**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

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**FORM 10-Q**

 

**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)**

**OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For the quarterly period ended June 30, 2004**

 

**Commission File Number 000-22371**

 

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**DECRANE AIRCRAFT HOLDINGS, INC.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                                                        |   | **34-1645569**      |
|-----------------------------------------------------------------------------------------------------|--------|---------------------|
| (State or other jurisdiction of                                                                     |   | (I.R.S. Employer    |
| incorporation or organization)                                                                      |   | Identification No.) |
|                                                                                                |   |                |
| **2361 Rosecrans Avenue, Suite 180, El Segundo, CA 90245**                                          |
| (Address, including zip code, of principal executive offices)                                       |
|                                                                                                |   |                |
| **(310) 725-9123**                                                                                  |
| (Registrant’s telephone number, including area code)                                           |
|                                                                                                |   |                |
| **(Not Applicable)**                                                                                |
| (Former address and telephone number of principal executive offices,  if changed since last report) |

 

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Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Actof 1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days.  ý** **Yes    oNo

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Act).  o Yes    ý No

 

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The number of shares of Registrant’s Common Stock, $.01 par value,outstanding as of August 9, 2004 was 100 shares.

 

 

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**Table of Contents**

 
| **Part I – Financial Information** |
|-----------------------------------------|
|                                    |   |   |
| **Item 1.**                             | **Financial Statements (Unaudited)** |   |
|                                    |   |   |
|                                    | Consolidated Balance Sheets as of June 30, 2004 and December 31, 2003 |   |
|                                    |   |   |
|                                    | Consolidated Statements of Operations for  the three months and six months  ended June 30, 2004 and 2003 |   |
|                                    |   |   |
|                                    | Consolidated Statements of Stockholder’s  Equity (Deficit) for the six months ended  June 30, 2004 |   |
|                                    |   |   |
|                                    | Consolidated Statements of Cash Flows for  the six months ended  June 30, 2004 and 2003 |   |
|                                    |   |   |
|                                    | Condensed Notes to Consolidated Financial  Statements |   |
|                                    |   |   |
| **Item 2.**                             | **Management’s Discussion and Analysis of Financial Condition and  Results of Operations** |   |
|                                    |   |   |
|                                    | Results of Operations |   |
|                                    |   |   |
|                                    | Performance Measures |   |
|                                    |   |   |
|                                    | Changes in Accounting Principles |   |
|                                    |   |   |
|                                    | Three months ended June 30 2004 |   |
|                                    |   |   |
|                                    | Six months ended June 30, 2004 |   |
|                                    |   |   |
|                                    | Restructuring,  Asset Impairment and Other Related Charges |   |
|                                    |   |   |
|                                    | Liquidity and Capital Resources |   |
|                                    |   |   |
|                                    | Disclosure of Contractual Obligations and  Commitments |   |
|                                    |   |   |
|                                    | Disclosure About Off-Balance Sheet  Commitments and Indemnities |   |
|                                    |   |   |
|                                    | Recent Accounting Pronouncements |   |
|                                    |   |   |
|                                    | Special Note Regarding Forward Looking  Statements and Risk Factors |   |
|                                    |   |   |
| **Item 3.**                             | **Quantitative and Qualitative Disclosure About Market Risk** |   |
|                                    |   |   |
| **Item 4.**                             | **Controls and Procedures** |   |
|                                    |   |   |
| **Part II – Other Information**    |
|                                    |   |   |
| **Item 1.**                             | **Legal Proceedings** |   |
|                                    |   |   |
| **Item 6.**                             | **Exhibits and Reports on Form 8-K** |   |
|                                    |   |   |
|                                    | Exhibits |   |
|                                    |   |   |
|                                    | Reports  on Form 8-K |   |
|                                    |   |   |
| **Signatures**                          |   |   |

 

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**PART I – FINANCIAL INFORMATION**

 

**ITEM 1.****                             FINANCIALSTATEMENTS**

 

**DECRANE AIRCRAFTHOLDINGS, INC. AND SUBSIDIARIES**

 

**Consolidated Balance Sheets**

 
| **(In thousands, except share data)**                                                                                                   |   | **June 30,  2004** |       | **December 31,  2003** |       |
|-----------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------|------------|-----------------------------|------------|
|                                                                                                                                    |   | **(Unaudited)**         | ** ** |                        | ** ** |
| **Assets**                                                                                                                              |   |                    |       |                        |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Current assets:                                                                                                                         |   |                    |       |                        |       |
| Cash and cash equivalents                                                                                                               |   | $                       | 2,362      |                        | $          | 6,936 |   |
| Accounts receivable, net                                                                                                                |   | 27,322                  |       | 21,455                      |       |
| Inventories                                                                                                                             |   | 52,314                  |       | 42,981                      |       |
| Prepaid expenses and other current assets                                                                                               |   | 1,176                   |       | 1,082                       |       |
| Total current assets                                                                                                                    |   | 83,174                  |       | 72,454                      |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Property and equipment, net                                                                                                             |   | 29,798                  |       | 30,900                      |       |
| Goodwill                                                                                                                                |   | 162,430                 |       | 162,430                     |       |
| Other assets, principally intangibles, net                                                                                              |   | 34,764                  |       | 38,092                      |       |
| Total assets                                                                                                                            |   | $                       | 310,166    |                        | $          | 303,876 |   |
|                                                                                                                                    |   |                    |       |                        |       |
| **Liabilities, Mandatorily Redeemable Preferred Stock and Stockholder’s  Equity (Deficit)**                                        |   |                    |       |                        |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Current liabilities:                                                                                                                    |   |                    |       |                        |       |
| Current portion of long-term debt                                                                                                       |   | $                       | 1,319      |                        | $          | 1,198 |   |
| Accounts payable                                                                                                                        |   | 17,377                  |       | 15,462                      |       |
| Accrued liabilities                                                                                                                     |   | 23,387                  |       | 17,890                      |       |
| Income taxes payable                                                                                                                    |   | 64                      |       | —                      |       |
| Total current liabilities                                                                                                               |   | 42,147                  |       | 34,550                      |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Long-term debt                                                                                                                          |   | 283,821                 |       | 268,208                     |       |
| Mandatorily redeemable preferred stock                                                                                                  |   | 44,602                  |       | —                      |       |
| Other long-term liabilities                                                                                                             |   | 7,836                   |       | 5,464                       |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Commitments and contingencies (Note 10)                                                                                                 |   |                    |       |                        |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Mandatorily redeemable preferred stock                                                                                                  |   | —                  |       | 40,835                      |       |
|                                                                                                                                    |   |                    |       |                        |       |
| Stockholder’s equity (deficit):                                                                                                    |   |                    |       |                        |       |
| Common stock, $.01 par value, 1,000 shares  authorized and 100 shares issued and outstanding as of June 30, 2004 and  December 31, 2003 |   | —                  |       | —                      |       |
| Additional paid-in capital                                                                                                              |   | 112,987                 |       | 112,987                     |       |
| Notes receivable for shares sold                                                                                                        |   | (1,305                  | )          | (1,268                      | )          |
| Accumulated deficit                                                                                                                     |   | (179,654                | )          | (156,632                    | )          |
| Accumulated other comprehensive loss                                                                                                    |   | (268                    | )          | (268                        | )          |
| Total stockholder’s equity (deficit)                                                                                               |   | (68,240                 | )          | (45,181                     | )          |
| Total liabilities, mandatorily redeemable  preferred stock and stockholder’s equity (deficit)                                      |   | $                       | 310,166    |                        | $          | 303,876 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

1

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**DECRANE AIRCRAFTHOLDINGS, INC. AND SUBSIDIARIES**

 

**ConsolidatedStatements of Operations**

 
|                                                               |   | **Three  Months Ended  June 30,** |    | **Six Months  Ended  June 30,** |   |
|--------------------------------------------------------------------|--------|-----------------------------------|---------|--------------------------------------|--------|
| **(In thousands)**                                                 |   | **2004**                          |    | **2003**                             |   | **2004** |   | **2003** |   |
|                                                               |   | **(Unaudited)**                   |    |
| Revenues                                                           |   | $                                 | 54,817  |                                 | $      | 44,113 |   | $ | 103,414 |   | $ | 86,013 |   |
| Cost of sales                                                      |   | 47,317                            |    | 38,714                               |   | 84,156 |   | 67,592 |   |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Gross profit                                                       |   | 7,500                             |    | 5,399                                |   | 19,258 |   | 18,421 |   |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Operating expenses:                                                |   |                              |    |                                 |   |   |   |   |   |
| Selling, general and administrative  expenses                      |   | 7,788                             |    | 6,979                                |   | 15,025 |   | 16,909 |   |
| Research and development expenses                                  |   | 2,001                             |    | 3,278                                |   | 4,182 |   | 4,851 |   |
| Impairment of goodwill                                             |   | —                            |    | 34,000                               |   | — |   | 34,000 |   |
| Amortization of intangible assets                                  |   | 913                               |    | 914                                  |   | 1,825 |   | 1,826 |   |
| Total operating expenses                                           |   | 10,702                            |    | 45,171                               |   | 21,032 |   | 57,586 |   |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Loss from operations                                               |   | (3,202                            | )       | (39,772                              | )      | (1,774 | ) | (39,165 | ) |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Other expenses:                                                    |   |                              |    |                                 |   |   |   |   |   |
| Interest expense                                                   |   | 8,750                             |    | 6,468                                |   | 17,452 |   | 12,337 |   |
| Mandatorily redeemable preferred stock  dividends                  |   | 1,801                             |    | —                               |   | 3,533 |   | — |   |
| Other expenses, net                                                |   | 91                                |    | 407                                  |   | 203 |   | 746 |   |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Loss from continuing operations before  provision for income taxes |   | (13,844                           | )       | (46,647                              | )      | (22,962 | ) | (52,248 | ) |
| Provision for income (taxes) benefit                               |   | (30                               | )       | 9,365                                |   | (60 | ) | 10,630 |   |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Loss from continuing operations                                    |   | (13,874                           | )       | (37,282                              | )      | (23,022 | ) | (41,618 | ) |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Discontinued operations and change in  accounting principle:       |   |                              |    |                                 |   |   |   |   |   |
| Income (loss) from discontinued operations,  net of tax            |   | —                            |    | 747                                  |   | — |   | (5,650 | ) |
| Cumulative effect of change in accounting  principle               |   | —                            |    | —                               |   | — |   | (13,764 | ) |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Net loss                                                           |   | (13,874                           | )       | (36,535                              | )      | (23,022 | ) | (61,032 | ) |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Accrued preferred stock dividends                                  |   | —                            |    | (1,540                               | )      | — |   | (3,020 | ) |
| Preferred stock redemption value accretion                         |   | —                            |    | (117                                 | )      | — |   | (234 | ) |
|                                                               |   |                              |    |                                 |   |   |   |   |   |
| Net loss applicable to common stockholder                          |   | $                                 | (13,874 | )                                    | $      | (38,192 | ) | $ | (23,022 | ) | $ | (64,286 | ) |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

2

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**DECRANE AIRCRAFTHOLDINGS, INC. AND SUBSIDIARIES**

 

**ConsolidatedStatement of Stockholder’s Equity (Deficit)**

 
|                                  |   |              |   |        |   | **Additional** |   | **Notes  Receivable** |   |              |   | **Accumulated  Other** |   |      |   |
|---------------------------------------|--------|-------------------|--------|-------------|--------|----------------|--------|-----------------------|--------|-------------------|--------|------------------------|--------|-----------|--------|
|                                  |   | **Common  Stock** |   | **Paid-in** |   | **For Shares** |   | **Accumulated**       |   | **Comprehensive** |   |                   |   |
| **(In thousands, except share data)** |   | **Shares**        |   | **Amount**  |   | **Capital**    |   | **Sold**              |   | **Deficit**       |   | **Loss**               |   | **Total** |   |
|                                  |   |              |   |        |   |           |   |                  |   |              |   |                   |   |      |   |
| Balance, December 31, 2003       |   | 100               |   | $           | — |           | $      | 112,987               |   | $                 | (1,268 | )                      | $      | (156,632  | )      | $ | (268 | ) | $ | (45,181 | ) |
|                                  |   |              |   |        |   |           |   |                  |   |              |   |                   |   |      |   |
| Comprehensive loss:                   |   |              |   |        |   |           |   |                  |   |              |   |                   |   |      |   |
| Net loss                              |   | —            |   | —      |   | —         |   | —                |   | (23,022           | )      | —                 |   | (23,022   | )      |
|                                  |   |              |   |        |   |           |   |                  |   |              |   |                   |   |      |   |
| Notes receivable interest accrued     |   | —            |   | —      |   | —         |   | (37                   | )      | —            |   | —                 |   | (37       | )      |
|                                  |   |              |   |        |   |           |   |                  |   |              |   |                   |   |      |   |
| Balance, June 30, 2004 (Unaudited)    |   | 100               |   | $           | — |           | $      | 112,987               |   | $                 | (1,305 | )                      | $      | (179,654  | )      | $ | (268 | ) | $ | (68,240 | ) |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

3

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**DECRANE AIRCRAFTHOLDINGS, INC. AND SUBSIDIARIES**

 

**ConsolidatedStatements of Cash Flows**

 
|                                                                                        |   | **Six Months  Ended  June 30,** |    |
|---------------------------------------------------------------------------------------------|--------|---------------------------------|---------|
| **(In thousands)**                                                                          |   | **2004**                        |    | **2003** |   |
|                                                                                        |   | **(Unaudited)**                 |    |
| **Cash flows from operating activities:**                                                   |   |                            |    |   |   |
| Net loss                                                                                    |   | $                               | (23,022 | ) | $ | (61,032 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used for) operating activities: |   |                            |    |   |   |
| Cumulative effect of change in accounting  principles                                       |   | —                          |    | 13,764 |   |
| Loss from discontinued operations                                                           |   | —                          |    | 5,650 |   |
| Depreciation and amortization                                                               |   | 6,184                           |    | 6,342 |   |
| Mandatorily redeemable preferred stock  dividends                                           |   | 3,533                           |    | — |   |
| Noncash portion of restructuring, asset  impairment and other related charges               |   | 2,978                           |    | 37,664 |   |
| Interest accretion on second-lien term debt                                                 |   | 1,213                           |    | — |   |
| Preferred stock redemption value accretion                                                  |   | 234                             |    | — |   |
| Deferred income taxes                                                                       |   | —                          |    | (11,659 | ) |
| Other, net                                                                                  |   | (13                             | )       | 295 |   |
| Changes in assets and liabilities:                                                          |   |                            |    |   |   |
| Accounts receivable                                                                         |   | (5,867                          | )       | 4,207 |   |
| Inventories                                                                                 |   | (12,144                         | )       | (7,854 | ) |
| Prepaid expenses and other assets                                                           |   | (270                            | )       | 541 |   |
| Accounts payable                                                                            |   | 1,915                           |    | (2,251 | ) |
| Accrued liabilities                                                                         |   | 5,432                           |    | (10,755 | ) |
| Income taxes payable                                                                        |   | 162                             |    | 385 |   |
| Other long-term liabilities                                                                 |   | 2,372                           |    | 4,761 |   |
| Net cash used for operating activities                                                      |   | (17,293                         | )       | (19,942 | ) |
|                                                                                        |   |                            |    |   |   |
| **Cash flows from investing activities:**                                                   |   |                            |    |   |   |
| Net proceeds from sale of Specialty  Avionics Group                                         |   | —                          |    | 132,800 |   |
| Capital expenditures                                                                        |   | (1,767                          | )       | (2,002 | ) |
| Cash paid for acquisition contingent  consideration                                         |   | —                          |    | (600 | ) |
| Net cash provided by (used for) investing  activities                                       |   | (1,767                          | )       | 130,198 |   |
|                                                                                        |   |                            |    |   |   |
| **Cash flows from financing activities:**                                                   |   |                            |    |   |   |
| Debt borrowings:                                                                            |   |                            |    |   |   |
| Revolving line of credit, net                                                               |   | 15,050                          |    | 9,250 |   |
| Other secured long-term                                                                     |   | 46                              |    | — |   |
| Debt repayments:                                                                            |   |                            |    |   |   |
| First-lien term debt                                                                        |   | —                          |    | (129,275 | ) |
| Other secured long-term debt                                                                |   | (610                            | )       | (1,173 | ) |
| Net cash provided by (used for) financing  activities                                       |   | 14,486                          |    | (121,198 | ) |
|                                                                                        |   |                            |    |   |   |
| Net cash provided by discontinued  operations                                               |   | —                          |    | 2,194 |   |
|                                                                                        |   |                            |    |   |   |
| Net decrease in cash and cash equivalents                                                   |   | (4,574                          | )       | (8,748 | ) |
| Cash and cash equivalents at beginning of  period                                           |   | 6,936                           |    | 12,421 |   |
| Cash and cash equivalents at end of period                                                  |   | $                               | 2,362   |   | $ | 3,673 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

4

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**DECRANE AIRCRAFTHOLDINGS, INC. AND SUBSIDIARIES**

 

**Condensed Notes toConsolidated Financial Statements**

**(Unaudited)**

 

**Note 1.           Summary of Significant AccountingPolicies**

** **

**Basis of Presentation**

** **

These consolidated interim financial statements areunaudited.  The Company believes theinterim financial statements are presented on a basis consistent with theaudited financial statements and include all adjustments necessary for a fairpresentation of the financial condition, results of operations and cash flows forsuch interim periods.  All of theseadjustments are normal recurring adjustments.

 

Preparation of these consolidated financial statementsin conformity with accounting principles generally accepted in the UnitedStates of America requires the Company to make estimates and judgments thataffect the reported amounts of assets, liabilities and disclosure of contingentassets and liabilities at the date of the consolidated financial statements andthe reported amounts of revenues and expenses during the reportingperiods.  Actual results could differfrom those estimates.

 

The results of operations for interim periods do notnecessarily predict the operating results for any other interim period or forthe full year.  The consolidated balancesheet as of December 31, 2003 has been derived from audited financialstatements but does not include all disclosures required by accountingprinciples generally accepted in the United States of America as permitted byinterim reporting requirements.  Theseconsolidated interim financial statements should be read in conjunction withManagement’s Discussion and Analysis of Financial Condition and Results ofOperations and the audited financial statements and related notes included inthe Company’s 2003 Form 10-K. Reclassifications have been made to the financial statements for priorperiods to conform to the current year presentation.

 

**Changes in Accounting Principles**

** **

***SFAS No. 150Adopted January 1, 2004***

** **

Effective January 1, 2004, the Company adopted SFASNo. 150, “Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity.”  SFAS No.150 establishes standards for the classification and measurement of certainfinancial instruments with characteristics of both liabilities and equity.  SFAS No. 150 requires classification offinancial instruments within its scope as a liability, including financialinstruments issued in the form of shares that are mandatorily redeemable,because those financial instruments are deemed to be, in essence, obligationsof the issuer.  As a result of adoptingSFAS No. 150 on January 1, 2004, the 16% mandatorily redeemable preferred stockwas reclassified as a liability and the quarterly dividend and redemption valueaccretion are reflected as charges against pre-tax income.  In periods prior to January 1, 2004, thesecharges were deducted in arriving at the net income or loss applicable to theCompany’s common stockholder.

