cities while raising large amounts of funds can be difficult. In order to meet their capital spending challenges, some municipalities are examining partnerships with the private sector.

 

Types of Contracts

 

Our contract operations are segmented by contract type into those that are project specific, stand alone operations (“O&M Services”) and those that are small, full service contracts operated by a common team of personnel resulting in a model that apportions a fractional amount of each cost

 

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center to each client (“Texas MUD Services”).

 

O&M Services

 

O&M Services contracts are agreements with cities, public entities and private utility owners that provide specific services such as facility operation and maintenance, meter reading, customer billing and collection, upgrades and improvements, municipal public works services and/or management, or management of entire water or wastewater systems. At December 31, 2009, we had more than 225 O&M contracts principally located in California, Colorado, Alabama, Mississippi and Georgia. Under a typical O&M contract, we charge a fee that covers a specified level of services. Services are typically provided evenly throughout the contract period utilizing dedicated personnel 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, hurricanes, earthquakes, electrical strikes 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. However, the contracts usually provide for reimbursement of these costs.

 

In most cases, O&M contracts are cancelable by either party only upon the occurrence of specified events defined as a breach of contract. O&M contracts can have terms ranging from month-to-month to up to 20 years, with the typical duration being two to three years. We have a strong focus on customer service and client satisfaction and our experience has been that approximately 95% of our O&M contracts are renewed upon expiration.

 

Contractual Service Backlog—Revenue included in backlog is generally realized over a multi-year period. O&M contracts typically have durations of two to three years, and the uncompleted remaining portion of these contracts is reflected in backlog. At December 31, 2009, our O&M Services contractual base service fee backlog was $28.9 million compared to $40.0 million at December 31, 2008. The drop in backlog was primarily due to one less year of term remaining on contracts included in backlog for both years, and, to a lesser extent, lost contracts. Base service fee backlog totaling approximately $12.7 million at December 31, 2009 is expected to be earned during 2010.

 

Texas MUD Services

 

A MUD is created either administratively or legislatively to operate under the rules of the TCEQ to provide water supply, wastewater treatment and drainage services to areas where existing municipal services are not available. At December 31, 2009, we had more than 320 contracts with more than 270 MUDs in the suburbs of Houston, Austin, Dallas 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/or wastewater facility operations and maintenance services, equipment maintenance, meter reading, billing and collection services and customer service functions. We have adopted a fractional business model for our MUD clients. We provide a common team of operators, customer service and billing personnel, allocating contracts a proportional share of each cost center. 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 generally include inflation adjustments. Changes in prices are negotiated on a contract-by-contract basis. Generally, MUD contracts are cancelable with 30 to 60 days 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. For example, many of our MUD contracts have been in existence for over ten years.

 

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Contractual Service Backlog—Revenue included in backlog is generally realized over a multi-year period. MUD contracts are generally cancelable with 30 to 60 days prior notice, however, if our contracts at December 31, 2009 were to remain with us through December 31, 2010, our Texas MUD Services contractual base service fee backlog would be $19.3 million compared to $23.2 million at December 31, 2008. Our base service fee represented only 29% and 33% of revenue generated in 2009 and 2008, respectively. In addition to base fees, Texas MUD Services generate additional revenue related to ancillary services such as repair and maintenance work and new housing related taps and inspections.

 

ACQUISITIONS AND DISPOSITIONS

 

During the five years ended December 31, 2009 and through the date of this report, we have acquired the stock or assets of several businesses that fit our long-term growth goals for our operating segments. We have also disposed of several businesses during the same time frame. Those acquisitions and dispositions that are material to our financial statements are summarized below. During this five-year period we also made seven additional acquisitions with an aggregate purchase price of $4.5 million.

 

Acquisitions

 

Utilities Acquisitions

 

Shelby County Alabama Wastewater System.  In 2005, we acquired the assets of a wastewater collection and treatment system servicing approximately 4,000 connections in Shelby County, Alabama, for $8.6 million in cash. The acquisition allowed us to expand our utility footprint into Alabama. Novus Utilities, the contract operations company in Birmingham Alabama we acquired in March 2005, has operated this facility since 1992 and was instrumental in the acquisition process. This synergy creates operating efficiencies by sharing overhead costs and employee competency in this region.

 

Riverview Wastewater System.  In 2008, we purchased the assets of another wastewater collection and treatment system servicing approximately 4,000 residential and commercial connections in a service area directly adjacent to our existing Shelby County, Alabama collection and treatment system. The purchase price of $23.4 million includes $22.5 million in cash at closing and $0.9 million of transaction costs.

 

Texas Utilities Acquisitions

 

Diamond and Water Services Water Systems.  In 2007, we acquired all of the stock of two water utilities comprised of 13 separate systems serving an aggregate 2,600 connections in a high population growth area northwest of San Antonio, Texas. The aggregate purchase price for these acquisitions was $5.8 million in cash and $0.9 million of assumed liabilities.

 

O&M Services Acquisitions

 

Novus Utilities.  In 2005, we acquired the assets of a Birmingham, Alabama-based contract operations company, Novus Utilities, Inc. This acquisition increased our market presence in the southeastern United States and introduced us to the Birmingham, Alabama area. We paid $2.7 million in cash and assumed $1.1 million of liabilities, which included $0.6 million of debt, in connection with this acquisition.

 

Dispositions

 

Master Tek.  In 2005, we sold Master Tek International, Inc, our subsidiary that provided utility submetering and billing and collection services to multi-family residential properties. We elected to sell Master Tek because of changes in the submetering market which would have required significant capital investments in future years. We believe growth opportunities involving our core competencies of operating and managing water and wastewater infrastructure exceed those of the

 

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submetering business.

 

We sold Master Tek for $12.2 million in cash. We received $11.1 million in cash at closing and $1.1 million was placed into an escrow account which was released upon final determination of customary representations and warranties. We used the proceeds from the sale to acquire the assets of a wastewater collection and treatment system located in Shelby County, Alabama, and to repay borrowings under our bank line of credit.

 

Master Tek contributed $3.7 million during the first six months of 2005 prior to the sale. As a result of the sale, Master Tek is reflected as a discontinued operation in the summary financial data in Item 6 -”Selected Financial Data.” The sale of this business, which was part of our contract services business, did not adversely affect the operations of our remaining businesses.

 

Texas Wholesale Water and Wastewater Operations.  During 2007, the Company committed to a plan to sell its wholesale water and wastewater operations in Texas. In December 2008, the Company completed the sale of its wholesale wastewater business for net cash proceeds of $2.2 million and a note receivable of $0.6 million. The wastewater operating results have been included in discontinued operations for all periods presented. In 2009 we decided not to sell the wholesale water component of the business, accordingly, the business activity of the water component has been included in consolidated continuing operations for all periods presented.

 

SouthWest Environmental Laboratories (“SWEL”).  On March 31, 2009, we entered into an agreement to sell the assets of our SWEL subsidiary for $0.5 million in cash paid at close and up to an additional $0.75 million of consideration consisting of 25% of the buyer’s quarterly aggregate invoice amounts subsequent to the sale. The sale closed on April 1, 2009, however, the business activity prior to the sale has been reflected in consolidated continuing operations based on the ongoing business relationship with the buyer.

 

New Mexico Utilities.  On January 19, 2007, the Albuquerque Bernalillo County Water Authority (“ABCWA”) and the City of Rio Rancho, New Mexico filed a petition in New Mexico District Court seeking to acquire, by condemnation, our New Mexico utility, New Mexico Utilities Inc. (“NMUI”), through the alleged power of eminent domain. In January 2009 we reached a settlement in these proceedings that resulted in the sale of NMUI in lieu of condemnation. On May 8, 2009 we received $53.9 million in cash at the closing of the sale ($60.0 million settlement and $0.9 million escrow release, less $7.0 million paid to ABCWA in settlement of sewer treatment fees) and recorded a gain on sale of $26.2 million. We used $12.3 million of the net proceeds to pay off NMUI bonds and related accrued interest and we used the remaining cash proceeds of $41.6 million to pay any unassumed liabilities of NMUI and to pay down our revolving credit facility. As a result of the sale, NMUI is reflected as a discontinued operation in this Form 10-K for all periods presented. See “Note 2 - Acquisitions, Assets Held for Sale and Dispositions” included in Part II Item 8 — “Financial Statements and Supplementary Data” for the summary of the historical results of discontinued operations.

 

OTHER INFORMATION

 

Credit Concentration

 

We have no individual customers who accounted for 10% or more of our consolidated revenue during each of the years in the three-year period ended December 31, 2009, or whose loss would have a material adverse effect on our consolidated revenue.

 

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

 

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artwork used in marketing, we have no other patents, licenses or trademarks.

 

Employees

 

At December 31, 2009, we employed approximately 1,224 people. Approximately 450 people were employed in Texas MUD Services, 359 in O&M Services, 120 in Utilities, 113 in Texas Utilities, 23 in our corporate office and 159 in central support groups. None of our employees are represented under a collective bargaining agreement. We believe relations with our employees are positive.

 

COMPANY INFORMATION

 

We make available free of charge through our internet website our press releases, annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after they are electronically filed with, or furnished to, the SEC. Our internet website also contains our Code of Ethical Conduct for all employees and our Code of Ethics for Directors and Executive Officers. Our address is: SouthWest Water Company; 624 South Grand Avenue, Suite 2900, Los Angeles, California 90017-3782. Our telephone number is (213) 929-1800 and our Internet website address is www.swwc.com.

 

Information about our executive officers can be found in “Item 10. Directors, Executive Officers and Corporate Governance—Executive Officers of the Registrant.”

 

ITEM 1A.  RISK FACTORS

 

You should consider each of the following factors as well as the other information in this Annual Report in evaluating our business and our prospects. The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties not presently known to us may also impair our business operations. If any of the following risks actually occur, our business and financial results could be harmed. In that case, the trading price of our common stock could decline. You should also refer to the other information set forth in this Annual Report, including our financial statements and the related notes.

 

Our operations are focused on our owned utilities and utilities we service under contract that are owned by cities, municipal utility districts and private companies. There are separate risk factors associated with each.

 

UTILITY BUSINESSES

 

Weather Conditions

 

Rainfall and weather conditions affect the financial results of our utility businesses.

 

·         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 revenue as we use higher-cost purchased water to meet customer demand. Therefore, while our revenue may increase, in some cases we may experience lower profit margins during periods of peak demand.

 

·         Drought, or conversely, unusually wet conditions, may also adversely impact our revenue and profitability. During a drought, we may experience both lower revenue due to consumer conservation efforts and higher water costs due to supply shortages. Since a relatively high percentage of our water is used for residential landscape irrigation, unusually wet conditions could result in decreased customer demand, lower revenue and lower profit. Consequently, the results of operations for one quarter should not be used to predict the results of future quarters.

 

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Conservation Efforts

 

Customer conservation can result in lower volumes of water sold.  We are experiencing a decline in per residential customer water usage in California, which we believe is due, in part, to conservation efforts.

 

·         Our utilities businesses are heavily dependent upon revenue generated from rates charged to our residential customers for the volume of water used. The rates we charge for water are regulated by state regulatory bodies and may not be unilaterally adjusted to reflect changes in demand. Declining usage also negatively impacts our long-term operating revenue if we are unable to secure rate increases or if growth in the residential customer base does not occur to the extent necessary to offset the per customer residential usage decline.  In August 2008, we implemented a Monterey-style water revenue adjustment mechanism at our California utility (see “Item 1 Business — Monterey-style Water Revenue Adjustment Mechanism” for more information) which has the effect of reducing, in part, the adverse impacts of our customers’ conservation efforts. However, increases to the WRAM have a negative impact on our liquidity by deferring collection of current period revenue or costs to future periods.

