##### Table of Contents

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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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|x | Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ---------------------------------------------------------------------------------------

For the Quarterly Period Ended September 30, 2006,

or



| ̈ | Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
|- | ----------------------------------------------------------------------------------------

For the Transition Period From  To
.

Commission file number: 0-13829



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PEMCO AVIATION GROUP, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Delaware                                                       |  | 84-0985295                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)

1943 North 50thStreet, Birmingham, Alabama 35212

(Address of principal executive offices)
(Zip Code)

205-592-0011

(Registrants telephone number, including area code)



---

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

Indicate by check mark whether the Company is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and
large accelerated filer in Rule 12b-2 of the Exchange Act.

(Check one): ̈Large accelerated filer ̈Accelerated filer    x  Non-accelerated filer.

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

Indicate the number of shares outstanding of each of
the registrants classes of common stock, as of the latest practicable date.



|                               |  |                                
|------------------------------ |  | -------------------------------
|Class                          |  | Outstanding at November 6, 2006
|Common Stock, $.0001 par value |  | 4,126,200                      



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##### Table of Contents

INDEX

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES



|                              |  |                                                                                                        |  |     
|----------------------------- |  | ------------------------------------------------------------------------------------------------------ |  | ----
|                              |  |                                                                                                        |  | PAGE
|PART I.
FINANCIAL INFORMATION |  |                                                                                                       
|                              |  |                                                                                                       
|Item 1.                       |  | Financial Statements (Unaudited)                                                                       |  | 1   
|                              |  |                                                                                                       
|                              |  | Consolidated Balance Sheets September 30, 2006 (Unaudited) and December 31, 2005                       |  | 1   
|                              |  |                                                                                                       
|                              |  | Unaudited Consolidated Statements of Operations For The Three Months Ended September 30, 2006 and 2005 |  | 3   
|                              |  |                                                                                                       
|                              |  | Unaudited Consolidated Statements of Operations For The Nine Months ended September 30, 2006 and 2005  |  | 4   
|                              |  |                                                                                                       
|                              |  | Unaudited Consolidated Statements of Cash Flows For The Nine Months ended September 30, 2006 and 2005  |  | 5   
|                              |  |                                                                                                       
|                              |  | Notes to Consolidated Financial Statements                                                             |  | 7   
|                              |  |                                                                                                       
|Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                  |  | 22  
|                              |  |                                                                                                       
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                                             |  | 34  
|                              |  |                                                                                                       
|Item 4.                       |  | Controls and Procedures                                                                                |  | 34  
|                              | 
|PART II.
OTHER INFORMATION    |  |                                                                                                       
|                              |  |                                                                                                       
|Item 1.                       |  | Legal Proceedings                                                                                      |  | 35  
|                              |  |                                                                                                       
|Item 1A.                      |  | Risk Factors                                                                                           |  | 35  
|                              |  |                                                                                                       
|Item 6.                       |  | Exhibits                                                                                               |  | 38  
|                              | 
|SIGNATURES                    |  |                                                                                                       



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##### Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

(In Thousands)



|                                               |  |                   |         |   |                  |   |         |  
|---------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                               |  | September 30,2006 |         |   | December 31,2005 |  
|                                               |  | Unaudited         |         |   |                  |  
|Current assets:                                |  |                   |         |   |                  |   |         |  
|Cash and cash equivalents                      |  | $                 | 74      |   |                  | $ | 26      |  
|Accounts receivable, net                       |  |                   | 28,062  |   |                  |   | 20,528  |  
|Inventories, net                               |  |                   | 17,560  |   |                  |   | 19,715  |  
|Deferred income taxes                          |  |                   | 4,534   |   |                  |   | 4,083   |  
|Prepaid expenses and other                     |  |                   | 2,100   |   |                  |   | 1,898   |  
|Assets of discontinued operations              |  |                   | 2,842   |   |                  |   | 2,188   |  
|                                               |  |                   |         |   |                  |   |         |  
|Total current assets                           |  |                   | 55,172  |   |                  |   | 48,438  |  
|                                               |  |                   |         |   |                  |   |         |  
|Machinery, equipment and improvements at cost: |  |                   |         |   |                  |   |         |  
|Machinery and equipment                        |  |                   | 31,483  |   |                  |   | 30,738  |  
|Leasehold improvements                         |  |                   | 30,746  |   |                  |   | 29,752  |  
|Construction-in-process                        |  |                   | 78      |   |                  |   | 265     |  
|                                               |  |                   |         |   |                  |   |         |  
|                                               |  |                   | 62,307  |   |                  |   | 60,755  |  
|Less accumulated depreciation and amortization |  |                   | (39,067 | ) |                  |   | (36,315 | )
|                                               |  |                   |         |   |                  |   |         |  
|Net machinery, equipment and improvements      |  |                   | 23,240  |   |                  |   | 24,440  |  
|                                               |  |                   |         |   |                  |   |         |  
|Other non-current assets:                      |  |                   |         |   |                  |   |         |  
|Deposits and other                             |  |                   | 2,687   |   |                  |   | 2,285   |  
|Deferred income taxes                          |  |                   | 10,535  |   |                  |   | 11,042  |  
|Related party receivable                       |  |                   | 519     |   |                  |   | 503     |  
|Intangible pension asset                       |  |                   | 8,476   |   |                  |   | 8,476   |  
|Intangible assets, net                         |  |                   | 122     |   |                  |   | 104     |  
|                                               |  |                   |         |   |                  |   |         |  
|                                               |  |                   | 22,339  |   |                  |   | 22,410  |  
|                                               |  |                   |         |   |                  |   |         |  
|Total assets                                   |  | $                 | 100,751 |   |                  | $ | 95,288  |  
|                                               |  |                   |         |   |                  |   |         |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



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##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

LIABILITIES AND STOCKHOLDERS EQUITY

(In Thousands, Except Common Share Information)



|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                             |  | September 30,2006 |         |   | December 31,2005 |  
|                                                                                                                                                             |  | Unaudited         |         |   |                  |  
|Current liabilities:                                                                                                                                         |  |                   |         |   |                  |   |         |  
|Current portion of long-term debt                                                                                                                            |  | $                 | 31,220  |   |                  | $ | 25,126  |  
|Current portion of pension liability                                                                                                                         |  |                   | 11,215  |   |                  |   | 11,019  |  
|Accounts payable - trade                                                                                                                                     |  |                   | 13,624  |   |                  |   | 11,402  |  
|Accrued health and dental                                                                                                                                    |  |                   | 988     |   |                  |   | 1,158   |  
|Accrued liabilities - payroll related                                                                                                                        |  |                   | 6,268   |   |                  |   | 5,650   |  
|Accrued liabilities - other                                                                                                                                  |  |                   | 4,886   |   |                  |   | 4,822   |  
|Customer deposits in excess of cost                                                                                                                          |  |                   | 6,441   |   |                  |   | 6,443   |  
|Liabilities of discontinued operations                                                                                                                       |  |                   | 967     |   |                  |   | 763     |  
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total current liabilities                                                                                                                                    |  |                   | 75,609  |   |                  |   | 66,383  |  
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Long-term debt, less current portion                                                                                                                         |  |                   | 1,969   |   |                  |   | 1,973   |  
|Long-term pension benefit liability                                                                                                                          |  |                   | 8,014   |   |                  |   | 13,139  |  
|Other long-term liabilities                                                                                                                                  |  |                   | 2,662   |   |                  |   | 2,254   |  
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total liabilities                                                                                                                                            |  |                   | 88,254  |   |                  |   | 83,749  |  
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Stockholders equity:                                                                                                                                        |  |                   |         |   |                  |   |         |  
|Preferred Stock, $0.0001 par value, 5,000,000 shares authorized, none outstanding                                                                            |  |                   |        |   |                  |   |        |  
|Common Stock, $0.0001 par value, 12,000,000 shares authorized, 4,126,200 and 4,113,659 outstanding at September 30, 2006 and
December 31, 2005, respectively |  |                   | 1       |   |                  |   | 1       |  
|Additional paid-in capital                                                                                                                                   |  |                   | 14,169  |   |                  |   | 13,188  |  
|Retained earnings                                                                                                                                            |  |                   | 28,871  |   |                  |   | 28,894  |  
|Treasury stock, at cost  413,398 shares at September 30, 2006 and December 31, 2005                                                                         |  |                   | (8,623  | ) |                  |   | (8,623  | )
|Accumulated other comprehensive income (loss):                                                                                                               |  |                   |         |   |                  |   |         |  
|Minimum pension liability                                                                                                                                    |  |                   | (21,921 | ) |                  |   | (21,921 | )
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                                   |  |                   | 12,497  |   |                  |   | 11,539  |  
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                                   |  | $                 | 100,751 |   |                  | $ | 95,288  |  
|                                                                                                                                                             |  |                   |         |   |                  |   |         |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