 

The following table summarizes the results ofoperations for the three months and six months ended June 30, 2003 as if SFASNo. 150 had been in effect as of the beginning of 2003.

 

5

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|                            |   | **Three  Months Ended  June 30, 2003** |    | **Six Months  Ended  June 30, 2003** |   |
|---------------------------------|--------|----------------------------------------|---------|-------------------------------------------|--------|
| **(In thousands)**              |   | **As  Reported**                       |    | **Pro Forma**                             |   | **As Reported** |   | **Pro Forma** |   |
|                            |   | **(Unaudited)**                        |    |
| Loss from continuing operations |   | $                                      | (37,282 | )                                         | $      | (38,939 | ) | $ | (41,618 | ) | $ | (44,872 | ) |
| Net loss                        |   | (36,535                                | )       | (38,192                                   | )      | (61,032 | ) | (64,286 | ) |
|                                 |        |                                        |         |                                           |        |  |  |  |  |  |  |  |  |

 

The pro forma data reflects preferred stock dividendsand redemption value accretion totaling $1,657,000 for three months ended June30, 2003 and $3,254,000 for the six months ended June 30, 2003 as chargesagainst income during the periods.

 

***Discontinued Useof Program Accounting Commencing January 1, 2003***

** **

As more fully described in “Note 1—Change inAccounting Principle” to the audited financial statements included in theCompany’s 2003 Form 10-K, the Company elected to discontinue the use of programaccounting for the costs of products manufactured for delivery underproduction-type contracts.  As a result,certain deferred program costs are no longer included in inventory commencingJanuary 1, 2003.

 

This change in accounting policy was made afterconcluding the 2003 fiscal year but was applied retroactively to the beginningof the year, January 1, 2003, as required by generally accepted accountingprinciples.  As a result of the change,program-related product development costs are now classified as a component ofresearch and development expenses in the consolidated financial statements ratherthan classified as a component of inventory cost.  The Company has restated its results of operations by chargingpreviously inventoried costs totaling $3,278,000 and $4,851,000 for the threemonths and six months ended June 30, 2003, respectively, to research anddevelopment expense and recording a $13,764,000 charge as of January 1,2003 to reflect the cumulative effect of the change in accounting principle.

 

**Stock Option Plan**

** **

The Company has one stock-based employee compensationplan, which is more fully described in the notes to its audited financialstatements.  As permitted under SFAS No.123, “Accounting for Stock-Based Compensation,” the Company measurescompensation expense related to the employee stock option plan utilizing theintrinsic value method as prescribed by Accounting Principles Board Opinion No.25, “Accounting for Stock Issued to Employees,” and relatedinterpretations.  No stock-basedemployee compensation cost is reflected in net income (loss), as all optionsgranted under the plan had an exercise price equal to the value of theunderlying common stock on the date of grant.

 

The following table illustrates the effect on netincome if the Company had applied the fair value recognition provisions of SFASNo. 123 to stock-based employee compensation.

 
|                                                                                                                                           |   | **Three  Months Ended  June 30,** |    | **Six Months  Ended  June 30,** |   |
|------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|---------|--------------------------------------|--------|
| **(In thousands)**                                                                                                                             |   | **2004**                          |    | **2003**                             |   | **2004** |   | **2003** |   |
|                                                                                                                                           |   | **(Unaudited)**                   |    |
| Net loss, as reported                                                                                                                          |   | $                                 | (13,874 | )                                    | $      | (36,535 | ) | $ | (23,022 | ) | $ | (61,032 | ) |
| Less total stock-based employee  compensation expense determined under the fair value based method for all  awards, net of related tax effects |   | (81                               | )       | (94                                  | )      | (162 | ) | (188 | ) |
| Pro forma net loss                                                                                                                             |   | $                                 | (13,955 | )                                    | $      | (36,629 | ) | $ | (23,184 | ) | $ | (61,220 | ) |

 

6

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The effect of applying SFAS No. 123 may not berepresentative of the pro forma effect in future years since additional optionsmay be granted during those future years.

 

**Note 2.           Restructuring, Asset Impairment andOther Related Charges**

** **

During the three months and six months ended June 30,2004 and 2003, the Company recorded restructuring, asset impairment and otherrelated charges as follows:

 
|                                                                       |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------------------------------------------------------|--------|-----------------------------------|--------|--------------------------------------|--------|
| **(In thousands)**                                                         |   | **2004**                          |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                                       |   | **(Unaudited)**                   |   |
| Nature of charges:                                                         |   |                              |   |                                 |   |   |   |   |   |
| Operational Realignment and Facilities  Restructuring                      |   | $                                 | 6,901  |                                 | $      | — |   | $ | 6,901 |   | $ | — |   |
| Seating Product Line and Furniture  Manufacturing Facilities Restructuring |   | —                            |   | 7,132                                |   | — |   | 7,132 |   |
| Goodwill impairment charges                                                |   | —                            |   | 34,000                               |   | — |   | 41,500 |   |
| Total pre-tax charges                                                      |   | $                                 | 6,901  |                                 | $      | 41,132 |   | $ | 6,901 |   | $ | 48,632 |   |
|                                                                       |   |                              |   |                                 |   |   |   |   |   |
| Business segment recording the charges:                                    |   |                              |   |                                 |   |   |   |   |   |
| Cabin Management                                                           |   | $                                 | 1,628  |                                 | $      | 41,132 |   | $ | 1,628 |   | $ | 41,132 |   |
| Systems Integration                                                        |   | 5,273                             |   | —                               |   | 5,273 |   | — |   |
| Total continuing operations                                                |   | 6,901                             |   | 41,132                               |   | 6,901 |   | 41,132 |   |
| Discontinued operations (Specialty  Avionics)                              |   | —                            |   | —                               |   | — |   | 7,500 |   |
| Total pre-tax charges                                                      |   | $                                 | 6,901  |                                 | $      | 41,132 |   | $ | 6,901 |   | $ | 48,632 |   |
|                                                                       |   |                              |   |                                 |   |   |   |   |   |
| Charged to operations:                                                     |   |                              |   |                                 |   |   |   |   |   |
| Cost of sales                                                              |   | $                                 | 6,083  |                                 | $      | 6,573 |   | $ | 6,083 |   | $ | 6,573 |   |
| Selling, general and administrative  expenses                              |   | 818                               |   | 559                                  |   | 818 |   | 559 |   |
| Impairment of goodwill                                                     |   | —                            |   | 34,000                               |   | — |   | 34,000 |   |
| Discontinued operations (Specialty  Avionics)                              |   | —                            |   | —                               |   | — |   | 7,500 |   |
| Total pre-tax charges                                                      |   | $                                 | 6,901  |                                 | $      | 41,132 |   | $ | 6,901 |   | $ | 48,632 |   |
|                                                                       |   |                              |   |                                 |   |   |   |   |   |
| Components of charges:                                                     |   |                              |   |                                 |   |   |   |   |   |
| Continuing operations:                                                     |   |                              |   |                                 |   |   |   |   |   |
| Noncash charges                                                            |   | $                                 | 2,978  |                                 | $      | 37,664 |   | $ | 2,978 |   | $ | 37,664 |   |
| Cash charges                                                               |   | 3,923                             |   | 3,468                                |   | 3,923 |   | 3,468 |   |
| Total continuing operations pre-tax charges                                |   | 6,901                             |   | 41,132                               |   | 6,901 |   | 41,132 |   |
| Discontinued operations (noncash charges)                                  |   | —                            |   | —                               |   | — |   | 7,500 |   |
| Total pre-tax charges                                                      |   | $                                 | 6,901  |                                 | $      | 41,132 |   | $ | 6,901 |   | $ | 48,632 |   |

 

7

----

 

**OperationalRealignment and Facilities Consolidation**

 

During the second quarter of fiscal 2004, the Companyadopted plans to restructure the operations of its Cabin Management and SystemsIntegration groups.  The restructuringplan for Cabin Management involves the realignment of production between itsmanufacturing facilities and the relocation and consolidation of the group’sheadquarters to Wichita, Kansas.  Theplan for Systems Integration involves combining the manufacturing activities oftwo facilities into a single facility and eliminating some product offeringsand service capabilities resulting in a partial downsizing of certainoperations.  These actions are designedto reduce engineering, production and inventory carrying costs by supportingfewer manufacturing locations and product offerings.  In connection with these actions, the Company recorded pre-taxcharges to operations totaling $6,901,000, comprised of the following:

 

•                  *Lease Termination and RelatedCharges. *Lease termination and other relatedcharges are comprised of the net losses expected to be incurred under theexisting long-term lease agreements for facilities permanently vacated.  The losses have been reduced by the expectedsublease income.  These expected losseswere based on estimated current market rates and anticipated dates that thesefacilities are subleased.  If marketrates decrease or should it take longer than expected to sublease thesefacilities, the actual loss could exceed these estimates.  Otherrelated charges include the write-off of leasehold improvements related to thevacated facilities.

 

•                  *Write-Down of SurplusInventory. *Inventory waswritten down to reflect its net realizable value for quantities on handexceeding current and forecast order backlog requirements related to the curtailed product offerings.

 

•                  *Severance and Other CompensationCosts. *The Company’s totalworkforce will be reduced by 25 employees, or 2% from December 31, 2003 levels,when the restructuring is completed during the third quarter of fiscal 2004.

 

•                  *Other Restructuring Charges.* Other charges pertain to legal, travel and relocation costs.

 

The Company expects to incur additionalrestructuring-related expenses of approximately $1,900,000 during the last halfof fiscal 2004 to complete the restructuring plans.  These expenses, which are primarily relocation and travel costs,will be expensed as incurred.

 

The components of the restructuring, asset impairmentand other related charges are as follows:

 
|                                                |   | **Total  Charges** |        | **Amounts Incurred** |     | **Balance at  June 30,  2004** |   |
|-----------------------------------------------------|--------|--------------------|-------------|----------------------|----------|-------------------------------------|--------|
| **(In thousands)**                                  |   |               | **Noncash** |                 | **Cash** |                                |   |
|                                                |   |               |        | **(Unaudited)**      |     |                                |   |
| Lease termination and other related charges         |   | $                  | 2,992       |                 | $        | (102                                | )      | $ | — |   | $ | 2,890 |   |
| Excess inventory write-downs                        |   | 2,811              |        | (2,811               | )        | —                              |   | — |   |
| Severance and other compensation costs              |   | 538                |        | —               |     | (20                                 | )      | 518 |   |
| Other restructuring charges                         |   | 560                |        | (65                  | )        | (183                                | )      | 312 |   |
| Total                                               |   | 6,901              |        | $                    | (2,978   | )                                   | $      | (203 | ) | $ | 3,720 |   |
|                                                |   |               |        |                 |     |                                |   |   |   |
| Other restructuring-related charges to be  incurred |   | 1,900              |        |                 |     |                                |   |   |   |
| Total expected restructuring charges                |   | $                  | 8,801       |                 |     |                                |   |   |   |   |

 

Future cash payments will be funded from existing cashbalances and internally generated cash from operations.

 

8

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**Seating Product Line and Furniture ManufacturingFacilities Restructuring**

** **

During the second quarter of fiscal 2003, the Companyconsolidated its seating product line offerings and adopted a restructuringplan to down-size a furniture manufacturing facility in response to continuingweakness in the business, VIP and head-of-state aircraft market.  These actions were designed to reduceengineering, production and inventory carrying costs by supporting fewerproduct offerings and achieve profitability at the furniture manufacturingfacility based on its lower production levels. In connection with these actions, the Company recorded pre-tax chargesto operations totaling $7,132,000, comprised of the following:

 

•                  *Lease Termination and RelatedCharges. *Leasetermination charges reflect lease cancellation costs for the facilities vacatedand possession returned to the lessor in connection with down-sizing afurniture manufacturing facility.  Otherrelated charges include the write-off of leasehold improvements related to thevacated facilities.

 

•                  *Excess Inventory Write-Downs. *Inventory was written downby $3,073,000 to reflect its net realizable value for quantities on handexceeding current and forecast order backlog requirements related to the curtailed seating product offerings.

 

•                  *Severance and Other CompensationCosts. *The Company reduced itstotal workforce at the down-sized facility by 49 employees, or 37%, fromDecember 31, 2002 levels.

 

The components of the restructuring, asset impairmentand other related charges are as follows:

 
|                                        |   |        |   |                  |   |                  |   | **Balance at** |   |
|---------------------------------------------|--------|-------------|--------|-----------------------|--------|-----------------------|--------|----------------|--------|
|                                        |   | **Total**   |   | **Amounts  Incurred** |   | **December 31,** |   |
| **(In thousands)**                          |   | **Charges** |   | **Noncash**           |   | **Cash**              |   | **2003**       |   |
| Lease termination and other related charges |   | $           | 3,876  |                  | $      | (591                  | )      | $              | (3,285 | ) | $ | — |   |
| Excess inventory write-downs                |   | 3,073       |   | (3,073                | )      | —                |   | —         |   |
| Severance and other compensation costs      |   | 183         |   | —                |   | (183                  | )      | —         |   |
| Total                                       |   | $           | 7,132  |                  | $      | (3,664                | )      | $              | (3,468 | ) | $ | — |   |

 

The restructuring activities were completed during2003.

 

**Goodwill Impairment Charges**

 

As a result of the continuing weakness in thebusiness, VIP and head-of-state aircraft market and the decision to down-size afurniture manufacturing facility, the goodwill associated with the furnituremanufacturing reporting unit was tested for recoverability in June 2003 andfound to be impaired.  As a result,$34,000,000 of goodwill associated with the reporting unit was written off andcharged to operations during the three months ended June 30, 2003.

 

As described in Note 3, on March 14, 2003, the Companyentered into a definitive agreement to sell its equity interests in thesubsidiaries comprising its Specialty Avionics Group for $140,000,000 incash.  Based upon the fair value of thegroup implied in the definitive agreement, the Company determined that thecarrying value of the group’s net assets was not fully recoverable.  As a result, the Company recorded a goodwillimpairment charge of $7,500,000 during the three months endedMarch 31, 2003 to reduce the carrying value to estimated netrealizable value.

 

9

----

 

**Note 3.           Disposition of Specialty AvionicsGroup**

** **

On May 23, 2003, the Company consummated the sale ofthe subsidiaries comprising its Specialty Avionics Group for $140,000,000 incash.  Based upon the fair value of thegroup implied in the definitive agreement which was signed during the first quarterof fiscal 2003, the Company determined that the carrying value of the group’snet assets was not fully recoverable. As required by SFAS No. 142, the Company recorded a goodwill impairmentcharge of $7,500,000 during the first quarter of fiscal 2003 to reduce thecarrying value to the estimated net realizable value established by thedefinitive agreement.  The Companyrecorded a modest gain on the sale, based on the actual financial position ofthe group on the date of sale.  As aresult of the sale, the Specialty Avionics Group is presented as a discontinuedoperation in the accompanying consolidated financial statements.

 

In accordance with the Financial Accounting StandardsBoard’s Emerging Issues Task Force Issue No. 87-24, “Allocation of Interest toDiscontinued Operations,” as amended, interest expense includes interest ondebt that is to be assumed by the buyer as well as interest on the $130,723,000of debt that was required to be repaid as a result of the sale.  Interest expense was based on the historicalinterest rates charged during each of the periods.  In addition, and also in accordance with EITF 87-24, costs andexpenses exclude the allocation of general corporate overhead.

 

The following tables summarize the results operationsand cash flows of the Specialty Avionics Group for the two months and fivemonths ended May 23, 2003, the date of sale.

 
|                                                |   | **May 23,  2003** |   |
|-----------------------------------------------------|--------|-------------------|--------|
| **(In thousands)**                                  |   | **Two  Months**   |   | **Five  Months** |   |
|                                                |   | **(Unaudited)**   |   |
| Revenues                                            |   | $                 | 13,125 |   | $ | 36,595 |   |
|                                                |   |              |   |   |   |
| Operating expenses:                                 |   |              |   |   |   |
| Costs and expenses                                  |   | 11,136            |   | 30,128 |   |
| Impairment of goodwill                              |   | —            |   | 7,500 |   |
| Amortization of intangible assets                   |   | 321               |   | 878 |   |
| Total operating expenses                            |   | 11,457            |   | 38,506 |   |
|                                                |   |              |   |   |   |
| Income (loss) from operations                       |   | 1,668             |   | (1,911 | ) |
|                                                |   |              |   |   |   |
| Other expenses:                                     |   |              |   |   |   |
| Interest expense:                                   |   |              |   |   |   |
| Debt required to be repaid with proceeds  from sale |   | 1,146             |   | 2,952 |   |
| Debt obligations assumed by the buyer               |   | 68                |   | 270 |   |
| Other expenses, net                                 |   | 52                |   | 153 |   |
|                                                |   |              |   |   |   |
| Pre-tax income (loss)                               |   | 402               |   | (5,286 | ) |
| Provision for income taxes                          |   | 344               |   | 1,053 |   |
|                                                |   |              |   |   |   |
| Income (loss) from operations                       |   | 58                |   | (6,339 | ) |
| Gain on sale, net of tax                            |   | 689               |   | 689 |   |
|                                                |   |              |   |   |   |
| Net income (loss) from discontinued  operations     |   | $                 | 747    |   | $ | (5,650 | ) |

 

10

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| **(In thousands)**                              |   | **Five  Months Ended  May 23,  2003** |   |
|-------------------------------------------------|--------|--------------------------------------------|--------|
|                                            |   | **(Unaudited)**                            |   |
| Cash Flows Provided By (Used For):              |   |                                       |   |
| Operating activities                            |   | $                                          | 3,760  |   |
| Investing activities                            |   | (902                                       | )      |
| Financing activities                            |   | (649                                       | )      |
| Net increase in cash and cash equivalents       |   | (13                                        | )      |
| Effect of foreign currency translation on  cash |   | (2                                         | )      |
| Net cash provided by discontinued  operations   |   | $                                          | 2,194  |   |

 

**Note 4.           Inventories**

** **

Inventories are comprised of the following as ofJune 30, 2004 and December 31, 2003:

 
| **(In thousands)**                                                           |   | **June 30,  2004** |   | **December 31,  2003** |   |
|------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                                         |   | **(Unaudited)**         |   |                        |   |
| Raw materials                                                                |   | $                       | 28,483 |                        | $      | 30,414 |   |
| Work-in-process                                                              |   | 15,216                  |   | 6,817                       |   |
| Finished goods                                                               |   | 1,860                   |   | 1,693                       |   |
| Costs and estimated earnings in excess of  billings on uncompleted contracts |   | 6,755                   |   | 4,057                       |   |
| Total inventories                                                            |   | $                       | 52,314 |                        | $      | 42,981 |   |

 

