Financial controls spring leak in water firm's growing unit.

SOUTHWEST Water Co.'s growing services business has been a big factor in the 55 percent increase in its stock price over the past year.

Revenues in the services division increased by 47 percent in 2003, contributing $116 million of the $172 million generated by the West Covina-based company and helping propel overall revenue growth of 32 percent.

"It's been a terrific performer," said Neil Berlant, a water industry analyst at Seidler Cos. and a fan of new technologies such as reverse osmosis being implemented by Southwest Water.

But rising expenses have been a concern, and last week the company disclosed that it's also having problems with internal financial controls.

In a conference call, Chief Financial Officer Richard Shields said management found deficiencies in the accounting procedures that resulted in a several-hour delay of fourth-quarter earnings, although the problems are not significant enough to cause an earnings restatement in any prior period.

He said little else, referring questions to the company's 10-K, filed with the Securities and Exchange Commission last week.

"These identified deficiencies impacted the quality and timeliness of the reporting and reconciliation of certain transactions in the service group," the 10-K stated. "The matters involving the reportable condition have been discussed in detail among management, the audit committee of our board of directors and our independent accountants."

Sandy Warren, a spokesman for Southwest Water, said he could not elaborate on the problems. Peter Moerbeek, promoted last month to president and chief operating officer, was unavailable for comment, Warren said.

The company said in the filing that it plans to hire more experienced accountants, increase oversight of financial reporting, expand its internal audit procedures and implement additional financial controls over the next six to nine months.

Strong earnings

Accounting problems notwithstanding, Southwest Water reported strong quarterly earnings last week.

For the fourth quarter ended Dec. 31, net income was $2 million, or 13 cents per diluted share, compared with $1.4 million (10 cents) for the like period a year earlier. Fourth quarter revenues rose 24.6 percent, to $44 million.

Southwest Water, founded in 1946 by a farmer with 1,000 acres in the San Gabriel Valley, now provides services to 2 million people in 36 states. It operates wastewater facilities and services utility customers in Los Angeles and Orange counties, Albuquerque, N.M., and Austin, Texas.

Two service units continue to be its strongest drivers of revenue: Aqua Services, a water and wastewater treatment facility in Houston, and Eco Resources Inc., also in Houston, which manages utility systems and a water treatment facilities, including one being built in San Juan Capistrano.

Operating expenses for the services division rose 49 percent in 2003, to $101.4 million, compared with $68 million in 2002.

Most of the expenses came from the acquisition in 2002 of Aqua Services and costs related to construction of the publicly financed water treatment facility in San Juan Capistrano, according to SEC filings.

Because many cities in Southern California are reliant on water from the Colorado River, Southwest Water has offered what it claims is a less expensive solution for cities.

In San Juan Capistrano, the company won a 20-year, $20 million operating contract to design, build and run reverse-osmosis water treatment facility. The plant is scheduled for completion later this year and will draw mineralized ground water that will be treated through a process that uses high pressure to filter out impurities in the water.

In its traditional water business, Southwest Water benefited last year from decisions that allowed its California utility to raise rates 17 percent for its customers in Southern California. Those increases added $4.3 million into Southwest's annual revenues.

At the same time, Los Angeles had more rainfall in 2003 than in 2002, one of the driest years on record. As a result, water demand from customers in California fell by 5 percent--a good sign for the state as a whole, but not so for a company that sells water.

Southwest Water Co.

[GRAPHIC OMITTED]

YEAR (Dec. 31)                   2003       2002

Revenue (millions)            $172.91    $130.8
Total Expenses (millions)      158.2        120
Operating Income (millions)     14.8       10.8
Net Income (millions)            7.2          6
Earnings Per Share             $0.49      $0.44

SUMMARY

Business: Water extraction and distribution

Headquarters: West Covina

CEO: Anton C. Gamier

Market Cap: $223 million Dividend Yield: 1.3%

Total Liabilities: $2"10.8 million P/E Ratio: 36.4

Long-Term Debt: $73.1 million