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##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands, Except Net Income/(Loss) per Common Share Information)



|                                                       |  |                                    |        |   |                                    |   |        |  
|------------------------------------------------------ |  | ---------------------------------- | ------ | - | ---------------------------------- | - | ------ | -
|                                                       |  | ThreeMonths EndedSeptember 30,2006 |        |   | ThreeMonths EndedSeptember 30,2005 |  
|Net sales                                              |  | $                                  | 38,343 |   |                                    | $ | 29,727 |  
|Cost of sales                                          |  |                                    | 33,274 |   |                                    |   | 27,886 |  
|                                                       |  |                                    |        |   |                                    |   |        |  
|Gross profit                                           |  |                                    | 5,069  |   |                                    |   | 1,841  |  
|                                                       |  |                                   
|Selling, general and administrative expenses           |  |                                    | 5,113  |   |                                    |   | 5,807  |  
|Provision for doubtful accounts                        |  |                                    |       |   |                                    |   | 1,519  |  
|                                                       |  |                                    |        |   |                                    |   |        |  
|Operating loss from continuing operations              |  |                                    | (44    | ) |                                    |   | (5,485 | )
|                                                       |  |                                   
|Interest expense                                       |  |                                    | (833   | ) |                                    |   | (468   | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Loss from continuing operations before income taxes    |  |                                    | (877   | ) |                                    |   | (5,953 | )
|Income tax benefit                                     |  |                                    | (303   | ) |                                    |   | (2,357 | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Loss from continuing operations                        |  |                                    | (574   | ) |                                    |   | (3,596 | )
|Income/(loss) from discontinued operations, net of tax |  |                                    | 27     |   |                                    |   | (151   | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Net loss                                               |  | $                                  | (547   | ) |                                    | $ | (3,747 | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Net income/(loss) per common share:                    |  |                                    |        |   |                                    |   |        |  
|Basic net loss from continuing operations              |  | $                                  | (0.14  | ) |                                    | $ | (0.87  | )
|Basic net income/(loss) from discontinued operations   |  | $                                  | 0.01   |   |                                    | $ | (0.04  | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Basic net loss per share                               |  | $                                  | (0.13  | ) |                                    | $ | (0.91  | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Diluted net loss from continuing operations            |  | $                                  | (0.14  | ) |                                    | $ | (0.87  | )
|Diluted net income/(loss) from discontinued operations |  | $                                  | 0.01   |   |                                    | $ | (0.04  | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Diluted net loss per share                             |  | $                                  | (0.13  | ) |                                    | $ | (0.91  | )
|                                                       |  |                                    |        |   |                                    |   |        |  
|Weighted average common shares outstanding:            |  |                                    |        |   |                                    |   |        |  
|Basic                                                  |  |                                    | 4,125  |   |                                    |   | 4,111  |  
|Diluted                                                |  |                                    | 4,125  |   |                                    |   | 4,111  |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



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##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(In Thousands, Except Net Income/(Loss) per Common Share Information)



|                                                             |  |                                   |         |   |                                   |   |         |  
|------------------------------------------------------------ |  | --------------------------------- | ------- | - | --------------------------------- | - | ------- | -
|                                                             |  | NineMonths EndedSeptember 30,2006 |         |   | NineMonths EndedSeptember 30,2005 |  
|Net sales                                                    |  | $                                 | 123,478 |   |                                   | $ | 109,856 |  
|Cost of sales                                                |  |                                   | 105,261 |   |                                   |   | 95,758  |  
|                                                             |  |                                   |         |   |                                   |   |         |  
|Gross profit                                                 |  |                                   | 18,217  |   |                                   |   | 14,098  |  
|                                                             |  |                                  
|Selling, general and administrative expenses                 |  |                                   | 15,882  |   |                                   |   | 16,203  |  
|Provision for/(reversal of) doubtful accounts                |  |                                   | (638    | ) |                                   |   | 1,519   |  
|                                                             |  |                                   |         |   |                                   |   |         |  
|Operating income/(loss) from continuing operations           |  |                                   | 2,973   |   |                                   |   | (3,624  | )
|                                                             |  |                                  
|Other income                                                 |  |                                   |        |   |                                   |   | 650     |  
|Interest expense                                             |  |                                   | (2,263  | ) |                                   |   | (1,352  | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Income/(loss) from continuing operations before income taxes |  |                                   | 710     |   |                                   |   | (4,326  | )
|Income tax expense/(benefit)                                 |  |                                   | 298     |   |                                   |   | (1,718  | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Income/(loss) from continuing operations                     |  |                                   | 412     |   |                                   |   | (2,608  | )
|Loss from discontinued operations, net of tax                |  |                                   | (435    | ) |                                   |   | (348    | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Net loss                                                     |  | $                                 | (23     | ) |                                   | $ | (2,956  | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Net income/(loss) per common share:                          |  |                                   |         |   |                                   |   |         |  
|Basic net income/(loss) from continuing operations           |  | $                                 | 0.10    |   |                                   | $ | (0.64   | )
|Basic net loss from discontinued operations                  |  | $                                 | (0.11   | ) |                                   | $ | (0.08   | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Basic net loss per share                                     |  | $                                 | (0.01   | ) |                                   | $ | (0.72   | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Diluted net income/(loss) from continuing operations         |  | $                                 | 0.10    |   |                                   | $ | (0.64   | )
|Diluted net loss from discontinued operations                |  | $                                 | (0.11   | ) |                                   | $ | (0.08   | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Diluted net loss per share                                   |  | $                                 | (0.01   | ) |                                   | $ | (0.72   | )
|                                                             |  |                                   |         |   |                                   |   |         |  
|Weighted average common shares outstanding:                  |  |                                   |         |   |                                   |   |         |  
|Basic                                                        |  |                                   | 4,122   |   |                                   |   | 4,107   |  
|Diluted                                                      |  |                                   | 4,122   |   |                                   |   | 4,107   |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



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##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                                                                          |  |                                   |        |   |                                   |   |        |  
|--------------------------------------------------------------------------------------------------------- |  | --------------------------------- | ------ | - | --------------------------------- | - | ------ | -
|                                                                                                          |  | NineMonths EndedSeptember 30,2006 |        |   | NineMonths EndedSeptember 30,2005 |  
|Cash flows from operating activities:                                                                     |  |                                   |        |   |                                   |   |        |  
|Net loss from operations                                                                                  |  | $                                 | (23    | ) |                                   | $ | (2,956 | )
|                                                                                                          |  |                                   |        |   |                                   |   |        |  
|Adjustments to reconcile net loss from operations to net cash (used in)/provided by operating activities: |  |                                   |        |   |                                   |   |        |  
|Depreciation and amortization of machinery, equipment and improvements                                    |  |                                   | 2,764  |   |                                   |   | 2,846  |  
|Amortization of intangible assets                                                                         |  |                                   | 204    |   |                                   |   | 37     |  
|Provision/(benefit) for deferred income taxes                                                             |  |                                   | 63     |   |                                   |   | (1,906 | )
|Funding over pension cost                                                                                 |  |                                   | (4,929 | ) |                                   |   | (2,995 | )
|Provision for/(reversal of) losses on receivables                                                         |  |                                   | (638   | ) |                                   |   | 1,519  |  
|Loss on disposals of machinery and equipment                                                              |  |                                   | 4      |   |                                   |   | 81     |  
|Provision for/(reversal of) losses on contracts-in-process                                                |  |                                   | (2,368 | ) |                                   |   | 1,433  |  
|Stock based compensation expense                                                                          |  |                                   | 857    |   |                                   |   | 221    |  
|Realized gain on deferred compensation plan investments                                                   |  |                                   |       |   |                                   |   | (340   | )
|Changes in assets and liabilities:                                                                        |  |                                   |        |   |                                   |   |        |  
|Accounts receivable, trade                                                                                |  |                                   | (7,607 | ) |                                   |   | 17,811 |  
|Inventories                                                                                               |  |                                   | 4,607  |   |                                   |   | (3,771 | )
|Prepaid expenses and other                                                                                |  |                                   | (224   | ) |                                   |   | (179   | )
|Deposits and other                                                                                        |  |                                   | (409   | ) |                                   |   | (354   | )
|Customer deposits in excess of cost                                                                       |  |                                   | 10     |   |                                   |   | 7,136  |  
|Accounts payable and accrued liabilities                                                                  |  |                                   | 3,326  |   |                                   |   | (6,907 | )
|                                                                                                          |  |                                   |        |   |                                   |   |        |  
|Total adjustments                                                                                         |  |                                   | (4,340 | ) |                                   |   | 14,632 |  
|                                                                                                          |  |                                   |        |   |                                   |   |        |  
|Net cash (used in)/provided by operating activities                                                       |  |                                   | (4,363 | ) |                                   |   | 11,676 |  
|                                                                                                          |  |                                   |        |   |                                   |   |        |  
|Cash flows from investing activities:                                                                     |  |                                   |        |   |                                   |   |        |  
|Capital expenditures                                                                                      |  |                                   | (1,581 | ) |                                   |   | (2,926 | )
|                                                                                                          |  |                                   |        |   |                                   |   |        |  
|Net cash used in investing activities                                                                     |  |                                   | (1,581 | ) |                                   |   | (2,926 | )
|                                                                                                          |  |                                   |        |   |                                   |   |        |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



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##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                     |  |                                   |        |   |                                   |   |         |  
|---------------------------------------------------- |  | --------------------------------- | ------ | - | --------------------------------- | - | ------- | -
|                                                     |  | NineMonths EndedSeptember 30,2006 |        |   | NineMonths EndedSeptember 30,2005 |  
|Cash flows from financing activities:                |  |                                   |        |   |                                   |   |         |  
|Proceeds from exercise of stock options              |  |                                   | 124    |   |                                   |   | 111     |  
|Net change under revolving credit facility           |  |                                   | 2,384  |   |                                   |   | (10,986 | )
|Principal payments under long-term debt              |  |                                   | (1,294 | ) |                                   |   | (1,131  | )
|Borrowings under long-term debt                      |  |                                   | 5,000  |   |                                   |   |        |  
|Payment of debt issuance cost                        |  |                                   | (222   | ) |                                   |   | (56     | )
|                                                     |  |                                   |        |   |                                   |   |         |  
|Net cash provided by/(used in) financing activities  |  |                                   | 5,992  |   |                                   |   | (12,062 | )
|                                                     |  |                                   |        |   |                                   |   |         |  
|Net increase/(decrease) in cash and cash equivalents |  |                                   | 48     |   |                                   |   | (3,312  | )
|                                                     |  |                                   |        |   |                                   |   |         |  
|Cash and cash equivalents, beginning of period       |  |                                   | 26     |   |                                   |   | 3,354   |  
|                                                     |  |                                   |        |   |                                   |   |         |  
|Cash and cash equivalents, end of period             |  | $                                 | 74     |   |                                   | $ | 42      |  
|                                                     |  |                                   |        |   |                                   |   |         |  
|Supplemental disclosure of cash flow information:    |  |                                   |        |   |                                   |   |         |  
|Cash paid/(received) during the period for:          |  |                                   |        |   |                                   |   |         |  
|Interest                                             |  | $                                 | 2,183  |   |                                   | $ | 1,359   |  
|                                                     |  |                                   |        |   |                                   |   |         |  
|Income taxes                                         |  | $                                 | (301   | ) |                                   | $ | 115     |  
|                                                     |  |                                   |        |   |                                   |   |         |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