 

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 reasonable rate of return. 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 revenue and earnings may fluctuate depending on the accuracy of our estimates, timing of our investments or expenses, or other factors. If we were unable to obtain a rate increase that completely offsets the effect of higher 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. For example, in Alabama the State has enacted new regulations for the discharge of treated wastewater effluent into the Cahaba River. The new standards require us to invest in advanced phosphate removal technology. While we will request the recovery of the cost of these new systems in rate increases, we cannot assure that we will be able to economically meet regulatory compliance with future regulations.

 

Water Sources

 

We have no assured access to water.

 

·         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 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, our largest revenue producing state. However, we cannot assure that we will be able to produce or purchase enough water to fully satisfy

 

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future customer demand in our California service area. For example, our California utility purchases some water from adjacent water purveyors who secure water from the Metropolitan Water District (“MWD”), especially during times of peak consumption. MWD receives water from both the California aqueduct system and the Colorado River. In 2007, the California Department of Water Resources, the operator of the California aqueduct system, was issued a court order to reduce by one-third the amount of water it draws from the Sacramento-San Joaquin Delta to protect endangered fish. Additionally, the aqueduct levees have recently come under scrutiny and there is a risk of failure in the event of a natural disaster. These events and others have impacted the amount of water that the MWD can provide to its customers and the price of that water has increased and may continue to do so. At our California utility, we have established water supply cost balancing accounts for expenses of purchased water.  Under the water supply cost balancing account procedures, changes in water supply costs, such as those that occurred due to changes in supply mix (purchased water volume vs. pumped water, for instance) compared to the authorized amounts are recorded to this balance sheet account which has the effect of reducing the adverse impacts of water cost fluctuations over time. However, increases to the supply cost balancing accounts have a negative impact on our liquidity by deferring collection of current period costs to future periods.

 

·         In Texas, many of our small utility systems rely on groundwater supply sources. Central Texas has been experiencing a severe drought since 2004. This drought has lowered ground water tables in nearby aquifers which has resulted in lower yields from the supply wells. This has caused us to limit supply to some customers by restricting water use. In some cases we have had to truck in water to fill operating storage tanks to support depleted supply.

 

·         We are currently examining various options to increase our available water supply in California and Texas. These options include drilling new wells, adding connections to other water purveyors and constructing water treatment facilities. We cannot assure 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.

 

Environmental and Water Quality 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. We cannot assure 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. While we may request rate increases to recover the cost of complying with standards that may be enacted in the future, we cannot assure that we will be successful in obtaining those rate increases.

 

·         Contamination of our water sources by third parties may adversely affect our operations. Our water sources are susceptible to contamination. We may not be able to recover costs incurred or revenue lost due to such contamination. Additionally, contamination

 

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exposes us to environmental liabilities, claims and litigation costs.

 

Condemnation through Eminent Domain

 

The assets of our utilities businesses are subject to condemnation through eminent domain.

 

·         Municipalities and other government subdivisions have historically been involved in the provision of water and wastewater services in the United States, and organized movements may arise from time to time in one or more of the service areas in which our utilities businesses operate to convert our assets to public ownership and operation through the governmental power of eminent domain. Should a municipality or other government subdivision seek to acquire our assets through eminent domain, we may resist the acquisition. Contesting an exercise of condemnation through eminent domain may result in costly legal proceedings and may divert the attention of the management of the affected utilities from the operation of its business.

 

SERVICE BUSINESSES

 

Contract Cancellations

 

Some of our operations and maintenance contracts may be canceled upon short notice, reducing our revenue and service backlog.

 

·         Our service businesses revenue backlog consists of new and existing contracts. We include new contracts in the backlog when we have a signed contract. Revenue included in our backlog may be realized over a multi-year period. The contracts signed by our service businesses typically have durations of two to three years and some are cancelable with 30 to 60 days prior notice or sooner if breached. The uncompleted portion of base revenue for these existing contracts is reflected in the backlog. Although our service businesses tend 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 service businesses. In addition, a client could cancel a long-term contract without notice. This would result in loss of revenue and operating profits and may result in litigation if a breach of contract occurs. Additionally, due to a variety of reasons including, but not limited to, budgetary constraints, lack of client processes or improper contract administration, modifications or extensions of our contracts could occur which would directly affect revenue and profit. Also our technical ability to properly perform contract requirements is critical inasmuch as deficiencies in performance could impact payments under our contracts or cause us to be susceptible to fines and penalties.

 

Environmental and Water Quality Risks

 

Our service businesses are subject to environmental and water quality risks.

 

·         We operate facilities on behalf of our clients under contract. These facilities must be operated in accordance with various federal and state water quality standards in addition to the terms of our contracts. 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 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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Competition

 

We operate in a competitive market.

 

·         Our service businesses compete 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 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 obtain new operating contracts as well as to renew existing contracts with cities, municipal utility districts and other agencies or clients.

 

·         Because we are mostly selling our services in a political environment, we are subject to changing trends and municipal preferences. In the United States, municipalities own and municipal employees operate many water and wastewater systems. A significant portion of our service businesses’ 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.

 

Escalating Costs

 

Our operating costs, construction costs and costs of providing services may rise faster than our revenue.

 

·         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 at a significantly higher pace than a generalized price index. The largest component of our operating costs is made up of salaries and wages. These costs are affected by the local supply and demand for qualified labor. Other large components of our costs are general liability insurance, workers’ compensation insurance, employee benefits and health insurance costs. These costs may increase at rates higher than the applicable general price index based on our actual claims incurred experience, and other factors, and, therefore, may result in a material adverse effect on our future results of operations.

 

Weather Conditions

 

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

 

·         Our service businesses contract operations can be impacted by inclement weather 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, therefore, may adversely impact our results of operations.

 

Natural Disasters or Terrorist Activities

 

We operate assets for others under contracts in areas that historically have experienced natural

 

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disasters or that may be disrupted by terrorist activities.

 

·         Some of our contracts 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 perform contract services resulting in contract terminations or reduced scope of work.

 

·         The assets covered by our contracts could be targeted by terrorists seeking to disrupt services to our customers.

 

OTHER RISK FACTORS

 

Definitive Merger Agreement

 

Consummation of the Merger is subject to the satisfaction of various closing conditions, including, among others, approval and adoption of the Merger Agreement by our stockholders, the absence of certain legal impediments to consummation of the Merger and the receipt of certain regulatory approvals.  As a result, we cannot guarantee that the closing conditions will be satisfied or that the Merger will be successfully completed. These conditions could have the effect of delaying consummation of the Merger or imposing additional costs.  Whether or not the Merger is completed:

 

§         management’s attention from ongoing business concerns may be diverted;

 

§         we may experience difficulties in employee retention or customer relationships;

 

§         we will be required to pay costs, fees and expenses related to the pending Merger; and

 

§         our current plans and operational results may be disrupted, and initiatives that we would have undertaken in the absence of the pending Merger may be delayed.

 

 

If the Merger is not completed, we may be required to pay a termination fee equal to 3% of the aggregate Merger Consideration or be responsible for reimbursement of expenses incurred in connection with the Merger Agreement

 

Any such events could have a material adverse effect on our results of operations and financial condition and could adversely affect our stock price. In addition, the current market price of our common stock may reflect a market assumption that the Merger will occur, and failure to complete the Merger could result in a decline in the market price of our common stock.

 

The Merger Agreement contains customary restrictions on our operations prior to consummation of the Merger, including making capital expenditures, incurring debt, acquiring and disposing of assets, entering into material contracts and capital transactions. These restrictions may prevent us from pursuing attractive business opportunities that may arise prior to the completion of the Merger and may impede our growth and limit the development of our business, which could negatively impact our revenue, earnings and cash flows.

 

Internal Control Weaknesses

 

We have identified material weaknesses in our internal control over financial reporting which could continue to impact our ability to report our results of operations and financial condition accurately and in a timely manner.

 

·         As required by Section 404 of the Sarbanes-Oxley Act of 2002, we have conducted an assessment of our internal control over financial reporting, identified material weaknesses and concluded that our internal control over financial reporting was not effective at December 31, 2009. For a detailed description of these material

 

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weaknesses, see Part II, Item 9A, “Controls and Procedures.” Each of our material weaknesses result in the likelihood that a material misstatement in our financial statements will not be prevented or detected. As a result, we must perform additional work at additional expense to obtain reasonable assurance regarding the reliability of our financial statements. Even with this additional work, given the material weaknesses identified, we cannot assure that additional financial statement errors will be prevented or detected or that in the future other material weaknesses may not be identified.

 

We have not completely remediated the material weaknesses in our internal control over financial reporting.

 

·         We are in the process of developing and implementing remediation efforts for the identified material weaknesses, and this work will continue during fiscal year 2010 and after. There can be no assurance as to when the remediation plan will be fully developed, when it will be implemented and the aggregate cost of implementation. Until our remedial efforts are completed, we will continue to devote significant time and attention to these efforts. If we do not complete our remediation in a timely fashion, or at all, there will also continue to be an increased risk that we will be unable to timely file future periodic reports with the SEC and that our future financial statements could contain errors that will be undetected. We will rely upon additional interim control procedures prescribed by management, including the use of manual mitigating control procedures and the utilization of external technical advisors, to fairly state our financial statements in all material respects. However, we cannot assure that these interim controls will be sufficient to assure that all errors will be detected.

 

Debt Covenants

 

We are subject to debt covenants.

 

·         We are obligated to comply with specified debt covenants under some 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, the acceleration of maturity schedules and cross default issues. Such actions by our creditors could have a material adverse effect on our results of operations or cash flows.

 

Capital Resources

 

Our capital resources may restrict our ability to operate and expand 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 are unable to renew our existing lines of credit, or if we are unable to execute additional financing alternatives, our capital spending could be reduced, delayed or eliminated and any future acquisitions could also be delayed or eliminated, which could negatively impact our revenue, revenue growth and profitability.

 

·         We have a capital planning process that evaluates our capital needs. We believe the plan is adequate at this time to fund our capital spending. However, we can not assure that conditions will not change that will make this plan insufficient which could result in the need for our capital spending to be reduced which could negatively impact our revenue, revenue growth and profitability.

 

·         See “Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations—Certain Contractual Commitments and Indemnities” for additional information with respect to our credit facilities.

 

Capital Market Transactions

 

We were unable to timely file our required SEC filings for the September 30, 2008, March 31, 2009 and June 30, 2009 Quarterly Reports on Form 10-Q and our 2008 Annual Report on Form 10-K. As

 

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a result, this has adversely affected our eligibility to use Registration Statements on Form S-3 for registration of our securities with the SEC. Use of Form S-3 requires, among other things, that the issuer be current and timely in its reports under the Exchange Act for at least the preceding twelve months. Because of our inability to use Form S-3, we will have to meet more demanding requirements to register securities, which may make it more difficult for us to effect public offering transactions, and our range of available financing alternatives could also be narrowed. We are required to continue to suspend our Dividend Reinvestment and Direct Stock Purchase Plans for one year from the time our re-audited and restated financials were filed with the SEC and we became compliant with all timely filings.