Total costs and estimated earnings on all uncompletedcontracts as of June 30, 2004 and December 31, 2004 are comprised ofthe following:

 
| **(In thousands)**                                                            |   | **June 30,  2004** |   | **December 31,  2003** |   |
|-------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                                          |   | **(Unaudited)**         |   |                        |   |
| Costs incurred on uncompleted contracts                                       |   | $                       | 79,663 |                        | $      | 71,824 |   |
| Estimated earnings recognized                                                 |   | 76,605                  |   | 77,782                      |   |
| Total costs and estimated earnings                                            |   | 156,268                 |   | 149,606                     |   |
| Less billings to date                                                         |   | (152,771                | )      | (145,661                    | )      |
| Net                                                                           |   | $                       | 3,497  |                        | $      | 3,945 |   |
|                                                                          |   |                    |   |                        |   |
| Balance sheet classification:                                                 |   |                    |   |                        |   |
| Asset – Costs and estimated earnings in  excess of billings              |   | $                       | 6,755  |                        | $      | 4,057 |   |
| Liability – Billings in excess of costs and  estimated earnings (Note 6) |   | (3,258                  | )      | (112                        | )      |
| Net                                                                           |   | $                       | 3,497  |                        | $      | 3,945 |   |

 

11

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**Note 5.   Other Assets, Principally Intangibles**

** **

Other assets are comprised of the following as of June30, 2004 and December 31, 2003:

 
| **(In thousands)**                                       |   | **June 30,  2004** |   | **December 31,  2003** |   |
|----------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                     |   | **(Unaudited)**         |   |                        |   |
| Identifiable intangible assets with finite  useful lives |   | $                       | 23,630 |                        | $      | 25,455 |   |
| Deferred financing costs                                 |   | 10,231                  |   | 11,812                      |   |
| Other non-amortizable assets                             |   | 903                     |   | 825                         |   |
| Total other assets                                       |   | $                       | 34,764 |                        | $      | 38,092 |   |

 

**Identifiable IntangibleAssets with Finite Useful Lives**

** **

Identifiable intangible assets with finite usefullives are comprised of the following as of June 30, 2004 and December 31,2003:

 
|                           |   | **June 30,  2004 (Unaudited )** |   | **December 31,  2003**   |   |
|--------------------------------|--------|---------------------------------|--------|-------------------------------|--------|
| **(In thousands)**             |   | **Cost**                        |   | **Accumulated  Amortization** |   | **Net** |   | **Cost** |   | **Accumulated  Amortization** |   | **Net** |   |
| FAA certifications             |   | $                               | 22,272 |                          | $      | (6,965 | ) | $ | 15,307 |   | $ | 22,272 |   | $ | (6,222 | ) | $ | 16,050 |   |
| Engineering drawings           |   | 7,645                           |   | (2,540                        | )      | 5,105 |   | 7,645 |   | (2,286 | ) | 5,359 |   |
| Other identifiable intangibles |   | 11,345                          |   | (8,127                        | )      | 3,218 |   | 11,345 |   | (7,299 | ) | 4,046 |   |
| Total identifiable intangibles |   | $                               | 41,262 |                          | $      | (17,632 | ) | $ | 23,630 |   | $ | 41,262 |   | $ | (15,807 | ) | $ | 25,455 |   |

 

Estimated annual amortization expense for allidentifiable intangible assets with finite useful lives for the five-yearperiod ending December 31, 2008 is as follows: 2004 – $3,644,000; 2005 –$3,477,000; 2006 – $2,275,000; 2007 – $2,175,000; and 2008 – $2,171,000.

 

**Note 6.           Accrued Liabilities**

** **

Accrued liabilities are comprised of the following asof June 30, 2004 and December 31, 2003:

 
| **(In thousands)**                                                           |   | **June 30,  2004** |   | **December 31,  2003** |   |
|------------------------------------------------------------------------------|--------|-------------------------|--------|-----------------------------|--------|
|                                                                         |   | **(Unaudited)**         |   |                        |   |
| Salaries, wages, compensated absences and  payroll related taxes             |   | $                       | 4,700  |                        | $      | 4,017 |   |
| Billings in excess of costs and estimated  earnings on uncompleted contracts |   | 3,258                   |   | 112                         |   |
| Accrued interest                                                             |   | 6,439                   |   | 4,969                       |   |
| Customer advances and deposits                                               |   | 2,439                   |   | 3,147                       |   |
| Current portion of accrued product warranty  obligations                     |   | 2,164                   |   | 2,064                       |   |
| Other accrued liabilities                                                    |   | 4,387                   |   | 3,581                       |   |
| Total accrued liabilities                                                    |   | $                       | 23,387 |                        | $      | 17,890 |   |

 

12

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**Note 7.           Long-Term Debt**

** **

Long-term debt includes the following amounts as ofJune 30, 2004 and December 31, 2003:

 
| **(In thousands)**                                                           |   | **June 30,  2004** |    | **December 31,  2003** |   |
|------------------------------------------------------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                                                                         |   | **(Unaudited)**         |    |                        |   |
| First-lien credit facility:                                                  |   |                    |    |                        |   |
| Term debt                                                                    |   | $                       | 80,521  |                        | $      | 80,521 |   |
| Revolving line of credit                                                     |   | 15,050                  |    | —                      |   |
| Second-lien term debt                                                        |   | 81,280                  |    | 80,067                      |   |
| Capital lease obligations and other debt,  secured by property and equipment |   | 8,289                   |    | 8,818                       |   |
| 12% subordinated notes                                                       |   | 100,000                 |    | 100,000                     |   |
| Total long-term debt                                                         |   | 285,140                 |    | 269,406                     |   |
| Less current portion                                                         |   | (1,319                  | )       | (1,198                      | )      |
| Long-term debt, less current portion                                         |   | $                       | 283,821 |                        | $      | 268,208 |   |

 

A portion of the interest charged on the second-lienterm debt is pay-in-kind or “accreted” interest, payable at maturity.  An additional $1,213,000 of pay-in-kindinterest accreted to the initial principal balance of the term debt during thesix months ended June 30, 2004 and $607,000 during the three months ended June30, 2004.

 

As of June 30, 2004, the Company had irrevocablestandby letters of credit in the amount of $318,000 issued and outstandingunder the first-lien credit facility, which reduces borrowings available underthe $24,000,000 revolving line of credit.

 

Subsequent to June 30, 2004, some of the holders ofthe 12% subordinated notes elected to exchange their notes for new 17% seniordiscount notes (Note 13).

 

**Note 8.   Mandatorily Redeemable Preferred Stock**

** **

As more fully described in “Note 1—Changes inAccounting Principles,” the Company adopted the provisions of SFAS No. 150,“Accounting for Certain Financial Instruments with Characteristics of bothLiabilities and Equity,” as of January 1, 2004.

 

The table below summarizes the increase in mandatorilyredeemable preferred stock during the six months ended June 30, 2004.

 
| **(In thousands, except share and per share data)**          |   | **Number  of  Shares** |   | **Mandatory  Redemption  Value** |   | **Unamortized  Issuance  Discount** |   | **Net  Book  Value** |   |
|--------------------------------------------------------------|--------|------------------------|--------|----------------------------------|--------|-------------------------------------|--------|----------------------|--------|
|                                                         |   |                   |   |                             |   |                                |   |                 |   |
| Balance,  December 31, 2003                             |   | 432,919                |   | $                                | 43,292 |                                | $      | (2,457)              |   | $ | 40,835 |   |
| Preferred stock dividends                                    |   | 35,326                 |   | 3,533                            |   | —                              |   | 3,533                |   |
| Redemption value accretion                                   |   | —                 |   | —                           |   | 234                                 |   | 234                  |   |
| Balance, June 30, 2004 (Unaudited)                           |   | 468,245                |   | $                                | 46,825 |                                | $      | (2,223               | )      | $ | 44,602 |   |
|                                                         |   |                   |   |                             |   |                                |   |                 |   |
| Per share liquidation value as of June 30,  2004 (Unaudited) |   |                   |   | $                                | 100.00 |                                |   |                 |   |   |

 

13

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Holders of the preferred stock are entitled toreceive, when, as and if declared, dividends at a rate equal to 16% perannum.  Prior to June 30, 2005, theCompany may, at its option, pay dividends either in cash or by the issuance ofadditional shares of preferred stock. Since the preferred stock issuance date on June 30, 2000, the Companyhas elected to issue additional shares in lieu of cash dividend payments.  The preferred stock is mandatorilyredeemable in cash on March 31, 2009.

 

Subsequent to June 30, 2004, the Company amended theterms of the preferred stock to eliminate the dividends unless the Companyachieves a defined leverage ratio (Note 13).

 

**Note 9.           Income Taxes**

** **

The components of income (loss) before income taxesand cumulative effect of change in accounting principle and the provisions forincome tax benefit are as follows:

 
|                                        |   | **Three  Months Ended  June 30,** |    | **Six Months  Ended  June 30,** |   |
|---------------------------------------------|--------|-----------------------------------|---------|--------------------------------------|--------|
| **(In thousands)**                          |   | **2004**                          |    | **2003**                             |   | **2004** |   | **2003** |   |
|                                        |   | **(Unaudited)**                   |    |
| Pre-tax income (loss) reported by:          |   |                              |    |                                 |   |   |   |   |   |
| Continuing operations                       |   | $                                 | (13,844 | )                                    | $      | (46,647 | ) | $ | (22,962 | ) | $ | (52,248 | ) |
| Discontinued operations                     |   | —                            |    | 402                                  |   | — |   | (5,286 | ) |
| Consolidated pre-tax loss                   |   | $                                 | (13,844 | )                                    | $      | (46,245 | ) | $ | (22,962 | ) | $ | (57,534 | ) |
|                                        |   |                              |    |                                 |   |   |   |   |   |
| Total provision for income taxes (benefit): |   |                              |    |                                 |   |   |   |   |   |
| Income tax benefit based on pre-tax loss    |   | $                                 | (4,619  | )                                    | $      | (22,077 | ) | $ | (7,143 | ) | $ | (22,633 | ) |
| Net deferred tax assets valuation allowance |   | 4,649                             |    | 13,056                               |   | 7,203 |   | 13,056 |   |
| Net provision for income taxes (benefit)    |   | $                                 | 30      |                                 | $      | (9,021 | ) | $ | 60 |   | $ | (9,577 | ) |
|                                        |   |                              |    |                                 |   |   |   |   |   |
| Allocation of total provision:              |   |                              |    |                                 |   |   |   |   |   |
| Continuing operations                       |   | $                                 | 30      |                                 | $      | (9,365 | ) | $ | 60 |   | $ | (10,630 | ) |
| Discontinued operations                     |   | —                            |    | 344                                  |   | — |   | 1,053 |   |
| Net provision for income taxes (benefit)    |   | $                                 | 30      |                                 | $      | (9,021 | ) | $ | 60 |   | $ | (9,577 | ) |

 

For the three months and six months ended June 30,2004, the provision for income taxes, based on the reported consolidatedpre-tax loss, differs from the amount determined by applying the applicableU.S. statutory federal rate to the pre-tax loss primarily due to the effects ofstate and foreign income taxes and non-deductible expenses, principallymandatorily redeemable preferred stock dividends due to the adoption of SFASNo. 150 effective January 1, 2004 (Note 1).

 

For the three months and six months ended June 30,2003, the provision for income taxes, based on the reported consolidatedpre-tax loss, differs from the amount determined by applying the applicableU.S. statutory federal rate to the pre-tax loss primarily due to the effects ofstate and foreign income taxes and non-deductible expenses, principally thenon-deductible portion of goodwill impairment charges.

 

As of June 30, 2003, the Company had net deferred taxassets of $12,841,000, prior to recording the valuation allowance in June 2003,as opposed to net deferred tax liabilities in prior periods.  The change to a net asset position wasprimarily caused by the $34,000,000 goodwill impairment charge recorded duringthe second quarter of fiscal 2003.  SFASNo. 109, “Accounting for Income Taxes,” requires the recognition of a deferredtax asset for the future income tax benefit of the goodwill deductions thatwill be taken for income tax purposes (i.e. the goodwill that has been writtenoff in the financial statements for book purposes will continue to be amortizedand deducted for tax purposes and accordingly represents a new deferred taxasset).

 

14

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As required by SFAS No. 109, the Company evaluated itsdeferred tax assets for expected recoverability based on the nature of theitem, the associated taxing jurisdictions, the applicable expiration dates andfuture taxable income forecasts that would impact utilization.  Since there is no loss carry back potentialand the Company does not have any tax planning strategies to assurerecoverability, the only possibility for recovery of the net deferred assets isfuture taxable income.  Since there havebeen prior year losses, the Company believes it was not prudent to rely onfuture taxable income as the means to support the carrying value of the netdeferred tax assets.  As a result of theevaluation, the Company recorded a $13,056,000 valuation allowance, eliminatingthe net deferred asset, as of June 30, 2003.

 

As more fully described in Note 11 to the auditedfinancial statements included in the Company’s 2003 Form 10-K, the Company hada net deferred tax asset of $19,528,000 fully offset by a valuation allowanceof the same amount as of December 31, 2003. Based upon the results of operations for the six months ended June 30,2004, the Company determined that an additional $7,203,000 valuation allowancewas required as of that date, $4,649,000 of which is applicable to thethree-month period.

 

**Note 10.         Commitments and Contingencies**

** **

**Litigation**

** **

Raytheon Aircraft Company (“Raytheon”) has filed acomplaint against the Company and one of its subsidiaries in the state court ofKansas with respect to alleged product liability related to certain aircraftseats sold to Raytheon by the Company’s subsidiary.  The complaint does not specify the amount of damages claimed byRaytheon, but the amount could be material.

 

This action has just been served on the Company and nodiscovery has commenced; accordingly, management has not had an opportunity todetermine the likely outcome of this claim. However, based on the allegations in the complaint and the factscurrently available, management does not know of a basis which would result inthis action having a material adverse effect on the Company’s business,consolidated financial position, results of operations or cash flows.  Further, the Company’s subsidiary may beindemnified by the entity from which it acquired the seat product line.

 

The Company and its subsidiaries are also involved inother routine legal and administrative proceedings incident to the normalconduct of business.  Managementbelieves the ultimate disposition of all such matters will not have a materialadverse effect on the Company’s business, consolidated financial position,results of operations or cash flows.

 

**Funding of DeCraneHoldings Preferred Stock Obligations**

** **

The Company is a wholly owned subsidiary of DeCraneHoldings whose capital structure also includes mandatorily redeemable preferredstock.  Since the Company is DeCraneHoldings’ only operating subsidiary and source of cash, the Company may berequired to fund DeCrane Holdings’ preferred stock dividend and redemptionobligations in the future.

 

DeCrane Holdings’ preferred stock dividends arepayable quarterly at a rate of 14% per annum. Prior to September 30, 2005, dividends are not paid in cash but insteadaccrete to the liquidation value of the preferred stock, which, in turn,increases the redemption obligation.  Onor after September 30, 2005, preferred stock dividends are required to be paidin cash, if declared, and the preferred stock is mandatorily redeemable onSeptember 30, 2009.  The DeCraneHoldings preferred stock has a total redemption value of $76,487,000 as of June30, 2004, including accumulated dividends.

 

15

----

 

Subsequent to June 30, 2004, the Company amended theterms of the preferred stock to eliminate the 14% dividends unless it achievesa defined leverage ratio (Note 13).

 

**Note 11.         Business Segment Information**

** **

The Company supplies products and services to thebusiness, VIP and head-of-state aircraft market within the aerospaceindustry.  The Company’s subsidiariesare organized into two groups, each of which is a strategic business thatdevelops, manufactures and sells distinct products and services.  The groups and a description of theirbusinesses are as follows:

 

•                  *Cabin Management –* manufactures interior cabin components,including cabin interior furnishings, cabin management systems, seating andcomposite components;

 

•                  *Systems Integration –* manufactures auxiliary fuel systems andauxiliary power units, provides system integration services, provides aircraftcompletion and refurbishment services and is a Boeing Business Jet authorizedservice center.

 

In prior periods, the Company’s Specialty AvionicsGroup was a third strategic business for which segment information wasprovided.  As a result of the sale ofthe Specialty Avionics Group, this group is reflected as a discontinuedoperation and segment information for prior periods has been restated.

 

Management utilizes more than one measurement toevaluate group performance and allocate resources; however, managementconsiders Adjusted EBITDA, as defined, to be the primary measurement of agroup’s overall core economic performance and return on invested capital.  Management also uses Adjusted EBITDA in theCompany’s annual budget and planning process for future periods, as one of thedecision-making criteria for funding discretionary capital expenditures andproduct development programs and as the measure in determining the value of acquisitionsand dispositions.  The board ofdirectors uses Adjusted EBITDA as one of the performance metrics fordetermining the amount of bonuses awarded to pursuant to the Company’s cashincentive bonus plan and as an indicator of enterprise value used in determiningthe exercise price of stock options granted and the acceleration of stockoption vesting pursuant to the Company’s incentive stock option plan.

 

Management defines Adjusted EBITDA as earnings,determined using program accounting for product development costs, beforeinterest, income taxes, depreciation and amortization, restructuring, assetimpairment and other related charges, acquisition related charges notcapitalized and other noncash and nonoperating charges.  Management believes the presentation of thismeasure is relevant and useful to investors because it allows investors andanalysts to view group performance in a manner similar to the method used bymanagement, helps improve their ability to understand the Company’s coresegment performance, adjusted for items management believes are unusual, andmakes it easier to compare the Company’s results with other companies that havedifferent financing, capital structures and tax rates.  In addition, management believes thesemeasures are consistent with the manner in which its lenders and investorsmeasure the Company’s overall performance and liquidity, including its abilityto service debt and fund discretionary capital expenditure and productdevelopment programs.

 

16

----

 

The financial measure Adjusted EBITDA, as defined,excludes certain charges reflected in the Company’s financial statements whichare prepared in accordance with accounting principles generally accepted in theUnited States of America (“GAAP”). However, the Company’s presentation of Adjusted EBITDA is in accordancewith the GAAP requirements of SFAS No. 131, “Disclosures about Segments of anEnterprise and Related Information,” which requires the Company to report theprimary measure of segment performance used by management to evaluate andmanage its businesses.  The Company’smethod of calculating Adjusted EBITDA may not be consistent with that of othercompanies and should be viewed in conjunction with measurements that are computedin accordance GAAP, such as net income (loss), the nearest comparable GAAPfinancial measure.  A reconciliation ofAdjusted EBITDA to net income (loss) is included herein to clarify thedifferences between these financial measures.

 

The accounting policies of the groups aresubstantially the same as those described in the summary of significantaccounting policies Note 1 to the audited financial statements.  Some transactions are recorded at theCompany’s corporate headquarters and are not allocated to the groups, such asmost of the Company’s cash and cash equivalents, debt and related net interestexpense, corporate headquarters costs and income taxes.