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##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of and for the Quarters Ended

September 30, 2006 and 2005

1.CONSOLIDATED FINANCIAL STATEMENTS

The interim consolidated financial statements have been prepared by Pemco Aviation Group, Inc. (the Company) following the requirements of the
Securities and Exchange Commission for interim reporting, and are unaudited. In the opinion of management, all adjustments necessary for a fair presentation are reflected in the interim financial statements. Such adjustments are of a normal and
recurring nature. The results of operations for the period ended September 30, 2006 are not necessarily indicative of the operating results expected for the full year. The interim financial statements should be read in conjunction with the
audited financial statements and notes thereto included in the Companys 2005 Annual Report on Form 10-K.

2.ASSIGNMENT OF LEASE

On September 2, 2004, the Company, through its Air International Incorporated (AIA) subsidiary, entered into an Asset
Purchase Agreement with Avantair, Inc. The Asset Purchase Agreement provided for the assignment of AIAs lease agreement with Pinellas County, Florida to Avantair, Inc., located on the leased premises located at the St. Petersburg-Clearwater
International Airport. During January 2005, Avantair, Inc. assigned its rights under the Asset Purchase Agreement to AvAero Services, LLC (AvAero). AIA completed the assignment of its lease agreement and the sale of the airplane hangars
and other personal property to AvAero pursuant to an Assignment, Assumption and Amendment of Lease dated April 21, 2005. The Company recognized a gain of approximately $650,000 that is included in other income on the consolidated statements of
operations for the nine months ended September 30, 2005.

3.NET INCOME (LOSS) PER SHARE

Basic net income (loss) per share was computed by dividing net income (loss) by the weighted average number of shares of Common Stock outstanding during
the periods. Diluted net income (loss) per share was computed by dividing net income (loss) by the weighted average number of shares of Common Stock and the dilutive effects of the shares awarded under the Companys Non-Qualified Stock Option
Plan, based on the treasury stock method using an average fair market value of the stock during the respective periods. In periods with net losses all common stock equivalents are excluded from the per share calculation; therefore, the basic loss
per share equals the diluted loss per share. The following table represents the net loss per share calculations for the three-month and nine-month periods ended September 30, 2006 and 2005:

(In Thousands, except net loss per share)



|                                |  |                                    |       |   |                                    |   |        |                                   |  |   |                                   |   |  |   |        |  
|------------------------------- |  | ---------------------------------- | ----- | - | ---------------------------------- | - | ------ | --------------------------------- |  | - | --------------------------------- | - |  | - | ------ | -
|                                |  | ThreeMonths EndedSeptember 30,2006 |       |   | ThreeMonths EndedSeptember 30,2005 |   |        | NineMonths EndedSeptember 30,2006 |  |   | NineMonths EndedSeptember 30,2005 |  
|Net loss                        |  | $                                  | (547  | ) |                                    | $ | (3,747 | )                                 |  | $ | (23                               | ) |  | $ | (2,956 | )
|Weighted average shares         |  |                                    | 4,125 |   |                                    |   | 4,111  |                                   |  |   | 4,122                             |   |  |   | 4,107  |  
|Basic net loss per share        |  | $                                  | (0.13 | ) |                                    | $ | (0.91  | )                                 |  | $ | (0.01                             | ) |  | $ | (0.72  | )
|Dilutive securities             |  |                                    |      |   |                                    |   |       |                                   |  |   |                                  |   |  |   |       |  
|Diluted weighted average shares |  |                                    | 4,125 |   |                                    |   | 4,111  |                                   |  |   | 4,122                             |   |  |   | 4,107  |  
|Diluted net loss per share      |  | $                                  | (0.13 | ) |                                    | $ | (0.91  | )                                 |  | $ | (0.01                             | ) |  | $ | (0.72  | )

For the three months and nine months ended September 30, 2006 and 2005, all options to
purchase shares of Common Stock were excluded from the computation of diluted net loss per share because the effect of including these potential shares are antidilutive.



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4.STOCK OPTIONS

On May 14, 2003, the Companys stockholders approved amendments to the Companys Non-Qualified Stock Option Plan (the Option Plan), pursuant to which a maximum of 2,000,000 shares of Common
Stock in the aggregate have been reserved for grants to key personnel. The Option Plan expires by its terms on September 8, 2009. Options available to be granted under the Option Plan amounted to approximately 350,000 at September 30,
2006. Generally, options granted under the Option Plan are granted with an exercise price equal to the market value of a share of Common Stock on the date of grant, become exercisable over staggered periods, and expire ten years after the date of
grant. Certain option awards provide for accelerated vesting if there is a change in control (as defined in the Option Plan).

Effective
January 1, 2006, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 123(R), Share Based Payment, which revises SFAS No. 123, Accounting for Stock-Based Compensation. The Company
elected to use the modified prospective transition method; therefore, prior period results were not restated. Prior to the adoption of SFAS No. 123(R), stock-based compensation expense related to stock options was not recognized in the results
of operations if the exercise price was at least equal to the market value of the common stock on the grant date, in accordance with Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.

SFAS No. 123(R) requires the Company to recognize expense related to the fair value of our stock-based compensation awards, including employee stock
options, over the service period (generally the vesting period) in the consolidated financial statements. SFAS No. 123(R) permits entities to use any option-pricing model that meets the fair value objective in the Statement. For options with
graded vesting, the Company values the stock option grants and recognizes compensation expense as if each vesting portion of the award was a separate award. Under the modified prospective method, awards that were granted, modified, or settled on or
after January 1, 2006 are measured and accounted for in accordance with SFAS No. 123(R). Unvested equity-classified awards that were granted prior to January 1, 2006 will continue to be accounted for in accordance with SFAS
No. 123, except that all awards are recognized in the results of operations over the remaining vesting periods. The compensation cost recorded for these awards will be based on their grant-date fair value as calculated for the pro forma
disclosures required by SFAS No. 123. The impact of forfeitures that may occur prior to vesting is also estimated and considered in the amount recognized. In addition, the realization of tax benefits in excess of amounts recognized for
financial reporting purposes will be recognized as a financing activity, rather than as an operating activity as in the past.

The
following table summarizes stock option activity for the nine months ended September 30, 2006:



|                                     |  |                |   |  |                                          |      
|------------------------------------ |  | -------------- | - |  | ---------------------------------------- | -----
|                                     |  | Shares         |   |  | Weighted averageexercise price
per share
|                                     |  | (In Thousands) |   |  |                                         
|Outstanding as of December 31, 2005  |  | 1,054          |   |  | $                                        | 20.42
|Granted                              |  | 79             |   |  |                                          | 17.42
|Exercised                            |  | (12            | ) |  |                                          | 9.89 
|Forfeited/Expired                    |  | (47            | ) |  |                                          | 22.03
|                                     |  |                |   |  |                                          |      
|Outstanding as of September 30, 2006 |  | 1,074          |   |  |                                          | 20.25
|                                     |  |                |   |  |                                          |      
|Exercisable as of September 30, 2006 |  | 1,004          |   |  | $                                        | 19.96
|                                     |  |                |   |  |                                          |      



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The weighted average remaining term for outstanding stock options was 5.94 years at September 30,
2006. The aggregate intrinsic value at September 30, 2006 was approximately $77,000 for stock options outstanding and $77,000 for stock options exercisable. The intrinsic value for stock options is calculated based on the exercise price of the
underlying awards and the market price of our Common Stock as of the reporting date.

Proceeds received from the exercise of stock options
were approximately $124,000 and $111,000 during the first nine months of 2006 and 2005, respectively. The intrinsic value related to the exercise of stock options was approximately $81,000 during the first nine months of 2006, which is currently
deductible for tax purposes. However, these tax benefits were not realized due to existing unused net operating loss carryforwards. The pre-tax compensation cost for stock-based employee compensation was $854,000 and $221,000 for the first nine
months of fiscal 2006 and 2005, respectively.

The following table illustrates what the effect on 2005 net income and earnings per share
would have been during 2005 if the Company had applied the fair value recognition provisions of SFAS No. 123 to stock option grants to employees.