 

Because of our late filings, NASDAQ issued Staff Deficiency Letters indicating our non-compliance with NASDAQ Marketplace rules. The Company explained the circumstances of the late filings and described our plan for regaining compliance at a hearing with NASDAQ. On July 1, 2009, the Company was notified that the NASDAQ had granted the Company’s request to extend the current filing compliance deadline to August 31, 2009. The Company regained compliance with NASDAQ listing requirements prior to August 31, 2009; however, if our shares are not listed on NASDAQ, stockholders will likely face decreased liquidity and it will be more difficult for us to raise capital.

 

Stock Price Fluctuations

 

Our common stock, which is traded on the NASDAQ, has experienced and may continue to experience significant price and volume fluctuations that could adversely affect the market price of our common stock without regard to our operating performance. In addition, we believe that factors such as quarterly fluctuations in financial results, earnings below analysts’ estimates and financial performance and other activities of other publicly traded companies in our industry could cause the price of our common stock to fluctuate substantially. Following periods of volatility in the market price of a company’s securities, stockholders have often instituted class action securities litigation against those companies. We can provide no assurance that our share price will remain stable going forward. Additionally, extended stock price declines could have an impact on our goodwill impairment analysis.

 

Information Technology

 

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

 

Risk Transfer

 

We evaluate our risks and insurance coverage annually. Our evaluation considers the identification of various risks and the costs and benefits of either transferring or retaining such risks. We consider the availability and costs of the risks we choose to transfer. Our insurance coverages for the risks we have chosen to transfer include insurance for the health of our employees and insurance for our assets, income and operations such as property, business interruption, liability, pollution, directors and officers, employment practices, and fiduciary and crime. We cannot assure that the risks we choose to transfer are available and at a reasonable cost. Our inability to secure or renew insurance coverage for risks we choose to transfer may adversely affect our financial condition, liquidity and results of operations.

 

Risk Retention

 

We retain certain risks which we have chosen not to transfer through our insurance coverages. Retained risks are those risks associated with deductibles, losses in excess of insurance coverage limits and losses associated with unidentified risks. We have retained risk associated with employee health insurance coverage as well as workers compensation and auto liability insurance coverage.

 

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We cannot assure that uninsured losses pertaining to risks we have retained or not identified will not adversely affect our financial condition, liquidity or 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, legal, economic and other local risks in the areas we service. We cannot control these local risks.

 

We have been named in litigation that may adversely affect our financial condition, results of operations and cash flows.

 

We are a named defendant in certain litigation. These lawsuits are described in Part I, Item 3, “Legal Proceedings.” Our attention may be diverted from our ordinary business operations by these lawsuits and we may incur significant expenses associated with the defense of these lawsuits (including substantial fees of lawyers and other professional advisors and potential obligations to indemnify current and former officers who may be parties to such action). Depending on the outcome of these lawsuits, we may be required to pay material damages and fines, forced to consent to injunctions on future conduct, or suffer other penalties, remedies or sanctions. The ultimate resolution of these matters could have a material adverse effect on our results of operations, financial condition, liquidity, our ability to meet our debt obligations and, consequently, negatively impact the trading price of our common stock.

 

General economic conditions may adversely affect our financial condition and results of operations.

 

A general economic downturn such as the one the U.S. economy is currently experiencing may lead to a number of impacts on our business that may affect our financial condition and results of operations. Such impacts may include: a reduction in discretionary and recreational water use by our residential water customers, particularly during the summer months when such discretionary usage is normally at its highest; a decline in usage by industrial and commercial customers as a result of decreased business activity; an increased incidence of customers’ inability to pay or delays in paying their utility bills, or an increase in customer bankruptcies, which may lead to higher bad debt expense and reduced cash flow; a lower natural customer growth rate due to a decline in new housing starts; and a decline in the number of active customers due to housing vacancies or abandonments.

 

We depend significantly on the services of the members of our management team, and the departure of any of those persons could cause our operating results to suffer.

 

Our success depends significantly on the continued individual and collective contributions of our management team. The loss of the services of key members of our management team or the inability to hire and retain experienced management personnel could harm our operating results.

 

Risks associated with potential acquisitions or investments may adversely affect us.

 

We may continue to seek to acquire or invest in additional regulated water or wastewater systems, including acquiring systems in markets in the United States where we do not currently operate. These possible transactions may result in:

 

·         incurrence of debt and contingent liabilities;

 

·         failure to have or to maintain effective internal control over financial reporting;

 

·         fluctuations in quarterly results;

 

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·         exposure to unknown risk and liabilities, such as environmental liabilities; and

 

·         other acquisition-related expenses.

 

We may also experience difficulty in obtaining required regulatory approvals for acquisitions, and any regulatory approvals we obtain may require us to agree to costly and restrictive conditions imposed by regulators. There may be difficulties integrating new businesses, including bringing newly acquired businesses up to the necessary level of regulatory compliance, retaining and integrating key personnel, achieving strategic objectives and integrating acquired assets and technological systems. The demands of identifying and transitioning newly acquired businesses or pursuing investment opportunities may also divert management’s attention from other business concerns and otherwise disrupt our business. Any of these risks may adversely affect our financial condition, results of operations and cash flows.

 

Delaware law contains anti-takeover provisions that could deter takeover attempts that could be beneficial to our stockholders

 

Provisions of Delaware law could make it more difficult for a third-party to acquire us, even if doing so would be beneficial to our stockholders. Section 203 of the Delaware General Corporation Law may make the acquisition of the Company and the removal of incumbent officers and directors more difficult by prohibiting stockholders holding 15% or more of our outstanding voting stock from acquiring the Company, without our board of directors’ consent, for at least three years from the date they first hold 15% or more of the voting stock.

 

Dividends

 

Since 1960, our practice has been to pay common stock cash dividends quarterly. The amount and timing of future dividends depends on our growth, results of operations, profitability and financial condition, as well as other factors deemed relevant by our Board of Directors. Many of the risk factors noted above could have an impact on our ability to declare and pay future dividends.

 

ITEM 1B.  UNRESOLVED STAFF COMMENTS

 

None.

 

ITEM 2.  PROPERTIES

 

FACILITIES

 

Administrative Offices and Warehouse Space

 

We lease administrative office and warehouse space at 18 locations in Alabama, California, Colorado, Georgia, Mississippi and Texas. These office and warehouse facilities total approximately 217,000 square feet. In addition, we own administrative and warehouse space at two locations in Alabama and Texas. The facilities we own total approximately 23,600 square feet of office space. We believe that these facilities are adequate to meet the needs of our existing operations and provide reasonable space for growth. The majority of our operations do not require uniquely specialized facilities, and we believe that additional or alternative space is available, if required, at reasonable prices. We may relocate some of our facilities as leases terminate to improve the location or size of the facility, or to provide better coordination among our operating units.

 

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Property, Plant and Equipment

 

Our utility segments utilize the majority of our property, plant and equipment. Property, plant and equipment, net of accumulated depreciation, at December 31, 2009, was as follows:

 

Property, Plant and Equipment, Net

 

December 31,
2009

 

 

 

(In thousands)

 

Combined utilities segments:

 

 

 

Texas

 

$

140,377

 

California

 

121,631

 

Alabama

 

39,190

 

Mississippi

 

29

 

Oklahoma

 

391

 

Total utilities segments

 

301,618

 

Service segments

 

6,656

 

Corporate

 

5,442

 

Total property, plant and equipment, net

 

$

313,716

 

 

Water Production and Distribution Systems

 

Our utility subsidiaries own and operate water production and distribution systems including well pumping plants, booster pumping stations, water treatment facilities, reservoir storage facilities, transmission and distribution mains, and service connections to individual customers. Our utilities have rights-of-way and easements in their service areas necessary to provide water services. Water production and distribution facilities held by our utilities at December 31, 2009 were as follows:

 

Water Production, Treatment and
Distribution Systems

 

California

 

Texas(1)

 

Mississippi

 

Water treatment plants

 

1

 

9

 

1

 

Transmission and distribution mains (in miles)

 

854

 

1,048

 

7

 

Storage reservoirs

 

32

 

249

 

1

 

Storage reservoir capacity (in millions of gallons)

 

74

 

13

 

 

Active wells

 

19

 

208

 

2

 

Inactive wells

 

5

 

43

 

 

Approximate groundwater pumping capacity (MGD(2))

 

59

 

27

 

1

 

Approximate surface water capacity (MGD(2))

 

 

4

 

 

 


(1)                 Includes the small utility we own in Oklahoma which we operate as part of our Texas Utilities.

 

(2)                 Million gallons per day.

 

Wastewater Facilities

 

We also own and operate wastewater collection and sewage treatment systems. These utilities also have rights-of-way and easements in their service areas necessary to provide their services. Wastewater collection and sewage treatment facilities held by our utilities at December 31, 2009 were as follows:

 

Wastewater Collection and
Sewage Treatment Systems

 

Texas(1)

 

Alabama

 

Mississippi

 

Wastewater treatment plants

 

16

 

14

 

4

 

Interceptor and collection lines (in miles)

 

196

 

289

 

9

 

Lift stations

 

44

 

250

 

4

 

Approximate wastewater treatment capacity (MGD(2))

 

5

 

7

 

1

 

 


(1)                 Consists of 16 separate collection and treatment systems including one in Oklahoma which we include as part of Texas Utilities.

 

(2)                 Million gallons per day.

 

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CAPITAL EXPENDITURES, REPAIRS AND MAINTENANCE

 

Capital investments in our water and wastewater utilities are an important and ongoing need of the Company. The capital investment is needed for several reasons; 1) to comply with regulations, existing and new, 2) to remove and replace aging infrastructure, 3) to create capacity for new growth, 4) to improve and enhance reliability and security and, 5) to provide improved customer service and functionality. Our capital program for the reported periods includes investments in all of these categories. The ongoing need for capital presents a challenge with regards to timing and total cost of projects. We review and establish a capital budget on an annual basis. The plan is modified through the year due to changes in circumstances. We intend to continue our capital expenditure programs of constructing and replacing reservoirs, wells and transmission and distribution lines in future years as needed and as approved by the regulating authorities.

 

Our employees perform normal maintenance and construction work while major construction projects are normally performed by general contractors. Ongoing repairs and maintenance expenses for our two utilities segments, expressed in dollars spent as well as the related percentage of our two utilities segments’ revenue, as well as consolidated capital expenditures for the three years ended December 31, 2009 were as follows:

 

 

 

Amount

 

Percent of
Segment
Revenue

 

(In thousands, except percentage data

 

 

 

 

 

Repairs and maintenance expense (Utilities Segments):

 

 

 

 

 

2009

 

$  4,004

 

4%

 

2008

 

$  3,861

 

4%

 

2007

 

$  3,675

 

4%

 

Capital expenditures (Consolidated):

 

 

 

 

 

2009

 

$16,516

 

 

 

2008

 

$32,135

 

 

 

2007

 

$29,834

 

 

 

 

MORTGAGES AND LIENS

 

Virtually all of our California utility’s property is subject to the lien of an Indenture of Mortgage and Deed of Trust dated October 1, 1986, as amended (the “California Indenture”), securing our California utility’s First Mortgage Bonds. The California Indenture contains certain restrictions common to such types of instruments regarding the disposition of property and includes various covenants and restrictions, including limitations on the amount of cash dividends that our California utility may pay to its parent company, SouthWest Water. Our California utility pays regular quarterly dividends to SouthWest Water. At December 31, 2009, our California utility was in compliance with the dividend limitations mandated by the California Indenture.