 

The tables below summarize selected financial data bybusiness segment.

 
|                          |   | **Three  Months Ended  June 30,** |    | **Six Months  Ended  June 30,** |   |
|-------------------------------|--------|-----------------------------------|---------|--------------------------------------|--------|
| **(In thousands)**            |   | **2004**                          |    | **2003**                             |   | **2004** |   | **2003** |   |
|                          |   | **(Unaudited)**                   |    |
| Revenues:                     |   |                              |    |                                 |   |   |   |   |   |
| Cabin Management              |   | $                                 | 40,990  |                                 | $      | 29,635 |   | $ | 75,328 |   | $ | 60,255 |   |
| Systems Integration           |   | 15,380                            |    | 14,718                               |   | 29,911 |   | 26,850 |   |
| Inter-group elimination (1)   |   | (1,553                            | )       | (240                                 | )      | (1,825 | ) | (1,092 | ) |
| Consolidated totals           |   | $                                 | 54,817  |                                 | $      | 44,113 |   | $ | 103,414 |   | $ | 86,013 |   |
|                          |   |                              |    |                                 |   |   |   |   |   |
| Adjusted EBITDA (as defined): |   |                              |    |                                 |   |   |   |   |   |
| Cabin Management              |   | $                                 | 6,182   |                                 | $      | 4,310 |   | $ | 9,622 |   | $ | 8,860 |   |
| Systems Integration           |   | 2,399                             |    | 4,180                                |   | 5,428 |   | 6,337 |   |
| Corporate (2)                 |   | (1,113                            | )       | (1,395                               | )      | (2,206 | ) | (3,507 | ) |
| Inter-group elimination (3)   |   | (2                                | )       | 2                                    |   | 1 |   | 112 |   |
| Consolidated totals           |   | 7,466                             |    | 7,097                                |   | 12,845 |   | 11,802 |   |
| Reconciling items (4)         |   | (21,340                           | )       | (43,632                              | )      | (35,867 | ) | (72,834 | ) |
| Net loss                      |   | $                                 | (13,874 | )                                    | $      | (36,535 | ) | $ | (23,022 | ) | $ | (61,032 | ) |

 
| **(In thousands)**               |   | **June 30,  2004** |    | **December 31,  2003** |   |
|----------------------------------|--------|-------------------------|---------|-----------------------------|--------|
|                             |   | **(Unaudited)**         |    |                        |   |
| Total assets (as of period end): |   |                    |    |                        |   |
| Cabin Management                 |   | $                       | 241,077 |                        | $      | 224,116 |   |
| Systems Integration              |   | 54,269                  |    | 58,395                      |   |
| Corporate (5)                    |   | 14,831                  |    | 21,456                      |   |
| Inter-group elimination (6)      |   | (11                     | )       | (91                         | )      |
| Consolidated totals              |   | $                       | 310,166 |                        | $      | 303,876 |   |

 

----

(1)                      Inter-groupsales are accounted for at prices comparable to sales to unaffiliatedcustomers, and are eliminated in consolidation.

 

(2)                      Reflects theCompany’s corporate headquarters costs and expenses not allocated to thegroups.

 

17

----

 

(3)                      Reflectselimination of the effect of inter-group profits in inventory.

 

(4)                      AdjustedEBITDA (as defined) excludes the following charges reflected in the Company’sfinancial statements which are prepared in accordance with generally acceptedaccounting principles:

 
|                                                                          |   | **Three  Months Ended  June 30,** |    | **Six Months  Ended  June 30,** |   |
|-------------------------------------------------------------------------------|--------|-----------------------------------|---------|--------------------------------------|--------|
| **(In thousands)**                                                            |   | **2004**                          |    | **2003**                             |   | **2004** |   | **2003** |   |
|                                                                          |   | **(Unaudited)**                   |    |
| Depreciation and amortization of long-lived  assets (a)                       |   | $                                 | (2,277  | )                                    | $      | (2,451 | ) | $ | (4,603 | ) | $ | (4,967 | ) |
| Adjustment to reflect program costs as  research and development expenses (b) |   | (1,481                            | )       | (3,278                               | )      | (3,097 | ) | (4,851 | ) |
| Restructuring, asset impairment and other  related charges                    |   | (6,901                            | )       | (41,132                              | )      | (6,901 | ) | (41,132 | ) |
| Acquisition related charges not capitalized                                   |   | (9                                | )       | (8                                   | )      | (18 | ) | (17 | ) |
| Interest expense                                                              |   | (8,750                            | )       | (6,468                               | )      | (17,452 | ) | (12,337 | ) |
| Mandatorily redeemable preferred stock  dividends                             |   | (1,801                            | )       | —                               |   | (3,533 | ) | — |   |
| Other expenses, net                                                           |   | (91                               | )       | (407                                 | )      | (203 | ) | (746 | ) |
| Provision for income (taxes) benefit                                          |   | (30                               | )       | 9,365                                |   | (60 | ) | 10,630 |   |
| Income (loss) from discontinued operations                                    |   | —                            |    | 747                                  |   | — |   | (5,650 | ) |
| Cumulative effect of change in accounting  principle                          |   | —                            |    | —                               |   | — |   | (13,764 | ) |
| Total reconciling items                                                       |   | $                                 | (21,340 | )                                    | $      | (43,632 | ) | $ | (35,867 | ) | $ | (72,834 | ) |

 

----

(a)                      Reflectsdepreciation and amortization of long-lived assets but excludes amortization ofdeferred financing costs, which are classified as a component of interestexpense, as follows:

 
|                                                |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|-----------------------------------------------------|--------|-----------------------------------|--------|--------------------------------------|--------|
| **(In thousands)**                                  |   | **2004**                          |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                |   | **(Unaudited)**                   |   |
| Depreciation and amortization of long-lived  assets |   | $                                 | 2,277  |                                 | $      | 2,451 |   | $ | 4,603 |   | $ | 4,967 |   |
| Amortization of deferred financing costs            |   | 791                               |   | 680                                  |   | 1,581 |   | 1,375 |   |
| Consolidated depreciation and amortization          |   | $                                 | 3,068  |                                 | $      | 3,131 |   | $ | 6,184 |   | $ | 6,342 |   |

 

(b)                     Under programaccounting, which the Company is required to use for determining covenantcompliance under its credit agreements, certain product development costsincurred in connection with specific contracted programs are deferred andcharged to cost of sales as revenues related to the program arerecognized.  For financial reportingpurposes, these costs are charged to research and development expense asincurred.  This adjustment reflects thenet difference between these two methods of accounting.

 

(5)                      Reflects theCompany’s corporate headquarters assets, excluding investments in and notesreceivable from subsidiaries.

 

(6)                      Reflectselimination of inter-group receivables and profits in inventory as of periodend.

 

18

----

 

**Note 12.         SupplementalCondensed Consolidating Financial Information**

** **

In conjunction with the 12% subordinated notesdescribed in Note 7, the following condensed consolidating financialinformation is presented segregating the Company, as the issuer, and theguarantor and non-guarantor subsidiaries. The accompanying financial information in the guarantor subsidiariescolumn reflects the financial position, results of operations and cash flowsfor those subsidiaries guaranteeing the notes. The non-guarantor subsidiaries are companies within the SpecialtyAvionics Group which was sold in May 2003 and are therefore classified as acomponent of discontinued operations.

 

The guarantor subsidiaries are wholly-ownedsubsidiaries of the Company and their guarantees are full and unconditional ona joint and several basis.  There are norestrictions on the ability of the guarantor subsidiaries to transfer funds tothe issuer in the form of cash dividends, loans or advances.  Separate financial statements of theguarantor subsidiaries are not presented because management believes that suchfinancial statements would not be material to investors.  Investments in subsidiaries in the followingcondensed consolidating financial information are accounted for under theequity method of accounting. Consolidating adjustments include the following:

 

(1)                       Elimination of investments insubsidiaries.

 

(2)                       Elimination of intercompanyaccounts.

 

(3)                       Elimination of equity inearnings of subsidiaries.

 

19

----

** **

**BalanceSheets**

 
|                                                       |   | **June 30,  2004 (Unaudited)** |    |
|------------------------------------------------------------|--------|--------------------------------|---------|
| **(In thousands)**                                         |   | **Issuer**                     |    | **Guarantor  Subsidiaries** |   | **Consolidating  Adjustments** |   | **Consolidated  Total** |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| **Assets**                                                 |   |                           |    |   |   |   |   |   |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| Current assets:                                            |   |                           |    |   |   |   |   |   |   |
| Cash and cash equivalents                                  |   | $                              | 1,710   |   | $ | 652 |   | $ | — |   | $ | 2,362 |   |
| Accounts receivable, net                                   |   | —                         |    | 27,322 |   | — |   | 27,322 |   |
| Inventories                                                |   | —                         |    | 52,314 |   | — |   | 52,314 |   |
| Other current assets                                       |   | 88                             |    | 1,088 |   | — |   | 1,176 |   |
| Total current assets                                       |   | 1,798                          |    | 81,376 |   | — |   | 83,174 |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| Property and equipment, net                                |   | 890                            |    | 28,908 |   | — |   | 29,798 |   |
| Other assets, principally goodwill                         |   | 12,143                         |    | 185,051 |   | — |   | 197,194 |   |
| Investments in subsidiaries                                |   | 79,245                         |    | — |   | (79,245 | ) (1) | — |   |
| Intercompany receivables                                   |   | 228,891                        |    | 56,857 |   | (285,748 | ) (2) | — |   |
| Total assets                                               |   | $                              | 322,967 |   | $ | 352,192 |   | $ | (364,993 | ) | $ | 310,166 |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| **Liabilities and Stockholder’s Equity (Deficit)**    |   |                           |    |   |   |   |   |   |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| Current liabilities:                                       |   |                           |    |   |   |   |   |   |   |
| Current portion of long-term debt                          |   | $                              | 46      |   | $ | 1,273 |   | $ | — |   | $ | 1,319 |   |
| Other current liabilities                                  |   | 8,852                          |    | 31,976 |   | — |   | 40,828 |   |
| Total current liabilities                                  |   | 8,898                          |    | 33,249 |   | — |   | 42,147 |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| Long-term debt, less current portion                       |   | 276,921                        |    | 6,900 |   | — |   | 283,821 |   |
| Mandatorily redeemable preferred stock                     |   | 44,602                         |    | — |   | — |   | 44,602 |   |
| Intercompany payables                                      |   | 56,857                         |    | 228,891 |   | (285,748 | ) (2) | — |   |
| Other long-term liabilities                                |   | 3,661                          |    | 4,175 |   | — |   | 7,836 |   |
|                                                       |   |                           |    |   |   |   |   |   |   |
| Stockholder’s equity (deficit):                       |   |                           |    |   |   |   |   |   |   |
| Paid-in capital                                            |   | 111,682                        |    | 151,492 |   | (151,492 | ) (1) | 111,682 |   |
| Retained earnings (deficit)                                |   | (179,654                       | )       | (72,247 | ) | 72,247 |  (1) | (179,654 | ) |
| Accumulated other comprehensive loss                       |   | —                         |    | (268 | ) | — |   | (268 | ) |
| Total stockholder’s equity (deficit)                  |   | (67,972                        | )       | 78,977 |   | (79,245 | ) | (68,240 | ) |
| Total liabilities and stockholder’s equity  (deficit) |   | $                              | 322,967 |   | $ | 352,192 |   | $ | (364,993 | ) | $ | 310,166 |   |

 

20

----

 
|                                                                                               |   | **December 31,  2003** |       |
|----------------------------------------------------------------------------------------------------|--------|------------------------|------------|
| **(In thousands)**                                                                                 |   | **Issuer**             |       | **Guarantor  Subsidiaries** |   | **Consolidating  Adjustments** |   | **Consolidated  Total** |   |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| **Assets**                                                                                         |   |                   |       |   |   |   |   |   |   |
| Current assets:                                                                                    |   |                   |       |   |   |   |   |   |   |
| Cash and cash equivalents                                                                          |   | $                      | 6,540      |   | $ | 396 |   | $ | — |   | $ | 6,936 |   |
| Accounts receivable, net                                                                           |   | —                 |       | 21,455 |   | — |   | 21,455 |   |
| Inventories                                                                                        |   | —                 |       | 42,981 |   | — |   | 42,981 |   |
| Other current assets                                                                               |   | 254                    |       | 828 |   | — |   | 1,082 |   |
| Total current assets                                                                               |   | 6,794                  |       | 65,660 |   | — |   | 72,454 |   |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| Property and equipment, net                                                                        |   | 1,047                  |       | 29,853 |   | — |   | 30,900 |   |
| Other assets, principally goodwill                                                                 |   | 13,615                 |       | 186,907 |   | — |   | 200,522 |   |
| Investments in subsidiaries                                                                        |   | 85,668                 |       | — |   | (85,668 | ) (1) | — |   |
| Intercompany receivables                                                                           |   | 261,631                |       | 100,642 |   | (362,273 | ) (2) | — |   |
| Total assets                                                                                       |   | $                      | 368,755    |   | $ | 383,062 |   | $ | (447,941 | ) | $ | 303,876 |   |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| **Liabilities, Mandatorily Redeemable  Preferred Stock and Stockholder’s Equity (Deficit)**   |   |                   | ** ** |   | ** ** |   | ** ** |   | ** ** |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| Current liabilities:                                                                               |   |                   |       |   |   |   |   |   |   |
| Current portion of long-term debt                                                                  |   | $                      | 11         |   | $ | 1,187 |   | $ | — |   | $ | 1,198 |   |
| Other current liabilities                                                                          |   | 8,532                  |       | 24,820 |   | — |   | 33,352 |   |
| Total current liabilities                                                                          |   | 8,543                  |       | 26,007 |   | — |   | 34,550 |   |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| Long-term debt, less current portion                                                               |   | 260,654                |       | 7,554 |   | — |   | 268,208 |   |
| Intercompany payables                                                                              |   | 100,642                |       | 261,631 |   | (362,273 | ) (2) | — |   |
| Other long-term liabilities                                                                        |   | 2,994                  |       | 2,470 |   | — |   | 5,464 |   |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| Mandatorily redeemable preferred stock                                                             |   | 40,835                 |       | — |   | — |   | 40,835 |   |
|                                                                                               |   |                   |       |   |   |   |   |   |   |
| Stockholder’s equity (deficit):                                                               |   |                   |       |   |   |   |   |   |   |
| Paid-in capital                                                                                    |   | 111,719                |       | 151,492 |   | (151,492 | ) (1) | 111,719 |   |
| Retained earnings (deficit)                                                                        |   | (156,632               | )          | (65,824 | ) | 65,824 |  (1) | (156,632 | ) |
| Accumulated other comprehensive loss                                                               |   | —                 |       | (268 | ) | — |   | (268 | ) |
| Total stockholder’s equity (deficit)                                                          |   | (44,913                | )          | 85,400 |   | (85,668 | ) | (45,181 | ) |
| Total liabilities, mandatorily redeemable  preferred stock and stockholder’s equity (deficit) |   | $                      | 368,755    |   | $ | 383,062 |   | $ | (447,941 | ) | $ | 303,876 |   |

 

21

----

 

**Statementsof Operations**

 
|                                              |   | **Six Months  Ended June 30, 2004 (Unaudited)** |    |
|---------------------------------------------------|--------|-------------------------------------------------|---------|
| **(In thousands)**                                |   | **Issuer**                                      |    | **Guarantor  Subsidiaries** |   | **Consolidating  Adjustments** |   | **Consolidated  Total** |   |
|                                              |   |                                            |    |   |   |   |   |   |   |
| Revenues                                          |   | $                                               | —  |   | $ | 103,414 |   | $ | — |   | $ | 103,414 |   |
| Cost of sales                                     |   | —                                          |    | 84,156 |   | — |   | 84,156 |   |
|                                              |   |                                            |    |   |   |   |   |   |   |
| Gross profit                                      |   | —                                          |    | 19,258 |   | — |   | 19,258 |   |
|                                              |   |                                            |    |   |   |   |   |   |   |
| Operating and other expenses (income):            |   |                                            |    |   |   |   |   |   |   |
| Selling, general and administrative  expenses     |   | 2,422                                           |    | 12,603 |   | — |   | 15,025 |   |
| Research and development expenses                 |   | —                                          |    | 4,182 |   | — |   | 4,182 |   |
| Amortization of intangible assets                 |   | —                                          |    | 1,825 |   | — |   | 1,825 |   |
| Interest expense                                  |   | 17,091                                          |    | 361 |   | — |   | 17,452 |   |
| Mandatorily redeemable preferred stock  dividends |   | 3,533                                           |    | — |   | — |   | 3,533 |   |
| Intercompany charges                              |   | (10,879                                         | )       | 10,879 |   | — |   | — |   |
| Equity in loss of subsidiaries                    |   | 6,423                                           |    | — |   | (6,423 | )(3) | — |   |
| Other expenses (income), net                      |   | 214                                             |    | (11 | ) | — |   | 203 |   |
| Provision for income taxes (benefit)              |   | 4,218                                           |    | (4,158 | ) | — |   | 60 |   |
|                                              |   |                                            |    |   |   |   |   |   |   |
| Net loss                                          |   | $                                               | (23,022 | ) | $ | (6,423 | ) | $ | 6,423 |   | $ | (23,022 | ) |

 
|                                                 |   | **Six Months  Ended June 30, 2003 (Unaudited)** |    |
|------------------------------------------------------|--------|------------------------------------------------------|---------|
| **(In thousands)**                                   |   | **Issuer**                                           |    | **Guarantor  Subsidiaries** |   | **Non-Guarantor  Subsidiaries** |   | **Consolidating  Adjustments** |   | **Consolidated  Total** |   |
|                                                 |   |                                                 |    |   |   |   |   |   |   |   |   |
| Revenues                                             |   | $                                                    | —  |   | $ | 86,013 |   | $ | — |   | $ | — |   | $ | 86,013 |   |
| Cost of sales                                        |   | —                                               |    | 67,592 |   | — |   | — |   | 67,592 |   |
| Gross profit                                         |   | —                                               |    | 18,421 |   | — |   | — |   | 18,421 |   |
|                                                 |   |                                                 |    |   |   |   |   |   |   |   |   |
| Operating and other expenses (income):               |   |                                                 |    |   |   |   |   |   |   |   |   |
| Selling, general and administrative  expenses        |   | 4,904                                                |    | 12,005 |   | — |   | — |   | 16,909 |   |
| Research and development expenses                    |   | —                                               |    | 4,851 |   | — |   | — |   | 4,851 |   |
| Impairment of goodwill                               |   | —                                               |    | 34,000 |   | — |   | — |   | 34,000 |   |
| Amortization of intangible assets                    |   | —                                               |    | 1,826 |   | — |   | — |   | 1,826 |   |
| Interest expense                                     |   | 12,116                                               |    | 221 |   | — |   | — |   | 12,337 |   |
| Intercompany charges                                 |   | (11,575                                              | )       | 11,575 |   | — |   | — |   | — |   |
| Equity in loss of subsidiaries                       |   | 46,968                                               |    | 218 |   | — |   | (47,186 | )(3) | — |   |
| Other expenses, net                                  |   | 586                                                  |    | 160 |   | — |   | — |   | 746 |   |
| Provision for income taxes (benefit)                 |   | 8,033                                                |    | (18,663 | ) | — |   | — |   | (10,630 | ) |
| Loss from discontinued operations                    |   | —                                               |    | 5,432 |   | 218 |   | — |   | 5,650 |   |
| Cumulative effect of change in accounting  principle |   | —                                               |    | 13,764 |   | — |   | — |   | 13,764 |   |
|                                                 |   |                                                 |    |   |   |   |   |   |   |   |   |
| Net loss                                             |   | $                                                    | (61,032 | ) | $ | (46,968 | ) | $ | (218 | ) | $ | 47,186 |   | $ | (61,032 | ) |

 

