Ten Year Financial Review
(Dollars in thousands except common share and other data) 1997 1996 1995 1994 1993 1992 1991 1990 1989 1988 SUMMARY OF OPERATIONS Operating revenue Residential $143,327 $134,035 $119,814 $114,751 $111,526 $101,842 $87,560 $90,178 $84,295 $81,404 Business 32,916 30,924 28,230 27,023 25,247 23,670 20,759 20,910 19,870 19,480 Industrial 6,282 6,150 5,836 5,478 5,123 4,925 4,490 5,146 5,166 4,754 Public authorities 9,636 9,023 8,149 7,995 7,396 6,892 5,734 6,412 6,225 6,232 Other 3,163 2,632 3,057 2,024 2,424 2,476 8,633 1,741 1,932 1,885 Total operating revenue 195,324 182,764 165,086 157,271 151,716 139,805 127,176 124,387 117,488 113,755 Operating expenses 160,975 152,397 139,694 131,766 123,861 116,031 102,855 101,017 95,150 91,265 Interest expense, other income and expenses, net 11,044 11,300 10,694 11,097 12,354 11,245 10,393 9,004 8,566 8,416 Net income $23,305 $19,067 $14,698 $14,408 $15,501 $12,529 $13,928 $14,366 $13,772 $14,074 COMMON SHARE DATA* Earnings per share $1.83 $1.50 $1.16 $1.22 $1.35 $1.09 $1.21 $1.25 $1.20 $1.22 Dividends declared 1.055 1.040 1.020 0.990 0.960 0.930 0.900 0.870 0.840 0.800 Dividend payout ratio 58% 69% 88% 81% 71% 85% 74% 70% 70% 65% Book value $13.00 $12.22 $11.72 $11.56 $10.90 $10.51 $10.35 $10.04 $9.66 $9.30 Market price at year-end 29.53 21.00 16.38 16.00 20.00 16.50 14.00 13.38 14.00 12.75 Common shares outstanding at year-end (in thousands) 12,619 12,619 12,538 12,494 11,378 11,378 11,378 11,378 11,378 11,344 Return on average common shareholders' equity 14.6% 12.7% 10.2% 10.6% 12.4% 10.4% 11.7% 12.4% 12.4% 13.2% Long-term debt interest coverage 4.2 3.6 3.2 3.2 3.2 2.9 3.2 3.6 3.4 3.8 BALANCE SHEET DATA Net utility plant $460,407 $443,588 $422,175 $407,895 $391,703 $374,613 $349,937 $325,409 $307,802 $289,363 Utility plant expenditures 32,907 35,683 27,250 28,275 28,829 35,188 34,459 26,861 27,277 23,994 Total assets 531,297 512,390 497,626 462,794 446,619 403,448 393,609 369,055 339,348 313,561 Long-term debt 139,205 142,153 145,540 128,944 129,608 122,069 103,505 104,905 86,012 86,959 Capitalization ratios: Common shareholders equity 53.5% 51.4% 49.7% 52.2% 48.2% 48.8% 52.4% 51.3% 55.1% 53.8% Preferred stock 1.1% 1.2% 1.2% 1.3% 1.4% 1.4% 1.5% 1.6% 1.8% 1.8% Long-term debt 45.4% 47.4% 49.1% 46.5% 50.4% 49.8% 46.1% 47.1% 43.1% 44.4% OTHER DATA Water production (million gallons) Wells 56,612 53,372 49,755 50,325 47,205 52,000 48,930 51,329 51,350 48,828 Purchased 53,190 51,700 49,068 49,300 48,089 40,426 36,686 45,595 45,978 48,254 Total water production 109,802 105,072 98,823 99,625 95,294 92,426 85,616 96,924 97,328 97,082 Metered customers 302,100 298,400 289,200 286,700 282,100 278,700 275,200 272,100 269,200 267,000 Flat rate customers 77,400 77,700 77,900 78,800 80,800 82,000 82,400 81,200 79,400 77,800 Customers at year-end 379,500 376,100 367,100 365,500 362,900 360,700 357,600 353,300 348,600 344,800 New customers added 3,400 9,000 1,600 2,600 2,200 3,100 4,300 4,700 3,800 7,000 Revenue per customer $515 $486 $450 $430 $418 $388 $356 $352 $337 $330 Utility plant per customer $1,707 $1,644 $1,592 $1,530 $1,469 $1,406 $1,327 $1,251 $1,198 $1,140 Employees at year-end 649 633 630 624 614 610 593 581 565 550 * Common share data is restated to reflect the effective two-for-one stock split on December 31, 1997.
Management's Discussion and Analysis of Financial Condition and Results of Operations In April 1997, shareholders of California Water Service Company ("Company") voted to approve a holding company structure. After receiving final regulatory approval required to complete the process, on December 31, 1997, California Water Service Group ("Group") was formed. Through the holding company formation procedure, the Company became one of the Group's two operating subsidiaries. The Company will continue to operate as a regulated utility. Its assets and operating revenues currently comprise virtually all of the Group's assets and revenues. The other subsidiary, CWS Utility Services, is a new entity that will provide non-regulated water operations and related services. The following discussion and analysis provides information regarding the Group, its assets and operations. In conjunction with formation of the holding company structure, each common share of Company stock was exchanged on a two-for-one basis for common shares of Group. Per share data has been restated where necessary to reflect the effective two-for-one stock split. FORWARD LOOKING STATEMENTS The Management's Discussion and Analysis section and other sections of this annual report contain forward looking statements. Such statements are inherently based on currently available information and expectations, estimates, assumptions and projections, and management's judgment about the Group, the water utility industry and general economic conditions. Such words as expects, intends, plans, believes, estimates, anticipates or variations of such words or similar expressions are intended to identify forward looking statements. The forward looking statements are not guarantees of future performance. Actual results may vary materially from what is contained in a forward looking statement. Factors which may cause a result different than expected include regulatory decisions, legislation and the impact of weather on operating results. The Group assumes no obligation to provide public updates of forward looking statements. BUSINESS The Company is a public utility supplying water service to 379,500 customers in 57 California communities through 21 separate water systems or districts. In the Company's 20 regulated systems, which serve 373,500 customers as shown on the map on page 7, rates and operations are subject to the jurisdiction of the California Public Utilities Commission ("CPUC"). An additional 6,000 customers receive service through a long-term lease of the City of Hawthorne water system, which is not subject to CPUC regulations. The Company also has contracts with various municipalities to operate water systems and provide billing services to an additional 29,500 customers. The Company also operates two reclaimed water systems under contract. The CPUC requires that water rates for each regulated district be determined independently. Rates for the City of Hawthorne system are established in accordance with an operating agreement and are subject to ratification by the City council. Fees for other operating agreements are based on contracts negotiated among the parties. RESULTS OF OPERATIONS Earnings and Dividends. 1997 net income was $23,305,000 compared to $19,067,000 in 1996 and $14,698,000 in 1995. Earnings per common share were $1.83 in 1997, $1.50 in 1996 and $1.16 in 1995. 