 

Substantially all of the assets of our Texas-based Monarch Utilities are pledged as security for its term loans. In addition, a wastewater treatment facility we own and operate is pledged as security for economic development revenue bonds issued by the city of Keystone, South Dakota, to finance the construction of that facility.

 

For additional information, see our consolidated financial statements and the accompanying notes to the financial statements included in this report.

 

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ITEM 3.  LEGAL PROCEEDINGS

 

Items required under Item 3 “Legal Proceedings” can be found in Note 10, “Commitments and Contingencies” included in Part II, Item 8, “Financial Statements and Supplementary Data”, and are incorporated herein by reference.

 

ITEM 4. REMOVED AND RESERVED

 

PART II

 

ITEM 5.  MARKET FOR THE REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES

 

MARKET INFORMATION

 

The following table shows the range of market prices of SouthWest Water’s common stock. Our common stock is traded on The NASDAQ Stock Market LLC under the symbol SWWC. There were 2,935 stockholders of record at February 28, 2010.

 

The prices shown reflect the high and low sales prices for our common stock.

 

 

 

Stock Price
Range

 

Cash

 

 

 

High

 

Low

 

Dividends
Declared

 

Year Ended December 31, 2008:

 

 

 

 

 

 

 

First Quarter

 

$12.75

 

$10.52

 

$0.0600

 

Second Quarter

 

11.62

 

9.87

 

0.0600

 

Third Quarter

 

13.40

 

9.41

 

0.0600

 

Fourth Quarter

 

12.56

 

2.67

 

0.0250

 

Year Ended December 31, 2009:

 

 

 

 

 

 

 

First Quarter

 

5.74

 

3.07

 

-      

 

Second Quarter

 

5.93

 

4.08

 

0.0250

 

Third Quarter

 

5.76

 

4.32

 

0.0250

 

Fourth Quarter

 

6.32

 

4.52

 

0.0500

 

 

DIVIDEND POLICY

 

Since 1960, our practice has been to pay common stock cash dividends quarterly. The amount and timing of future dividends depends on our growth, results of operations, profitability and financial condition, as well as other factors deemed relevant by our Board of Directors. Our current quarterly dividend rate is $0.05 per share of common stock.  Under U.S. federal income tax law, dividends to holders of our common stock are taxable to the extent they are paid out of current or accumulated earnings and profits. Generally, the amount of the dividend treated as a return of capital should reduce the tax basis to the holders of our common stock in such stock.  The dividend payments in 2009 represent a return of capital as the Company is in a negative accumulated earnings and profit position resulting from fourth quarter operating losses incurred in 2008 and the tax-basis loss in 2009. (see Note 9 “Stockholders’ Equity” included in Part II, Item 8, “Financial Statements and Supplementary Data.”)

 

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STOCK PERFORMANCE GRAPH

 

The following graph compares the cumulative total return to holders of the Company’s common stock during the five most recent fiscal years versus the cumulative total return during the same period achieved by the 11 publicly held water utilities (“Water Utility Index”) and that achieved by the Standard & Poor’s 500 Stock Index on December 31st of each year. The comparison assumes an initial investment of $100 made on December 31, 2004 in each of the Company’s common stock, the Water Utility Index and the Standard & Poor’s 500 Stock Index. The cumulative total returns assume the reinvestment of all dividends. The historical stock performance reflected in the graph is not necessarily indicative of future stock performance.

 

 

 

 

 

Current Value of a
December 31, 2004 Investment
in:

 

 

 

 

 

 

 

 

 

S&P 500

 

Water
Utility

 

Price of:

 

 

 

SWWC

 

Composite

 

Index

 

SWWC

 

S&P 500

 

December 31, 2004

 

$100.00

 

$100.00

 

$100.00

 

$12.81

 

$1,212

 

December 31, 2005

 

113.50

 

103.00

 

134.54

 

14.31

 

1,248

 

December 31, 2006

 

110.89

 

117.03

 

137.09

 

13.76

 

1,418

 

December 31, 2007

 

102.72

 

121.16

 

130.68

 

12.52

 

1,468

 

December 31, 2008

 

26.85

 

74.53

 

119.30

 

3.22

 

903

 

December 31, 2009

 

50.40

 

92.01

 

116.43

 

5.89

 

1,115

 

 


Notes:

 

(1)                 Assumes that dividends are reinvested.

 

(2)                 Includes the impact of stock splits and stock dividends.

 

(3)                 Water Utility Index includes ARTNA, AWR, AWK, CTWS, CWT, MSEX, PNNW, SWWC, SJW, WTR and YORW weighted for market capitalization.

 

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SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

 

Information relating to securities authorized for issuance under equity compensation plans is set forth under the caption “Equity Compensation Plan Information” in Item 12—“Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.”

 

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ITEM 6.  SELECTED FINANCIAL DATA

 

The following tables include selected summary financial data for each of our last five fiscal years and should be read in conjunction with Part II, Item 8, “Financial Statements and Supplementary Data,” and Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” (“MD&A”)

 

 

Years Ended December 31,(1)

 

 

 

 

(In thousands, except ratio and per share data)

2009

 

2008

 

2007

 

2006

 

2005

 

Summary of Income Statement Data:

 

 

 

 

 

 

 

 

 

 

Operating revenue (2)

$211,093 

 

$210,657 

 

$204,807 

 

$202,754 

 

$184,280 

 

Impairment of goodwill and other long-lived assets

8,115 

 

27,103 

 

4,839 

 

187 

 

180 

 

Operating income (loss)

(11,836) 

 

(27,130) 

 

7,539 

 

12,169 

 

8,231 

 

Income (loss) from continuing operations

(14,034) 

 

(27,595) 

 

(1,449) 

 

3,426 

 

703 

 

Income (loss) from discontinued operations

18,101 

 

(4,322) 

 

3,038 

 

2,547 

 

(1,100) 

 

Cumulative effect of change in accounting principle, net of tax

— 

 

— 

 

— 

 

273 

 

— 

 

Net income (loss)

4,067 

 

(31,917) 

 

1,589 

 

6,246 

 

(397) 

 

Net income (loss) applicable to common stockholders

4,049 

 

(31,941) 

 

1,565 

 

6,222 

 

(421) 

 

Ratio of earnings to fixed charges(2)(3)

 

 

 

 

 

 

 

 

 

 

Ratio

— 

 

— 

 

— 

 

1.41x 

 

1.03x 

 

Deficiency

$  21,602 

 

$  35,350 

 

$       407 

 

$ — 

 

$ — 

 

 

 

Years Ended December 31,(1)

 

 

 

 

 

2009

 

2008

 

2007

 

2006

 

2005

 

Per Common Share Data:

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per common share:

 

 

 

 

 

 

 

 

 

 

Continuing operations:

 

 

 

 

 

 

 

 

 

 

Basic

$(0.57) 

 

$(1.13) 

 

$(0.06) 

 

$0.15 

 

$0.03 

 

Diluted

(0.57) 

 

(1.13) 

 

(0.06) 

 

0.15 

 

0.03 

 

Cumulative effect of change in accounting principle:

 

 

 

 

 

 

 

 

 

 

Basic

— 

 

— 

 

— 

 

0.01 

 

— 

 

Diluted

— 

 

— 

 

— 

 

0.01 

 

— 

 

Discontinued operations:

 

 

 

 

 

 

 

 

 

 

Basic

0.74 

 

(0.18) 

 

0.13 

 

0.11 

 

(0.05) 

 

Diluted

0.74 

 

(0.18) 

 

0.13 

 

0.11 

 

(0.05) 

 

Applicable to common stockholders:

 

 

 

 

 

 

 

 

 

 

Basic

0.17 

 

(1.31) 

 

0.07 

 

0.27 

 

(0.02) 

 

Diluted

0.17 

 

(1.31) 

 

0.07 

 

0.27 

 

(0.02) 

 

Cash dividends declared per common share

0.10 

 

0.20 

 

0.23 

 

0.21 

 

0.20 

 

 

 

Years Ended December 31,(1)

 

 

 

 

(In thousands)

2009

 

2008

 

2007

 

2006

 

2005

 

Balance Sheet and Other Data:

 

 

 

 

 

 

 

 

 

 

Additions to property, plant and equipment (2)

 $

16,516 

 

 $

32,135 

 

 $

29,834 

 

 $

30,248 

 

 $

20,695 

 

Total assets

400,095 

 

527,207 

 

504,124 

 

466,616 

 

427,078 

 

Total debt(4)

154,991 

 

192,791 

 

147,920 

 

130,895 

 

127,600 

 

Stockholders’ equity

115,914 

 

113,800 

 

146,754 

 

145,595 

 

127,895 

 


(1)                                 Reflects historical selected consolidated financial statement data derived from the audited consolidated financial statements and related notes. See “Item 1. Business—Significant Acquisitions and Dispositions” for additional information.

 

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(2)                                 Amounts represent continuing operations for the periods presented.

 

(3)                                 For the purposes of calculating the ratio of earnings to fixed charges, earnings represent income or loss from continuing operations before income taxes and fixed charges, minus interest capitalized. Fixed charges consist of:

 

·                  interest, both expensed and capitalized;

 

·                  amortization of debt expense and discount or premium relating to any indebtedness; and

 

·                  one-third of rental expenses under operating leases which is considered to be a reasonable approximation of the interest portion of such expense.

 

(4)         Total debt is defined as total borrowings under bank lines of credit and long-term debt, including current maturities.

 

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

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations (the “MD&A”) is intended to help the reader understand the results of operations and financial condition of SouthWest Water. The MD&A is provided as a supplement to, and should be read in conjunction with, our consolidated financial statements and the accompanying notes to the consolidated financial statements included in this report. The MD&A also contains forward-looking statements. See “Forward-Looking Statements” on page 1 of this report for additional information.

 

OVERVIEW

 

SouthWest Water’s principal business activity is to operate and maintain water and wastewater infrastructure. Through our operating subsidiaries, we own 144 systems and operate hundreds more under contract to cities, utility districts and private companies. SouthWest Water was incorporated in California in 1954 and reincorporated in Delaware in 1988. We maintain our corporate offices in Los Angeles, California.

 

In the past ten years, we have completed 19 acquisitions of both utility and contract service businesses. These businesses operated largely independent of each other, resulting in a complex business structure with varying business practices. Beginning in 2007, we implemented changes to better integrate the acquisitions and our various business operations. Our operations were divided into four major operating segments in 2008 to focus the distinct strategies of each of our operating businesses. Each operating segment is led by a Managing Director and a Financial Director and has embedded in it the direct operating cost and infrastructure to deliver its plan. Common support functions such as environmental health and safety, financial and accounting, information technology and some of our customer call centers are centralized; these consolidated departments’ allocate their costs to each operating segment.

 

As a result of this reorganization, we now have four reporting segments. We separate our segments first by whether we own the utility or we provide contract services to others. Our owned water and wastewater utilities are referred to as our Utilities operations (“Utilities”). In our financial statements we report our Texas Utilities operations (“Texas Utilities”) as a separate segment because of different economic characteristics. This is principally because the Texas Utilities predominantly under-recovered their current cost of service, which includes a reasonable return on equity. We have made large investments in these operations since acquisition which have not yet been recovered through the rates we charge. Our contract operations are generally segmented by contract type into those that are larger, stand alone operations (“O&M Services”) and those that are small, full service contracts operated by a common team of personnel resulting in a model that

 

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proportions a fractional cost to each client (“Texas MUD Services”).

