Summary of ARTESIAN RESOURCES CORP

Item 7. - Management's Discussion and Analysis of Financial Condition and Results of Operations.

OVERVIEW

Our profitability is primarily attributable to the sale of water by Artesian Water. Gross water sales comprises 89.2% of total operating revenues, the amount of which is subject to seasonal fluctuations, particularly during summer when water demand may vary with rainfall and temperature. In the event temperatures during the typically warmer months are cooler than expected, or rainfall is greater than expected, the demand for water may decrease and our revenues may be adversely affected. We believe the effects of weather are short term and do not materially affect the execution of our strategic initiatives.

Our water sales revenues were affected in 2008 and 2007 by rate increases approved by the DEPSC.

Artesian Water, Artesian Water Maryland and Artesian Water Pennsylvania provide water service to residential, commercial, industrial, governmental, municipal and utility customers. Our largest operating subsidiary, Artesian Water, accounted for approximately 92% of our total operating revenues in 2008 and serves approximately 29% of Delaware's total population. In October 2008, Artesian Water Maryland signed an agreement with Cecil County to purchase four water facilities, with closing expected to occur by June 30, 2009. In December 2008, the MDPSC approved an application for Artesian Water Maryland to construct a water system from the Delaware state line, interconnecting with the Artesian Water system, to the Town of Elkton. The Town of Elkton desired an additional source of water supply.

Artesian Wastewater, owns wastewater infrastructure and began providing wastewater services in Delaware in July 2005. Artesian Wastewater Maryland was incorporated on June 3, 2008 to provide regulated wastewater services in the state of Maryland. In October 2008, Artesian Wastewater Maryland signed two asset purchase agreements with Cecil County to purchase four wastewater facilities in Maryland. Closings on these transactions are expected to occur on or before June 30, 2009. Our wastewater customers are billed a flat monthly fee, which contributes to providing a revenue stream unaffected by weather.

Artesian Utility provides contract water and wastewater operation services to 23 private, municipal and governmental institutions in the southeastern part of Pennsylvania. Artesian Utility currently operates a 2.5 million gallon per day wastewater facility for Middletown under a 20-year contract that expires on February 1, 2021. Artesian Utility also operates an approximately 250,000 gallon per day wastewater facility in Middletown. In addition, we operate an additional wastewater facility in Middletown in order to support the 2.5 million gallon per day wastewater facility described above.

On June 30, 2008, Artesian Utility signed an agreement with Northern Sussex Regional Water Recycling Complex, LLC, or NSRWRC, for the design, construction and operation of the Northern Sussex Regional Water Recycling Complex, a wastewater treatment facility to be located in Sussex County, Delaware. NSRWRC was created for the purpose of developing the treatment facility site, which once constructed, will be operated by Artesian Wastewater.

Artesian Development owns an approximately six-acre parcel of land zoned for office buildings located immediately adjacent to our corporate headquarters. In 2007, Artesian Development purchased approximately eighteen acres of land, in Sussex County, to construct an office facility, a water treatment plant and a wastewater facility.

Artesian Consulting provides engineering services to developers for residential and commercial development. The acquisition of Meridian in June 2008 included the assignment of certain current contract agreements to provide engineering services to developers and includes services to be provided to Artesian Water.

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In addition to services discussed above, Artesian Resources initiated a Water Service Line Protection Plan, or WSLP Plan, in March 2005. The WSLP Plan covers all parts, material and labor required to repair or replace participants' leaking water service lines up to an annual limit. As of December 31, 2008, approximately 13,100, or 20.5%, of our 64,000 eligible water customers had signed up for the WSLP Plan. The WSLP Plan was expanded in the second quarter of 2008 to include maintenance or repair to customers' sewer lines. This plan, Sewer Service Line Protection Plan, or SSLP Plan, covers all parts, material and labor required to repair or replace participants' leaking or clogged sewer lines up to an annual limit. As of December 31, 2008, approximately 4,800, or 10.5%, of our 46,000 eligible customers had signed up for the SSLP Plan.

While water sales revenues are our primary source of revenues, we continue to explore and develop relationships with developers and municipalities in order to increase revenues from contract water operations and wastewater management services. Our contract operations and wastewater management services provide a revenue stream that is not affected by changes in weather patterns. We plan to continue developing and expanding our contract operations and wastewater services in a manner that complements our growth in water service to new customers. Our anticipated growth in these areas is subject to changes in residential and commercial construction, which may be affected by interest rates, inflation and general housing and economic market conditions. As a result of the general economic downturn, we my not be able to increase our contract operations and wastewater services at the rate we had previously expected. We will continue to focus attention on expanding our contract operations opportunities with municipalities and private water providers in Delaware and surrounding areas.