(In Thousands, Except Per Share Information)



|                                                                    |  |                                    |        |   |                                   |   |        |  
|------------------------------------------------------------------- |  | ---------------------------------- | ------ | - | --------------------------------- | - | ------ | -
|                                                                    |  | ThreeMonths EndedSeptember 30,2005 |        |   | NineMonths EndedSeptember 30,2005 |  
|Net loss  as reported                                              |  | $                                  | (3,747 | ) |                                   | $ | (2,956 | )
|Stock based compensation under fair value method, net of tax effect |  |                                    | (167   | ) |                                   |   | (723   | )
|                                                                    |  |                                    |        |   |                                   |   |        |  
|Net loss  pro forma                                                |  | $                                  | (3,914 | ) |                                   | $ | (3,679 | )
|                                                                    |  |                                    |        |   |                                   |   |        |  
|Net loss per share, basic  as reported                             |  | $                                  | (0.91  | ) |                                   | $ | (0.72  | )
|                                                                    |  |                                    |        |   |                                   |   |        |  
|Net loss per share, diluted  as reported                           |  | $                                  | (0.91  | ) |                                   | $ | (0.72  | )
|                                                                    |  |                                    |        |   |                                   |   |        |  
|Net loss per share, basic  pro forma                               |  | $                                  | (0.95  | ) |                                   | $ | (0.90  | )
|                                                                    |  |                                    |        |   |                                   |   |        |  
|Net loss per share, diluted  pro forma                             |  | $                                  | (0.95  | ) |                                   | $ | (0.90  | )
|                                                                    |  |                                    |        |   |                                   |   |        |  

The pro forma compensation costs presented in the table above and in prior filings for the Company
have been calculated using an option pricing model and may not be indicative of amounts that should be expected in future years.

The fair
value of the options granted during 2006 and 2005 were estimated on the date of grant using the binomial method and the following weighted-average assumptions:



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|                        |  |               |  |      
|----------------------- |  | ------------- |  | -----
|                        |  | 2006          |  | 2005 
|Risk-free interest rate |  | 4.84% - 4.88% |  | 4.50%
|Expected volatility     |  | 59%           |  | 61%  
|Expected term           |  | 4.20          |  | 4.92 
|Dividend yield          |  | 0%            |  | 0%   
|Exercise Factor         |  | 2.0           |  | 2.0  
|Post-Vest %             |  | 6.51%         |  | 6.51%

The fair value of the options granted prior to 2005 was estimated on the date of grant using a
different option-pricing model and the following weighted-average assumptions: risk-free interest rates of 1.7% - 1.9%, expected volatility of 61% - 66%, an expected life of 2.3 years - 2.5 years, and no dividend yield. Both of the options pricing
models used to calculate the fair value of the options granted require the input of subjective assumptions that will usually have a significant impact on the fair value estimated. The assumptions for grants subsequent to December 31, 2005 were
developed based on SFAS No. 123(R) and SEC guidance contained in Staff Accounting Bulletin (SAB) No. 107, Share-Based Payment.

SFAS No. 123(R) requires the recognition of stock-based compensation for the number of awards that are ultimately expected to vest. As a result, for most awards, recognized stock compensation was reduced for estimated forfeitures prior
to vesting primarily based on historical annual forfeiture rates of approximately 9%. Estimated forfeitures will be reassessed in subsequent periods and may change based on new facts and circumstances. As of September 30, 2006, approximately
$368,000 of unrecognized stock compensation related to unvested awards (net of estimated forfeitures), and is expected to be recognized over a weighted-average period of 0.8 years.

5.INVENTORIES

Inventories as of September 30, 2006 and December 31, 2005 consisted
of the following:

(In Thousands)



|                                              |  |                   |         |   |                  |   |         |  
|--------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                              |  | September 30,2006 |         |   | December 31,2005 |  
|Work in process                               |  | $                 | 27,799  |   |                  | $ | 24,584  |  
|Finished goods                                |  |                   | 786     |   |                  |   | 786     |  
|Raw materials and supplies                    |  |                   | 11,980  |   |                  |   | 12,371  |  
|                                              |  |                   |         |   |                  |   |         |  
|Total                                         |  |                   | 40,565  |   |                  |   | 37,741  |  
|Less reserves for obsolete inventory          |  |                   | (3,008  | ) |                  |   | (2,857  | )
|Less milestone payments and customer deposits |  |                   | (19,997 | ) |                  |   | (15,169 | )
|                                              |  |                   |         |   |                  |   |         |  
|                                              |  | $                 | 17,560  |   |                  | $ | 19,715  |  
|                                              |  |                   |         |   |                  |   |         |  

A substantial portion of the above inventories relate to U.S. Government contracts or
sub-contracts. The Company receives milestone payments on the majority of its government contracts.



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##### Table of Contents

6.DEBT

Debt as of September 30, 2006 and December 31, 2005 consisted of the following:

(In Thousands)



|                                                                                                                 |  |                   |         |   |                  |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                 |  | September 30,2006 |         |   | December 31,2005 |  
|Revolving Credit Facility; interest at LIBOR plus 2.75% (8.08% at September 30, 2006)                            |  | $                 | 23,884  |   |                  | $ | 21,500  |  
|Bank Term Loan; interest at LIBOR plus 3.00% (8.33% at September 30, 2006)                                       |  |                   | 1,250   |   |                  |   | 2,000   |  
|Treasury Stock Term Loan; Interest at LIBOR plus 3.00% (8.33% at September 30, 2006)                             |  |                   | 898     |   |                  |   | 1,437   |  
|Airport Authority Term Loan; interest at BMA plus 0.36% (3.90% at September 30, 2006)                            |  |                   | 2,140   |   |                  |   | 2,140   |  
|Senior Secured Note; interest fixed at 15%                                                                       |  |                   | 5,000   |   |                  |   |        |  
|Capital Lease Obligations; interest from 5.0% to 11.0%, collateralized by security interest in certain equipment |  |                   | 17      |   |                  |   | 22      |  
|                                                                                                                 |  |                   |         |   |                  |   |         |  
|Total long-term debt                                                                                             |  |                   | 33,189  |   |                  |   | 27,099  |  
|Less portion reflected as current                                                                                |  |                   | (31,220 | ) |                  |   | (25,126 | )
|                                                                                                                 |  |                   |         |   |                  |   |         |  
|Long term-debt, net of current portion                                                                           |  | $                 | 1,969   |   |                  | $ | 1,973   |  
|                                                                                                                 |  |                   |         |   |                  |   |         |  

On December 16, 2002, the Company entered into a Credit Agreement with Wachovia Bank and
Compass Bank (the Credit Agreement) that provides for a revolving credit facility and a term loan (the Revolving Credit Facility and Bank Term Loan, respectively). During 2003 and 2004, the Company and its primary
lenders, Wachovia Bank and Compass Bank, entered into a series of amendments to the Credit Agreement that adjusted the maturity dates and commitment levels. On June 28, 2005, the Credit Agreement was amended to extend the Revolving Credit
Facility maturity date to October 15, 2006 and to reduce the commitment amount to $28.0 million. Until the Credit Agreement was amended and restated on October 12, 2006 (see below), the interest on the Revolving Credit Facility was
computed at LIBOR plus 2.00% to 2.75%, based on the ratio of adjusted funded debt to earnings before interest, taxes, depreciation and amortization, each as defined in the Credit Agreement (8.08% at September 30, 2006).

Borrowing availability under the Revolving Credit Facility is tied to percentages of eligible accounts receivable and inventories. The Company had
borrowings of approximately $23.9 million outstanding under the Revolving Credit Facility at September 30, 2006. Additional availability under the Revolving Credit Facility at September 30, 2006 was $2.9 million.

The Bank Term Loan matures on December 31, 2007 and bears interest at LIBOR plus 2.25% to 3.00% (8.33% at September 30, 2006), determined based
on the ratio of adjusted funded debt to earnings before interest, taxes, depreciation and amortization, each as defined in the Credit Agreement. The loan is payable in 60 monthly installments of $83,333 plus interest.

The Treasury Stock Term Loan matures on December 31, 2007 and bears interest at LIBOR plus 3.00% (8.33% at September 30, 2006). The loan is
payable in 31 monthly installments of $59,890.

The Airport Authority Term Loan was originated on November 26, 2002, has a term of 15
years, and bears interest at the Bond Market Association (BMA) plus 0.36% (3.90% at September 30, 2006). The amount outstanding under the Airport Authority Term Loan at September 30, 2006 was $2.1 million and is payable in 14
annual installments of approximately $180,000. A Letter of Credit supports the Airport Authority Term Loan and has a fee of 1.0% per year based on the outstanding loan balance with a five-year term.

On February 15, 2006, the Company entered into a note purchase agreement with Silver Canyon Services, Inc. (Silver Canyon), pursuant to
which the Company issued to Silver Canyon a senior secured note in the



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principal amount of $5.0 million (the Note). The principal amount of the Note becomes due and
payable on the earlier of (i) February 15, 2007, or (ii) the date on which amounts outstanding under the Companys Revolving Credit Facility with Wachovia Bank and Compass Bank become due and payable. The Note accrues interest at
an annual rate of 15%, which is payable quarterly in arrears commencing March 1, 2006. The Company may, at its election, redeem the Note at a price equal to 100% of the principal amount then outstanding, together with accrued and unpaid
interest thereon. The Note with Silver Canyon is subordinate to any debt incurred by the Company under the Revolving Credit Facility. The Note contains customary events of default consistent with the events of default defined in the thirteenth
amendment of the Credit Agreement with Wachovia and Compass on February 15, 2006. The payment of all outstanding principal, interest and other amounts owing under the Note may be declared immediately due and payable upon the occurrence of an
event of default, subject to certain standstill provisions with Wachovia and Compass. On July 31, 2006, the Silver Canyon debt was purchased by the Special Value Bond Fund, LLC which is managed by Tennenbaum Capital Partners, LLC, a related
party of the Company.

All of the above facilities have provisions for increases in the interest rate and acceleration of debt during any
period when an event of default exists.