 

Utilities consist of our owned water and wastewater utilities located in California, Alabama, Mississippi. In previous periods, the utilities segment included the business activities of our New Mexico Utility (“NMUI”) that was sold on May 8, 2009. The NMUI activities are now included in discontinued operations for all periods presented. See “Note 2 - Acquisitions, Assets Held for Sale and Dispositions” included in Part II Item 8 – “Financial Statements and Supplementary Data” for the summary of the historical results of discontinued operations. Residential customers make up the largest component of our Utilities customer base, with these customers representing approximately 94% of our water and wastewater connections. Substantially all of our Utilities customers are metered which allows us to measure and bill for each customer’s water consumption. Each of the operations in this segment has a unique service territory that is subject to state and federal regulations regarding standards of water quality, safety, environmental and other matters. The rates that we can charge for water and wastewater service include the opportunity to earn a reasonable rate of return on investments in these utilities as approved by state regulatory agencies; except for some of our Alabama wastewater rates which are governed by our service agreements. Some of these governmental agencies approve a forward looking recovery of costs and some approve recovery of costs based on a historical test year. Our Utilities operations require ongoing capital investments to maintain and enhance the reliability and quality of the service we provide, as well as the opportunity for revenue growth from rate increases and new connections.

 

Texas Utilities consists of 123 small, mostly rural systems that are grouped into nine jurisdictional utilities across Texas. Residential customers make up the largest component of our Texas Utilities customer base, with these customers representing approximately 98% of our water and wastewater connections. Substantially all of our Texas Utilities customers are metered which allows us to measure and bill for our customers’ water consumption. These systems are broadly dispersed geographically. The majority of the systems are organized as one utility with a single tariff, known as Monarch Utilities. The Monarch systems, as well as two smaller systems acquired in 2007, were in various stages of disrepair at the time of acquisition and we continue to spend significant amounts of capital to maintain regulatory compliance and to improve the quality of service. We are not yet recovering all of these costs in our rates and as a result, the Texas Utilities have a lower rate of return than typically expected from a utility. We intend to actively pursue recovery of these costs in the rate setting process. All other aspects of operations for these utilities are the same as our Utilities operations; therefore, as soon as we are recovering our costs, including a reasonable rate of return on investment, we expect to aggregate this segment with our Utilities segment.

 

O&M Services generally consists of operations that are project-specific contracts with cities, public agencies and private owners. Most contracts are stand-alone operations staffed with project-specific personnel, with an average contract life of two to three years. Under a typical O&M contract, we charge a fee that covers a specified level of service that includes facility operations and maintenance and may include other water or wastewater related services. Services are typically provided evenly throughout the contract period and are billed on a monthly basis. If we provide services beyond the scope of a contract, we bill for the additional services on a time-and-materials basis or negotiate a unique price. These contracts are largely located in California, Colorado, Alabama, Mississippi, and Georgia. We have one contract that represents approximately 22% of the revenue of this segment, which we are currently re-negotiating, and one that represents approximately 14%, which is due for renewal in November 2010. None of the remaining contracts represent more than 7% of this segment’s revenue.

 

Texas MUD Services is a full service provider of utility services to a large number of small utilities in Texas that are mostly owned by municipal utility districts (“MUD”). A MUD is created to provide water supply, wastewater treatment and drainage service to areas where municipal services are not available. We service over 270 MUD clients with a common team of client managers, operators, customer service and billing personnel. Therefore these contracts are allocated a proportional amount of each cost center creating a business model that is significantly different from that of

 

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O&M Services. Under a typical MUD contract, we bill a monthly base fee to provide a specified level of service; usually water and/or wastewater facility inspections, routine operations, equipment maintenance, and utility customer service including meter reading, call center, dispatch, billing and collection services. We 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 generally include inflation adjustments. The majority of our MUD contracts are cancelable with 30 to 60 day prior notice by either party, but tend to last for long periods due to the close working relationships between the operators and the clients. No one district represents more than 4% of the overall revenue of this segment and the majority represent less than 1% of revenue.

 

Impacts to Results of Operations 2007-2009

 

Utilities & Texas Utilities:  Our utilities segments’ results of operations are generally influenced by a variety of factors that are similar between the two segments and the industry in general. A more complete understanding of these factors can be gained by reviewing this section along with the Risk Factors section herein. As we review and discuss performance, the general areas of impact we evaluate are as follows:

 

·                  Growth Related:  Growth in our utilities segments is generally characterized by the following drivers; 1) growth in the number of connections served within existing utility certified service areas, or 2) acquisition of new service areas. In our Utilities segment, our largest utility is our California utility which is a substantially built out system that does not generally see much change in connection count. The majority of our other utilities are in markets that experienced significant new home construction prior to 2007 (ranging from 2% to 8% annual growth). We have seen this significantly decline with growth averaging less than 1% across all systems in 2008 and 2009. Growth through acquisitions was most significant in 2008 with the acquisition of a 4,000 connection wastewater utility system in Alabama in early 2008 as well as the full year impacts of some smaller acquisitions made in Texas in 2007. We did not purchase any utility assets during 2009.

 

·                  Rate Related:  Each of our utilities will increase rates from time to time as allowed by the regulator or governing contract, to recover expenses and realize a return on invested capital. Rate cases can take months or years to impact results due to the time needed to prepare, present and ultimately receive approval from the regulator. In each of our utilities, we have a long-term rate strategy that matches our expectation for growth, regulatory change and demand. Our California utility benefited from step rate increases in 2007 and 2008 and a general rate increase implemented January 1, 2009. Our Texas Utilities benefited from an interim rate increase in late 2007 from our Monarch rate filing, which was resolved through an all-party settlement in December 2008. The settlement also required us to refund $0.5 million in 2009 with a revenue reserve impacting 2008 results. We also reached all-party settlements in three smaller pending Texas rate cases implemented in the latter half of 2008 and a rate step-increase at one utility during 2009. In Alabama we have contractual agreements with the local government over our Shelby County and Riverview wastewater utilities that provide us with the ability to request rate increases annually, pursuant to the terms of the contracts. Accordingly, we requested and received increases in January of 2007, 2008 and 2009 of 8%, 8% and 13.9%, respectively at our Shelby County utility and a 4.5% increase in January of 2009 at our Riverview utility

 

·                  Demand Related:  The demand for our water is a major driver of our operating results. Our utility results are largely dependent upon the sale and distribution of water, the amount of which is dependent on seasonal weather fluctuations, particularly during the summer months when water demand will vary greatly with rainfall and temperature levels. Not only does rainfall vary from season to season, but from year to year. The uniform rate design that regulators require for our utilities can result in unrecovered

 

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fixed costs and lower earnings during periods of abnormally low water use. This can occur during abnormal weather conditions, such as when summer temperatures are cooler than normal or during mandatory restrictions on water use because of drought. Also, demand related changes can occur as a result of conservation and socio-economic impacts. Demand related changes often impact both the revenue of the utility and the cost of production. In 2008 and 2009 we saw increased demand and demand-related costs in Texas due to drought conditions. We saw lower demand at our California utility in both 2008 and 2009, largely due to conservation and socio-economic conditions associated with the decline in general economic conditions.

 

·                  Supply Related:  The cost of water and related commodities is a major driver of our results. Utilities that purchase water are subject to changes in operations due to the amount and cost of that water. Purchased water supply changes are typically driven by longer term climate issues such as extended drought but can also be driven by short-term maintenance needs. In 2008 and 2009, we saw increased cost of production in Texas as we purchased more water than in previous years at a higher cost per gallon, due to the inability of our owned sources of ground water to produce enough water to meet the heightened demand due to drought conditions. In California we saw the unit cost of water increase in 2009.  This is related to increases in the price of Metropolitan Water District purchases, and by the Main San Gabriel Watermaster action of lowering the safe yield in the basin.  In addition the Watermaster raised the rate for replacement water for water pumped in excess of water rights held. This caused an additional increase in cost of purchased water sources. It should be noted that changes in cost from levels adopted in rate cases receive balancing account treatment negating the cost increases on the income statement.

 

·                  Operation & Maintenance Related (O&M):  Our operation and maintenance costs include fuel, power, labor, labor benefits, facility costs, and other ordinary costs of producing or treating water. These costs are impacted by compliance with environmental and health safety standards. They are also typically subject to inflation effects and while we can file for recovery after inflation effects are incurred in backward looking rate making jurisdictions, we often experience a lag between the time we incur these costs and when we receive the rate increase to cover these costs. In California, which is a forward looking rate making environment, we estimate the impacts of inflation in our rate filings and must absorb any costs that are different than our estimates.

 

·                  General & Administrative Related (G&A):  Our general and administrative costs include expenses directly incurred by the segment such as management expense as well as costs for services performed by centralized support functions that are then allocated to each segment. These support costs include IT, shared financial services, customer service center and environmental health and safety. In 2007 and 2008, we made large investments in our consolidated support functions that have driven costs higher as we build a foundation upon which to drive sustainable continuous improvement into the organization. As the efficiencies of these investments take hold, we have targeted objectives to reduce the fixed costs of supporting our operations. However, we anticipate that in the near term we will continue to experience higher costs due to these consolidation efforts as well as the remediation of our material internal control weaknesses (see “Item 9A - Controls and Procedures” for a detailed discussion of our material internal control weaknesses).

 

·                  Other:  Other is reserved for unusual items that may impact results from time to time. Most significantly in 2008 our Texas Utilities impaired goodwill by $25.2 million.

 

O&M Services Segment:  Our O&M Services segment results of operations are generally influenced by a variety of factors. As we review and discuss performance, the general areas of impact we evaluate are as follows:

 

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·                  Contract Growth:  Growth is generally due to new contracts, additional project work under existing contracts and contract price increases. Our primary driver of contract growth in 2008 and 2009 has been from increased contract pricing and expanding the scope of work provided to existing customers.

 

·                  Lost Work:  Lost work is generally driven by lost contracts or a reduction in project work for existing contracts. We lost a number of contracts in 2007 and 2008 due to increased competition in our service territories, specifically in the southeast. We also cancelled two of our contracts in California in 2008 due in part to the financial under-performance of the contracts. In 2009 our portfolio stabilized but we continued to see fluctuations in the amount of project work we do for our clients.

 

·                  General & Administrative Related (G&A):  Our general and administrative costs include expenses directly incurred by the segment such as management expense as well as costs for services performed by centralized support functions that are then allocated to each segment. These support costs include IT, shared financial services, customer service center and environmental health and safety. In 2007 and 2008, we made large investments in our consolidated support functions that have driven costs higher as we build a foundation upon which to drive sustainable continuous improvement into the organization. As the efficiencies of these investments take hold, we have targeted objectives to reduce the fixed costs of supporting our operations. However, we anticipate that in the near term we will continue to experience higher costs due to these consolidation efforts as well as the remediation of our material internal control weaknesses (see “Item 9A – Controls and Procedures” for a detailed discussion of our material internal control weaknesses).

 

·                  Other:  Other is reserved for unusual items that may impact results from time to time, such as legal fees, fines or the elimination of certain service offerings. Most significantly in 2008 and 2009, we eliminated certain non-core service offerings including electrical contracting and construction management, and incurred legal fees including reserves for potential compliance related fines, some of which were favorably settled in 2008.