22

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**Statementsof Cash Flows**

 
|                                                  |   | **Six Months  Ended June 30, 2004 (Unaudited)** |    |
|-------------------------------------------------------|--------|-------------------------------------------------|---------|
| **(In thousands)**                                    |   | **Issuer**                                      |    | **Guarantor  Subsidiaries** |   | **Consolidating  Adjustments** |   | **Consolidated  Total** |   |
| **Cash flows from operating activities:**             |   |                                            |    |   |   |   |   |   |   |
| Net loss                                              |   | $                                               | (23,022 | ) | $ | (6,423 | ) | $ | 6,423 |   | $ | (23,022 | ) |
| Noncash adjustments:                                  |   |                                            |    |   |   |   |   |   |   |
| Equity in loss of subsidiaries                        |   | 6,423                                           |    | — |   | (6,423 | )(3) | — |   |
| Other noncash adjustments                             |   | 6,717                                           |    | 7,412 |   | — |   | 14,129 |   |
| Changes in working capital                            |   | (9,992                                          | )       | 1,592 |   | — |   | (8,400 | ) |
| Net cash provided by (used for) operating  activities |   | (19,874                                         | )       | 2,581 |   | — |   | (17,293 | ) |
|                                                  |   |                                            |    |   |   |   |   |   |   |
| **Cash flows from investing activities:**             |   |                                            |    |   |   |   |   |   |   |
| Capital expenditures                                  |   | —                                          |    | (1,767 | ) | — |   | (1,767 | ) |
| Net cash used for investing activities                |   | —                                          |    | (1,767 | ) | — |   | (1,767 | ) |
|                                                  |   |                                            |    |   |   |   |   |   |   |
| **Cash flows from financing activities:**             |   |                                            |    |   |   |   |   |   |   |
| Net revolving line of credit borrowings               |   | 15,050                                          |    | — |   | — |   | 15,050 |   |
| Other secured long-term borrowings                    |   | —                                          |    | 46 |   | — |   | 46 |   |
| Other secured long-term debt repayments               |   | (6                                              | )       | (604 | ) | — |   | (610 | ) |
| Net cash provided by (used for) financing  activities |   | 15,044                                          |    | (558 | ) | — |   | 14,486 |   |
| Net increase (decrease) in cash and  equivalents      |   | (4,830                                          | )       | 256 |   | — |   | (4,574 | ) |
| Cash and equivalents at beginning of period           |   | 6,540                                           |    | 396 |   | — |   | 6,936 |   |
| Cash and equivalents at end of period                 |   | $                                               | 1,710   |   | $ | 652 |   | $ | — |   | $ | 2,362 |   |

 

23

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|                                                  |   | **Six Months  Ended June 30, 2003 (Unaudited)** |    |
|-------------------------------------------------------|--------|------------------------------------------------------|---------|
| **(In thousands)**                                    |   | **Issuer**                                           |    | **Guarantor  Subsidiaries** |   | **Non-Guarantor  Subsidiaries** |   | **Consolidating  Adjustments** |   | **Consolidated  Total** |   |
|                                                  |   |                                                 |    |   |   |   |   |   |   |   |   |
| **Cash flows from operating activities:**             |   |                                                 |    |   |   |   |   |   |   |   |   |
| Net loss                                              |   | $                                                    | (61,032 | ) | $ | (46,968 | ) | $ | (218 | ) | $ | 47,186 | (3) | $ | (61,032 | ) |
| Noncash adjustments:                                  |   |                                                 |    |   |   |   |   |   |   |   |   |
| Cumulative effect of change in accounting  principle  |   | —                                               |    | 13,764 |   | — |   | — |   | 13,764 |   |
| Loss from discontinued operations                     |   | —                                               |    | 5,432 |   | 218 |   | — |   | 5,650 |   |
| Equity in loss of subsidiaries                        |   | 46,968                                               |    | 218 |   | — |   | (47,186 | )(3) | — |   |
| Other noncash adjustments                             |   | (21,973                                              | )       | 54,615 |   | — |   | — |   | 32,642 |   |
| Changes in working capital                            |   | 15,765                                               |    | (26,731 | ) | — |   | — |   | (10,966 | ) |
| Net cash used for operating activities                |   | (20,272                                              | )       | 330 |   | — |   | — |   | (19,942 | ) |
|                                                  |   |                                                 |    |   |   |   |   |   |   |   |   |
| **Cash flows from investing activities:**             |   |                                                 |    |   |   |   |   |   |   |   |   |
| Net proceeds from sale of                             |   |                                                 |    |   |   |   |   |   |   |   |   |
| Specialty Avionics Group                              |   | 132,800                                              |    | — |   | — |   | — |   | 132,800 |   |
| Capital expenditures                                  |   | (26                                                  | )       | (1,976 | ) | — |   | — |   | (2,002 | ) |
| Cash paid for acquisitions, net of cash  acquired     |   | (600                                                 | )       | — |   | — |   | — |   | (600 | ) |
| Net cash provided by (used for) investing  activities |   | 132,174                                              |    | (1,976 | ) | — |   | — |   | 130,198 |   |
|                                                  |   |                                                 |    |   |   |   |   |   |   |   |   |
| **Cash flows from financing activities:**             |   |                                                 |    |   |   |   |   |   |   |   |   |
| Net revolving line of credit borrowings               |   | 9,250                                                |    | — |   | — |   | — |   | 9,250 |   |
| First-lien term debt repayments                       |   | (129,275                                             | )       | — |   | — |   | — |   | (129,275 | ) |
| Other secured long-term debt repayments               |   | (649                                                 | )       | (524 | ) | — |   | — |   | (1,173 | ) |
| Net cash provided by (used for) financing  activities |   | (120,674                                             | )       | (524 | ) | — |   | — |   | (121,198 | ) |
| Net cash provided by discontinued  operations         |   | —                                               |    | 2,194 |   | — |   | — |   | 2,194 |   |
| Net increase (decrease) in cash and equivalents       |   | (8,772                                               | )       | 24 |   | — |   | — |   | (8,748 | ) |
| Cash and equivalents at beginning of period           |   | 12,343                                               |    | 78 |   | — |   | — |   | 12,421 |   |
| Cash and equivalents at end of period                 |   | $                                                    | 3,571   |   | $ | 102 |   | $ | — |   | $ | — |   | $ | 3,673 |   |

 

24

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**Note 13. SubsequentEvent**

** **

On July 23, 2004, holders of $64,485,000 of theCompany’s 12% senior subordinated notes due September 30, 2008 (the “existingnotes”) exchanged their notes for new 17% senior discount notes due September30, 2008 (the “new notes”).  The newnotes do not bear cash interest and have an initial accreted value equal to theprincipal amount of the notes exchanged. The new notes accrete in value at a 17% annual rate and will have a$127,771,000 aggregate accreted principal value at maturity.  The new notes are senior unsecuredobligations of the Company and are guaranteed by its subsidiaries.  Except for the changes in the interest rateand payment and ranking described above, the new notes have terms substantiallyidentical to those contained in the existing notes, although covenants limitingthe incurrence of indebtedness, the granting of liens and the making ofrestricted payments are more restrictive.

 

Concurrent with the note exchange, the Company amendedthe terms of its 16% senior preferred stock. DeCrane Holdings, the Company’s parent, also amended the terms of its14% preferred stock as well.  Theamended terms provide that further dividends do not accrue on the preferredstock, except if a leverage ratio (as defined) falls below certain specifiedlevels or if certain triggering events occur, such as failure to discharge anymandatory redemption obligations, and the like.  Depending upon the future leverage ratio achieved, dividends willresume at various dividend rates.  Alldividends accrued through the amendment date and future dividends, if any, arenot payable until redemption.  Theamendment for the 16% preferred stock accelerates the mandatory redemption datefrom March 31, 2009 to December 31, 2008 while the September 30, 2009 mandatoryredemption date for the 14% preferred stock remained unchanged.  The amendment to the 16% preferred stockalso adds several restrictive covenants. The holders of the 16% preferred stock were issued 348,945 shares ofDeCrane Holdings common stock in connection with the amendment.

 

25

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**ITEM 2.****          MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

The following discussionsshould be read in conjunction with our financial statements and accompanyingnotes included in this report.

 

**Results of Operations**

 

### **Performance Measures**

 

The following discussionof our results of operations includes discussions of financial measures andoperating statistics we use to evaluate the performance of, and trends in, ourbusinesses.  We believe the presentationof these measures and statistics are relevant and useful to investors becauseit allows them to view performance and trends in a manner similar to themethods we use.  These measures andstatistics, and why they are important to us and could be of interest to you,are described below.

 

**Adjusted EBITDA.**  Ourdiscussion of the results of operations includes discussions of financialmeasures determined in accordance with accounting principles generally acceptedin the United States of America (“GAAP”) as well as the financial measureAdjusted EBITDA, which excludes certain charges reflected in our GAAP basisfinancial statements.  Our presentationof Adjusted EBITDA is in accordance with the GAAP requirements of SFAS No. 131,“Disclosures about Segments of an Enterprise and Related Information,” whichrequires us to report the primary measure of segment performance we use toevaluate and manage our businesses.

 

We utilize more than onemeasurement to evaluate segment performance and allocate resources among ouroperating segments; however, we consider Adjusted EBITDA, as defined below, tobe the primary measurement of overall operating segment core economicperformance and return on invested capital. We also use Adjusted EBITDA in the annual budgeting and planning forfuture periods, as one of the decision-making criteria for fundingdiscretionary capital expenditure and product development programs and as themeasure for determining the value of acquisitions and dispositions.  Our board of directors uses Adjusted EBITDAas one of the performance metrics for determining the amount of bonuses awardedto pursuant to the cash incentive bonus plan and as an indicator of enterprisevalue used in determining the exercise price of stock options granted and theacceleration of stock option vesting pursuant the incentive stock option plan.

 

We define Adjusted EBITDAas earnings, determined using program accounting for product development costs,before interest, income taxes, depreciation and amortization, restructuring,asset impairment and other related charges, acquisition related charges notcapitalized and other noncash and nonoperating charges.  We believe the presentation of this measureis relevant and useful to investors because it allows investors and analysts toview group performance in a manner similar to the method we use, helps improvetheir ability to understand our core segment performance, adjusted for items webelieve are unusual, and makes it easier to compare our results with othercompanies that have different financing, capital structures and tax rates.  In addition, we believe these measures areconsistent with the manner in which our lenders and investors measure ouroverall performance and liquidity, including our ability to service debt andfund discretionary capital expenditure and product development programs.

 

Our method of calculatingAdjusted EBITDA may not be consistent with that of other companies and shouldbe viewed in conjunction with measurements that are computed in accordanceGAAP, such as net income (loss), the nearest comparable GAAP financialmeasure.  Adjusted EBITDA should not beviewed as substitutes for or superior to net income (loss), cash flow fromoperations or other data prepared in accordance with GAAP as a measure of ourprofitability or liquidity.  The notesto our financial statements include information about our operating segments,including Adjusted EBITDA, and should be read in conjunction with thediscussions presented herein.  The notesto our financial statements

 

26

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also include areconciliation of Adjusted EBITDA to net income (loss) to clarify thedifferences between these financial measures.

 

**Bookings and Backlog.**  Bookings andbacklog are operating statistics we use as leading trend indicators of futuredemand for our products and services. Bookings and backlog are based upon the value of purchase ordersreceived from our customers, which will result in revenues, if and when suchorders are filled.

 

Bookings represent thetotal invoice value of purchase orders received during the period and backlogrepresents the total invoice value of unfilled purchase orders as of the end ofa period.  Orders may be subject tochange or cancellation by the customer prior to shipment.  The level of unfilled orders at any givendate during the year will be materially affected by the timing of our receiptof orders and the speed with which those orders are filled.

 

### **Changes in Accounting Principles**

### ** **

**Adoption of SFAS No. 150.**  EffectiveJanuary 1, 2004, we adopted SFAS No. 150, “Accounting for CertainFinancial Instruments with Characteristics of both Liabilities andEquity.”  SFAS No. 150 establishesstandards for the classification and measurement of certain financialinstruments with characteristics of both liabilities and equity.  SFAS No. 150 requires classification offinancial instruments within its scope as a liability, including financialinstruments issued in the form of shares that are mandatorily redeemable,because those financial instruments are deemed to be, in essence, obligationsof the issuer.  As a result of adoptingSFAS No. 150 on January 1, 2004, the 16% mandatorily redeemable preferredstock was reclassified as a liability and the quarterly dividend and redemptionvalue accretion are reflected as charges against pre-tax income.  In periods prior to January 1, 2004,these charges were deducted in arriving at the net income or loss applicable toour common stockholder.

 

The following tablesummarizes the results of operations for the three months and six months endedJune 30, 2003 as if SFAS No. 150 had been in effect as of the beginning of2003.

 
|                            |   | **Three  Months Ended  June 30, 2003** |   | **Six Months  Ended  June 30, 2003** |   |
|---------------------------------|--------|---------------------------------------------|--------|-------------------------------------------|--------|
| **(In  millions)**              |   | **As  Reported**                            |   | **Pro Forma**                             |   | **As  Reported** |   | **Pro Forma** |   |
|                            |   |                                        |   |
| Loss from continuing operations |   | $                                           | (37.3  | )                                         | $      | (39.0 | ) | $ | (41.6 | ) | $ | (44.9 | ) |
| Net loss                        |   | (36.5                                       | )      | (38.2                                     | )      | (61.0 | ) | (64.3 | ) |
|                                 |        |                                             |        |                                           |        |  |  |  |  |  |  |  |  |

 

The pro forma datareflects preferred stock dividends and redemption value accretion totaling $1.7million for three months ended June 30, 2003 and $3.3 million for the sixmonths ended June 30, 2003 as charges against income during the periods.

 

**Change in Accounting for Product Development Costs.** In addition, and as more fully described in “Note 1—Change in AccountingPrinciple” to the audited financial statements included in the Company’s 2003Form 10-K, we elected to discontinue the use of program accounting for thecosts of products manufactured for delivery under production-typecontracts.  As a result, certaindeferred program costs are no longer included in inventory commencingJanuary 1, 2003.

 

This change in accountingpolicy was made after concluding the 2003 fiscal year but was appliedretroactively to the beginning of the year, January 1, 2003, as requiredby generally accepted accounting principles. As a result of the change, program-related product development costs arenow classified as a component of research and development expenses in theconsolidated financial statements rather than classified as a component ofinventory cost.  We have restated theresults of operations by charging previously inventoried costs totaling $3.3million and $4.9 million for the three months and six months

 

27

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ended June 30, 2003,respectively, to research and development expense and recording a $13.8 millioncharge as of January 1, 2003 to reflect the cumulative effect of thechange in accounting principle.

 

### **Restructuring, AssetImpairment and Other Related Charges**

### ** **

Our results of operationsfor 2003 and 2004 have been affected by restructuring, impairment and otherrelated charges pertaining to a series of restructuring activities.  These charges, which affect thecomparability of our reported results of operations between periods, are morefully described in “—Restructuring, Asset Impairment and Other Related Charges”below.

 

### **Three Mo**nths Ended June 30, 2004 Compared toThree Months Ended June 30, 2003

### ** **

**Revenues.* ***Revenues increased $10.7 million, or24.3%, to $54.8 million for the three months ended June 30, 2004 from$44.1 million for the three months ended June 30, 2003.  By segment, revenues changed as follows:

 
|                                |   | **Increase  (Decrease)  From 2003** |   |
|-------------------------------------|--------|-------------------------------------|--------|
| **(In  millions)**                  |   | **Amount**                          |   | **Percent** |   |
|                                |   |                                |   |   |   |
| Cabin Management                    |   | $                                   | 11.4   |   | 38.3 | % |
| Systems Integration                 |   | 0.7                                 |   | 4.5 |   |
| Increase in inter-group elimination |   | (1.4                                | )      |   |   |
| Total                               |   | $                                   | 10.7   |   |   |   |

 

*CabinManagement. *Revenues increased by $11.4 million, or38.3% compared to the prior year due to a higher volume of corporate jetproduction by aircraft manufacturers. The increase consisted of the following:

 

•      a $10.8 million increase in aircraftfurniture and related products revenues;

 

•      a $1.1 million increase in cabinmanagement and entertainment systems revenues; and

 

•      a $0.3 million increase in seatingproducts revenues; offset by

 

•      a $0.8 million decrease in other productand services revenues.

 

*SystemsIntegration.*  Revenues increased by $0.7 million, or 4.5%compared to the prior year, due to:

 

•      a $2.5 million increase in completion andservice center revenues; and

 

•      a $1.0 million increase in commercialaircraft systems integration engineering services; offset by

 

•      a $2.8 million decrease resulting fromlower production of auxiliary fuel systems pursuant to our supply contract withBoeing Business Jet.

 

BBJhas exercised its option to convert the supply contract to a “requirements”contract, from a guaranteed “take-or-pay” contract, commencing January 1,2005.  Production under the“take-or-pay” portion of the contract for 2004 was completed during the secondquarter of fiscal 2004 and no new orders have been placed pursuant to the new“requirements” contract.  Based upon thenumber of auxiliary fuel systems BBJ has in its inventory, we believe we maynot receive any orders for additional systems until late in fiscal 2005.  During the three months ended June 30,2004, auxiliary fuel systems revenues were $3.3 million compared to $6.1million for the same period last year.

 

28

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**Grossprofit.**  Gross profit increased $2.1 million, or38.9%, to $7.5 million for the three months ended June 30, 2004 from $5.4million for the same period in the prior year. By segment, gross profit changed as follows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 8.5    |   | 121.9 | % |
| Systems Integration |   | (6.4                                | )      | (121.4 | ) |
| Total               |   | $                                   | 2.1    |   |   |   |

 

*CabinManagement.*  Gross profit increased by $8.5 millioncompared to the prior year, primarily due to:

 

•      a $5.8 million decrease in restructuringcharges incurred in 2004 compared to those incurred during the same period in2003 related to our furniture and seating operations;

 

•      a $2.4 million increase related to highervolume in aircraft furniture and related products revenues; and

 

•      a $0.6 million increase in gross profitrelated to higher volume for our cabin management and entertainment systems;offset by

 

•      a $0.3 million decrease in gross profitrelated to other products.

 

*SystemsIntegration.*  Gross profit decreased by $6.4 million, or121.4% compared to the prior year, primarily due to:

 

•      $5.3 million of restructuring chargesincurred in 2004 related to the reorganization of our manufacturing operations;and

 

•      a $1.6 million decrease resulting fromlower revenues from auxiliary fuel systems and a change in product deliverymix; offset by

 

•      a $0.5 million increase resulting fromthe increase in commercial aircraft systems integration engineering servicesrevenues.

 

**Selling,general and administrative expenses.**  Selling,general and administrative expenses increased $0.8 million, or 11.6%, to $7.8million for the three months ended June 30, 2004, from $7.0 million forthe same period in the prior year.  Bysegment, SG&A expenses changed as follows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 0.5    |   | 13.1 | % |
| Systems Integration |   | 0.6                                 |   | 47.6 |   |
| Corporate           |   | (0.3                                | )      |   |   |
| Total               |   | $                                   | 0.8    |   |   |   |

 

*CabinManagement. *SG&A expenses increased by $0.5million, or 13.1% compared to the prior year, primarily as a result of restructuringcharges.