1997 revenue, net income and earnings per share represent the highest levels ever achieved by the Group. The weighted average number of common shares outstanding in each of the three years was 12,619,000, 12,580,000 and 12,506,000, respectively. At its January 1997 meeting, the Board of Directors increased the common stock dividend rate for the 30th consecutive year. 1997 also marked the 53rd consecutive year that a dividend had been paid on the Company's common stock. The annual dividend rate paid in 1997 was $1.055, an increase of 1.4% over the 1996 rate of $1.04 per share which was an increase of 2.0% compared with the 1995 dividend of $1.02 per share. The dividend increases were based on projections that the higher dividend could be sustained while still providing the Group with adequate financial flexibility. Earnings not paid as dividends are reinvested in the business. The dividend payout ratio was 58% in 1997, 69% in 1996 and 88% in 1995, an average of 72% for the three- year period. The variation in payout ratios among the three years is primarily attributable to earnings per share fluctuations. Operating Revenue. Operating revenue, including revenue from City of Hawthorne customers, was a record $195.3 million, exceeding the record set the previous year of $182.8 million, a $12.6 million or 7% increase. 1995 revenue was $165.1 million. General and step rate increases contributed $6.4 million, while offset rate adjustments, primarily for purchased water cost increases, added $0.2 million. Increased customer usage added $3.9 million. Average revenue per customer for each of the three years ended December 31, 1997 and was $515, $486 and $450, respectively. The revenue changes were mainly driven by consumption levels and rate increases. Rainfall for the 1996-97 season was concentrated in December 1996 and January 1997, then virtually ceased. The summer months were dry and warm, resulting in the highest average recorded consumption level for metered accounts at 315 ccf., a 4% increase for the year. The increase in average consumption followed a very strong consumption year in 1996. The increase in revenue during the first half of 1997 benefited from the June, 1996 rate case decision affecting 47% of customers. The CPUC decision for the applications filed in 1996 became effective in April 1997, affecting 11% of the customers. The customer count increased 0.9% to 379,500. Sales to 3,352 new customers increased revenue $2.1 million. The City of Hawthorne system was operated for the full year in 1997, while the 1996 operation was for a ten-month period. Operating revenue in 1996 increased $17.7 million, or 11% greater than 1995's operating revenue. Offset rate adjustments, primarily for purchased water cost increases, added $2.2 million to revenue, while general and step rate increases contributed $7.8 million. Increased customer usage added $3.1 million. Average billed water consumption per metered customer was 303 ccf, a 6% increase for the year. Following a wet first quarter, during which heavy rainfall assured an adequate supply for the year, warm, dry spring and summer weather caused an increase in consumption. In June, rate increases in five districts, covering 47% of customers, became effective and added significantly to revenue in the second half of the year. The number of customers increased 2.4% for the year due to the addition of the 6,000 City of Hawthorne customers in March and other customers added in existing service areas. Sales to a total of 9,000 new accounts provided $4.6 million in additional revenue. The 1995 revenue increase was $7.8 million, or 5% greater than 1994. Offset rate adjustments, mainly for purchased water cost increases, added $3.8 million while general and step rate increases contributed $2.2 million. Increased customer usage added $1.1 million. Average billed water consumption per metered customer was 286 ccf., an increase of 1 ccf for the year. Only consumption in the fourth quarter exceeded that of the prior year, the first three 1995 quarters recorded usage which was less than 1994's. The consumption pattern reflects 1995's weather. The winter was unusually wet. Rain and cool weather continued through the spring and negatively influenced summer usage. With the exception of August, which showed a slight increase in consumption, all months through the third quarter recorded a sales decline from the prior year. Lack of rain and mild weather in the fourth quarter resulted in increased average customer usage of 14%. Sales to 1,600 new customers during the year accounted for $0.7 million in additional revenue. Operating and Interest Expenses. Operating expenses, including those for the Hawthorne operation, increased $8.6 million in 1997, $12.7 million in 1996 and $7.9 million in 1995. Well production supplied 51.2% of the water delivered to all systems in 1997, while 48.4% was purchased from wholesale suppliers and 0.4% came from the Company's Bear Gulch district watershed. Water production was 110 billion gallons, up 5% from 1996's 105 billion gallons. Production in 1995 was 99 billion gallons. The production levels in 1997 and 1996 reflect increased customer usage. Total cost of water production, including purchased water, purchased power and pump taxes, was $68.9 million in 1997, $67.3 million in 1996 and $62.2 million in 1995. Purchased water expense was the largest component of operating expense in each year. This year purchased water expense was $52.2 million, an increase of $0.6 million. The overall purchased water expense was reduced by $2.5 million due to refunds received from two wholesale suppliers in May 1997. Well production, which increased 6% in 1997 because of increased demand, caused a $0.9 million increase in pump taxes and purchased power costs. In 1996, well production was up 8%, however, purchased power decreased $0.6 million due to the availability of less expensive power in several districts. In 1997, the Bear Gulch watershed yielded 0.5 billion gallons, the same production as in 1996. Employee payroll and benefits charged to operations and maintenance expense was $32.9 million this past year, $31.2 million in 1996 and $29.9 million in 1995. The increases in payroll and related benefits are attributable to general wage increases effective at the start of each year and additional hours worked. At year-end 1997, 1996 and 1995, there were 649, 633 and 630 employees, respectively. Income taxes were $14.0 million in 1997, $12.2 million in 1996 and $9.9 million in 1995. The changes in taxes are generally due to increased taxable income. Long-term debt interest expense decreased $0.3 million due to the retirement of Series K bonds in November 1996 and Series L bonds in November 1997, and annual sinking fund payments each year. Interest on long-term debt increased $0.7 million in 1996 because of the sale, in August, 1995, of $20 million of senior notes which were outstanding for the full year. In 1995, bond interest expense increased $0.4 million, also because of the senior note sale. Interest on short-term bank borrowings in 1997 was $0.3 million more than in 1996 which was $0.2 million less than 1995's expense. The additional interest expense this year reflects increased short-term borrowings, especially during the latter part of the year. 1996's expense reduction reflects a reduced requirement for short-term borrowings due to increased water sales which resulted in improved cash flow and funds available in 1996 from the 1995 senior note sale. Interest on short-term bank borrowings decreased $0.3 million in 1995, despite higher short-term rates during 1995 compared to 1994. The reduction in the expense reflects the payoff of outstanding short-term bank borrowings upon the issuance of senior notes and reduced short- term borrowing needs. Due to improved earnings, interest coverage of long-term debt before income taxes was 4.2 in 1997, 3.6 in 1996 and 3.2 in 1995. Other Income. Other income is derived from management contracts under which the Company operates