 

Texas MUD Services Segment:  Our Texas MUD Services segments’ results of operations are generally influenced by a variety of factors. As we review and discuss performance, the general areas of impact we evaluate are as follows:

 

·                  Contract Growth:  New contracts, additional project work and contract price increases are offset by lost contracts, reductions in project work, or a reduction in other ancillary services such as new taps and inspection services for new home construction. In 2008 and 2009 we lost a number of contracts due to increased competition in our service territories and our ancillary service work was significantly impacted due to reduced taps and inspection services associated with the slowdown in new home construction. However, we focused operations in 2009 on service and repair work and therefore experienced increased revenue from these activities.

 

·                  General & Administrative Related (G&A):  Our general and administrative costs include expenses directly incurred by the segment such as management expense as well as costs for services performed by centralized support functions that are then allocated to each segment. These support costs include IT, shared financial services, customer service center and environmental health and safety.

 

·                  Other:  Other is reserved for unusual items that may impact results from time to time. Most significantly in 2007 and 2008, we discontinued offering non-core service offerings including specialty pipe rehabilitation work and bookkeeping services.

 

Corporate Segment:  Our corporate segment represents costs related to executive management, investor relations, human resources, general legal and insurance, certain IT functions that support

 

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all operations and public company needs, audit costs, and other expenses generally related to the parent organization. Most of the costs are general and administrative in nature and not subject to much variation; however, on occasion, we do have other costs that flow through the segment. In 2009 we also incurred $12.6 million of costs related to the restatement of our prior period financial statements. In 2007 and 2008, the expenses associated with our Cornerstone project were largely supported by the corporate segment. This project upgraded our core IT infrastructure such as phones, servers and communications links and implemented a single company-wide financial ledger system. In the fourth quarter of 2008, the remaining portions of the project were put on hold and certain portions of the project were eliminated, resulting in an impairment of the capital investment of $1.3 million. Total project expenses were $1.9 million in 2007 and $5.4 million in 2008, which includes the costs to suspend the project. The total capital investment in 2007 and 2008 was $10.0 million and $8.4 million respectively, of which $9.4 million has been placed into service. In May 2009, the Company determined that it was not probable that the implementation of the remaining uncompleted software modules would be completed; as a result, we recorded an impairment charge of $8.0 million.

 

Acquisitions

 

Our financial position, results of operations and cash flows have been affected by our history of acquisitions. Our most recent significant acquisitions, which affect the comparability of the historical financial condition and results of operations described in the MD&A, are:

 

Utilities:

 

·                 a Birmingham, Alabama-based wastewater collection and treatment system that serves approximately 4,000 residential and commercial connections in a service area directly adjacent to our existing Shelby County collection and treatment system, acquired in January 2008;

 

·                   a Madison County, Alabama-based wastewater collection and treatment system servicing approximately 120 connections acquired in November 2007; and,

 

·                   a northern Mississippi-based water and wastewater utility serving approximately 275 water connections and servicing approximately 355 wastewater connections through four collection systems acquired in February 2007.

 

Texas Utilities:

 

·                 two San Antonio, Texas-based water utilities serving approximately 2,600 connections acquired in May 2007.

 

Assets Held for Sale and Dispositions

 

In December 2008, we completed the sale of our wholesale wastewater business in Texas for net cash proceeds of $2.2 million and a receivable of $0.6 million. We decided not to sell the wholesale water component of the business; accordingly, the business activity of the water component has been reflected in consolidated continuing operations for all periods presented.

 

We entered into an agreement to sell the assets of our Southwest Environmental Laboratories, Inc. subsidiary in 2009 for cash consideration of $0.5 million paid at close and up to an additional $0.8 million of consideration consisting of 25% of the buyer’s quarterly aggregate invoice amounts subsequent to the sale. The sale closed on April 1, 2009 however, the business activity prior to the sale has been reflected in consolidated continuing operations based on the ongoing business relationship with the buyer.

 

In January 2009 we reached a settlement in proceedings against NMUI, whereby we agreed to sell the NMUI business in settlement of threat of condemnation. On May 8, 2009 we received

 

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$53.9 million in cash at closing ($60.0 million settlement and $0.9 million escrow release, less $7.0 million paid to the condemning entity in settlement of sewer treatment fees) and recorded a gain of $26.2 million, net of $0.1 million of transaction costs. We used $12.3 million of the net proceeds to pay down NMUI bonds and related accrued interest and the remaining cash proceeds of $41.6 million was used to pay any unassumed liabilities of NMUI and to pay down our revolving credit facility. The sale reflects a $107.2 million reduction in assets, offset by reduction in liabilities of $79.5 million, which includes a $69.0 million reduction in contributions in aid of construction. The NMUI operations have been reflected in earnings (loss) from discontinued operations for all periods presented.

 

For income tax purposes, this transaction is considered an involuntary conversion under Section 1033 of the Internal Revenue Code, which allows for tax deferral on the gain if we acquire a qualified replacement property by December 31, 2011. We currently intend to acquire qualified replacement property; however, there can be no assurance that we will successfully complete such an acquisition.

 

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RESULTS OF OPERATIONS

 

2009 Compared to 2008

 

Consolidated operating revenue increased $0.4 million, or 0.2%, to $211.1 million for the year ended December 31, 2009 from $210.7 million for the prior year. Consolidated operating expenses decreased $14.9 million, or 6.2%, to $222.9 million for the year ended December 31, 2009 from $237.8 million for 2008. Resulting operating loss decreased $15.3 million to a loss of $11.8 million for the year ended December 31, 2009, from operating loss of $27.1 million for the prior year. The 2009 operating loss includes the impacts of $12.6 million of restatement related costs and $8.1 million of impairments of goodwill and other long-lived assets. The 2008 loss includes a $27.1 million impairment of goodwill and other long-lived assets. The operations of our New Mexico utility and our wholesale wastewater operations in Texas are not reflected in the results below, as they were sold in May 2009 and December 2008, respectively, and are therefore part of discontinued operations for all periods shown. In 2009 we decided not to sell our wholesale water operations in Texas which had previously been reported as part of discontinued operations, accordingly, these operations are now included as continuing operations as part of our Texas Utilities segment discussed below.

 

 

Year Ended 
December 31,

 

 

 

Percent of Revenue

(In thousands, except percentages)

2009

 

2008

 

Increase
(Decrease)

 

2009

 

2008

Utilities

 

 

 

 

 

 

 

 

 

Operating Revenue

$

65,168

 

$

60,927

 

$

4,241

 

100.0%

 

100.0%

Operating Expenses

45,880

 

41,202

 

4,678

 

70.4%

 

67.6%

Operating Income

$

19,288

 

$

19,725

 

$

(437)

 

29.6%

 

32.4%

 

 

 

 

 

 

 

 

 

 

Texas Utilities

 

 

 

 

 

 

 

 

 

Operating Revenue

$

36,525

 

$

34,784

 

$

1,741

 

100.0%

 

100.0%

Operating Expenses

29,068

 

53,821

 

(24,753)

 

79.6%

 

154.7%

Operating Income (Loss)

$

7,457

 

$

(19,037)

 

$

26,494

 

20.4%

 

(54.7)%

 

 

 

 

 

 

 

 

 

 

O&M Services

 

 

 

 

 

 

 

 

 

Operating Revenue

$

36,976

 

$

40,493

 

$

(3,517)

 

100.0%

 

100.0%

Operating Expenses

36,677

 

43,374

 

(6,697)

 

99.2%

 

107.1%

Operating Income (Loss)

$

299

 

$

(2,881)

 

$

3,180

 

0.8%

 

(7.1)%

 

 

 

 

 

 

 

 

 

 

Texas MUD Services

 

 

 

 

 

 

 

 

 

Operating Revenue

$

72,424

 

$

74,453

 

$

(2,029)

 

100.0%

 

100.0%

Operating Expenses

73,845

 

77,568

 

(3,723)

 

102.0%

 

104.2%

Operating Income (Loss)

$

(1,421)

 

$

(3,115)

 

$

1,694

 

(2.0)%

 

(4.2)%

 

 

 

 

 

 

 

 

 

 

Corporate

 

 

 

 

 

 

 

 

 

Operating Revenue

$

 

$

 

$

 

 

 

 

Operating Expenses

37,459

 

21,822

 

15,637

 

 

 

 

Operating Income (Loss)

$

(37,459)

 

$

(21,822)

 

$

(15,637)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

Operating Revenue

$

211,093

 

$

210,657

 

$

436

 

100.0%

 

100.0%

Operating Expenses

222,929

 

237,787

 

(14,858)

 

105.6%

 

112.9%

Operating Income (Loss)

$

(11,836)

 

$

(27,130)

 

$

15,294

 

(5.6)%

 

(12.9)%

 

Utilities

 

(In thousands)

Operating
Revenue

 

Operating
Expense

 

Operating
Income

Year ended December 31, 2008

$

60,927

 

$

41,202

 

$

19,725

Growth related

490

 

278

 

 

Rate related

4,916

 

 

 

Demand related

(2,606)

 

 

 

Balancing account

1,234

 

1,234

 

 

Supply related

 

(142)

 

 

O&M related

 

71

 

 

G&A related

 

2,916

 

 

Other

207

 

321

 

 

Year ended December 31, 2009

$

65,168

 

$

45,880

 

$

19,288

 

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Table of Contents

 

The principal operating trends driving this segment’s results in 2009 were rate increases and increased costs of purchased water. In California, we have seen reduced consumption due to customer conservation efforts; however, we have seen increased unit costs of delivered water driven by lower allowed pumping amounts from our owned wells and higher costs of purchased water. We believe these trends are likely to continue in 2010. Further details on 2009 results as compared to 2008 are discussed below.

 

Operating revenue increased $4.2 million, or 7.0%, to $65.2 million for the year ended December 31, 2009 from $60.9 million for the prior year. The net increase was primarily due to the following events:

 

·                  Growth Related: A $0.5 million increase primarily due to the acquisition of the Riverview wastewater treatment plant in Alabama at the end of January 2008.

 

·                  Rate Related: A $4.9 million increase due to rate increases in California and Alabama, of which $4.2 million is due to our California utility implementing a water general rate increase on January 1, 2009 and a water rate step increase on July 1, 2008.

 

·                  Demand Related: A $2.6 million decrease primarily due to reduced consumption at our California utility related to customers’ conservation efforts.

 

·                  Balancing Account: A $1.2 million increase related to balancing account surcharges approved by the CPUC and collected in California to recover certain deferred water supply costs which are further described in the Regulated Utility Accounting section in “Note 1 - Business, Basis of Presentation and Summary of Significant Accounting Policies” within Part II, Item 8, “Financial Statements and Supplementary Data.”

 

·                  Other: A $0.2 million increase related to a conservation rate adjustment on revenue.

 

Operating expenses increased $4.7 million, or 11.4%, to $45.9 million for the year ended December 31, 2009, from $41.2 million for the prior year. The net increase was primarily due to the following events:

 

·                  Growth Related: A $0.3 million increase due to acquisition of the Riverview wastewater treatment plant in Alabama at the end of January 2008.

 

·                  Balancing Account: A $1.2 million increase in costs recognized related to the balancing account surcharges which are further described in the Regulated Utility Accounting section in “Note 1 - Business, Basis of Presentation and Summary of Significant Accounting Policies” within Part II, Item 8, “Financial Statements and Supplementary Data.”