 

*SystemsIntegration. *SG&A expenses increased by $0.6million, or 47.6% compared to the prior year, primarily as a result of highersales and marketing activities associated with the aircraft completion portionof our business.

 

*Corporate. *SG&A expenses decreased by $0.3 million comparedto the prior year due principally to lower costs pursuant to the incentivecompensation plan.

 

29

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**Researchand development expenses. **Research and developmentexpenses decreased $1.3 million, or 38.9%, to $2.0 million for the three monthsended June 30, 2004 compared to $3.3 million in the prior year.  By segment, research and development expenses changedas follows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | (1.8   | ) | (60.5 | )% |
| Systems Integration |   | 0.5                                 |   | 219.8 |   |
| Total               |   | $                                   | (1.3   | ) |   |   |

 

*Cabin Management. *R&D expenses decreased $1.8 million, or 60.5%compared to the prior year.  Thedecrease is primarily related to the near completed development of our newsingle-design seat technology and design of new interior furnishing componentsfor a major customer’s recently introduced new model of aircraft.

 

*Systems Integration. *R&D expenses increased $0.5 million, or 219.8%compared to the prior year.  Theincrease is principally due to the ongoing development of our videosurveillance system for different models of commercial aircraft and a designmodification to an existing product.

 

**Depreciationand amortization of intangibles.**  Depreciationand amortization expense decreased $0.2 million to $2.3 million for the threemonths ended June 30, 2004 from $2.5 million for the same period in theprior year.  The decline is attributableto reduced capital expenditures and a lower depreciable base.  Depreciation and amortization changed asfollows:

 
|                                        |   | **Increase  (Decrease)  From 2003** |   |
|---------------------------------------------|--------|-------------------------------------|--------|
| **(In  millions)**                          |   | **Amount**                          |   | **Percent** |   |
|                                        |   |                                |   |   |   |
| Depreciation charged to:                    |   |                                |   |   |   |
| Cost of sales                               |   | $                                   | (0.1   | ) | (6.4 | )% |
| Selling, general and administrative expense |   | (0.1                                | )      | (20.2 | ) |
| Amortization of intangible assets           |   | 0.0                                 |   |   |   |
| Total                                       |   | $                                   | (0.2   | ) |   |   |

 

**AdjustedEBITDA. **As described above in“—Performance Measures–Adjusted EBITDA,” we use this financial measure toevaluate the core economic performance of our operating segments.  The notes to our financial statementsinclude additional information about Adjusted EBITDA, and should be read inconjunction with the discussions presented herein.  The notes to our financial statements also include areconciliation of Adjusted EBITDA to net income (loss), a GAAP financialmeasure, to clarify the differences between these two measures.

 

*Cabin Management. *Adjusted EBITDAincreased by $1.9 million, or 43.5%, to $6.2 million for the three months endedJune 30, 2004 compared to $4.3 million for the same period in the prioryear primarily due to:

 

•      a $2.4 million increase in gross profitrelated to our business, VIP and head-of-state aircraft furniture and seatingoperations, excluding the effect of restructuring charges;

 

•      a $0.6 million increase in gross profitrelated to our cabin management and entertainment systems;

 

•      a $1.8 million decrease in research anddevelopment spending; offset by

 

•      a $2.4 million unfavorable impactresulting from adjusting for program costs;

 

•      a $0.3 million decrease in gross profitrelated to other products; and

 

30

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•      a $0.2 million increase in SG&Aspending.

 

*SystemsIntegration. *Adjusted EBITDA decreased by $1.8million, or 42.6%, to $2.4 million for the three months ended June 30,2004 compared to $4.2 million for the same period in the prior year due to:

 

•      a $1.2 million decline in gross profit,excluding the effect of restructuring charges; and

 

•      a $0.6 million increase in SG&Aspending.

 

**Impairment of goodwill.**During the three months ended June 30,2003, a $34.0 million charge was recorded to reflect the impairment of goodwillin connection with the impairment testing provision of SFAS No. 142, “Goodwilland Other Intangible Assets.”  See“—Restructuring, Asset Impairment and Other Related Charges.”

 

**Operating income (loss).**  The operating loss decreased $36.6 million,or 91.9%, to a loss of $3.2 million for the three months ended June 30,2004, from a loss of $39.8 million for the same period in the prior year.  By segment, the operating loss changed asfollows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | (43.8  | ) | (105.8 | )% |
| Systems Integration |   | 7.6                                 |   | 234.5 |   |
| Corporate           |   | (0.4                                | )      |   |   |
| Total               |   | $                                   | (36.6  | ) |   |   |

 

*CabinManagement. *The operating loss decreased by $43.8 million,or 105.8% compared to the prior year, due to:

 

•      a $34.0 million decrease in impairmentcharges;

 

•      a $5.5 million decrease in restructuringcharges incurred in 2004 as compared to 2003;

 

•      a $2.4 million increase in gross profit,primarily due to lower revenues related to our furniture and seatingoperations;

 

•      a $0.6 million increase in gross profitrelated to higher volume for our cabin management and entertainment systems;and

 

•      a $1.8 million decrease in research anddevelopment expenses; offset by

 

•      a $0.3 million decrease in gross profitrelated to other products; and

 

•      a $0.2 million increase in SG&Aspending.

 

*SystemsIntegration. *The operating loss increased by $7.6million, or 234.5% compared to the prior year, due to:

 

•      $5.3 million of restructuring chargesincurred in 2004;

 

•      a $0.6 million increase in SG&Aspending;

 

•      a $1.1 million decrease resulting fromreduced gross profit on lower revenues; and

 

•      a $0.6 million increase in research anddevelopment expenses.

 

31

----

 

**Interestexpense.**  Interest expense increased $2.3 million, or35.3%, to $8.8 million for the three months ended June 30, 2004 comparedto $6.5 million for the same period in the prior year.  The increase is attributable to:

 

•      $3.0 million of additional interestexpense attributable to $80.0 million of second-lien term debt issued inDecember 2003; and

 

•      a $0.3 million increase in other interestexpense; offset by

 

•      a $1.0 million decrease in our first-lieninterest expense due to lower principal balances outstanding resulting from thepartial refinancing with second-lien debt in December, offset, in part, by a1.5% increase in interest rate margins charged by our lenders based on ourconsolidated debt leverage ratio.

 

**Mandatorily redeemable preferred stock dividends. **Dividends on our 16% mandatorily redeemable preferredstock totaled $1.8 million for the three months ended June 30, 2004.  As more fully described in “—Changes inAccounting Principles” above, effective January 1, 2004 we adopted SFASNo. 150, “Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity.”  As aresult of adopting of SFAS No. 150, the 16% quarterly preferred stock dividendsare reflected as a charge against pre-tax income.  In periods prior to January 1, 2004, preferred stockdividends were deducted in arriving at the net income or loss applicable to ourcommon stockholder and amounted to $1.5 million for the three months endedJune 30, 2003.  The increasebetween periods is attributable to the quarterly compounding of the dividendsaccrued but not declared and paid.

 

**Provisionfor income tax benefit.**  The provision for income taxesis comprised of the following:

 
|                                                 |   | **Three  Months Ended  June 30,** |   |
|------------------------------------------------------|--------|----------------------------------------|--------|
| **(In  millions)**                                   |   | **2004**                               |   | **2003** |   |
|                                                 |   |                                   |   |   |   |
| Income tax (benefit) based on reported  pre-tax loss |   | $                                      | (4.6   | ) | $ | (22.5 | ) |
| Net deferred tax asset valuation allowance           |   | 4.6                                    |   | 13.1 |   |
| Net income tax benefit                               |   | $                                      | — |   | $ | (9.4 | ) |

 

For the three monthsended June 30, 2003, the provision for income taxes, based on the reportedconsolidated pre-tax loss, differs from the amount determined by applying theapplicable U.S. statutory federal rate to the pre-tax loss primarily due to theeffects of state and foreign income taxes and non-deductible expenses,principally the non-deductible portion of goodwill impairment charges.

 

For the three monthsended June 30, 2004, the provision for income taxes, based on the reportedconsolidated pre-tax loss, differs from the amount determined by applying theapplicable U.S. statutory federal rate to the pre-tax loss primarily due to theeffects of state and foreign income taxes and non-deductible expenses,principally mandatorily redeemable preferred stock dividends due to theadoption of SFAS No. 150 effective January 1, 2004 described above.

 

As of June 30, 2003,there were net deferred tax assets of $12.8 million, prior to recording thevaluation allowance in June 2003, as opposed to net deferred taxliabilities in prior periods.  Thechange to a net asset position was primarily caused by the $34.0 milliongoodwill impairment charge recorded during the second quarter of fiscal 2003.  SFAS No. 109, “Accounting for Income Taxes,”requires the recognition of a deferred tax asset for the future income taxbenefit of the goodwill deductions that will be taken for income tax purposes(i.e. the goodwill that has been written off in the financial statements forbook purposes will continue to be amortized and deducted for tax purposes andaccordingly represents a new deferred tax asset).

 

As required by SFAS No.109, we evaluated the deferred tax assets for expected recoverability based onthe nature of the item, the associated taxing jurisdictions, the applicableexpiration dates and future

 

32

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taxable income forecaststhat would impact utilization.  Sincethere is no loss carry back potential and we do not have any tax planningstrategies to assure recoverability, the only possibility for recovery of thenet deferred assets is future taxable income. Since there have been prior year losses, we believe it was not prudentto rely on future taxable income as the means to support the carrying value ofthe net deferred tax assets.  As aresult of the evaluation, we recorded a $13.1 million valuation allowance,eliminating the net deferred asset, as of June 30, 2003.

 

As more fully describedin Note 11 to the audited financial statements included in the Company’s 2003Form 10-K, there were net deferred tax asset of $19.5 million fully offset by avaluation allowance of the same amount as of December 31, 2003.  Based upon the results of operations for thesix months ended June 30, 2004, we determined that an additional $7.2million valuation allowance was required as of that date, $4.6 million of whichis applicable to the three-month period.

 

**Loss from continuing operations.** The loss from continuing operations decreased $23.4 million to a loss of$13.9 million for the three months ended June 30, 2004 compared to a lossof $37.3 million for the same period in the prior year, primarily due to:

 

•      a $36.6 million operating loss decrease;offset by

 

•      a $2.0 million increase in interest andother expenses (net);

 

•      a $9.4 million decrease in income taxbenefit; and

 

•      $1.8 million of preferred stock dividendsresulting from the adoption of SFAS No. 150, “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity” as describedabove.

 

**Income from discontinued operations. **Income from discontinued operations was $0.7 millionfor the three months ended June 30, 2003 and reflects the results ofoperations of our Specialty Avionics Group which was sold on May 22, 2003.

 

**Netloss.**  Net loss decreased $22.7 million to a netloss of $13.9 million for the three months ended June 30, 2004 compared toa net loss of $36.5 million for the same period in the prior year.  The decrease is attributable to:

 

•      a decrease in loss from continuingoperations of $23.4 million; offset by

 

•      a decrease in the income fromdiscontinued operations of $0.7 million.

 

**Net lossapplicable to common stockholder.**  Net lossapplicable to DeCrane Holdings, our common stockholder, decreased $24.3 millionto a net loss of $13.9 million for the three months ended June 30, 2004compared to a net loss of $38.2 million for the same period in the prioryear.  The decrease in the net lossapplicable to our common stockholder is attributable to:

 

•      a $22.7 million decrease in our net loss;and

 

•      a $1.6 million decrease in preferredstock dividends and redemption value accretion resulting from theJanuary 1, 2004 adoption of SFAS No. 150 which requires preferred stockdividends be deducted from the net income or loss for the period.

 

33

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**Bookingsand Backlog. **Bookings decreased $1.4 million, or 2.8%,to $50.5 million for the three months ended June 30, 2004 compared to$51.9 million for the same period in the prior year.  Backlog increased $15.2 million to $73.2 million as ofJune 30, 2004 compared to $58.0 million as of December 31, 2003.  By segment, bookings and backlog changed asfollows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Bookings:           |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 16.9   |   | 63.9 | % |
| Systems Integration |   | (18.3                               | )      | (71.8 | ) |
| Total               |   | $                                   | (1.4   | ) |   |   |
|                |   |                                |   |   |   |
| Backlog:            |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 14.1   |   | 41.7 | % |
| Systems Integration |   | 1.1                                 |   | 4.5 |   |
| Total               |   | $                                   | 15.2   |   |   |   |

 

Cabin Management’sbookings and backlog increased as a result of the increase in our customer’saircraft production schedules during the period.  Systems Integration’s bookings decrease resulted from a $24.0million decrease in orders for auxiliary fuel systems offset by an increase inbookings for other products and services.

 

### **Six Month**s Ended June 30, 2004 Compared toSix Months Ended June 30, 2003

### ** **

**Revenues.* ***Revenues increased $17.4 million, or20.2%, to $103.4 million for the six months ended June 30, 2004 from $86.0million for the three months ended June 30, 2003.  By segment, revenues changed as follows:

 
|                                |   | **Increase  (Decrease)  From 2003** |   |
|-------------------------------------|--------|-------------------------------------|--------|
| **(In  millions)**                  |   | **Amount**                          |   | **Percent** |   |
|                                |   |                                |   |   |   |
| Cabin Management                    |   | $                                   | 15.1   |   | 25.0 | % |
| Systems Integration                 |   | 3.1                                 |   | 11.4 |   |
| Increase in inter-group elimination |   | (0.8                                | )      |   |   |
| Total                               |   | $                                   | 17.4   |   |   |   |

 

*CabinManagement. *Revenues increased by $15.1 million, or25.0% compared to the prior year due to a higher volume of corporate jetproduction by aircraft manufacturers. The increase consisted of the following:

 

•      an $11.9 million increase in aircraftfurniture and related products revenues;

 

•      a $2.3 million increase in cabinmanagement and entertainment systems revenues; and

 

•      a $1.7 million increase in seatingproducts revenues; offset by

 

•      a $0.8 million decrease in other productand services revenues.

 

*SystemsIntegration.*  Revenues increased by $3.1 million, or 11.4%compared to the prior year, due to:

 

•      a $3.3 million increase in completion andservice center revenues; and

 

•      a $2.0 million increase in commercialaircraft systems integration engineering services; offset by

 

34

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•      a $2.2 million decrease resulting fromlower production of auxiliary fuel systems pursuant to our supply contract withBoeing Business Jet.

 

BBJhas exercised its option to convert the supply contract to a “requirements”contract, from a guaranteed “take-or-pay” contract, commencing January 1,2005.  Production under the“take-or-pay” portion of the contract for 2004 is complete and no new ordershave been placed pursuant to the new “requirements” contract.  Based upon the number of auxiliary fuelsystems BBJ has in its inventory, we believe we may not receive any orders foradditional systems until late in fiscal 2005. During the six months ended June 30, 2004, auxiliary fuel systemsrevenues were $11.8 million compared to $14.0 million for the same period lastyear.  During the year endedDecember 31, 2003, BBJ auxiliary fuel systems provided approximately $26.4million, or 15.5%, of our consolidated revenues.

 

**Grossprofit.**  Gross profit increased $0.8 million, or4.5%, to $19.2 million for the six months ended June 30, 2004 from $18.4million for the same period in the prior year. By segment, gross profit changed as follows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 7.8    |   | 101.6 | % |
| Systems Integration |   | (7.0                                | )      | (65.6 | ) |
| Total               |   | $                                   | 0.8    |   |   |   |

 

*CabinManagement.*  Gross profit increased by $7.8 million, or101.6% compared to the prior year, primarily due to:

 

•      a $5.8 million decrease in restructuringcharges incurred in 2004 compared to those incurred during the same period in2003 related to our furniture and seating operations;

 

•      a $0.9 million increase related to highervolume in aircraft furniture and related products revenues; and

 

•      a $1.4 million increase in gross profitrelated to higher volume for our cabin management and entertainment systems;offset by

 

•      a $0.3 million decrease in gross profitrelated to other products.

 

*SystemsIntegration.*  Gross profit decreased by $7.0 million, or65.6% compared to the prior year, primarily due to:

 

•      $5.3 million of restructuring chargesincurred in 2004 related to the reorganization of our manufacturing operations;

 

•      a $1.3 million decrease resulting fromreduced auxiliary fuel system revenues; and

 

•      a $1.0 million decrease resulting fromthe change in product delivery mix; offset by

 

•      a $0.6 million increase resulting fromthe increase in commercial aircraft systems integration engineering servicesrevenues.

 

**Selling,general and administrative expenses.**  Selling,general and administrative expenses decreased $1.9 million, or 11.1%, to $15.0million for the six months ended June 30, 2004, from $16.9 million for thesame period in the prior year.  Bysegment, SG&A expenses changed as follows:

 

35

----

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 0.3    |   | 4.1 | % |
| Systems Integration |   | (0.8                                | )      | (16.0 | ) |
| Corporate           |   | (1.4                                | )      |   |   |
| Total               |   | $                                   | (1.9   | ) |   |   |

 

*CabinManagement. *SG&A expenses increased by $0.3million, or 4.1% compared to the prior year, primarily as a result ofrestructuring charges.

 

*SystemsIntegration. *SG&A expenses decreased by $0.8million, or 16.0% compared to the prior year, due to lower labor and employeebenefit costs resulting from workforce reductions as well as other costreduction efforts offset by an increase in sales and marketing activitiesassociated with the aircraft completion portion of our business.

 

*Corporate. *SG&A expenses decreased by $1.4 million comparedto the prior year due principally to lower costs pursuant to the incentivecompensation plan.

 

**Researchand development expenses. **Research anddevelopment expenses decreased $0.7 million, or 13.8%, to $4.2 million for thesix months ended June 30, 2004 compared to $4.9 million in the prioryear.  By segment, research and development expenses changedas follows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | (1.6   | ) | 35.8 | % |
| Systems Integration |   | 0.9                                 |   | 271.8 |   |
| Total               |   | $                                   | (0.7   | ) |   |   |

 

*Cabin Management. *R&D expenses decreased $1.6 million, or 35.8%compared to the prior year.  Theincrease is primarily related to the near completed development of our newsingle-design seat technology and design of new interior furnishing componentsfor a major customer’s recently introduced new model of aircraft.

 

*Systems Integration. *R&D expenses increased $0.9 million, or 271.8%compared to the prior year.  Theincrease is principally due to the ongoing development of our videosurveillance system for different models of commercial aircraft and a designmodification to an existing product.

 

**Depreciationand amortization of intangibles.**  Depreciationand amortization expense decreased $0.4 million to $4.6 million for the sixmonths ended June 30, 2004 from $5.0 million for the same period in theprior year.  The decline is attributableto reduced capital expenditures and a lower depreciable base.  Depreciation and amortization changed asfollows:

 
|                                        |   | **Increase  (Decrease)  From 2003** |   |
|---------------------------------------------|--------|-------------------------------------|--------|
| **(In  millions)**                          |   | **Amount**                          |   | **Percent** |   |
|                                        |   |                                |   |   |   |
| Depreciation charged to:                    |   |                                |   |   |   |
| Cost of sales                               |   | $                                   | (0.2   | ) | (6.7 | )% |
| Selling, general and administrative expense |   | (0.2                                | )      | (20.3 | ) |
| Amortization of intangible assets           |   | 0.0                                 |   |   |   |
| Total                                       |   | $                                   | (0.4   | ) |   |   |

 

36

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**AdjustedEBITDA. **As described above in“—Performance Measures–Adjusted EBITDA,” we use this financial measure toevaluate the core economic performance of our operating segments.  The notes to our financial statementsinclude additional information about Adjusted EBITDA, and should be read inconjunction with the discussions presented herein.  The notes to our financial statements also include a reconciliationof Adjusted EBITDA to net income (loss), a GAAP financial measure, to clarifythe differences between these two measures.