Ensuring our customers have a dependable supply of safe, high-quality water has been, and will continue to be, our highest priority. In 2003, Delaware passed legislation requiring all water utilities to certify by July 2006, and each three years thereafter, that they had sufficient sources of self-supply to serve their respective systems. On March 8, 2005, we filed our certification of self-sufficiency of supply with the DEPSC. The review was completed on June 20, 2006, and the DEPSC concluded that we demonstrated that we had sufficient water supply to meet the demands of our customers through 2006. In addition and as required by law, on June 30, 2006, we filed with the DEPSC a new certification of self-sufficiency for the period through 2009. After completion of their review, on July 24, 2007, the DEPSC accepted our certification of sufficient water supply through 2009. As required, we will file a new certification of self-sufficiency with the DEPSC by June 30, 2009, for the period through 2012.

Water Industry

The Federal Environmental Protection Agency's September 2008 report states that the United States' water industry is comprised of approximately 52,000 community water systems, 78% of which serve less than 3,300 customers. There are currently 13 publicly traded water utilities based in the United States. The rest are privately or municipally owned systems. The water industry is capital intensive, with the highest capital investment in plant and equipment per dollar of revenue among all utilities. Increasingly stringent drinking water regulations to meet the requirements of the Safe Drinking Water Act of 1974 have required the water industry to invest in more advanced treatment systems and processes, which require a heightened level of expertise. We are currently in full compliance with the requirements of the Safe Drinking Water Act. Even though our water utility was founded in 1905, the majority of our investment in infrastructure occurred in the last 30 years.

We believe that Delaware's generally lower cost of living in the region, availability of development sites in relatively close proximity to the Atlantic Ocean in Sussex County, and attractive financing rates for construction and mortgages have resulted, and will continue to result, in increases to our customer base. Substantial portions of Delaware are currently not served by a public water system, which could also assist in an increase to our customer base as systems are added. According to the US Census Bureau, Delaware's population increased an estimated 11.4% from 2000 to 2008, as compared to the nationwide growth rate of approximately 8.0%. General economic conditions, particularly in the housing market, resulted in a much lower rate of new customer additions than experienced in many years.

Interest rates for mortgages have fallen from 6.69% on average in December 2001 to 5.51% through December 2008. Long-term interest rates for our recent First Mortgage Bond issuance (see Note 6 to our Financial Statements) reflect a similar trend, as we were able to reduce our overall weighted cost of debt from 7.93% in 2001 to 6.05% at the end of 2008.

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Wastewater Industry

The Federal Environmental Protection Agency's September 2004 report states that over 75% of the United States' population is served by centralized wastewater collection and treatment systems, the remaining 25% of the population uses decentralized wastewater treatment systems, or on-site systems. Approximately 16,000 municipal wastewater treatment facilities are in operation in the United States. Approximately 701,000 people are served by publicly owned wastewater treatment facilities in Delaware, with an estimated growth to approximately 846,000. Approximately 41,000 people are served by publicly owned wastewater treatment facilities in Cecil County, Maryland, with an estimated growth to approximately 52,000.

The Clean Water Act has established the foundation for wastewater discharge control in the United States. The Clean Water Act established a control program for ensuring that communities have clean water by regulating the release of contaminants into waterways. Permits that limit the amounts of pollutants discharged are required of all wastewater dischargers under the National Pollutant Discharge Elimination System permit program. The Clean Water Act also requires that wastewater treatment plant discharges meet a minimum of secondary treatment. The secondary treatment process can remove up to 90% of the organic matter in wastewater. Over 30% of the wastewater treatment facilities produce cleaner discharges by providing even greater levels of treatment. We operate environmentally friendly wastewater systems that meet or exceed all requirements of federal, state and local standards.