Principal maturities of debt as of September 30, 2006, over the next five years and in the
aggregate thereafter are as follows:

(In Thousands)



|           |  |   |       
|---------- |  | - | ------
|Current    |  | $ | 31,220
|2-3 years  |  |   | 369   
|4-5 years  |  |   | 360   
|Thereafter |  |   | 1,240 
|           |  |   |       
|           |  | $ | 33,189
|           |  |   |       

The total amount of the Revolving Credit Facility and Senior Secured Note that are included in the
2006 maturity of debt listed above relates to the scheduled expiration of the Amended and Restated Revolving Credit Facility on August 31, 2007 and the scheduled maturity of the Senior Secured Note on February 15, 2007. The above loans are
collateralized by substantially all of the assets of the Company and have various covenants that limit or prohibit the Company from incurring additional indebtedness, disposing of assets, merging with other entities, declaring dividends, or making
capital expenditures in excess of certain amounts in any fiscal year. Additionally, the Company is required to maintain various financial ratios and minimum net worth amounts.

For the six months ended June 30, 2006, the Company violated a debt covenant requiring the Company to achieve income before income taxes of $1.0
million. The Company obtained a waiver from the lender for the debt covenant violation for the six-month period ended June 30, 2006. During each quarter of 2005, the Company violated the fixed charge coverage ratio covenant under the Revolving
Credit Facility due to losses incurred by the Company during 2005. As of September 30, 2005, the Company violated the adjusted tangible net worth covenant. On March 31, 2005, the Company obtained a waiver from the lender for the fixed
charge coverage ratio covenant violation with respect to the first quarter of 2005 and the fourth quarter of 2004. The Credit Agreement was amended to revise the calculation of the fixed charge coverage ratio for the second and third quarters of
2005 to use annualized 2005 results rather than total results of the past four quarters, and to increase the adjusted tangible net worth covenant from approximately $30.0 million to $33.5 million. On August 11, 2005, the Company obtained a
waiver from the lender for the fixed charge coverage ratio covenant violation with respect to the second and third quarters of 2005. The Credit Agreement was amended to revise the calculation of the fixed charge coverage ratio for the fourth quarter
of 2005, decreasing the required ratio of operating income to fixed charges from 1.2 to 1.0 and increasing the adjusted tangible net worth covenant from approximately $33.5 million to $38.5 million. As of December 31, 2005, the Company was in
violation of the fixed charge coverage ratio and the adjusted tangible net worth ratio. The Company obtained a waiver from the lender for all debt covenant violations through December 31, 2005. On February 15, 2006, the Credit Agreement
was amended to establish financial covenants for 2006. The covenants established a minimum adjusted tangible net worth for each quarter, minimum earnings before tax beginning June 30, 2006, and a fixed charge coverage ratio for the year ending
December 31, 2006. As discussed below, the debt covenants were amended on October 12, 2006.



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On October 12, 2006, the Company entered into an Amended and Restated Credit Agreement
(Amended Credit Agreement) with its lenders. The Amended Credit Agreement:



| |  |  | extended the maturity date of the Revolving Credit Facility to August 31, 2007,
| | - |  | -------------------------------------------------------------------------------



| |  |  | maintained the maximum principal amount of the Revolving Credit Facility at $28.0 million including any unused letters of credit,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | provided for an increase in the maximum principal amount of the Revolving Credit Facility to $31.0 million if the Company is awarded the new KC-135 contract,
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | provided for an increase in the borrowing base by increasing eligible Work-in-Process Inventory from 50% to 65%,
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | changed the interest rate on the Revolving Credit Facility to a rate ranging from LIBOR plus 1.5% to LIBOR plus 6.0% determined on quarterly earnings before interest, taxes,
depreciation and amortization (EBITDA) as defined in the Amended Credit Agreement, and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | established new debt covenants as follows:
| | - |  | ------------------------------------------



| | i) | Beginning with the quarter ending December 31, 2006, a fixed charge coverage ratio of not less than 1.0 to 1.0, to be tested at each quarter-end thereafter on a cumulative
basis commencing October 1, 2006 and ending on the last day of the respective quarter-end.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | ii) | At all times, maintain a ratio of adjusted liabilities to adjusted tangible net worth of not more than 2.5 to 1.0.
| | --- | ------------------------------------------------------------------------------------------------------------------



| | iii) | Achieve a cumulative EBITDA of not less than $400,000 for the period from September 1, 2006 to September 30, 2006; $2.85 million for the period from September 1, 2006
to December 31, 2006; $3.75 million for the period from September 1, 2006 to March 31, 2007; and $6.0 million for the period from September 1, 2006 to June 30, 2007.
| | ---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

There can be no assurances that the Company will satisfy all of the debt covenants or that the availability under the Revolving Credit Facility will be
sufficient to continue its operations. If the Company violates the debt covenants, all debt may become due and payable. If additional financing is needed, the Companys results of operations in 2006 and 2005 and the lack of a long-term KC-135
contract will likely make it more difficult and expensive, if not impossible, for the Company to raise additional capital that may be necessary to continue its operations. If the Company cannot raise adequate funds on acceptable terms, the business
could be materially harmed.

7.STOCKHOLDERS EQUITY

Holders of stock options under the Companys Option Plan exercised options for 2,715 and 4,250 shares, respectively, of the Companys Common Stock during the three months ended September 30, 2006 and
2005. The Company recorded the exercise price of the options, totaling approximately $29,000 and $86,000 (net of tax benefit), respectively, to Additional Paid-In Capital during the third quarter of 2006 and 2005 relating to these exercises. During
the nine months ended September 30, 2006 and 2005, holders of stock options exercised options for 12,541 and 6,921 shares, respectively, of the Companys Common Stock. The Company recorded the exercise price of the options, totaling
approximately $124,000 and $137,000 (net of tax benefit) respectively, to Additional Paid-In Capital during the nine months ended September 30, 2006 and 2005 relating to these exercises.

In accordance with SFAS No. 123(R), the Company has not recorded a tax benefit related to the exercise of stock options in Additional Paid-In Capital
during 2006 due to the net operating loss position of the Company.

8.DEFERRED COMPENSATION PLAN

The Company has a deferred compensation arrangement for its Chief Executive Officer that generally provides for payments upon retirement, death or
termination of employment. The Company funds the deferred compensation liability by making contributions to a rabbi trust. The contributions are invested in U.S. Treasury bills, and do not include Company Common Stock. During the first quarter of



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2005, the Company liquidated the assets and reinvested the entire proceeds reflecting the Companys
decision to more actively manage the portfolio. Concurrent with this change, the Company reclassified the investments from available-for-sale to trading securities, which results in the recognition of unrealized holding gains and losses in current
earnings rather than in stockholders equity. The Company recognized a $0.3 million gain upon the sale of the assets, which is reflected as a reduction to SG&A in the accompanying consolidated statements of operations for the nine month
period ended September 30, 2005. The fair market values of the assets in the rabbi trust at September 30, 2006 and December 31, 2005 were $2.4 million and $2.0 million, respectively, and are reflected in the deposits and other line
item in the accompanying consolidated balance sheets. The deferred compensation liability is adjusted, with a corresponding charge or credit to compensation cost, to reflect changes in the fair market value of the compensation liability. The amounts
accrued under this arrangement were $2.4 million and $2.0 million at September 30, 2006 and December 31, 2005, respectively, and are reflected in other long-term liabilities in the accompanying consolidated balance sheets.

9.EMPLOYEE BENEFIT PLANS

The Company has a
defined benefit pension plan (the Plan) in effect, which covers substantially all employees at its Birmingham and Dothan, Alabama facilities who meet minimum eligibility requirements. Benefits for non-union employees are based upon
salary and years of service, while benefits for union employees are based upon a fixed benefit rate and years of service. The funding policy is consistent with the funding requirements of federal laws and regulations concerning pensions.

Components of the Plans net periodic pension cost were as follows:

(In Thousands)



|                                   |  |                                    |        |   |                                    |   |        |                                   |  |   |                                   |   |  |   |        |  
|---------------------------------- |  | ---------------------------------- | ------ | - | ---------------------------------- | - | ------ | --------------------------------- |  | - | --------------------------------- | - |  | - | ------ | -
|                                   |  | ThreeMonths EndedSeptember 30,2006 |        |   | ThreeMonths EndedSeptember 30,2005 |   |        | NineMonths EndedSeptember 30,2006 |  |   | NineMonths EndedSeptember 30,2005 |  
|Service cost                       |  | $                                  | 589    |   |                                    | $ | 743    |                                   |  | $ | 2,046                             |   |  | $ | 2,063  |  
|Interest cost                      |  |                                    | 1,890  |   |                                    |   | 1,864  |                                   |  |   | 5,629                             |   |  |   | 5,412  |  
|Expected return on plan assets     |  |                                    | (2,270 | ) |                                    |   | (2,218 | )                                 |  |   | (6,802                            | ) |  |   | (6,654 | )
|Amortization of prior service cost |  |                                    | 372    |   |                                    |   | 318    |                                   |  |   | 1,000                             |   |  |   | 620    |  
|Amortization of net loss           |  |                                    | 587    |   |                                    |   | 506    |                                   |  |   | 1,809                             |   |  |   | 1,518  |  
|                                   |  |                                    |        |   |                                    |   |        |                                   |  |   |                                   |   |  |   |        |  
|Net pension cost                   |  | $                                  | 1,168  |   |                                    | $ | 1,213  |                                   |  | $ | 3,682                             |   |  | $ | 2,959  |  
|                                   |  |                                    |        |   |                                    |   |        |                                   |  |   |                                   |   |  |   |        |  

10.CONTINGENCIES

United States Government Contracts - The Company, as a U.S. Government contractor and sub-contractor, is subject to audits, reviews, and investigations by the government related to its negotiation and
performance of government contracts and its accounting for such contracts. Failure to comply with applicable U.S. Government standards by a contractor may result in suspension from eligibility for award of any new government contracts and a guilty
plea or conviction may result in debarment from eligibility for awards. The U. S. Government may, in certain cases, also terminate existing contracts, recover damages, and impose other sanctions and penalties. The Company believes, based on all
available information, that the outcome of any U.S. Government audits, reviews, and investigations would not have a material effect on the Companys financial position or results of operations.