three municipally owned water systems, contracts for operation of five privately owned water systems, agreements for operation of two reclaimed water systems, provides billing services to various cities, leases certain facilities, other nonutility sources and interest on short-term investments. Total other income was $1.1 million in 1997, $0.8 million in 1996 and $0.9 million in 1995. Income from the various operating and billing contracts excluding short-term interest income was $1 million this year, $0.7 million in 1996 and 1995. Following the August 1995 senior note issue, available funds generated significant interest income. This source for temporary investments was not available in 1997 or 1996. There was $14.5 million in temporary borrowings at the end of 1997, $7.5 million at the end of 1996 and none at the end of 1995. RATES AND REGULATION General rate case applications were filed for four districts representing 7% of total accounts in July 1997. The applications request additional revenue of about $650,000 for 1998. Future step rate increases for two of the districts of about $110,000 for each year 1999 through 2001 were also requested. In the other two districts, proposed step rate increases would be based on a hybrid - CPI each year through the year 2003. During 1996, general rate case applications were filed with the CPUC for two districts, Livermore and Palos Verdes, which represent about 11% of the Company's customers. In April, the CPUC granted the Company a return on common equity (ROE) of 10.35%. Additional 1997 revenue, including memorandum and balancing account adjustments, was $2.4 million. The decision included provisions for future step rate increases to become effective in the next three years of $1.7 million in 1998 and $0.1 million in 1999 and 2000. The CPUC also authorized step rate increases for 1997 in various districts totaling $1.5 million and $1.4 million for undercollection of expense balancing accounts. The CPUC's decision on the Company's 1995 rate case filing was effective in June 1996. The decision, which involved five districts representing 47% of the Company's customers, authorized an ROE of 10.3%. It added $5.4 million of revenue during the first full year, including $1.2 million of step rate increases effective at the start of 1996. Over a four-year period, the decision is expected to provide about $10.6 million in new revenue. The decision includes a provision to accelerate recovery of the Company's utility plant investment, resulting in an annualized depreciation rate of about 2.6% for the five districts. Historically, the Company's annual depreciation rate has been 2.4% of utility plant. During 1998, 14 districts, representing about 80% of all customers, are eligible for rate increase filings. The Company will review earnings levels in those districts and file for additional rate consideration as it deems appropriate. The filings are expected to be made in July. WATER SUPPLY The Company's source of supply varies among its 21 operating districts. Certain districts obtain all of their supply from wells, some districts purchase all of their supply from wholesale suppliers and other districts obtain their supply from both sources. The Company operates two treatment plants which process surface water supplies. In each of the past three years, approximately half of the total Company supply has been pumped from Company owned wells and half purchased from wholesale suppliers. Total water production for 1997, 1996 and 1995 was 109,802, 105,072 and 98,823 million gallons, respectively. Generally, between mid-spring and mid-fall little precipitation falls in the Company's service areas. Water demand is highest during the warm, dry summer period and less in the cool, wet winter. Rain and snow during the winter months replenish underground water basins and fill reservoirs providing the water supply for subsequent delivery to customers. To date, snow and rainfall accumulation during the 1997-98 winter has exceeded normal levels for the third year in a row. Water storage in state reservoirs exceeds historic levels. The Company believes that its source of supply from both underground aquifers and purchased sources is adequate to meet customer demands for 1998 in all service areas. ENVIRONMENTAL MATTERS The Company is subject to regulations of the United States Environmental Protection Agency (EPA), the California Department of Health Services and various county health departments concerning water quality matters. It is also subject to the jurisdiction of various state and local regulatory agencies relating to environmental matters, including handling and disposal of hazardous materials. The Company believes it is in compliance with all monitoring and treatment requirements set forth by the various agencies. In the past several years, substantially all of the Company's wells have been equipped with chlorinators, providing disinfection of water extracted from underground sources. The cost of the new treatment is being recovered in customer rates as authorized by the CPUC. Water purchased from wholesale suppliers is treated before delivery to the Company. During 1996, Congress approved amendments to the Safe Drinking Water Act. The revised law provides improvements in establishing regulations for potential contaminants. Among the considerations by EPA in determining whether to regulate a particular substance are potential impact on public health, the likelihood of the contaminants' occurrence and a cost/benefit analysis. The Company believes the amended law provides a prudent approach to safeguarding potable water supplies. Various regulatory agencies could require increased monitoring and possibly additional treatment of water supplies. The Company intends to request recovery for any additional treatment costs through the ratemaking process. LIQUIDITY AND CAPITAL RESOURCES Liquidity. The Company's liquidity is provided by utilization of a $50 million short-term bank line of credit which is split evenly between Group and Company, and by internally generated funds. Prior to 1997, the line of credit was $30 million. The Group's $25 million portion of the bank credit line may be drawn upon for use by the Group, including funding operations of either of its two operating subsidiaries. The Company's $25 million portion of the credit line may be used solely for purposes of regulated water operations. Additional information regarding the bank line of credit is presented in Note 4 to the financial statements. Internally generated funds come from retention of a portion of earnings, depreciation and deferred income taxes. Because of the seasonal nature of the water business, the need for short-term borrowings under the line of credit generally increases during the first six months of the year. Due to greater summer usage, cash flow from operations increases and bank borrowings can be repaid. The Company believes that long-term financing is available to it through equity and debt markets. Standard & Poor's and Moody's have maintained their ratings of the Company's first mortgage bonds at AA- and Aa3, respectively. Long-term financing, which includes issuance of common stock, first mortgage bonds, senior notes and other debt securities is used to replace short-term borrowings and fund construction. Developer contributions in aid of construction