The Federal Environmental Protection Agency's September 2004 Clean Watersheds Needs Survey report estimates that nationwide capital investment needs for wastewater pollution control in the United States is $134.4 billion for wastewater treatment and collection systems. The increase in overall national needs is due to a combination of population growth, more protective water quality standards, and aging infrastructure. Our capital plan for the next five years includes projects for wastewater treatment plant improvements, additions and acquisitions in both Delaware and Maryland. Capital improvements are planned and budgeted to meet anticipated changes in regulations and needs for increased capacity related to projected growth. The DEPSC and MDPSC have generally recognized the operating and capital costs associated with these improvements in setting wastewater rates for current customers and capacity charges for new customers.

Strategic Direction

Our strategy is to significantly increase customer growth, revenues, earnings and dividends by expanding our water and wastewater services across the Delmarva Peninsula. We remain focused on providing superior service to our customers and continuously seeking ways to improve our efficiency and performance. By providing both water and wastewater services, we are positioned as the primary resource for developers and communities throughout the Delmarva Peninsula seeking to fill both needs simultaneously. We have a proven ability to acquire and integrate high growth, established utilities, through which we have captured additional service territories that will serve as a base for future revenue. We have completed four acquisitions during the past two years, to include our integration of their operations, infrastructure, technology and employees. We believe this experience presents a strong platform for further expansion and that our success to date also produces positive relationships and credibility with regulators, municipalities, developers and customers in both existing and prospective service areas.

In our regulated water division, our strategy is to focus on a wide spectrum of activities, which include identifying new and dependable sources of supply; developing the wells, treatment plants and delivery systems to get water to customers and educating customers on the wise use of water. Our strategy includes focusing our efforts to expand in new regions added to our Delaware service territory over the last 10 years, where growth is strong and demand is increasing. In addition, we believe growth will be developed in the Maryland counties on the Delmarva Peninsula. We plan to expand our regulated water service area in the Cecil County designated growth corridor and to expand our business through the design, construction, operation and management, as well as acquisition, of additional water systems. The expansion of our exclusive franchise areas elsewhere in Maryland and the award of additional contracts will similarly enhance our operations within the state.

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We believe the effects of weather are short term and do not materially affect the execution of our strategic initiatives. As we anticipated, our initiatives south of the Chesapeake & Delaware Canal, or the C&D Canal, have provided for nearly all of our customer growth in Artesian Water, providing approximately 99% of our growth in customers in 2008. We expect continued growth in these regions. This shift in growth is primarily the result of the build out of our service area in northern New Castle County. In 2008, we increased our customer base by 1.0% and increased our service territory by approximately 18.2 square miles. We have also expanded the provision of our services into Maryland. Cecil County has designated the Interstate 95 corridor as a preferred growth area for business and residential expansion. Recently, the federal Base Re-Alignment and Closure Commission announced the relocation of approximately 14,000 jobs to nearby Aberdeen, Maryland by 2011. The Wilmington Metropolitan Area Planning Commission projects Cecil County will grow 86% between 2000 and 2030 and the Maryland Department of Planning projects that Cecil County will experience the highest rate of household growth through 2025 of any jurisdiction in the state. Artesian Water Maryland signed an agreement in October 2008 with Cecil County for the purchase of specific water facilities, which is expected to close by June 30, 2009. Once completed, this will add four water facilities to our service area. We continue to increase our sources of supply to assure we have adequate high quality water supply to meet our customer growth expectations in all of the states in which we provide water.

In our regulated wastewater division, we foresee significant growth opportunities and will continue to seek strategic partnerships and relationships with developers and municipalities to complement existing agreements for the provision of wastewater service in Delaware, Maryland and the surrounding areas. Artesian Wastewater completed an agreement with Georgetown, Delaware in July 2008 to provide wastewater treatment and disposal services for Georgetown's growth and annexation areas. Artesian Wastewater will provide up to 1 mgd of wastewater capacity for the town within the next 10 years. Artesian Wastewater Maryland signed two agreements in October 2008 with Cecil County for the purchase of specific wastewater facilities, which are expected to close by June 30, 2009. Once completed, these acquisitions will add four wastewater facilities to our service area.

We will continue to seek acquisitions of water and wastewater contract operations on the Delmarva Peninsula. The purchase of water and wastewater operations agreements assists in our expansion efforts in water and wastewater activity. We will continue to expand our contract design and construction services of water and wastewater facilities for developers, municipalities and other utilities and will continue to actively pursue water and wastewater operation contracts with municipalities across the Delmarva Peninsula.