A Significant Portion of the Companys Revenue is Derived From a Few of its Customers - A small number of the Companys customers account
for a significant percentage of its revenues. The KC-135 program comprised 44% and 44% of the Companys total revenues during the nine-month periods ended September 30, 2006 and 2005, respectively. The Companys two largest programs
generated approximately 58% and 69% of its revenues during the nine-month periods ended September 30, 2006 and 2005, respectively. Termination or a disruption of any of its significant customer contracts (including by way of option years not
being exercised), or the inability of the Company to renew or replace any of these customer



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contracts when they expire, could have a material adverse effect on the Companys business,
financial position or results of operations. The Company has submitted a proposal on a new KC-135 contract which would commence in 2007; failure to win such contract would have a material adverse effect on the Company.

Litigation

Breach of Contract
Lawsuits

On October 12, 1995, Falcon Air AB filed a complaint in the United States District Court, Northern District of Alabama,
alleging that the modification by the Company of three Boeing 737 aircraft to quick-change configuration was defective, limiting the commercial use of the aircraft. The District Court released the case to alternative dispute resolution until the
Company requested reinstatement of the case on September 13, 2001. Reinstatement was denied, and on October 31, 2001 the Company filed an appeal with the 11thCircuit Court of Appeals for determination on certain procedural issues. The parties have subsequently entered into arbitration which settled during
consecutive mediation efforts. Management believes that the settlement was in the best interest of the Company. The estimated cost of the settlement of $1.1 million was fully reserved as of December 31, 2005. During the second quarter of 2006,
the Company received approval to use refurbished aircraft doors rather than replacing existing doors with new ones, which reduced the settlement reserve from $1.1 million to $0.7 million lowering cost of sales for the second quarter of 2006. On
September 23, 2006, Falcon Air declared bankruptcy. No work has been performed on their aircraft to date.

On January 16, 2004,
the Company filed a complaint in the Circuit Court of Dale County, Alabama against GE Capital Aviation Services, Inc. (GECAS) for monies owed for modification and maintenance services provided on six 737-300 aircraft, all of which were
re-delivered to GECAS during 2003 and are in service. On January 20, 2004, the Company received service of a suit filed against the Companys Pemco World Air Services, Inc. subsidiary in New York state court, claiming breach of contract
with regard to two of the aircraft re-delivered. On March 5, 2004, the Company filed a motion to dismiss the claim filed in the New York state court, which motion was denied. On March 24, 2004, the Circuit Court of Dale County, Alabama
denied a motion filed by GECAS to dismiss or stay the proceedings. GECAS has subsequently paid in full charges owed on four of the six aircraft. The New York Court ordered mediation in the matter. Mediation took place on October 6, 2004, but
was unsuccessful in bringing resolution. Litigation is currently in the discovery phase, discovery cutoff being set at December 31, 2006. Management believes that the results of the claim by GECAS will not have a material impact on the
Companys financial position or results of operations.

On November 9, 1994, the Company was awarded a contract to perform
standard depot level maintenance (SDLM) and engineering design work (Executive Transport) on an H-3 helicopter. A modification of the contract occurred in September 1996, to include Egyptian Air Force helicopters in the depot
level maintenance program (EDLM). In 2002, the Company filed three separate Requests for Equitable Adjustment (REA) with the Navy totaling over $4.9 million plus interest. The claims include entitlement to additional sums due
to severe funding issues and lack or delay of required support in materials, equipment and engineering data for the H-3 program. Negotiations for settlement were unsuccessful. In January 2004, the Company elected to file the claims with the Armed
Services Board of Contract Appeals, which consolidated the SDLM, Executive Transport and EDLM appeals into one case for litigation purposes. The parties entered into voluntary mediation on March 29, 2006 and settled the case. The government has
agreed to pay $1.85 million to the Company in settlement of all three claims. The Company recorded $0.8 million of revenue related to the settlement during the first quarter of 2006. The Company paid $0.2 million in legal fees related to this
settlement during the first quarter of 2006 which is reflected in selling, general and administrative expenses on the Unaudited Consolidated Statement of Operations. Approximately $1.0 million of revenue related to the claim had been recognized in
periods prior to 2005.

Employment Lawsuits

In December 1999, the Company and Pemco Aeroplex were served with a purported class action in the U.S. District Court, Northern District of Alabama, seeking declaratory, injunctive relief and other compensatory and
punitive damages based upon alleged unlawful employment practices of race discrimination and racial harassment by the Companys managers, supervisors and other employees. The complaint sought damages in the amount of $75.0 million. On
July 27, 2000, the U.S. District Court determined that the group would not be certified as a class since the plaintiffs withdrew their request for class certification. The Equal Employment



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Opportunity Commission (EEOC) subsequently entered the case purporting a parallel class
action. The Court denied consolidation of the cases for trial purposes but provided for consolidated discovery. On June 28, 2002, a jury determined that there was no hostile work environment in the original case and granted verdicts for the
Company with regard to all 22 plaintiffs. Nine plaintiffs elected to settle with the Company prior to the trial. On December 13, 2002, the Court granted the Company summary judgment in the EEOC case. That judgment was appealed to the
11thCircuit Court of Appeals by the EEOC. The panel reinstated the case to federal district court. On
October 27, 2004, the Company petitioned the 11thCircuit to rehear the case en banc. The petition was denied
on December 23, 2004. The Company filed a Petition for a Writ of Certiorari with the United States Supreme Court on March 23, 2005, which was denied on October 3, 2005. The case is now remanded to federal district court in Birmingham,
Alabama. The parties attended mediation on August 30 and 31, 2006, but no settlement was reached. Informal discussions are continuing. The Company believes it has taken effective remedial and corrective action, acted promptly in respect to any
specific complaint by an employee, and will vigorously defend this case. Management believes that the results of this claim will not have a material impact on the Companys financial position or results of operations.

Various claims alleging employment discrimination, including race, sex, disability and age, have been made against the Company and its subsidiaries by
current and former employees at its Birmingham and Dothan, Alabama facilities in proceedings before the EEOC and before state and federal courts in Alabama. Workers compensation claims brought by employees are also pending in Alabama state
court. The Company believes that none of these claims, individually or in the aggregate, are material to the Company and that such claims are more reflective of the general increase in employment-related litigation in the U.S., and Alabama in
particular, than of any actual discriminatory employment practices by the Company or any subsidiary. Except for workers compensation benefits as provided by statute, the Company intends to vigorously defend itself in all litigation arising
from these types of claims. Management believes that the results of these claims will not have a material impact on the Companys financial position or results of operations.

Environmental Compliance

In December
1997, the Company received an inspection report from the Environmental Protection Agency (EPA) documenting the results of an inspection at the Birmingham, Alabama facility. The report cited various violations of environmental laws. The
Company has taken actions to correct the items raised by the inspection. On December 21, 1998, the Company and the EPA entered into a Consent Agreement and Consent Order (CACO) resolving the complaint and compliance order. As part
of the CACO, the Company agreed to assess a portion of the Birmingham facility for possible contamination by certain constituents and remediate such contamination as necessary. During 1999, the Company drilled test wells and took samples under its
Phase I Site Characterization Plan. These samples were forwarded to the EPA in 1999. A Phase II Site Characterization Plan (Phase II Plan) was submitted to the EPA in 2001 upon receiving the agencys response to the 1999 samples.
The Phase II Plan was approved in January 2003, wells were installed and favorable sampling events were recorded. The Company compiled the results and submitted a revised work plan to the agency which was accepted on July 30, 2004. The
Media Clean-up Standard Report, as required, was submitted to the EPA in January 2005. It is the Companys policy to accrue environmental remediation costs when it is probable that such costs will be incurred and when a range of loss can be
reasonably estimated. The Company reviews the status of all significant existing or potential environmental issues and adjusts its accruals as necessary. The Company anticipates the total cost of the Phase II Plan to be approximately $550,000, of
which the Company has paid approximately $450,000 as of September 30, 2006. The Company recorded liabilities of approximately $100,000 related to the Phase II Plan at both September 30, 2006 and December 31, 2005, which are included
in accrued liabilities  other on the accompanying Consolidated Balance Sheets. Management believes that the results of the Phase II Plan will not have a material impact on the Companys financial position or results of operations.

In March 2005, Pemco Aeroplex received notice from the South Carolina Department of Health and Environmental Control (DHEC)
that Pemco Aeroplex was believed to be a potentially responsible party (PRP) with regard to contamination found on the Philips Service site located in Rock Hill, South Carolina. Pemco was listed as a PRP due to alleged use by the Company
of contract services for the disposal of hazardous substances. The Company joined a large group of existing PRP notification recipients in retaining environmental counsel. The Company believes that the paint chips were disposed of by the contract
services provider, Philips Service Company, beginning in 1997. Philips Service Company filed for bankruptcy in 2003.



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The contamination may be primarily linked to a diesel fuel tank leak from which more than 200,000 gallons
of diesel product were lost or released into the environment at the Rock Hill site. The database of manifests located on-site at Philips Service Company has been reviewed and the waste-in compilations have been completed. It is believed that the
Companys potential liability will not exceed $50,000.

The Company is subject to various environmental regulations at the federal,
state and local levels, particularly with respect to the stripping, cleaning and painting of aircraft. Compliance with environmental regulations has not had, and is not expected to have, a material effect on the Companys financial position or
results of operations.