and refundable advances for construction are also sources of funds for various construction projects. Additional long-term financing was not necessary in either 1997 or 1996. Operating and capital requirements were met by borrowings under the bank short-term line of credit and by internally generated funds. During August, 1995, Series A, 7.28%, 30-year senior notes were issued. The proceeds from the issue were used to repay outstanding bank borrowings, redeem upon maturity the outstanding $2,565,000 Series J first mortgage bonds and fund the 1995 and a portion of the 1996 construction programs. During the first quarter of 1998, the Group plans to implement a new Dividend Reinvestment and Stock Purchase Plan (Plan). The Plan will replace the Company's former Dividend Reinvestment Plan. Under the new Plan, shareholders may reinvest dividends to purchase additional Group common stock. Another feature of the Plan allows existing shareholders and other interested investors to purchase Group common shares. Shares required for the Plan may be purchased on the open market or newly issued shares. Therefore, the Plan will provide the Group with an alternative means of developing additional equity if new shares were to be issued. Initially, the intention is to purchase shares required for the Plan on the open market. If new shares are issued to satisfy future Plan requirements, the impact on earnings per share could be dilutive because of the added shares outstanding. Also, shareholders not participating in the Plan would experience dilution of their ownership percentage. In 1996, under the Company's former Dividend Reinvestment Plan, 80,438 new common shares were issued to shareholders who elected to reinvest their dividends, providing the Company with $1.4 million in additional equity. In 1995, 44,634 new shares were issued under the Plan during the third and fourth quarters providing equity of $0.7 million. Reinvestment shares required for the 1995 first and second quarter dividends were purchased on the open market and redistributed to Plan participants. Currently, about 10% of outstanding shares participate in the Company's dividend reinvestment program. Capital Requirements. Capital requirements consist primarily of new construction expenditures for expanding and replacing the Company's utility plant facilities, and the acquisition of new water properties. They also include refunds of advances for construction and retirement of bonds. During 1997, utility plant expenditures totaled $32.9 million compared to $35.7 million in 1996. This year's expenditures included $25.5 million provided by Company funding and $7.4 million received from developers through contributions in aid of construction and refundable advances. Company funded expenditures were in the following areas: wells, pumping and water treatment equipment and storage facilities, $6.9 million; distribution systems, $9.7 million; services and meters, $5.2 million; equipment, $3.7 million. Company projects were funded by internally generated funds and the short-term bank line of credit. In 1996, expenditures included the $6.5 million up-front City of Hawthorne lease payment. The system is being leased for 15 years. A portion of the proceeds from the August 1995 senior notes issue was also available to fund a portion of the 1996 Company construction program. The 1998 Company construction program has been authorized by the Board of Directors for $31.0 million. Expenditures are expected to be in the following areas: wells, pumping and water treatment equipment and storage facilities, $11.9 million; distribution systems, $8.7 million; services and meters, $5.4 million; and equipment, $5.0 million. The funds for this program are expected to be provided by cash from operations, bank borrowings and long-term debt financing. New subdivision construction generally will be financed by developers' contributions and refundable advances. Company funded construction budgets over the next five years are projected to be $125 million. Since 1986, proceeds received from developers for installation of new facilities were subject to income tax. During 1996, Congress enacted legislation which exempted from taxable income the majority of proceeds received from developers to fund advances for construction and contributions in aid of construction. As part of the legislation, future water utility plant additions will generally be depreciated for federal tax purposes on a straight-line, 25-year life basis. The federal tax exemption of developer funds will reduce the Company's cash flow requirement for income taxes. In 1997, California adopted similar legislation regarding the taxability of payments received from developers. Capital Structure. The Company's total capitalization at December 31, 1997 and 1996 was $306.7 million and $299.9 million, respectively. Capital ratios were: 1997 1996 Common equity 53.5% 51.4% Preferred stock 1.1% 1.2% Long-term debt 45.4% 47.4% The increase in the common equity percentage from 1996 to 1997 and the corresponding decrease in the long-term debt percentage were primarily caused by strong 1997 earnings which contributed to shareholders' equity. During the year, no new debt was sold or equity issued. Also contributing to the change was the retirement of Series L, first mortgage bonds in November 1997 along with the annual bond sinking fund payments which were also made in November. The 1997 return on average common equity was 14.6% compared with 12.7% in 1996 and 10.2% in 1995. The most recent CPUC authorized rate of return on common equity is 10.35%. Shareholder Rights Plan. As explained in Note 3 to the Consolidated Financial Statements, in January 1998, the Board of Directors adopted a Shareholder Rights Plan (Plan). In connection with the Plan, a dividend distribution of one's right to purchase preferred stock under certain circumstances was also authorized. The Plan is designed to protect shareholders and maximize shareholder value in the event of an unsolicited takeover proposal by encouraging a prospective acquirer to negotiate with the Board. NEW ACCOUNTING STANDARDS During 1997, the Financial Accounting Standards Board issued two statements which will be effective for the Group in 1998. Statement No. 130, "Reporting Comprehensive Income," requires comprehensive income items be classified separately and the accumulated balance be reported in the equity section of the financial statements. Statement No. 131, "Disclosures about Segments of an Enterprise and Related Information," establishes disclosure requirements concerning operating business segments, products and services, geographic areas and major customers. The Group, which will adopt both statements during 1998, does not anticipate that either statement will have a material impact on its financial position or operating results. YEAR 2000 The Group is familiar with the concerns and technological complexities associated with achieving Year 2000 compliance of computer based systems. A program is in place with a goal to assure that Group's systems achieve Year 2000 compliance by the end of 1998. In addition, the program includes attaining comfort that our business partners will also achieve Year 2000 compliance without a disruption of our business processes. The Group believes that the Year 2000 transition will be completed without a material