 

*Cabin Management. *Adjusted EBITDAincreased by $0.7 million, or 8.6%, to $9.6 million for the six months endedJune 30, 2004 compared to $8.9 million for the same period in the prioryear primarily due to:

 

•      a $0.9 million increase in gross profitrelated to our business, VIP and head-of-state aircraft furniture and seatingoperations, excluding the effect of restructuring charges;

 

•      a $1.4 million increase in gross profitrelated to our cabin management and entertainment systems;

 

•      a $1.6 million decrease in research anddevelopment spending; offset by

 

•      a $2.8 million unfavorable impactresulting from adjusting for program costs;

 

•      a $0.3 million decrease in gross profitrelated to other products; and

 

•      a $0.1 million increase in SG&Aspending.

 

*SystemsIntegration. *Adjusted EBITDA decreased by $0.9million, or 14.4%, to $5.4 million for the six months ended June 30, 2004compared to $6.3 million for the same period in the prior year due to:

 

•      a $1.7 million decline in gross profit,excluding the effect of restructuring charges; offset by

 

•      a $0.8 million decrease in SG&Aspending.

 

**Impairment of goodwill.**During the six months ended June 30,2003, a $34.0 million charge was recorded to reflect the impairment of goodwillin connection with the impairment testing provision of SFAS No. 142, “Goodwilland Other Intangible Assets.”  See“—Restructuring, Asset Impairment and Other Related Charges.”

 

**Operating income (loss).**  The operating loss decreased $37.4 million,or 95.5%, to a loss of $1.8 million for the six months ended June 30,2004, from a loss of $39.2 million for the same period in the prior year.  By segment, the operating loss changed asfollows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | (43.1  | ) | (107.8 | )% |
| Systems Integration |   | 7.1                                 |   | 153.8 |   |
| Corporate           |   | (1.4                                | )      |   |   |
| Total               |   | $                                   | (37.4  | ) |   |   |

 

*CabinManagement.  *The operating loss decreased by $43.1million, or 107.8% compared to the prior year, due to:

 

•      a $34.0 million decrease in impairmentcharges;

 

•      a $5.5 million decrease in restructuringcharges incurred in 2004 as compared to 2003;

 

•      a $0.9 million increase in gross profit,primarily due to lower revenues related to our furniture and seatingoperations;

 

•      a $1.6 million increase in gross profitrelated to higher volume for our cabin management and entertainment systems;and

 

37

----

 

•      an $1.6 million decrease in research anddevelopment expenses; offset by

 

•      a $0.3 million decrease in gross profitrelated to other products; and

 

•      a $0.2 million increase in SG&Aspending.

 

*SystemsIntegration. *The operating loss increased by $7.1million, or 153.8% compared to the prior year, due to:

 

•      $5.3 million of restructuring chargesincurred in 2004;

 

•      a $3.2 million decrease resulting fromreduced gross profit on lower revenues; and

 

•      a $0.9 million increase in research anddevelopment expenses; offset by

 

•      a net $1.5 million increase resultingfrom the conversion of a major customer supply contract to a requirements-onlycontract;

 

•      a $0.8 million decrease in SG&Aspending.

 

**Interestexpense.**  Interest expense increased $5.2 million, or41.5%, to $17.5 million for the six months ended June 30, 2004 compared to$12.3 million for the same period in the prior year.  The increase is attributable to:

 

•      $5.9 million of additional interestexpense attributable to $80.0 million of second-lien term debt issued inDecember 2003; and

 

•      a $0.6 million increase in other interestexpense; offset by

 

•      a $1.3 million decrease in our first-lieninterest expense due to lower principal balances outstanding resulting from thepartial refinancing with second-lien debt in December, offset, in part, by a1.5% increase in interest rate margins charged by our lenders based on ourconsolidated debt leverage ratio.

 

**Mandatorily redeemable preferred stock dividends. **Dividends on our 16% mandatorily redeemable preferredstock totaled $3.5 million for the six months ended June 30, 2004.  As more fully described in “—Changes inAccounting Principles” above, effective January 1, 2004 we adopted SFASNo. 150, “Accounting for Certain Financial Instruments with Characteristics ofboth Liabilities and Equity.”  As aresult of adopting of SFAS No. 150, the 16% quarterly preferred stock dividendsare reflected as a charge against pre-tax income.  In periods prior to January 1, 2004, preferred stock dividendswere deducted in arriving at the net income or loss applicable to our commonstockholder and amounted to $3.0 million for the six months ended June 30,2003.  The increase between periods isattributable to the quarterly compounding of the dividends accrued but notdeclared and paid.

 

**Provisionfor income tax benefit.**  The provision for income taxesis comprised of the following:

 
|                                                 |   | **Six Months  Ended  June 30,** |   |
|------------------------------------------------------|--------|--------------------------------------|--------|
| **(In  millions)**                                   |   | **2004**                             |   | **2003** |   |
|                                                 |   |                                 |   |   |   |
| Income tax (benefit) based on reported  pre-tax loss |   | $                                    | (7.1   | ) | $ | (23.7 | ) |
| Net deferred tax asset valuation allowance           |   | 7.2                                  |   | 13.1 |   |
| Net provision for income tax (benefit)               |   | $                                    | 0.1    |   | $ | (10.6 | ) |

 

For the six months endedJune 30, 2003, the provision for income taxes, based on the reportedconsolidated pre-tax loss, differs from the amount determined by applying theapplicable U.S. statutory federal rate to the pre-tax loss primarily due to theeffects of state and foreign income taxes and non-deductible expenses,principally the non-deductible portion of goodwill impairment charges.

 

38

----

 

For the six months endedJune 30, 2004, the provision for income taxes, based on the reportedconsolidated pre-tax loss, differs from the amount determined by applying theapplicable U.S. statutory federal rate to the pre-tax loss primarily due to theeffects of state and foreign income taxes and non-deductible expenses,principally mandatorily redeemable preferred stock dividends due to theadoption of SFAS No. 150 effective January 1, 2004 described above.

 

As of June 30, 2003,there were net deferred tax assets of $12.8 million, prior to recording thevaluation allowance in June 2003, as opposed to net deferred taxliabilities in prior periods.  Thechange to a net asset position was primarily caused by the $34.0 milliongoodwill impairment charge recorded during the second quarter of fiscal2003.  SFAS No. 109, “Accounting forIncome Taxes,” requires the recognition of a deferred tax asset for the futureincome tax benefit of the goodwill deductions that will be taken for income taxpurposes (i.e. the goodwill that has been written off in the financialstatements for book purposes will continue to be amortized and deducted for taxpurposes and accordingly represents a new deferred tax asset).

 

As required by SFAS No.109, we evaluated the deferred tax assets for expected recoverability based onthe nature of the item, the associated taxing jurisdictions, the applicableexpiration dates and future taxable income forecasts that would impactutilization.  Since there is no losscarry back potential and we do not have any tax planning strategies to assurerecoverability, the only possibility for recovery of the net deferred assets isfuture taxable income.  Since there havebeen prior year losses, we believe it was not prudent to rely on future taxableincome as the means to support the carrying value of the net deferred taxassets.  As a result of the evaluation,we recorded a $13.1 million valuation allowance, eliminating the net deferredasset, as of June 30, 2003.

 

As more fully describedin Note 11 to the audited financial statements included in the Company’s 2003Form 10-K, there were net deferred tax asset of $19.5 million fully offset by avaluation allowance of the same amount as of December 31, 2003.  Based upon the results of operations for thesix months ended June 30, 2004, we determined that an additional $7.2million valuation allowance was required as of that date.

 

**Loss from continuing operations.** The loss from continuing operations decreased $18.6 million to a loss of$23.0 million for the six months ended June 30, 2004 compared to a loss of$41.6 million for the same period in the prior year, primarily due to:

 

•      a $37.4 million operating loss decrease;offset by

 

•      a $4.6 million increase in interest andother expenses (net);

 

•      a $10.7 million decrease in income taxbenefit; and

 

•      $3.5 million of preferred stock dividendsresulting from the adoption of SFAS No. 150, “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity” as describedabove.

 

**Loss from discontinued operations. **Lossfrom discontinued operations was $5.6 million for the six months endedJune 30, 2003 and reflects the results of operations of our SpecialtyAvionics Group which was sold on May 22, 2003.

 

**Cumulative effect of change in accounting principle.** As more fully described in “—Changes in Accounting Principles” above,the $13.8 million charge during the six months ended June 30, 2003 was toreflect the cumulative effect of the change in accounting for productdevelopment costs.

 

39

----

 

**Netloss.**  Net loss decreased $38.0 million to a netloss of $23.0 million for the six months ended June 30, 2004 compared to anet loss of $61.0 million for the same period in the prior year.  The decrease is attributable to:

 

•      a decrease in loss from continuingoperations of $18.6 million;

 

•      a net decrease in cumulative effect ofchange in accounting principles of $13.8 million; and

 

•      a decrease in the loss from discontinuedoperations of $5.6 million.

 

**Net lossapplicable to common stockholder.**  Net lossapplicable to DeCrane Holdings, our common stockholder, decreased $41.3 millionto a net loss of $23.0 million for the six months ended June 30, 2004compared to a net loss of $64.3 million for the same period in the prioryear.  The decrease in the net lossapplicable to our common stockholder is attributable to:

 

•      a $38.0 million decrease in our net loss;and

 

•      a $3.3 million decrease in preferredstock dividends and redemption value accretion resulting from theJanuary 1, 2004 adoption of SFAS No. 150 which requires preferred stockdividends be deducted from the net income or loss for the period.

 

**Bookings. **Bookings increased $25.3 million, or 27.2%, to $118.6million for the six months ended June 30, 2004 compared to $93.3 millionfor the same period in the prior year. By segment, bookings changed as follows:

 
|                |   | **Increase  (Decrease)  From 2003** |   |
|---------------------|--------|-------------------------------------|--------|
| **(In  millions)**  |   | **Amount**                          |   | **Percent** |   |
|                |   |                                |   |   |   |
| Cabin Management    |   | $                                   | 25.7   |   | 41.9 | % |
| Systems Integration |   | (0.4                                | )      |   |   |
| Total               |   | $                                   | 25.3   |   |   |   |

 

Cabin Management’sbookings increased as a result of the increase in our customer’s aircraftproduction schedules during the period.

 

**Restructurin**g, Asset Impairment and Other Related Charges

 

The following discussionshould be read in conjunction with Note 2 accompanying our financial statementsincluded in this report.

 

During the three monthsand six months ended June 30, 2003, we recorded restructuring, assetimpairment and other related pre-tax charges related to a series ofrestructuring activities.  Thesecharges, and the effect these charges had on our reported results ofoperations, are summarized below.

 

40

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|                                                                       |   | **Three  Months Ended  June 30,** |   | **Six Months  Ended  June 30,** |   |
|----------------------------------------------------------------------------|--------|----------------------------------------|--------|--------------------------------------|--------|
| **(In  millions)**                                                         |   | **2004**                               |   | **2003**                             |   | **2004** |   | **2003** |   |
|                                                                       |   |                                   |   |                                 |   |   |   |   |   |
| Nature of charges:                                                         |   |                                   |   |                                 |   |   |   |   |   |
| Operational Realignment and Facilities  Restructuring                      |   | $                                      | 6.9    |                                 | $      | — |   | $ | 6.9 |   | $ | — |   |
| Seating Product Line and Furniture  Manufacturing Facilities Restructuring |   | —                                 |   | 7.1                                  |   | — |   | 7.1 |   |
| Goodwill impairment charges                                                |   | —                                 |   | 34.0                                 |   | — |   | 41.5 |   |
| Total pre-tax charges                                                      |   | $                                      | 6.9    |                                 | $      | 41.1 |   | $ | 6.9 |   | $ | 48.6 |   |
|                                                                       |   |                                   |   |                                 |   |   |   |   |   |
| Business segment recording the charges:                                    |   |                                   |   |                                 |   |   |   |   |   |
| Cabin Management                                                           |   | $                                      | 1.6    |                                 | $      | 41.1 |   | $ | 1.6 |   | $ | 41.1 |   |
| Systems Integration                                                        |   | 5.3                                    |   | —                               |   | 5.3 |   | — |   |
| Total charged to continuing operations                                     |   | 6.9                                    |   | 41.1                                 |   | 6.9 |   | 41.1 |   |
| Specialty Avionics (discontinued  operations)                              |   | —                                 |   | —                               |   | — |   | 7.5 |   |
| Total pre-tax charges                                                      |   | $                                      | 6.9    |                                 | $      | 41.1 |   | $ | 6.9 |   | $ | 48.6 |   |
|                                                                       |   |                                   |   |                                 |   |   |   |   |   |
| Charged to operations:                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Cost of sales                                                              |   | $                                      | 6.1    |                                 | $      | 6.5 |   | $ | 6.1 |   | $ | 6.5 |   |
| Selling, general and administrative  expenses                              |   | 0.8                                    |   | 0.6                                  |   | 0.8 |   | 0.6 |   |
| Impairment of goodwill                                                     |   | —                                 |   | 34.0                                 |   | — |   | 34.0 |   |
| Total charged to continuing operations                                     |   | 6.9                                    |   | 41.1                                 |   | 6.9 |   | 41.1 |   |
| Charged to discontinued operations                                         |   | —                                 |   | —                               |   | — |   | 7.5 |   |
| Total pre-tax charges                                                      |   | $                                      | 6.9    |                                 | $      | 41.1 |   | $ | 6.9 |   | $ | 48.6 |   |
|                                                                       |   |                                   |   |                                 |   |   |   |   |   |
| Components of charges:                                                     |   |                                   |   |                                 |   |   |   |   |   |
| Noncash charges                                                            |   | $                                      | 3.0    |                                 | $      | 37.6 |   | $ | 3.0 |   | $ | 37.6 |   |
| Cash charges                                                               |   | 3.9                                    |   | 3.5                                  |   | 3.9 |   | 3.5 |   |
| Total charged to continuing operations                                     |   | 6.9                                    |   | 41.1                                 |   | 6.9 |   | 41.1 |   |
| Charged to discontinued operations                                         |   | —                                 |   | —                               |   | — |   | 7.5 |   |
| Total pre-tax charges                                                      |   | $                                      | 6.9    |                                 | $      | 41.1 |   | $ | 6.9 |   | $ | 48.6 |   |

 

**Operational Realignment andFacilities Restructuring**

 

During the second quarterof fiscal 2004, we adopted plans to restructure the operations of our CabinManagement and Systems Integration groups. The restructuring plan for Cabin Management involves the realignment ofproduction between its manufacturing facilities and the relocation andconsolidation of the group’s headquarters to Wichita, Kansas.  The plan for Systems Integration involvescombining the manufacturing activities of two facilities into a single facilityand eliminating some product offerings and service capabilities resulting in apartial downsizing of certain operations. These actions are designed to reduce engineering, production andinventory carrying costs by supporting fewer manufacturing locations andproduct offerings.  In connection withthese actions, we recorded pre-tax charges to operations totaling $6.9 millionduring the second quarter of fiscal 2004, of which $3.0 million were noncashcharges.

 

The charges are comprisedof the write-down of surplus inventory, lease termination and related charges,and severance and other compensation costs. We also expect to incur additional restructuring-related expenses ofapproximately $1.9 million during the last half of fiscal 2004 to complete therestructuring plans.  These expenses,which are primarily relocation and travel costs, will be expensed asincurred.  Future cash payments, whichwill aggregate approximately $5.6 million, will be funded from existing cashbalances and internally generated cash from operations.

 

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**Seating Product Line and FurnitureManufacturing Facilities Restructuring**

 

During the second quarterof fiscal 2003, we consolidated our seating product line offerings and adopteda restructuring plan to down-size a furniture manufacturing facility inresponse to continuing weakness in the business, VIP and head-of-state aircraftmarket.  These actions were designed toreduce engineering, production and inventory carrying costs by supporting fewerproduct offerings and achieve profitability at the furniture manufacturingfacility based on its lower production levels. In connection with these actions, we recorded pre-tax charges tooperations totaling $7.1 million during the second quarter of fiscal 2003, ofwhich $3.6 million were noncash charges. The charges are comprised of the write-off of excess and obsoleteinventory costs related to the discontinued product offerings, leasetermination and related charges, and severance and other compensationcosts.  These restructuring activitieswere completed by the end of fiscal 2003.

 

**Goodwill ImpairmentCharges**

** **

As a result of thecontinuing weakness in the business, VIP and head-of-state aircraft market andthe decision to down-size a furniture manufacturing facility, the goodwillassociated with the furniture manufacturing reporting unit was tested forrecoverability in June 2003 and found to be impaired.  As a result, $34.0 million of goodwill associatedwith the reporting unit was written off and charged to operations during thethree months ended June 30, 2003.

 

On March 14, 2003,we entered into a definitive agreement to sell our equity interests in thesubsidiaries comprising the Specialty Avionics Group for $140.0 million incash.  Based upon the fair value of thegroup implied in the definitive agreement, we determined that the carryingvalue of the group’s net assets was not fully recoverable.  As a result, we recorded a goodwillimpairment charge of $7.5 million during the three months endedMarch 31, 2003 to reduce the carrying value to estimated netrealizable value.

 

**Liquidity and Capital Resources**

** **

Our principal cash needsare for debt service, working capital, capital expenditures and possiblestrategic acquisitions, as well as to provide DeCrane Holdings with cash tofinance its needs, which consists primarily of cash dividends on its preferredstock, if declared.  Our principalsources of liquidity are expected to be cash flow from operations, potentialcapital market transactions and third party borrowings, principally under ourfirst-lien credit facility.

 

**Cash Flows During the SixMonths Ended June 30, 2004**

** **

Net cash used foroperating activities was $17.3 million for the six months ended June 30,2004 and consisted of $8.9 million of cash used by operations after adding backdepreciation, amortization, preferred stock dividends, noncash restructuringcharges, interest accretion and other noncash items, $10.8 million used forworking capital and a $2.4 million increase in other liabilities.  The following factors contributed to the$10.8 million working capital increase:

 

•      a $5.8 million increase in accountsreceivables due to higher revenues;

 

•      a $12.1 million increase in inventorycommensurate with higher revenues and order backlog; and

 

•      a $0.2 million net increase in otherworking capital items; offset by

 

•      a $7.3 million increase in accountspayable and accrued expenses.

 

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Net cash used forinvesting activities consisted of capital expenditures of $1.8 million for thesix months ended June 30, 2004.  Weanticipate spending approximately $3.0 to $5.0 million for capital expendituresin 2004.

 

Net cash providedby financing activities was $14.5 million for the six months endedJune 30, 2004 and consisted of:

 

•      $15.1 million of debt borrowings,primarily on the revolving line of credit; offset by

 

•      $0.6 million of other secured long-termdebt repayments.