 

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·                  Supply Related: A $0.1 million decrease primarily due to less purchased water in California driven by lower demand offset by increased unit cost of purchased water in California.

 

·                  O&M Related: A $0.1 million increase primarily due to increased depreciation expense of $0.6 million offset by various cost savings, primarily a decrease in bonus compensation.

 

·                  G&A Related: A $2.9 million increase due to $1.0 million of allocations of operational management and overhead costs to our Southeast utilities, as well as increased costs associated with the upgrade of information technology and financial systems, lower overhead recovery due to fewer capital projects than in the comparable period, and insurance related expenses.

 

·                  Other: A $0.3 million increase, primarily due to an increase in legal expenses, offset by impairment of goodwill of $0.4 million at our Alabama utilities in the comparable period of 2008.

 

As a result of the above events, operating income decreased $0.4 million, or 2.2%, to $19.3 million for the year ended December 31, 2009, from $19.7 million for the prior year.

 

Texas Utilities

 

(In thousands)

Operating
Revenue

 

Operating
Expense

 

Operating
Income
(Loss)

Year ended December 31, 2008

$

34,784

 

$

53,821

 

$

(19,037)

Growth related

(32)

 

 

 

Rate related

625

 

 

 

Demand related

394

 

 

 

Supply related

 

412

 

 

O&M related

 

152

 

 

G&A related

 

(296)

 

 

Other

754

 

(25,021)

 

 

Year ended December 31, 2009

$

36,525

 

$

29,068

 

$

7,457

 

The principal operating trends driving this segment’s results in 2009 were rate increases and a multi-year drought that has increased consumption and reduced aquifer levels. With heavy rains in late 2009, we are seeing aquifers replenish, however we cannot provide assurance that they will replenish sufficiently to reduce the need to supplement our owned water sources. Further details on 2009 results as compared to 2008 are discussed below.

 

Operating revenue increased $1.7 million, or 5.0%, to $36.5 million for year ended December 31, 2009 from $34.8 million for the prior year. The increase was primarily due to the following events:

 

·                  Rate Related: A $0.6 million increase due to $1.5 million of rate increases at two utilities implemented in the latter half of 2008 and a rate step-increase at one utility during the first quarter of 2009. These increases were offset by a decrease of $1.0 million due to settlement rates implemented at our Monarch utility during the first quarter of 2009 which were below the rates charged in 2008.

 

·                  Demand Related: A $0.4 million increase due to increased consumption as a result of weather patterns that were hot and dry compared to 2008 weather.

 

·                  Other: A $0.8 million increase due to reserves taken in late 2008 for potential customer refunds in rate settlements.

 

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Operating expenses decreased $24.8 million, or 46.0%, to $29.1 million for the year ended December 31, 2009, from $53.8 million for the prior year. The net decrease was primarily due to the following events:

 

·                  Supply Related: A $0.4 million increase due to increased purchased water costs as a result of the inability of our owned sources of ground water to produce enough water reflecting ongoing drought conditions and well repairs requiring a temporary alternate source of supply.

 

·                  O&M Related: A $0.2 million increase primarily due to lower auto, labor and supply costs offset by increased depreciation and asset retirements.

 

·                  G&A Related: A $0.3 million decrease primarily due to lower professional fees related to the preparation of rate cases.

 

·                  Other: A $25.0 million decrease primarily due to $25.2 million impairment of goodwill and other long-lived assets in 2008.

 

As a result of the above events, operating income increased $26.5 million to $7.5 million for the year ended December 31, 2009, from an operating loss of $19.0 million in the prior year.

 

O&M Services

 

(In thousands)

Operating
Revenue

 

Operating
Expense

 

Operating
Income

Year ended December 31, 2008

$

40,493

 

$

43,374

 

$

(2,881)

Contract growth

2,985

 

1,107

 

 

Lost work

(6,225)

 

(6,540)

 

 

G&A related

 

(336)

 

 

Other

(277)

 

(928)

 

 

Year ended December 31, 2009

$

36,976

 

$

36,677

 

$

299

 

The principal operating trends driving this segment’s results in 2009 were terminated contracts and increased operating efficiencies. We believe that our portfolio of contracts have stabilized and anticipate that going forward we will return to an approximate 95% renewal rate on our contracts. We are also actively pursuing and winning new contracts. In contrast, project work is more difficult to project as it fluctuates from year to year depending on our clients’ capital improvement needs and budgetary constraints. We believe our direct cost cutting measures are largely complete and therefore do not anticipate continued improvements of this magnitude in 2010.

 

Operating revenue decreased $3.5 million, or 8.7%, to $37.0 million for the year ended December 31, 2009 from $40.5 million for the prior year. The net decrease in revenue was primarily due to the following events:

 

·                  Contract Growth: A $3.0 million increase, primarily due to increased project work and scope increases with continuing clients.

 

·                  Lost Work: A $6.2 million decrease due to $4.0 million from lost contracts, (including $2.1 million related to two underperforming contracts that were terminated by management in late 2008,) as well as $2.2 million from reduced project work with continuing clients.

 

·                  Other: A $0.3 million decrease primarily due to the elimination of certain non-core service offerings in Colorado.

 

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Operating expenses decreased $6.7 million, or 15.4% to $36.7 million for the year ended December 31, 2009, from $43.4 million for the prior year. The net decrease was primarily due to the following events:

 

·                  Contract Growth: A $1.1 million increase primarily due to project work with continuing clients and expanded scope on contracts with continuing clients.

 

·                  Lost Work: A $6.5 million decrease due to lost contracts and reduced project work.

 

·                  G&A Related: A $0.3 million decrease primarily due to various savings and efficiency gains in general and administrative costs.

 

·                  Other: A $0.9 million decrease primarily due to favorable settlements of certain fines that had been reserved in 2008.

 

As a result of the above events, operating income was $0.3 million for the year ended December 31, 2009 compared to an operating loss of $2.9 million in the prior year.

 

Texas MUD Services

 

(In thousands)

Operating
Revenue

 

Operating
Expense

 

Operating
Income

Year ended December 31, 2008

$

74,453

 

$

77,568

 

$

(3,115)

Contract Growth

(2,029)

 

(2,614)

 

 

G&A related

 

(1,216)

 

 

Other

 

107

 

 

Year ended December 31, 2009

$

72,424

 

$

73,845

 

$

(1,421)

 

The principal operating trends driving this segment’s results in 2009 were terminated contracts, increased service order work and increased efficiencies. We have experienced aggressive competition in our markets and although we believe the situation is stabilizing, we may experience some continued contract loss. Service order work was a focus of operations in 2009 and due to the amount completed we do not anticipate we will sustain this level of work in 2010. We believe our direct cost cutting measures are largely complete and therefore do not anticipate continued improvements of this magnitude in 2010. Further details on 2009 results as compared to 2008 are discussed below.

 

Operating revenue decreased $2.0 million, or 2.7%, to $72.4 million for year ended December 31, 2009 from $74.5 million for the prior year. The net decrease was primarily due to the following events:

 

·                  Contract Growth: A $2.0 million decrease in revenue due to a $5.0 million decrease from lost contracts, a $2.4 million decrease related to the sale of our environmental testing laboratory on April 1, 2009, a $2.0 million decrease in housing related services as a result of the slowdown in the new housing market, offset by a $7.4 million increase primarily due to increases in service order work.

 

Operating expenses decreased $3.7 million, or 4.8%, to $73.8 million for the year ended December 31, 2009, from $77.6 million for the prior year. The net decrease was primarily due to the following events:

 

·                  Contract Growth: A $2.6 million decrease due to $5.3 million from lost contracts and $2.3 million due to the sale of our environmental testing laboratory and $0.3 million from reduced housing related services, offset by a $5.3 million increase primarily related to increases in service order work.

 

·                  G&A Related: A $1.2 million decrease primarily due to various savings and efficiency gains in general and administrative costs.

 

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·                  Other: A $0.1 million increase related to the settlement of a legal issue, offset by impairment of long-lived assets in the comparable period of 2008.

 

As a result of the above events, operating loss decreased $1.7 million to a loss of $1.4 million for the year ended December 31, 2009, compared to loss of $3.1 million for the prior year.

 

Corporate

 

Operating expenses increased $15.6 million, or 71.7%, to $37.5 million for the year ended December 31, 2009, from $21.8 million for the prior year.

 

The net increase was primarily due to the following events:

 

·                  Project Costs: A $3.4 million decrease as a result of costs incurred in 2008 related to our Cornerstone internal-use software development project. In October 2008, we announced the suspension of the project due to the uncertain financial markets that led to the decision to minimize all cash expenditures.

 

·                  Other: A $18.7 million increase, primarily driven by $12.6 million of financial restatement related costs, including audit fees and accounting resource expenses to support the restatement of historical financial results, and $8.0 million related to a write-off of Cornerstone assets net of recoveries from vendors, offset by reduced expenses related to the write-off of $1.3 million of Cornerstone assets in December 2008, reduced expenses related to incurred bank amendment fees in the fourth quarter of 2008, as well as reduced costs associated with consulting expenses incurred in 2008.

 

Depreciation and amortization

 

Depreciation and amortization expense was $14.9 million in 2009 and $14.3 million in 2008. The increase was principally a result of additions to property, plant and equipment during the year by $16.5 million.

 

Other Income (Expense)

 

Aggregate other expenses increased $1.8 million, or 22.6% to $9.7 million for the year ended December 31, 2009, compared to $7.9 million for the prior year as follows:

 

(In thousands)

2009

 

2008

 

Change

Interest expense

$

(9,856)

 

$

(8,402)

 

$

(1,454)

Interest income

190

 

520

 

(330)

Other, net

 

 

Total

$

(9,666)

 

$

(7,882)

 

$

(1,784)

 

Interest Expense.  Interest expense increased by $1.5 million, or 17.3%, to $9.9 million for the year ended December 31, 2009 from $8.4 million for the same period during the prior year.

 

The change in total interest incurred is primarily due to an increase in amortization of debt financing cost on our revolving line of credit. In addition, the weighted average annual interest rate on total borrowings increased to approximately 5.8% for the year ended December 31, 2009 from 4.0% for the same period in the prior year.

 

Interest Income.  Interest income decreased $0.3 million for the year ended December 31, 2009 principally as a result of a decline in interest rate in our various interest bearing operating accounts.

 

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Table of Contents

 

Provision for Income Taxes

 

Our effective consolidated income tax rate on continuing operations was a benefit of 34.7% for the year ended December 31, 2009 compared to 21.2% for 2008. The fluctuation in rates primarily relates to the non-deductible goodwill impairments in 2008

 

Income loss from Discontinued Operations

 

Income net of tax from discontinued operations, which pertains primarily to NMUI which was sold in May 2009, was $18.1 million for the year ended December 31, 2009.

 

2008 Compared to 2007

 

Consolidated operating revenue increased $5.9 million, or 2.9%, to $210.7 million for the year ended December 31, 2008 from $204.8 million for the prior year. Consolidated operating expenses increased $40.5 million, or 20.5%, to $237.8 million for the year ended December 31, 2008 from $197.3 million for 2007. Resulting operating income decreased $34.7 million to a loss of $27.1 million for the year ended December 31, 2008 from operating income of $7.5 million for the prior year. The 2008 operating loss includes the impacts of $27.1 million of impairments of goodwill and other long-lived assets as well as other costs described below. The operations of our New Mexico utility and our wholesale wastewater operations in Texas are not reflected in the results below, as they were sold in May 2009 and December 2008, respectively, and are therefore part of discontinued operations for the periods prior to sale. Our wholesale water operations in Texas are included in Texas Utilities below as we decided not to sell these operations in 2009 and therefore have included them as continuing operations as part of our Texas Utilities segment discussed below.