adverse effect on its operations or financial position. CONSOLIDATED BALANCE SHEET (In thousands) December 31, 1997 1996 ASSETS Utility plant: Land $7,860 $7,536 Depreciable plant and equipment 627,584 600,329 Construction work in progress 4,026 3,300 Intangible assets 8,178 7,267 Total utility plant 647,648 618,432 Less depreciation and amortization 187,241 174,844 Net utility plant 460,407 443,588 Current assets: Cash and cash equivalents 1,742 1,368 Receivables: Customers 10,890 11,437 Other 3,972 1,528 Unbilled revenue 5,136 5,577 Materials and supplies at average cost 2,105 2,324 Taxes and other prepaid expenses 4,423 4,537 Total current assets 28,268 26,771 Other assets: Regulatory assets 38,345 37,556 Unamortized debt premium and expense 3,748 3,943 Other 529 532 Total other assets 42,622 42,031 $531,297 $512,390 See accompanying notes to consolidated financial statements. December 31, 1997 1996 (In thousands) CAPITALIZATION AND LIABILITIES Capitalization: Common stock $44,941 $44,941 Retained earnings 119,124 109,285 Total common shareholders' equity 164,065 154,226 Preferred stock without mandatory redemption provision 3,475 3,475 Long-term debt 139,205 142,153 Total capitalization 306,745 299,854 Current liabilities: Short-term borrowings 14,500 7,500 Accounts payable 15,499 14,692 Accrued taxes 2,985 3,002 Accrued interest 1,919 1,947 Other accrued liabilities 8,241 7,653 Total current liabilities 43,144 34,794 Unamortized investment tax credits 3,006 3,086 Deferred income taxes 25,761 23,736 Regulatory liabilities 12,493 12,627 Advances for construction 95,878 95,226 Contributions in aid of construction 44,270 43,067 $531,297 $512,390 CONSOLIDATED STATEMENT OF INCOME For the years ended December 31, 1997 1996 1995 (In thousands, except per share data) Operating revenue $195,324 $182,764 $165,086 Operating expenses: Operations: Purchased water 52,155 51,514 46,370 Purchased power 12,462 12,075 12,689 Pump taxes 4,302 3,753 3,151 Administrative and general 23,521 21,664 19,989 Other 24,019 23,000 21,635 Maintenance 9,319 8,317 7,722 Depreciation and amortization 13,670 12,665 11,436 Income taxes 13,950 12,150 9,850 Property and other taxes 7,577 7,259 6,852 Total operating expenses 160,975 152,397 139,694 Net operating income 34,349 30,367 25,392 Other income and expenses, net 858 607 768 Income before interest expense 35,207 30,974 26,160 Interest expense: Long-term debt interest 11,405 11,663 10,984 Other interest 497 244 478 Total interest expense 11,902 11,907 11,462 Net income $23,305 $19,067 $14,698 Earnings per share of common stock $1.83 $1.50 $1.16 Average number of common shares outstanding 12,619 12,580 12,506 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF COMMON SHAREHOLDERS' EQUITY Common Shares Common Retained Outstanding Stock Earnings Total (In thousands, except shares) Balance at December 31, 1994 12,494,068 $42,800 $ 101,647 $144,447 Net income 14,698 14,698 Dividends paid: Preferred stock 153 153 Common stock 12,750 12,750 Total dividends paid 12,903 12,903 Income reinvested in business 1,795 1,795 Dividend reinvestment 44,634 707 707 Balance at December 31, 1995 12,538,702 43,507 103,442 146,949 Net income 19,067 19,067 Dividends paid: Preferred stock 153 153 Common stock 13,071 13,071 Total dividends paid 13,224 13,224 Income reinvested in business 5,843 5,843 Dividend reinvestment 80,438 1,434 1,434 Balance at December 31, 1996 12,619,140 44,941 109,285 154,226 Net income 23,305 23,305 Dividends paid: Preferred stock 153 153 Common stock 13,313 13,313 Total dividends paid 13,466 13,466 Income reinvested in business 9,839 9,839 Balance at December 31, 1997 12,619,140 $44,941 $119,124 $164,065 See accompanying notes to consolidated financial statements. CONSOLIDATED STATEMENT OF CASH FLOWS For the years ended December 31, 1997 1996 1995 (In thousands) Operating activities: Net income $23,305 $19,067 $14,698 Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 13,670 12,665 11,436 Deferred income taxes and investment tax credits, net 1,945 (2,169) 1,698 Regulatory assets and liabilities, net (923) 503 (1,181) Changes in operating assets and liabilities: Receivables (1,897) 698 (1,936) Unbilled revenue 441 729 (314) Accounts payable 807 (115) 2,576 Other current liabilities 543 1,579 1,560 Other changes, net 1,510 235 1,258 Net adjustments 16,096 14,125 15,097 Net cash provided by operating activities 39,401 33,192 29,795 Investing activities: Utility plant expenditures: Company funded (25,491) (27,631) (20,039) Developer advances and contributions in aid of construction (7,416) (8,052) (7,211) Net cash used in investing activities (32,907) (35,683) (27,250) Financing activities: Net short-term borrowings $7,000 $7,500 $(7,000) Proceeds from issuance of long-term debt 20,000 Proceeds from issuance of common stock 1,434 707 Advances for construction 4,536 4,998 5,368 Refunds of advances for construction (3,685) (3,631) (3,524) Contributions in aid of construction 2,443 3,896 3,183 Retirements of first mortgage bonds including premiums (2,948) (3,387) (3,404) Dividends paid (13,466) (13,224) (12,903) Net cash provided by (used in) financing activities (6,120) (2,414) 2,427 Change in cash and cash equivalents 374 (4,905) 4,972 Cash and cash equivalents at beginning of year 1,368 6,273 1,301 Cash and cash equivalents at end of year $1,742 $1,368 $6,273 SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION: Cash paid during the year for: Interest (net of amounts capitalized) $11,734 $11,721 $11,050 Income taxes $14,525 $12,775 $8,258 See accompanying notes to consolidated financial statements Notes to Consolidated Financial Statements December 31, 1997, 1996 and 1995 In April 1997, shareholders of California Water Service Company ("Company") voted to approve a holding company structure. The formation process was completed on December 31, 1997 at which time California Water Service Group ("Group") became the parent company. As a result of the holding company formation, the Company became one of Group's two operating subsidiaries. The Company will continue to operate as a utility regulated by the California Public Utilities Commission (CPUC). The other subsidiary, CWS Utility Services, is a new entity which will perform non-regulated water related services and operations. The consolidated financial statements include the accounts of the Company which comprise virtually all of the Group's assets and revenues. In conjunction with formation of the holding company structure, common shares of Company stock were exchanged on a two-for-one basis for common shares of Group. Prior years' share data has been restated to reflect the effects of the exchange which is equivalent to a stock split. NOTE 1. Summary of Significant Accounting Policies The consolidated financial statements include the accounts of California Water Service Group and its wholly-owned subsidiaries, California Water Service Company and CWS Utility Services, collectively referred to as the Group. Intercompany transactions and balances have been eliminated. The accounting records of the Company are maintained in accordance with the uniform system of accounts prescribed by the CPUC. Certain prior years' amounts have been reclassified, where necessary, to conform to the current presentation. The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Revenue. Revenue