In our non-regulated division, we are actively pursuing opportunities to expand our contract operations in southern Delaware. Artesian Development purchased eighteen acres of land, also located in Sussex County, Delaware, which will allow for construction of an office facility, water treatment facility and wastewater treatment facility. Artesian Consulting continues to provide engineering services to design on-site and off-site water and wastewater systems for developers as demand increases. Also, with the expansion efforts in our water and wastewater divisions, Artesian Consulting will provide increased design and engineering services.

Regulatory Matters and Inflation

Our water and wastewater utility operations are subject to regulation by their respective state regulatory commissions, which have broad administrative power and authority to regulate rates charged for service, determine franchise areas and conditions of service, approve acquisitions, authorize the issuance of securities and other matters. The profitability of our utility operations is influenced to a great extent by the timeliness and adequacy of rate allowances we are granted by the respective regulatory commissions or authorities in the states in which we operate.

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We are subject to regulation by the following state regulatory commissions: The DEPSC regulates both Artesian Water and Artesian Wastewater, Artesian Water Maryland and Artesian Wastewater Maryland are subject to the regulatory jurisdiction of the MDPSC, and Artesian Water Pennsylvania is subject to the regulatory jurisdiction of the PAPUC.

As of December 31, 2008, we had approximately 75,800 metered water customers and 632 wastewater customers in Delaware, and served a population of approximately 250,000 (including contract services), representing approximately 29% of Delaware's total population. Increases in the number of customers served by Artesian Water and Artesian Wastewater contributed to a portion of the increase in our operating revenues. Water customers increased by approximately 700, while wastewater customers increased by approximately 220.

Our regulated utilities periodically seek rate increases to cover the cost of increased operating expenses, increased financing expenses due to additional investments in utility plant and other costs of doing business. In Delaware, utilities are permitted by law to place rates into effect, under bond, on a temporary basis pending completion of a rate increase proceeding. The first temporary increase may be up to the lesser of $2.5 million on an annual basis or 15% of gross water sales. Should the rate case not be completed within seven months, by law, the utility may put the entire requested rate relief, up to 15% of gross water sales, in effect under bond until a final resolution is ordered and placed into effect. If any such rates are found to be in excess of rates the DEPSC finds to be appropriate, the utility must refund the portion found to be in excess to customers with interest. The timing of our rate increase requests are therefore dependent upon the estimated cost of the administrative process in relation to the investments and expenses that we hope to recover through the rate increase. We can provide no assurances that rate increase requests will be approved by applicable regulatory agencies; and, if approved, we cannot guarantee that these rate increases will be granted in a timely or sufficient manner to cover the investments and expenses for which we initially sought the rate increase.

As permitted under Delaware law, an interim increase in rates designed to increase annualized revenues by $2.5 million was placed in effect July 10, 2006 pending conclusion of our filing with the DEPSC for rate relief. On December 19, 2006, the DEPSC approved a Settlement Agreement in this case. The increase in annual revenue requirement under the Settlement Agreement of $6 million was generated in two steps. The first step was placed in effect on January 1, 2007 to generate approximately $4.8 million in annual revenue. The second step was placed in effect July 24, 2007. The second step rates were designed to recover approximately $1.2 million of annual revenue which reflected the issuance of additional equity issued by Artesian Resources and invested in Artesian Water in June and July of 2007 of approximately $20 million.

On January 25, 2008, Artesian Water submitted a notice to the DEPSC of our intent to file an application for a rate increase. On April 22, 2008, Artesian Water filed a petition with the DEPSC to implement new rates to meet a requested increase in revenue of 28.8%, or approximately $14.2 million, on an annualized basis. On July, 11, 2008, pursuant to the DEPSC's minimum filing requirements, Artesian filed a supplemental filing with the DEPSC to update financial schedules for actual experience through March 31, 2008 and to reflect additional changes affecting the requested increase. The overall result was a reduction to the requested increase in revenue of 1.5%, to 27.3% or approximately $13.5 million, on an annualized basis.