 

 

 

Year Ended
December 31,

 

 

 

Percent of Revenue

 

(In thousands)

 

2008

 

2007

 

Increase
(Decrease)

 

2008

 

2007

 

Utilities

 

 

 

 

 

 

 

 

 

 

 

Operating Revenue

 

$

60,927

 

$

56,653

 

$

4,274

 

100.0%

 

100.0%

 

Operating Expenses

 

41,202

 

33,998

 

7,204

 

67.6%

 

60.0%

 

Operating Income

 

$

19,725

 

$

22,655

 

$

(2,930)

 

32.4%

 

40.0%

 

Texas Utilities

 

 

 

 

 

 

 

 

 

 

 

Operating Revenue

 

$

34,784

 

$

27,911

 

$

6,873

 

100.0%

 

100.0%

 

Operating Expenses

 

53,821

 

29,141

 

24,680

 

154.7%

 

104.4%

 

Operating Income (Loss)

 

$

(19,037)

 

$

(1,230)

 

$

(17,807)

 

(54.7)%

 

(4.4)%

 

O&M Services

 

 

 

 

 

 

 

 

 

 

 

Operating Revenue

 

$

40,493

 

$

40,922

 

$

(429)

 

100.0%

 

100.0%

 

Operating Expenses

 

43,374

 

42,291

 

1,083

 

107.1%

 

103.3%

 

Operating Income (Loss)

 

$

(2,881)

 

$

(1,369)

 

$

(1,512)

 

(7.1)%

 

(3.3)%

 

Texas MUD Services

 

 

 

 

 

 

 

 

 

 

 

Operating Revenue

 

$

74,453

 

$

79,321

 

$

(4,868)

 

100.0%

 

100.0%

 

Operating Expenses

 

77,568

 

76,480

 

1,088

 

104.2%

 

96.4%

 

Operating Income (Loss)

 

$

(3,115)

 

$

2,841

 

$

(5,956)

 

(4.2)%

 

3.6%

 

Corporate

 

 

 

 

 

 

 

 

 

 

 

Operating Revenue

 

$

 

$  —

 

$  —

 

 

 

 

 

Operating Expenses

 

21,822

 

15,358

 

6,464

 

 

 

 

 

Operating Income (Loss)

 

$

(21,822)

 

$

(15,358)

 

$

(6,464)

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

Operating Revenue

 

$

210,657

 

$

204,807

 

$

5,850

 

100.0%

 

100.0%

 

Operating Expenses

 

237,787

 

197,268

 

40,519

 

112.9%

 

96.3%

 

Operating Income (Loss)

 

$

(27,130)

 

$

7,539

 

$

(34,669)

 

(12.9)%

 

3.7%

 

 

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Table of Contents

 

Utilities

 

(In thousands)

 

Operating
Revenue

 

Operating
Expense

 

Operating
Income

 

Year ended December 31, 2007

 

$

56,653

 

$

33,998

 

$

22,655

 

Growth related

 

5,382

 

4,648

 

 

 

Rate related

 

2,233

 

277

 

 

 

Demand related

 

(3,341)

 

(89)

 

 

 

Supply related

 

 

 

 

 

O&M related

 

 

1,598

 

 

 

G&A related

 

 

318

 

 

 

Other

 

 

452

 

 

 

Year ended December 31, 2008

 

$

60,927

 

$

41,202

 

$

19,725

 

 

Operating revenue increased $4.3 million, or 7.5%, to $60.9 million for year ended December 31, 2008 from $56.7 million for the prior year. The net increase was primarily due to the following events:

 

·     Growth Related: A $5.4 million increase primarily due to the acquisition of the Riverview wastewater treatment plant in Alabama at the end of January 2008.

 

·     Rate Related: A $2.2 million increase due to rate increases in California and Alabama. The majority of the increase is due to our California utility implementing a 3.0% water rate step increase on July 1, 2008 and a 1.6% water rate step increase on July 1, 2007, representing increased revenue of $2.0 million.

 

·     Demand Related: A $3.3 million decrease primarily due to reduced consumption at our California utility related to customers’ conservation efforts as well as weather patterns that were cooler with more precipitation in spring of 2008 compared to spring of 2007.

 

Operating expenses increased $7.2 million, or 21.2%, to $41.2 million for the year ended December 31, 2008, from $34.0 million for the prior year. The net increase was primarily due to the following events:

 

·     Growth Related: A $4.6 million increase due to acquisitions, primarily the Riverview wastewater treatment plant in Alabama at the end of January 2008.

 

·     Rate Related: A $0.3 million increase due to rate case expenses.

 

·     Demand Related: A $0.1 million decrease due to $1.5 million decrease in production costs primarily as a result of reduced consumption in California offset by higher average unit costs of delivered water.

 

·     O&M Related: A $1.6 million increase for operations and maintenance costs, primarily related to $1.1 million in staffing additions and salary increases and $0.4 million in increased depreciation expenses at our California utility.

 

·     G&A Related: A $0.3 million increase due to increased costs associated with the implementation of our strategy to consolidate support functions.

 

·     Other: A $0.5 million increase due to goodwill impairment at our Alabama utilities.

 

As a result of the above events, operating income decreased $2.9 million, or 12.9%, to $19.7 million for the year ended December 31, 2008, from $22.7 million for the prior year. The 2008 operating income includes the impacts of the $0.5 million of Other costs described above.

 

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Texas Utilities

 

(In thousands)

 

Operating
Revenue

 

Operating
Expense

 

Operating
Income
(Loss)

 

Year ended December 31, 2007

 

$

27,911

 

$

29,141

 

$

(1,230)

 

Growth related

 

756

 

254

 

 

 

Rate related

 

4,869

 

107

 

 

 

Demand related

 

1,248

 

820

 

 

 

Supply related

 

-

 

616

 

 

 

O&M related

 

-

 

589

 

 

 

G&A related

 

-

 

1,053

 

 

 

Other

 

-

 

21,241

 

 

 

Year ended December 31, 2008

 

$

34,784

 

$

53,821

 

$

(19,037)

 

 

Operating revenue increased $6.9 million, or 24.6%, to $34.8 million for year ended December 31, 2008 from $27.9 million for the prior year. The increase was primarily due to the following events:

 

·     Growth Related: A $0.8 million increase due to acquisitions and growth in connections served, primarily due to a full year of operations from two San Antonio-based utilities acquired in May 2007.

 

·     Rate Related: A $4.9 million increase due to rate increases with $3.6 million due to the implementation of our Monarch filed rates in October 2007, which included a refund of $0.6 million, and the remainder due to the implementation of new rates at four smaller utilities.

 

·     Demand Related: A $1.2 million increase due to increased consumption as a result of weather patterns that were hot and dry compared to 2007 weather patterns.

 

Operating expenses increased $24.7 million, or 84.7%, to $53.8 million for the year ended December 31, 2008, from $29.1 million for the prior year. The net increase was primarily due to the following events:

 

·     Growth Related: A $0.3 million increase due to a full year of operations from two San Antonio-based utilities acquired in May 2007.

 

·     Rate Related: A $0.1 million increase due to rate case expenses.

 

·     Demand Related: A $0.8 million increase in costs associated with increased consumption as a result of weather patterns that were hot and dry compared to 2007 weather patterns.

 

·     Supply Related: A $0.6 million increase due to increased purchased water as a result of the inability of our owned sources of ground water to produce enough water to meet the heightened demand due to drought conditions.

 

·     O&M Related: A $0.6 million increase for operations and maintenance costs, primarily related to retirements of assets of $0.3 million and increased repair and maintenance and labor expense of $0.5 million, offset by lower general operating expenses.

 

·     G&A Related: A $1.1 million increase due to general and administrative costs, primarily due to increased costs associated with our strategy to consolidate support functions, bad debt and professional fees.

 

·     Other: A $21.2 million increase primarily related to impairment of goodwill and other long-lived assets of $25.2 million in 2008 as compared to $4.2 million in 2007. During

 

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annual impairment testing at October 31, 2008, global market events, including the credit market crisis, resulted in declines in valuation multiples of comparable water utilities and a decline in our stock price. These combined factors led to a lower estimated fair value for all of our reporting units. Discounted cash flow models were updated based upon the current expectations of future period performance and consideration for past performance. The discount rate was adjusted for Texas Utilities from 10% in 2007 to 11% in 2008. The increase in discount rates reflects the factors that are commonly considered in determining premiums, including, risks related to financial projections, access to capital markets, litigation/regulatory risk, among others. In addition, the discount rates were higher related to the general cost of capital increase associated with both debt and equity markets.

 

As a result of the above events, operating loss increased $17.8 million to a loss of $19.0 million for the year ended December 31, 2008, from a loss of $1.2 million for the prior year. The 2008 operating loss includes the impacts of $21.2 million of Other costs described above.

 

O&M Services

 

(In thousands)

 

Operating
Revenue

 

Operating
Expense

 

Operating
Income

 

Year ended December 31, 2007

 

$

40,922

 

$

42,291

 

$

(1,369)

 

Contract growth

 

3,634

 

3,340

 

 

 

Lost work

 

(1,324)

 

(1,143)

 

 

 

G&A related

 

-

 

711

 

 

 

Other

 

(2,739)

 

(1,825)

 

 

 

Year ended December 31, 2008

 

$

40,493

 

$

43,374

 

$

(2,881)

 

 

Operating revenue decreased $0.4 million, or 1.0%, to $40.5 million for the year ended December 31, 2008 from $40.9 million for the prior year. The decrease in revenue was primarily due to the following events:

 

·     Contract Growth: A $3.6 million increase, primarily due to $2.6 million of increased project work and price increases in California in 2008 and $1.0 million in the southeast.

 

·     Lost Work: A $1.3 million decrease due to lost contracts and reduced project work, primarily driven by $1.2 million of lost contracts, the majority of which were in our Southeast division.

 

·     Other: A $2.7 million decrease as we stopped pursuing electrical contract projects in Colorado.

 

Operating expenses increased $1.1 million, or 2.6% to $43.4 million for the year ended December 31, 2008, from $42.3 million for the prior year. The net increase was primarily due to the following events:

 

·     Contract Growth: A $3.3 million increase due to new and expanded scope on contracts identified above.

 

·     Lost Work: A $1.1 million decrease due to lost contracts and reduced project work.

 

·     G&A Related: A $0.7 million increase due to general and administrative costs related to our strategy to consolidate support functions.

 

·     Other: A $1.8 million decrease primarily as a result of $2.5 million in lower costs as we stopped pursuing electrical contracts and a decrease of $0.6 million related to impairments in 2007, partially offset by $1.3 million of increased legal costs incurred including reserves for potential compliance-related fines related to alleged violations in

 

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prior years.

 

As a result of the above events, operating loss increased $1.5 million to $2.9 million for the year ended December 31, 2008, from $1.4 million for the prior year.

 

Texas MUD Services

 

(In thousands)

 

Operating
Revenue

 

Operating
Expense

 

Operating
Income

 

Year ended December 31, 2007

 

$

79,321

 

$

76,480

 

$

2,841

 

Contract Growth

 

(2,895)

 

59

 

 

 

G&A related