consists of monthly cycle customer billings for regulated water service at rates authorized by the CPUC and billings to City of Hawthorne customers. Revenue from metered accounts includes unbilled amounts based on the estimated usage from the latest meter reading to the end of the accounting period. Flat rate accounts which are billed at the beginning of the service period are included in revenue on a pro rata basis for the portion applicable to the current accounting period. Utility Plant. Utility plant is carried at original cost when first constructed or purchased, except for certain minor units of property recorded at estimated fair values at dates of acquisition. Cost of depreciable plant retired is eliminated from utility plant accounts and such costs are charged against accumulated depreciation. Maintenance of utility plant, other than transportation equipment, is charged to operation expenses. Maintenance and depreciation of transportation equipment are charged to a clearing account and subsequently distributed primarily to operations. Interest is capitalized on plant expenditures during the construction period and amounted to $267,000 in 1997, $261,000 in 1996, and $207,000 in 1995. Intangible assets acquired as part of water systems purchased are stated at amounts as prescribed by the CPUC. All other intangibles have been recorded at cost. Included in intangible assets is $6,500,000 paid to the City of Hawthorne to lease the city's water system and associated water rights. The lease payment is being amortized on a straight-line basis over the 15-year life of the lease. The Group continually evaluates the recoverability of utility plant by assessing whether the amortization of the balance over the remaining life can be recovered through the expected and undiscounted future cash flows. Long-Term Debt Premium, Discount and Expense. The discount and expense on long-term debt is being amortized over the original lives of the related debt issues. Premiums paid on the early redemption of certain debt issues and unamortized original issue discount and expense of such issues are amortized over the life of new debt issued in conjunction with the early redemption. Cash Equivalents. Cash equivalents include highly liquid investments, primarily U.S. Treasury and U.S. Government agency interest bearing securities, stated at cost with original maturities of three months or less. Depreciation. Depreciation of utility plant for financial statement purposes is computed on the straight-line remaining life method at rates based on the estimated useful lives of the assets, ranging from 5 to 65 years. The provision for depreciation expressed as a percentage of the aggregate depreciable asset balances was 2.5% in 1997 and 1996, and 2.4% in 1995. For income tax purposes, as applicable, the Company computes depreciation using the accelerated methods allowed by the respective taxing authorities. Plant additions since June 1996, are depreciated on a straight-line basis for tax purposes. Advances for Construction. Advances for Construction consist of payments received from developers for installation of water production and distribution facilities to serve new developments. Advances are excluded from rate base. Such payments are refundable to the developer without interest over a 20-year or 40-year period. Refund amounts under the 20-year contracts are based on annual revenues from each extension. Unrefunded balances at the end of the contract period are credited to Contributions in Aid of Construction and are no longer refundable. Refunds on contracts entered into since 1982 are made in equal annual amounts over 40 years. At December 31, 1997, the amounts refundable under the 20-year contracts were $9,547,000 and under the 40-year contracts $86,331,000. Estimated refunds for 1998 for all water main extension contracts are $3,800,000. Contributions in Aid of Construction. Contributions in Aid of Construction represent payments received from developers, primarily for fire protection purposes, which are not subject to refunds. Facilities funded by contributions are included in utility plant, but excluded from rate base. Depreciation related to contributions is charged to Contributions in Aid of Construction. Income Taxes. The Group accounts for income taxes using the asset and liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. Measurement of the deferred tax assets and liabilities is at enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. It is anticipated that future rate action by the CPUC will reflect revenue requirements for the tax effects of temporary differences recognized which have previously been flowed through to customers. The CPUC has granted the Company customer rate increases to reflect the normalization of the tax benefits of the federal accelerated methods and available investment tax credits (ITC) for all assets placed in service after 1980. ITC are deferred and amortized over the lives of the related properties. Advances for Construction and Contributions in Aid of Construction received from developers subsequent to 1986 were taxable for federal income tax purposes and subsequent to 1991 subject to state income tax. In 1996 the federal tax law, and in 1997 the state tax law, changed and a major portion of subsequent advances and contributions are non-taxable. Earnings per Share. In 1997, the Group adopted Statement of Financial Accounting Standards (SFAS) No. 128, "Earnings per Share", issued by the Financial Accounting Standards Board. SFAS No. 128 changes the standard for computing earnings per share (EPS) by replacing the presentation of primary EPS with basic EPS for all periods presented. Per share data is calculated using income available to common shareholders divided by the weighted average number of shares outstanding during the year. The adoption of SFAS No. 128 had no effect on the Group's EPS amounts. The Group has no dilutive securities, accordingly, diluted EPS is not shown. NOTE 2. Preferred Stock As of December 31, 1997 and 1996, 380,000 shares of preferred stock were authorized. Dividends on outstanding shares are payable quarterly at a fixed rate before any dividends can be paid on common stock. Preferred shares are entitled to sixteen votes each with the right to cumulative votes at any elections of directors. The outstanding 139,000 shares of $25 par value cumulative, 4.4% Series C preferred shares are not convertible to common stock. A premium of $243,250 would be due upon voluntary liquidation of Series C. There is no premium in the event of an involuntary liquidation. NOTE 3. Common Shareholders' Equity The Group is authorized to issue 25,000,000 shares of no par value common stock. All share data has been restated to reflect the two-for- one stock split effective December 31, 1997. As of December 31, 1997 and 1996, 12,619,140 shares of common stock were issued and outstanding. All shares of common stock are eligible to participate in the Group's dividend reinvestment plan. Approximately 10% of shareholders participate in the plan. In 1996 and 1995, 80,438 and 44,634, respectively, new shares were issued under the reinvestment plan. Shareholder Rights Plan. In January 1998, the Board of Directors adopted a Shareholder Rights Plan (Rights Plan) and authorized a dividend distribution of one right (Right) to purchase 1/100th share