 

**Debt Obligations and CapitalResources as of June 30, 2004**

 

As of June 30, 2004,first-lien credit facility borrowings and second-lien term debt totaling $105.6million are at variable interest rates based on defined margins over thecurrent prime rate or LIBOR.  We alsohad $100.0 million of 12% subordinated notes, $71.3 million of 15% second-lienterm debt and other secured indebtedness totaling $8.2 million outstanding asof June 30, 2004.  In addition, our16% mandatorily redeemable preferred stock, which has characteristics of both aliability and equity, had a $46.8 million mandatorily redemption value as ofJune 30, 2004.

 

As of June 30, 2004,we had $41.0 million of working capital and $8.6 million of borrowingsavailable under our $24.0 million revolving line of credit, which expires inMarch 2006.

 

**Recent Developments Affecting DebtObligations and Preferred Stock Dividends**

 

On July 23, 2004,holders of $64.5 million of our 12% senior subordinated notes dueSeptember 30, 2008 (the “existing notes”) exchanged their notes for new17% senior discount notes due September 30, 2008 (the “new notes”).  The new notes do not bear cash interest andhave an initial accreted value equal to the principal amount of the notesexchanged.  The new notes accrete invalue at a 17% annual rate and will have a $127.8 million aggregate accretedprincipal value at maturity.  The newnotes are senior unsecured obligations of DeCrane Aircraft and are guaranteedby its subsidiaries.  Except for thechanges in the interest rate and payment and ranking described above, the newnotes have terms substantially identical to those contained in the existingnotes, although covenants limiting the incurrence of indebtedness, the grantingof liens and the making of restricted payments are more restrictive.  The exchange will help conserve workingcapital by reducing our cash interest expense by $7.7 million annually throughSeptember 2008.

 

Concurrent with the noteexchange, we amended the terms of our 16% senior preferred stock.  DeCrane Holdings, our parent, also amendedthe terms of its 14% preferred stock as well. The amended terms provide that further dividends do not accrue on thepreferred stock, except if a leverage ratio (as defined) falls below certainspecified levels or if certain triggering events occur, such as failure todischarge any mandatory redemption obligations, and the like.  Depending upon the future leverage ratioachieved, dividends will resume at various dividend rates.  All dividends accrued through the amendmentdate and future dividends, if any, are not payable until redemption.  The amendment for the 16% preferred stockaccelerates the mandatory redemption date from March 31, 2009 toDecember 31, 2008 while the September 30, 2009 mandatory redemptiondate for the 14% preferred stock remained unchanged.  The amendment to the 16% preferred stock also adds severalrestrictive covenants.  The holders ofthe 16% preferred stock were issued 348,945 shares of DeCrane Holdings commonstock in connection with the amendment.

 

We continue to exploretransactions that would improve our liquidity and reduce our cash needs.  We have not entered into any commitments todo so and cannot assure you that we will be able to do so in the future.  For example, as disclosed in a CurrentReport on Form 8-K date July 20, 2004, we are engaged in discussions withsome of the holders of the remaining 12% senior subordinated notes that did

 

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not participate inexchange for the 17% notes.  We areproposing that such holders exchange their existing 12% senior subordinatednotes for new senior notes that would bear interest at an annual rate of 2% incash and 10% in kind.  No letters ofintent or definitive agreements with respect to such proposal have beenexecuted, and any such transaction would require negotiation and execution ofdefinitive documentation and the consent of our other lenders, including theholders who participated in the 17% note exchange.  As a result, any such exchange transaction may not occur.

 

**Financial Condition and Liquidity**

 

We believe our expectedoperating cash flows, together with borrowings under our first-lien creditfacility ($8.6 million of which was available as of June 30, 2004, thecommitment for which expires in March 2006), will be sufficient to meetour operating expenses, working capital requirements, capital expenditures anddebt service obligations for the next twelve months.  However, our working capital needs generally increase as ourorder backlog and revenues increase, particularly with respect to orders wherewe must incur development costs and build inventory but we may not receive fullpayment until delivery.  Any significantdelay in payments could increase our working capital needs beyond ourexpectations.  Further, our ability tocomply with our debt financial covenants, pay principal or interest and satisfysuch cash obligations will depend on our future operating performance as wellas competitive, legislative, regulatory, business and other factors beyond ourcontrol.  Although we cannot be certain,we expect to be in compliance with the revised financial covenants through theend of the year based on our current operating plan.  See “Special Note Regarding Forward-Looking Statements and RiskFactors.”

 

**Disclosure of Contractual Obligations and Commitments**

** **

The following tablesummarizes our known contractual obligations to make future cash payments as ofJune 30, 2004, as well an estimate of the periods during which thesepayments are expected to be made.  Theinformation presented in the table reflects the changes resulting from theJuly 2004 events previously described in “Liquidity and CapitalResources—Recent Developments Affecting Debt Obligations and Preferred StockDividends.”

 
|                                       |   |      |   | **Years  Ending December 31,** |   |
|--------------------------------------------|--------|-----------|--------|-------------------------------------|--------|
| **(In  millions)**                         |   | **Total** |   | **2004**                            |   | **2005  and  2006** |   | **2007  and  2008** |   | **2009  and  Beyond** |   |
|                                       |   |      |   |                                |   |   |   |   |   |   |   |
| Long-term debt (a):                        |   |      |   |                                |   |   |   |   |   |   |   |
| First-lien credit facility (b):            |   |      |   |                                |   |   |   |   |   |   |   |
| Term debt                                  |   | $         | 80.5   |                                | $      | — |   | $ | 15.0 |   | $ | 65.5 |   | $ | — |   |
| Revolving line of credit                   |   | 15.0      |   | —                              |   | 15.0 |   | — |   | — |   |
| Second-lien term debt (c)                  |   | 81.3      |   | —                              |   | — |   | 81.3 |   | — |   |
| 17% senior discount notes (d)              |   | 64.5      |   | —                              |   | — |   | 64.5 |   | — |   |
| 12% subordinated notes (e)                 |   | 35.5      |   | —                              |   | — |   | 35.5 |   | — |   |
| Capital lease obligations (f)              |   | 3.2       |   | 0.3                                 |   | 0.9 |   | 0.6 |   | 1.4 |   |
| Other indebtedness (f)                     |   | 5.1       |   | 0.4                                 |   | 1.7 |   | 0.6 |   | 2.4 |   |
| Total long-term debt                       |   | 285.1     |   | 0.7                                 |   | 32.6 |   | 248.0 |   | 3.8 |   |
|                                       |   |      |   |                                |   |   |   |   |   |   |   |
| Mandatorily redeemable preferred stock (g) |   | 46.8      |   | —                              |   | — |   | 46.8 |   | — |   |
| Other long-term liabilities                |   | 7.8       |   | —                              |   | 5.3 |   | 2.1 |   | 0.4 |   |
| Operating lease obligations                |   | 13.3      |   | 1.5                                 |   | 5.0 |   | 2.4 |   | 4.4 |   |
| Total obligations as of June 30, 2004 |   | $         | 353.0  |                                | $      | 2.2 |   | $ | 42.9 |   | $ | 299.3 |   | $ | 8.6 |   |

 

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(a)       Excludes interest payments, which are describedin the following notes.

 

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(b)       The first-lien credit facility bears interest atvariable rates and therefore the amount of future interest payments areuncertain.  The debt bears interestbased on a margin over, at our option, the prime rate or LIBOR.  As of June 30, 2004, the current primerate was 4.00% and the current LIBOR was 1.08%.  The margins applicable to portions of amounts borrowed varydepending on our consolidated debt leverage ratio.  Currently, the applicable margins are 4.00% to 4.75% for primerate borrowings and 5.25% to 6.00% for LIBOR borrowings.  The weighted-average interest rate on allfirst-lien debt was 6.92% as of June 30, 2004.

 

(c)       The second-lien term debt is comprised of $70.0million of fixed rate debt and $10.0 million of variable rate debt.  The fixed rate debt bears interest at 15%;12% payable quarterly in cash and 3% pay-in-kind or “accreted” interest,payable at maturity.  The variable ratedebt bears cash interest, at our option, at the prime rate plus 7.5% or LIBORplus 8.5%, plus 3% pay-in-kind interest payable at maturity.  The weighted-average interest rate on allsecond-lien debt was 14.33% as of June 30, 2004.  All of the second-lien debt matures on June 30, 2008, atwhich time the cash payment obligation will be $91.7 million, including the 3%pay-in-kind interest obligation.

 

(d)       The 17% senior discount notes do not bear cashinterest expense but instead accrete in value at a 17% annual rate untilmaturity on September 30, 2008. The notes will have a $127.8 million aggregate accreted principal valueat maturity.

 

(e)       Interest on the 12% subordinated notes ispayable semiannually.

 

(f)        Interest is generally payable monthly.

 

(g)       Dividends do not accrue on the preferred stockunless a leverage ratio (as defined) falls below certain specified levels.  Depending on the future leverage ratioachieved, dividends may accrue at either a 4% or 16% annual rate.  Future dividends, in any, are not payableuntil redemption.  The mandatoryredemption date is December 31, 2008. Our debt instruments restrict our ability to make payments on ourpreferred stock.

 

**Disclosure About Off-Balance Sheet Commitments andIndemnities**

 

We are a wholly-ownedsubsidiary of DeCrane Holdings, whose capital structure also includesmandatorily redeemable preferred stock. Since we are DeCrane Holdings’ only operating subsidiary and source ofcash, we may be required to fund DeCrane Holdings’ redemption obligation in thefuture, subject to significant limitations contained in our first-lien creditagreement, second-lien term notes and the senior discount notes andsubordinated notes indentures.  TheDeCrane Holdings preferred stock has a total redemption value of $76.5 millionas of June 30, 2004 and the preferred stock is mandatorily redeemable onSeptember 30, 2009.

 

During our normal courseof business, we have entered into agreements containing indemnities pursuant towhich we may be required to make payments in the future.  These indemnities are in connection withfacility leases and liabilities for specified claims arising from investmentbanking services our financial advisors provide to us.  The duration of these indemnities,commitments and guarantees varies, and in certain cases, is indefinite.  Substantially all of these indemnitiesprovide no limitation on the maximum potential future payments we could beobligated to make and is not quantifiable. We have not recorded any liability for these indemnities since no claimshave been asserted to date.

 

In connection with thesale of the Specialty Avionics Group, we made indemnities to the buyer with respectto a number of customary, and certain other specific, representations andwarranties.  Our indemnities withrespect to some of these matters are limited in terms of duration with themaximum of potential future payments capped at $14.0 million and ourindemnities with respect to specified environmental matters will expire notlater than October 2010 and provides for a maximum liability of $5.0million, while others will have no limitations.

 

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As of June 30, 2004,we also had irrevocable standby letters of credit in the amount of $0.3 millionissued and outstanding under our first-lien credit facility.

 

**Recent Accounting Pronouncements**

** **

**Accounting Pronouncements AdoptedJanuary 1, 2004**

 

As more fully describedin Note 1 accompanying our financial statements included in this report and“—Changes in Accounting Principles” above, effective January 1, 2004 weadopted the provisions of SFAS No. 150, “Accounting for Certain FinancialInstruments with Characteristics of both Liabilities and Equity.”

 

**Special Note Regarding Forward-Looking Statements andRisk Factors**

** **

All statements other thanstatements of historical facts included in this report, including statementsabout our future performance and liquidity and future industry performance, areconsidered forward-looking statements within the meaning of the PrivateSecurities Litigation Reform Act of 1995. These statements are subject to known and unknown risks, uncertaintiesand other factors, which are difficult to predict.  We are vulnerable to a variety of factors that affect manybusinesses, such as:

 

•      fuel prices and general economicconditions that affect demand for aircraft and air travel, which in turn affectdemand for our products and services;

 

•      acts, and ongoing threats, of globalterrorism, military conflicts and health epidemics that affect demand foraircraft and air travel, which in turn affect demand for our products andservices;

 

•      our reliance on key customers and theadverse effect a significant decline in business from any one of them wouldhave on our business;

 

•      our reliance on large projects, whereunanticipated needs to incur development costs and acquire inventory or delaysin payment could increase our working capital needs;

 

•      changes in prevailing interest rates andthe availability of financing to fund our plans for continued growth;

 

•      competition from larger companies;

 

•      Federal Aviation Administrationprescribed standards and licensing requirements, which apply to many of theproducts and services we provide;

 

•      inflation, and other general changes incosts of goods and services;

 

•      price and availability of raw materials,component parts and electrical energy;

 

•      liability and other claims assertedagainst us that exceeds our insurance coverage;

 

•      the ability to attract and retainqualified personnel;

 

•      labor disturbances; and

 

•      changes in operating strategy, or ouracquisition and capital expenditure plans.

 

Some of the moresignificant factors listed above are further described in our 2003 AnnualReport on Form 10-K and should be read in conjunction with this report.  Changes in such factors could cause ouractual results to differ materially from those contemplated in such forward-lookingstatements.  Although we believe thatthe expectations reflected in such forward-looking statements are reasonable,we can give no assurance that such expectations will prove to be correct.  We undertake no obligation to releasepublicly any revisions to these forward-looking statements to reflect events orcircumstances after

 

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the date hereof or toreflect the occurrence of unanticipated events.  You should not rely on our forward-looking statements as if theywere certainties.

 

**ITEM 3**.          QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK

 

We are exposed to variousmarket risks, including interest rates and changes in foreign currency exchangerates.  Market risk is the potentialloss arising from adverse changes in prevailing market rates and prices.  From time to time, we use derivativefinancial instruments to manage and reduce risks associated with thesefactors.  We do not enter intoderivatives or other financial instruments for trading or speculative purposes.

 

**Interest Rate Risk.**  A significantportion of our capital structure is comprised of long-term variable andfixed-rate debt.

 

Market risk related toour variable-rate debt is estimated as the potential decrease in pre-taxearnings resulting from an increase in interest rates.  The interest rates applicable tovariable-rate debt are, at our option, based on defined margins over thecurrent prime rate or LIBOR.  As ofJune 30, 2004, the current prime rate was 4.0% and the current LIBOR was1.08%.  Based on $105.6 million ofvariable-rate debt outstanding as of June 30, 2004, a hypothetical onepercent rise in interest rates, to 5.00% for prime rate borrowings and 2.08%for LIBOR borrowings, would reduce our pre-tax earnings by $1.0 millionannually.

 

To limit a portion of ourexposure related to rising interest rates, we have entered into an interestrate swap contract to effectively convert our variable-rate industrial revenuebonds to 4.2% fixed-rate debt until maturity in 2008.  The contract is considered to be a hedge against changes in theamount of future cash flows associated with interest payments on this portionof our variable-rate debt.  Market riskrelated to this interest rate swap contract is estimated as the potential higherinterest expense we will incur if the variable interest rate decreases belowthe 4.2% fixed rate.  Based on the $3.0million of variable-rate debt converted to fixed-rate debt outstanding as ofJune 30 2004, a hypothetical one percent decrease in the variable interestrate to 3.2%, would reduce our pre-tax earnings by less than $0.1 millionannually.

 

The estimated fair valueof our $100.0 million fixed-rate long-term debt increased $20.0 million, or44.4%, to approximately $65.0 million as of June 30, 2004 from $45.0million as of December 31, 2003. Market risk related to our fixed-rate debt is deemed to be the potentialincrease in fair value resulting from a decrease in interest rates.  For example, a hypothetical ten percentdecrease in the interest rates, from 12.0% to 10.8%, would increase the fairvalue of our fixed-rate debt by approximately $5.0 million.

 

**Foreign Currency Exchange Rate Risk.** Our foreign customers are located in various parts of the world,primarily Canada, the Far and Middle East and Western Europe, and we have a subsidiarywith manufacturing facilities in Mexico. To limit our foreign currency exchange rate risk related to sales to ourcustomers, orders are almost always valued and sold in U.S. dollars.  We have entered into forward foreignexchange contracts in the past, primarily to limit exposure related to foreigninventory procurement and operating costs. While we have not entered into any such contracts since 1998, we may doso in the future depending on the volume of non-U.S. dollar denominatedtransactions and our assessment of future foreign exchange rate trends.

 

**ITEM 4**.          CONTROLS AND PROCEDURES

** **

The management of DeCraneAircraft Holdings, Inc. (the “Company”), under the supervision and with theparticipation of the Company’s Chief Executive Officer and Chief FinancialOfficer, conducted an evaluation of the Company’s “disclosure controls andprocedures” (as defined in Exchange Act Rules 13a-15(e) or 15d-15(e)) as of theend of the period covered by this report. Based on that evaluation, the

 

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Chief Executive Officerand Chief Financial Officer concluded that the Company’s disclosure controlsand procedures were effective as of the end of the period covered by thisreport.

 

There was no change inthe Company’s internal control over financial reporting identified inconnection with the evaluation required by paragraph (d) of Exchange Act Rules13a-15 or 15d-15 that occurred during the Company’s last fiscal quarter thathas materially affected, or is reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**PART II – OTHER INFORMATION**

 

**ITEM1****.****          LEGAL PROCEEDINGS**

 

See Note 10 to theconsolidated financial statements included in this report.

 

**ITEM6****.****          EXHIBITS AND REPORTS ONFORM 8-K**

 

a.         Exhibits

 

31.1             Chief Executive Officer Certification Pursuant toSection 302 of the Sarbanes-Oxley Act of 2002 *

 

31.2             Chief Financial Officer Certification Pursuant toSection 302 of the Sarbanes-Oxley Act of 2002 *

 

32                Chief Executive Officer and Chief Financial OfficerCertifications Pursuant to Pursuant to Section 906 of the Sarbanes-OxleyAct of 2002 *

 

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*                  Filed herewith

 

b.         Reports on Form 8-K

 

On June 2, 2004 wefiled a Form 8-K Current Report.  UnderItem 9 we disclosed entering into non-binding letters of intent with severalholders of our 12% senior subordinated notes to exchange their notesaggregating approximately $65 million for new 17% senior discount notes, whichbear no cash interest but instead accrete in value at a 17% annual rate untilmaturity, and the holders of our 16% preferred stock to amend the terms of thepreferred stock.

 

On July 20, 2004 wefiled a Form 8-K Current Report.  UnderItem 9 we disclosed we are in discussion with certain holders of our 12% seniorsubordinated notes not participating in the exchange described in ourJune 2, 2004 Form 8-K Current Report to exchange their notes for new notesbearing interest at a rate of 2% in cash and 10% in kind at maturity.

 

On July 23, 2004 wefiled a Form 8-K Current Report.  UnderItem 9 we disclosed we had completed the exchange of notes and amended theterms of our 16% preferred stock as we had described in our June 2, 2004Form 8-K Current Report.

 

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**SIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|                  | **DECRANE  AIRCRAFT HOLDINGS, INC. (Registrant)** |
|-----------------------|---------------------------------------------------|
|                  |                                              |   |
|                  |                                              |   |
| August 16,  2004 | By:                                               | /s/  RICHARD J. KAPLAN |   |
|                  | Name:                                             | Richard J.  Kaplan |
|                  | Title:                                            | Senior Vice  President, Chief Financial Officer, |
|                  |                                              | Secretary,  Treasurer and Director |

 

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