11.SEGMENT INFORMATION

The Company has three reportable segments: Government Services Segment (GSS), Commercial Services Segment (CSS), and Manufacturing and Components Segment (MCS). The GSS, located in
Birmingham, Alabama, provides aircraft maintenance and modification services for government and military customers. The CSS, located in Dothan, Alabama, provides commercial aircraft maintenance and modification services on a contract basis to the
owners and operators of large commercial aircraft and also distributes aircraft parts. The MCS, located in California, designs and manufactures a wide array of proprietary aerospace products including various space systems, such as guidance control
systems and launch vehicles, and aircraft cargo-handling systems.

The accounting policies of the segments are the same as those described
in the summary of significant accounting policies in the Companys 2005 Annual Report on Form 10-K. The Company evaluates performance based on total (external and inter-segment) revenues, gross profits and operating income. The Company accounts
for inter-segment sales and transfers as if the sales or transfers were to third parties. The amount of intercompany profit is eliminated. The Company does not allocate income taxes to segments.

The Companys reportable segments are strategic business units that offer different products and services. They are managed separately because each
business requires different operating and marketing strategies. The CSS and MCS may generate revenues from governmental entities or programs and the GSS may generate revenues from commercial entities.



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The following table presents information about segment profit or loss for the three months ended September 30, 2006
and 2005 excluding discontinued operations:

(In Thousands)



|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ | --- |  | ----- | ------ |  | - | ------ | -
|Three Months Ended September 30, 2006     |  | GSS |        |   | CSS |   |        | MCS |  | Total |       
|Revenues from external domestic customers |  | $   | 18,652 |   |     | $ | 14,887 |     |  | $     | 3,021  |  | $ | 36,560 |  
|Revenues from external foreign customers  |  |     | 18     |   |     |   | 1,765  |     |  |       |       |  |   | 1,783  |  
|Inter-company revenues                    |  |     | 1      |   |     |   | 101    |     |  |       |       |  |   | 102    |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Total segment revenues                    |  |     | 18,671 |   |     |   | 16,753 |     |  |       | 3,021  |  |   | 38,445 |  
|Elimination                               |  |     |        |   |     |   |        |     |  |       |        |  |   | (102   | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Total revenue                             |  |     |        |   |     |   |        |     |  |       |        |  | $ | 38,343 |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Gross profit                              |  | $   | 975    |   |     | $ | 2,879  |     |  | $     | 1,215  |  | $ | 5,069  |  
|Segment operating profit/(loss)           |  |     | (1,122 | ) |     |   | 662    |     |  |       | 416    |  |   | (44    | )
|Interest expense                          |  |     |        |   |     |   |        |     |  |       |        |  |   | (833   | )
|Income tax benefit                        |  |     |        |   |     |   |        |     |  |       |        |  |   | 303    |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Net loss from continuing operations       |  |     |        |   |     |   |        |     |  |       |        |  | $ | (574   | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Assets                                    |  | $   | 49,265 |   |     | $ | 38,043 |     |  | $     | 10,601 |  | $ | 97,909 |  
|Depreciation/amortization                 |  |     | 365    |   |     |   | 391    |     |  |       | 29     |  |   | 785    |  
|Capital additions                         |  |     | 167    |   |     |   | 18     |     |  |       | 19     |  |   | 204    |  
|                                          |  |     |        |  
|Three Months Ended September 30, 2005     |  | GSS |        |   | CSS |   |        | MCS |  | Total |       
|Revenues from external domestic customers |  | $   | 18,041 |   |     | $ | 8,475  |     |  | $     | 2,660  |  | $ | 29,176 |  
|Revenues from external foreign customers  |  |     |       |   |     |   | 551    |     |  |       |       |  |   | 551    |  
|Inter-company revenues                    |  |     |       |   |     |   | 96     |     |  |       |       |  |   | 96     |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Total segment revenues                    |  |     | 18,041 |   |     |   | 9,122  |     |  |       | 2,660  |  |   | 29,823 |  
|Elimination                               |  |     |        |   |     |   |        |     |  |       |        |  |   | (96    | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Total revenue                             |  |     |        |   |     |   |        |     |  |       |        |  | $ | 29,727 |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Gross profit/(loss)                       |  | $   | 1,430  |   |     | $ | (365   | )   |  | $     | 776    |  | $ | 1,841  |  
|Segment operating profit/(loss)           |  |     | (1,088 | ) |     |   | (4,617 | )   |  |       | 220    |  |   | (5,485 | )
|Interest expense                          |  |     |        |   |     |   |        |     |  |       |        |  |   | (468   | )
|Income tax benefit                        |  |     |        |   |     |   |        |     |  |       |        |  |   | 2,357  |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Net loss from continuing operations       |  |     |        |   |     |   |        |     |  |       |        |  | $ | (3,596 | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Assets                                    |  | $   | 49,432 |   |     | $ | 33,134 |     |  | $     | 4,366  |  | $ | 86,932 |  
|Depreciation/amortization                 |  |     | 394    |   |     |   | 646    |     |  |       | 32     |  |   | 1,072  |  
|Capital additions                         |  |     | 961    |   |     |   | 77     |     |  |       | 86     |  |   | 1,124  |  



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##### Table of Contents

The following table presents information about segment profit or loss for the nine months ended September 30, 2006
and 2005 excluding discontinued operations:

(In Thousands)



|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ | --- |  | ----- | ------ |  | - | ------- | -
|Nine Months Ended September 30, 2006      |  | GSS |        |   | CSS |   |        | MCS |  | Total |       
|Revenues from external domestic customers |  | $   | 65,220 |   |     | $ | 41,260 |     |  | $     | 8,649  |  | $ | 115,129 |  
|Revenues from external foreign customers  |  |     | 18     |   |     |   | 8,331  |     |  |       |       |  |   | 8,349   |  
|Inter-company revenues                    |  |     | 102    |   |     |   | 125    |     |  |       |       |  |   | 227     |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Total segment revenues                    |  |     | 65,340 |   |     |   | 49,716 |     |  |       | 8,649  |  |   | 123,705 |  
|Elimination                               |  |     |        |   |     |   |        |     |  |       |        |  |   | (227    | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Total revenue                             |  |     |        |   |     |   |        |     |  |       |        |  | $ | 123,478 |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Gross profit                              |  | $   | 6,245  |   |     | $ | 8,909  |     |  | $     | 3,063  |  | $ | 18,217  |  
|Segment operating profit/(loss)           |  |     | (485   | ) |     |   | 2,439  |     |  |       | 1,019  |  |   | 2,973   |  
|Other income                              |  |     |        |   |     |   |        |     |  |       |        |  |   |        |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |       |        |  |   | (2,263  | )
|Income tax expense                        |  |     |        |   |     |   |        |     |  |       |        |  |   | (298    | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Income from continuing operations         |  |     |        |   |     |   |        |     |  |       |        |  |   | 412     |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Assets                                    |  | $   | 49,265 |   |     | $ | 38,043 |     |  | $     | 10,601 |  | $ | 97,909  |  
|Depreciation/amortization                 |  |     | 1,228  |   |     |   | 1,253  |     |  |       | 102    |  |   | 2,583   |  
|Capital additions                         |  |     | 1,345  |   |     |   | 170    |     |  |       | 33     |  |   | 1,548   |  
|                                          |  |     |        |  
|Nine Months Ended September 30, 2005      |  | GSS |        |   | CSS |   |        | MCS |  | Total |       
|Revenues from external domestic customers |  | $   | 58,702 |   |     | $ | 38,976 |     |  | $     | 7,826  |  | $ | 105,504 |  
|Revenues from external foreign customers  |  |     |       |   |     |   | 4,352  |     |  |       |       |  |   | 4,352   |  
|Inter-company revenues                    |  |     |       |   |     |   | 294    |     |  |       |        |  |   | 294     |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Total segment revenues                    |  |     | 58,702 |   |     |   | 43,622 |     |  |       | 7,826  |  |   | 110,150 |  
|Elimination                               |  |     |        |   |     |   |        |     |  |       |        |  |   | (294    | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Total revenue                             |  |     |        |   |     |   |        |     |  |       |        |  | $ | 109,856 |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Gross profit                              |  | $   | 6,853  |   |     | $ | 5,058  |     |  | $     | 2,187  |  | $ | 14,098  |  
|Segment operating profit/(loss)           |  |     | (560   | ) |     |   | (3,836 | )   |  |       | 772    |  |   | (3,624  | )
|Other income                              |  |     |        |   |     |   |        |     |  |       |        |  |   | 650     |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |       |        |  |   | (1,352  | )
|Income tax benefit                        |  |     |        |   |     |   |        |     |  |       |        |  |   | 1,718   |  
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Loss from continuing operations           |  |     |        |   |     |   |        |     |  |       |        |  | $ | (2,608  | )
|                                          |  |     |        |   |     |   |        |     |  |       |        |  |   |         |  
|Assets                                    |  | $   | 49,432 |   |     | $ | 33,134 |     |  | $     | 4,366  |  | $ | 86,932  |  
|Depreciation/amortization                 |  |     | 1,186  |   |     |   | 1,503  |     |  |       | 71     |  |   | 2,760   |  
|Capital additions                         |  |     | 2,094  |   |     |   | 268    |     |  |       | 239    |  |   | 2,601   |  



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Due to the long-term nature of much of the Companys business, the depreciation and amortization amounts recorded in
the consolidated statements of operations will not directly match the change in accumulated depreciation and amortization reflected on the Companys consolidated balance sheets. This is a result of the capitalization of depreciation costs on
long-term contracts into work-in-process inventory.

12.RECENT ACCOUNTING PRONOUNCEMENTS

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN
No. 48) which clarifies the criteria for the recognition of tax benefits under SFAS No. 109, Accounting for Income Taxes. FIN No. 48 is effective for fiscal years beginning after December 15, 2006, and requires
that the cumulative effect of applying its provisions be disclosed separately as a one-time, non-cash charge against the opening balance of retained earnings in the year of adoption. The Company is currently evaluating the potential impact of FIN
No. 48 and any impact on its financial position cannot be readily determined at this time.