of Series D Preferred Stock for each outstanding share of Common Stock. The Rights will become effective in February 1998 and expire in February 2008. The Rights Plan is designed to provide shareholders protection and to maximize shareholder value by encouraging a prospective acquirer to negotiate with the Board. Each Right represents a right to purchase 1/100th share of Series D Preferred Stock at the price of $120, subject to adjustment ("the Purchase Price"). Each share of Series D Preferred Stock is entitled to receive a dividend equal to 100 times any dividend paid on common stock and 100 votes per share in any shareholder election. The Rights become exercisable upon occurrence of a Distribution Date. A Distribution Date event occurs if (a) any person accumulated 15% of the then outstanding Common Stock, (b) any person presents a tender offer which caused the person's ownership level to exceed 15% and the Board determined the tender offer not to be fair to Group's shareholders, or (c) the Board determines that a shareholder maintaining a 10% interest in the Common Stock could have an adverse impact on the Group or could attempt to pressure Group to repurchase the holder's shares at a premium. Until the occurrence of a Distribution Date, each Right trades with the Common Stock and is not separately transferable. When a Distribution Date occurs: (a) Group would distribute separate Rights Certificates to Common Shareholders and the Rights would subsequently trade separate from the Common Stock; and (b) each holder of a Right, other than the Acquiring Person (whose Rights will thereafter be void), will have the right to receive upon exercise at its then current Purchase Price that number of shares of Common Stock having a market value of two times the Purchase Price of the Right. If Group merges into the acquiring person, transfers a significant portion of its assets to the acquiring person or enters into any transaction that unfairly favors the acquiring person or disfavors Group's other shareholders, the Right becomes a right to purchase Common Stock of the acquiring person having a market value of two times the Purchase Price. The Board may determine that in certain circumstances a proposal which would cause a distribution date is in the Group shareholders' best interest. Therefore, the Board may, at its option, redeem the Rights at a redemption price of $.001 per Right. NOTE 4. Short-Term Borrowings As of December 31, 1997, the Group maintained a bank line of credit providing unsecured borrowings of up to $50,000,000 at the prime lending rate or lower rates as quoted by the bank. Subsequent to December 31, 1997, $25,000,000 of the bank line was transferred to California Water Service Group, with the remaining line of $25,000,000 available solely to the Company. The agreement does not require minimum or specific compensating balances. The following table represents borrowings under the bank line of credit. Dollars in Thousands 1997 1996 1995 Maximum short-term borrowings $14,500 $9,500 $13,000 Average amount outstanding 5,164 1,662 5,142 Weighted average interest rate 7.22% 6.94% 7.26% Interest rate at December 31 7.29% 6.98% NOTE 5. Long-Term Debt As of December 31, 1997 and 1996 long-term debt outstanding was: In Thousands 1997 1996 First Mortgage Bonds: Series L 6.75% due 1997 $ $2,138 Series P 7.875% due 2002 2,625 2,640 Series S 8.50% due 2003 2,640 2,655 Series BB 9.48% due 2008 16,740 16,920 Series CC 9.86% due 2020 18,900 19,100 Series DD 8.63% due 2022 19,500 19,600 Series EE 7.90% due 2023 19,600 19,700 Series FF 6.95% due 2023 19,600 19,700 Series GG 6.98% due 2023 19,600 19,700 119,205 122,153 Senior Notes: Series A 7.28% due 2025 20,000 20,000 Total long-term debt $139,205 $142,153 The first mortgage bonds are held by institutional investors and secured by substantially all of the Company's utility plant. Aggregate maturities and sinking fund requirements for each of the succeeding five years 1998 through 2002 are $620,000, $2,240,000, $2,240,000, $2,240,000 and $4,790,000, respectively. The senior notes are held by institutional investors and are unsecured and require interest only payments until maturity. NOTE 6. Income Taxes Income tax expense consists of the following: In Thousands Federal State Total 1997 Current $8,970 $2,894 $11,864 Deferred 2,280 (194) 2,086 Total $11,250 $2,700 $13,950 1996 Current $9,356 $3,274 $12,630 Deferred 444 (924) (480) Total $9,800 $2,350 $12,150 1995 Current $6,839 $2,729 $9,568 Deferred 1,161 (879) 282 Total $8,000 $1,850 $9,850 Income tax expense computed by applying the current federal tax rate of 35% to pretax book income differs from the amount shown in the Consolidated Statement of Income. The difference is reconciled in the table below: In Thousands 1997 1996 1995 Computed "expected" tax expense $13,039 $10,926 $8,592 Increase (reduction) in taxes due to: State income taxes net of federal tax benefit 1,755 1,528 1,203 Investment tax credits (152) (119) (132) Other (692) (185) 187 Total income tax $13,950 $12,150 $9,850 The components of deferred income tax expense in 1997, 1996 and 1995 were: In Thousands 1997 1996 1995 Depreciation $2,457 $3,544 $3,854 Developer advances and contributions (334) (3,749) (3,455) Bond redemption premiums (62) (73) (75) Investment tax credits (93) (93) (90) Other 118 (109) 48 Total deferred income tax expense $2,086 $(480) $282 The tax effects of differences that give rise to significant portions of the deferred tax assets and deferred tax liabilities at December 31, 1997 and 1996 are presented in the following table: In Thousands 1997 1996 Deferred tax assets: Developer deposits for extension agreements and contributions in aid of construction $43,980 $45,901 Federal benefit of state tax deductions 2,998 4,177 Book plant cost reduction for future deferred ITC amortization 1,776 1,832 Insurance loss provisions 334 286 Total deferred tax assets 49,088 52,196 Deferred tax liabilities: Utility plant, principally due to depreciation differences 74,029 74,407 Premium on early retirement of bonds 1,215 1,290 Other (395) 235 Total deferred tax liabilities 74,849 75,932 Net deferred tax liabilities $25,761 $23,736 A valuation allowance was not required during 1997 and 1996. Based on historical taxable income and future taxable income projections over the periods in which the deferred assets are deductible, management believes it is more likely than not the Group will realize the benefits of the deductible differences. NOTE 7. Employee Benefit Plans Pension Plan. The Company provides a qualified defined benefit, non- contributory, pension plan for substantially all employees. The cost of the plan was charged to expense and utility plant. The Company makes annual contributions to fund the amounts accrued for pension cost. Plan assets are invested in mutual funds, pooled equity, bond and short-term investment accounts. The data below includes the unfunded, non-qualified, supplemental executive retirement plan. Net pension cost for the years ending December 31, 1997, 1996 and 1995 included the following components: In Thousands 1997 1996 1995 Service cost-benefits earned during the year $1,545 $1,543 $1,265 Interest cost on projected obligation 2,805 2,583 2,360 Actual return on plan assets (6,023) (4,784) (5,817) Net amortization and deferral 3,915 2,789 4,220 Net pension cost $2,242 $2,131 $2,028 The following table sets forth the plan's funded status and the plan's accrued assets (liabilities) as of December 31, 1997 and 1996: In Thousands 1997 1996 Accumulated benefit obligation, including vested benefits of $31,519 in 1997 and $28,059 in 1996 $(32,242) $(28,679) Projected benefit obligation (44,576) (39,296) Plan assets at fair value 42,390 38,293 Projected benefit obligation in excess of plan assets (2,186) (1,003) Unrecognized net gain (5,203) (6,120) Prior service cost not yet recognized in net periodic pension cost 5,370 4,991 Remaining net transition obligation at adoption date January 1, 1987 1,144 1,430 Accrued pension liability recognized in the balance sheet $(875) $(702) The projected long-term rate of return on plan assets used in determining pension cost was 8.0% for the years 1997, 1996 and 1995. A discount rate of 7.0% in 1997, 7.4% in 1996 and 7.0% in 1995, and future compensation increases of 4.5% in 1997, 1996 and 1995 were used to calculate the projected benefit obligations as of the end of the respective years. Savings Plan. The Company sponsors a 401(k) qualified, defined contribution savings plan that allows participants to contribute up to 15% of pre-tax compensation. The Company matched fifty cents for each dollar contributed by the employee up to a maximum Company match of 4.0%, 3.5% and 3.0% of the employees' compensation in 1997, 1996 and 1995, respectively. Company contributions were $1,045,000, $858,000 and $711,000 for the years 1997, 1996 and 1995, respectively. Other Postretirement Plans. The Company provides substantially all active employees with medical, dental and vision benefits through a self-insured plan. Employees retiring at or after age 58 with 10 or more years of service are offered, along with their spouses and dependents, continued participation in the plan by payment of a premium. Retired employees are also provided with a $5,000 life insurance benefit. The Company records the costs of postretirement benefits during the employees' years of active service. The CPUC has issued a decision which authorizes rate recovery of tax deductible funding of postretirement benefits and permits recording of a regulatory asset for the portion of costs that will be recoverable in future rates. Net postretirement benefit cost for the years ending December 31, 1997, 1996 and 1995 included the following components: In Thousands 1997 1996 1995 Service cost - benefits earned $280 $166 $131 Interest cost on accumulated postretirement benefit obligation 549 383 391 Actual return on plan assets (424) (63) (30) Net amortization of transition obligation 710 278 260 Net periodic postretirement benefit cost $1,115 $764 $752 Postretirement benefit expense recorded in 1997, 1996 and 1995, was $581,000, $523,000 and $507,000, respectively. $1,441,000, which is recoverable through future customer rates, is recorded as a regulatory asset. The Company intends to make annual contributions to the plan up to the amount deductible for tax purposes. Plan assets are invested in mutual funds, short-term money market instruments and commercial paper. The following table sets forth the plan's funded status and the plan's accrued assets (liabilities) as of December 31, 1997 and 1996: In Thousands 1997 1996 Accumulated postretirement benefit obligation $(3,982) $(2,959) Other fully eligible participants (818) (604) Other active participants (3,430) (2,310) Total (8,230) (5,873) Plan assets at fair value 936 582 Accumulated postretirement benefit obligation in excess of plan assets (7,294) (5,291) Unrecognized net loss 2,129 407 Remaining unrecognized transition obligation 3,724 3,972 Net postretirement benefit liability included in current liabilities $(1,441) $(912) For 1997 measurement purposes, a 6.0% annual rate of increase in the per capita cost of covered benefits was assumed; the rate was assumed to decrease gradually to 5% in the year 2000 and remain at that level thereafter. The health care cost trend rate assumption has a significant effect on the amounts reported. Increasing the assumed health care cost trend rates by one percentage point in each year would increase the accumulated postretirement benefit obligation as of December 31, 1997, by $1,226,000 and the aggregate of the service and interest cost components of the net periodic postretirement benefit cost for the year ended December 31, 1997, by $144,000. The discount rate used in determining the accumulated postretirement benefit obligation was 7% at December 31, 1997, 7.4% at December 31, 1996, and 7% at December 31, 1995. The long-term rate of return on plan assets was 8% for 1997, 1996 and 1995. NOTE 8. Fair Value of Financial Instruments For those financial instruments for which it is practicable to estimate a fair value the following methods and assumptions were used: Cash Equivalents. The carrying amount of cash equivalents approximates fair value because of the short-term maturity of the instruments. Long-term Debt. The fair value of the Group's long-term debt is estimated at $155,000,000 as of December 31, 1997 and $159,000,000 as of December 31, 1996, using a discounted cash flow analysis, based on the current rates available to the Group for debt of similar maturities. Advances for Construction. The fair value of advances for construction contracts is estimated at $21,000,000 as of December 31, 1997 and 1996, based on data provided by brokers. NOTE 9. Quarterly Financial and Common Stock Market Data (Unaudited) The Group's common stock is traded on the New York Stock Exchange under the symbol "CWT". There were approximately 11,000 common stock shareholders at December 31, 1997. Quarterly dividends have been paid on common stock for 212 consecutive quarters and the quarterly rate has been increased during each year since 1968. The stock quotations presented, adjusted for the two-for-one split, are those of the Company which traded on the New York Stock Exchange prior to its December 31, 1997 merger with the Group. 1997 First Second Third Fourth (In thousands, except per share amounts) Operating revenue $37,558 $55,083 $59,551 $43,132 Net operating income 5,712 11,788 10,540 6,309 Net income 2,921 8,878 7,860 3,646 Earnings per share .23 .70 .62 .28 Common stock market price range: High 22.63 23.88 25.22 29.59 Low 19.50 18.63 21.13 23.44 Dividends paid .264 .264 .264 .264 1996 First Second Third Fourth Operating revenue $32,298 $49,048 $59,230 $42,188 Net operating income 4,028 8,698 11,488 6,153 Net income 1,177 5,836 8,673 3,381 Earnings per share .09 .46 .68 .27 Common stock market price range: High 18.63 17.81 19.13 21.88 Low 16.25 16.75 16.25 17.94 Dividends paid .26 .26 .26 .26 Independent Auditors' Report Shareholders and Board of Directors California Water Service Group: We have audited the accompanying consolidated balance sheet of California Water Service Group and subsidiaries as of December 31, 1997 and 1996, and the related consolidated statements of income, common shareholders' equity and cash flows for each of the years in the three-year period ended December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of California Water Service Group and subsidiaries as of December 31, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 1997, in conformity with generally accepted accounting principles. San Jose, California January 23, 1998