Delaware statute permits water utilities to put into effect, on a semi-annual basis, increases related to specific types of distribution system improvements through a Distribution System Improvement Charge or DSIC. This charge is available to water utilities to be implemented between general rate increase applications that normally recognize changes in a water utility's overall financial position. The DSIC approval process is less costly when compared to the approval process for general rate increase requests. The DSIC rate applied between base rate filings is capped at 7.5% of the amount billed to customers under otherwise applicable rates and charges, and the DSIC rate increase applied can not exceed 5% within any 12-month period. In December 2007, Artesian Water filed an application with the DEPSC for approval to collect a 0.46% increase, effective January 1, 2008, to recover the costs of eligible non-revenue producing improvements made since the last rate increase in 2006. The DEPSC approved the DSIC effective January 1, 2008 subject to audit at a later date. During 2008, we earned approximately $99,000 in DSIC revenue. On June 21, 2008, the Company discontinued the collection of DSIC pursuant to Delaware law which requires the Company to discontinue a DSIC when new base rates are put into effect. We did not have DSIC in effect during 2007.

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As permitted by law, on June 21, 2008, we placed temporary rates into effect, designed to generate an increase in annual operating revenue of approximately 5.0%, or $2.5 million on an annualized basis, until new rates are approved by the DEPSC. Also pursuant to law, on December 17, 2008, we placed temporary rates into effect, designed to generate an additional increase in annual operating revenue of approximately 10% or $5.0 million on an annualized basis, given that the rate case had not been concluded in a seven month period. Evidentiary hearings were held on December 8-9, 2008 and a final Commission decision is anticipated in the third quarter of 2009 in reference to the implementation of our requested rate increase.

In 2003, legislation was enacted in Delaware requiring all water utilities serving within northern New Castle County, Delaware to certify by July 2006, and each three years thereafter, that they have sufficient sources of self-supply to serve their respective systems. On June 30, 2006, Artesian Water filed our certification related to the adequacy of our water supply through 2009. After completion of their review, on July 24, 2007, the DEPSC accepted our certification of sufficient water supply. As required, we will file a new certification of self-sufficiency with the DEPSC by June 30, 2009, for the period through 2012.

In 1999, the General Assembly passed legislation restructuring the electric industry in Delaware. Since the passage of electric restructuring legislation in 1999, electricity prices had been capped for customers of Delmarva Power and the Delaware Electric Cooperative. Those rate caps were lifted in 2005 for customers of the Delaware Electric Cooperative and in May 2006 for Delmarva Power customers. Our electric charges increased in 2005 due to higher billing rates charged by Delaware Electric Cooperative after the cap was removed. In 2006, our electric charges increased further due to the increase from Delmarva Power. Although we were unable to escape the significant increase associated with the expiration of the price caps, we sought to mitigate future significant increases by signing a two-year supply contract, at a fixed price, with Pepco Holdings, Inc. in May of 2006 and another in April of 2008. This new pricing is included in our most recent request for rate relief filed with the DEPSC.

On April 10, 2006, the DEPSC made effective new rules under Regulation Docket 15 that govern the terms and conditions under which water utilities require advances or contributions from customers or developers. These regulations require that developers pay for all water facilities within a new development, with such funding recorded as contributions in aid of construction by the water utility. In addition, the utility is required to receive a contribution in aid of construction of $1,500 for each new residential connection to its system towards the cost of water supply, treatment and storage facilities. These regulations further require developers to fully pay for facilities to serve satellite systems. These required contributions are intended to place a greater burden upon new customers to pay for the cost of facilities required to serve them. On April 8, 2008, the DEPSC reopened this docket to assess the effectiveness of the 2006 rules and regulations requiring water utilities to collect contributions in aid of construction. We anticipate this proceeding to continue into 2009.

On March 20, 2007, the DEPSC entered Order No. 7142 which re-opened Regulation Docket No. 51. By this Order, the Commission proposes to repeal rules implemented in 2001 and replace them with new "Regulations Governing Certificates of Public Convenience and Necessity." The proposed rules address the content of how notifications are sent to landowners, the definitions for the "Proposed Service Area," and the requirement of the applying utility to certify that it will actually provide water services to a new proposed service territory within three years. If water service is not provided within the three year time frame, the proposed rule provides a mechanism for the Commission to determine whether the utility should be able to retain the new CPCN. The DEPSC has indicated that in the March 2009 proceedings they intend to recommend that a utility provide water service to a new proposed service territory within five years. These proposed rules have not been adopted and they may not be adopted or could be modified prior to adoption. As of December 31, 2008, no final decision had been made by the DEPSC.

Our water and wastewater utilities in Maryland are subject to regulation by the MDPSC. If we are seeking new franchise areas, we must first seek approval from the county government and this franchise area must be included in that county's master sewer and water plan. Final granting of these franchise areas must then . . .