In September 2006, the FASB issued Statement of Financial
Accounting Standards (SFAS) No. 157, Fair Value Measurements (FAS No. 157) which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles, and expands
disclosures about fair value measurements. FAS No. 157 is effective for our fiscal year beginning January 1, 2008. The Company is in the process of evaluating this guidance and therefore has not yet determined the impact that FAS
No. 157 will have on the consolidated financial statements.

In September 2006, the FASB issued SFAS No. 158, Employers Accounting for
Defined Benefit Pension and Other Postretirement Plans  an amendment of FASB Statements No. 87, 88, 106 and 132(R)(FAS No. 158) which improves financial reporting by requiring an employer to recognize the overfunded
or underfunded status of a defined benefit postretirement plan as an asset or liability in its statements of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income of a
business entity. This statement also improves financial reporting by requiring an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. FAS No. 158 is effective as of the fiscal year
ending after December 15, 2006. The Company, whose pension plan is currently underfunded, is currently evaluating the potential impact of FAS No. 158 and any impact on its financial position cannot be readily determined at this time.

In September 2006, the SEC staff issued Staff Accounting Bulletin No. 108, Considering the Effects of Prior Year Misstatements when Quantifying
Misstatements in Current Year Financial Statements(SAB 108). SAB 108 was issued to provide consistency between how registrants quantify financial misstatements.

Historically, there have been two widely-used methods for quantifying the effects of financial statement misstatements. These methods are referred to as the roll-over and iron-curtain methods.
The roll-over method quantifies the amount by which the current year income statement is misstated. Exclusive reliance on an income statement approach can result in the accumulation of error on the balance sheet that may not have been material to
any individual income statement, but which may misstate one or more balance sheet accounts. The iron curtain method quantifies the error as the cumulative amount by which the current year balance sheet is misstated. Exclusive reliance on a balance
sheet approach can result in disregarding the effects of errors in the current year income statement that result from the correction of an error existing in previously issued financial statements.

SAB 108 established an approach that requires quantification of financial statement misstatements based on the effects of the misstatement on each of the companys
financial statements and the related financial statement disclosures. This approach is commonly referred to as the dual approach because it requires quantification of errors under both the roll-over and the iron curtain methods.

SAB 108 allows registrants to initially apply the dual approach either by (1) retroactively adjusting prior financial statements as if the dual
approach had always been used or by (2) recording the cumulative effect of initially applying the dual approach as adjustments to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment recorded to
the opening balance of retained earnings. Use of this cumulative effect transition method requires detailed disclosure of the nature and amount of each individual error being corrected through the cumulative adjustment and how and when
it arose.

We will initially apply SAB 108 using the cumulative effect transition method in connection with the preparation of our annual financial
statements for the year ending December 31, 2006. No change to the Companys financial position or results of operations is expected.



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13.DISCONTINUED OPERATIONS

As a result of continued operating losses, in September 2006, the Board of Directors of the Company approved a formal plan to divest the Companys Pemco Engineering operation and had identified a strategic buyer.
The operation had previously been included in the MCS segment.

In accordance with SFAS No. 144, Accounting for the Impairment or
Disposal of Long-Lived Assets, this business unit has been reported as discontinued operations and, accordingly, income and losses from discontinued operations have been reported separately from continuing operations. Net sales and income (loss)
from discontinued operations for the three- and nine-month periods ended September 30, 2006 and 2005 were as follows:



|                                           |  |                    |       |                   |                   |       |                   |  |   |                   |   |  |   |       |  
|------------------------------------------ |  | ------------------ | ----- | ----------------- | ----------------- | ----- | ----------------- |  | - | ----------------- | - |  | - | ----- | -
|                                           |  | Three Months Ended |       |                   | Nine Months Ended |      
|                                           |  | September 30,2006  |       | September 30,2005 |                   |       | September 30,2006 |  |   | September 30,2005 |  
|                                           |  | (In Thousands)     |       |                   | (In Thousands)    |      
|Net Sales                                  |  | $                  | 1,474 |                   | $                 | 1,298 |                   |  | $ | 3,628             |   |  | $ | 3,816 |  
|                                           |  |                    |       |                  
|Income/(loss) before income taxes          |  | $                  | 41    |                   | $                 | (268  | )                 |  | $ | (670              | ) |  | $ | (536  | )
|Income tax expense/(benefit)               |  |                    | 14    |                   |                   | (117  | )                 |  |   | (235              | ) |  |   | (188  | )
|                                           |  |                    |       |                   |                   |       |                   |  |   |                   |   |  |   |       |  
|Income/(loss) from discontinued operations |  | $                  | 27    |                   | $                 | (151  | )                 |  | $ | (435              | ) |  | $ | (348  | )
|                                           |  |                    |       |                   |                   |       |                   |  |   |                   |   |  |   |       |  

Included within the results from discontinued operations is an allocation of interest expense.
Interest expense allocated to discontinued operations was $45,000 and $124,000 for the three and nine-month periods ended September 30, 2006, respectively, and $21,000 and $45,000 for the three- and nine-month periods ended September 30,
2005, respectively.

To conform with this presentation, all prior periods have been restated. As a result, the assets and liabilities of the
discontinued operations have been reclassified on the balance sheet from the historical classifications and presented under the captions assets of discontinued operations and liabilities of discontinued operations,
respectively. As of September 30, 2006 and 2005, net assets of discontinued operations consisted of the following:



|                                          |  |                   |       |                  |   |      
|----------------------------------------- |  | ----------------- | ----- | ---------------- | - | -----
|                                          |  | September 30,2006 |       | December 31,2005
|                                          |  | (In Thousands)   
|Accounts Receivable                       |  | $                 | 1,035 |                  | $ | 324  
|Inventory                                 |  |                   | 1,320 |                  |   | 1,238
|Prepaid expenses and other current assets |  |                   | 49    |                  |   | 27   
|                                          |  |                   |       |                  |   |      
|Current Assets                            |  |                   | 2,404 |                  |   | 1,589
|                                          |  |                   |       |                  |   |      
|Property, plant and equipment, net        |  |                   | 410   |                  |   | 562  
|Deposits and other                        |  |                   | 28    |                  |   | 37   
|                                          |  |                   |       |                  |   |      
|Non-current Assets                        |  |                   | 438   |                  |   | 599  
|                                          |  |                   |       |                  |   |      
|Total Assets                              |  | $                 | 2,842 |                  | $ | 2,188
|                                          |  |                   |       |                  |   |      
|Accounts Payable                          |  | $                 | 887   |                  | $ | 656  
|Accrued Expenses                          |  |                   | 80    |                  |   | 107  
|                                          |  |                   |       |                  |   |      
|Current Liabilities                       |  |                   | 967   |                  |   | 763  
|                                          |  |                   |       |                  |   |      
|Net Assets                                |  | $                 | 1,875 |                  | $ | 1,425
|                                          |  |                   |       |                  |   |      

As of September 30, 2006, there was approximately $17,000 of accrued expenses incurred as a
result of the Companys exit from Pemco Engineering. Subsequent to the quarter ended September 30, 2006, the Company completed the sale of substantially all of the assets and liabilities of Pemco Engineers. The Company does not anticipate
a material gain or loss as a result of this sale.



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##### Table of Contents

Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations

INTRODUCTION

The following discussion should be read in conjunction with the Companys consolidated financial statements and notes thereto included herein.

OVERVIEW

The Company operates primarily in the
aerospace and defense industry and its principal business is providing aircraft maintenance and modification services to military and commercial customers. The Company conducts its business through three operating segments: Government Services
Segment (GSS), Commercial Services Segment (CSS), and Manufacturing and Components Segment (MCS). The Companys services are generally provided under traditional contracting agreements that include
fixed-price, time and material, cost-plus and variations of such arrangements. The Companys revenues and cash flows are derived primarily from services provided under these contracts, and cash flows include the receipt of milestone or progress
payments under certain contracts.

RESULTS OF OPERATIONS

Three months ended September 30, 2006

Versus three months ended September 30, 2005

The table below presents major highlights from the three months ended September 30, 2006 and 2005 excluding the results of discontinued operations, except for Net
Loss.

(In Millions)



|                                             |  |      |       |   |      |   |       |        |  |       |  
|-------------------------------------------- |  | ---- | ----- | - | ---- | - | ----- | ------ |  | ----- | -
|                                             |  | 2006 |       |   | 2005 |   |       | Change | 
|Revenue                                      |  | $    | 38.34 |   |      | $ | 29.73 |        |  | 29.0  | %
|Gross profit                                 |  |      | 5.07  |   |      |   | 1.84  |        |  | 175.3 | %
|Operating loss from continuing operations    |  |      | (0.04 | ) |      |   | (5.49 | )      |  | 99.2  | %
|Loss from continuing operations before taxes |  |      | (0.88 | ) |      |   | (5.95 | )      |  | 85.3  | %
|Loss from continuing operations              |  |      | (0.57 | ) |      |   | (3.60 | )      |  | 84.2  | %
|Net loss                                     |  |      | (0.55 | ) |      |   | (3.75 | )      |  | 85.3  | %
|EBITDA                                       |  |      | 0.74  |   |      |   | (4.42 | )      |  | 116.7 | %

EBITDA for the quarters ended September 30, 2006 and 2005 excluding the results of discontinued operations
was calculated using the following approach:

(In Millions)



|                                |  |      |       |   |      |   |       |  
|------------------------------- |  | ---- | ----- | - | ---- | - | ----- | -
|                                |  | 2006 |       |   | 2005 |  
|Loss from continuing operations |  | $    | (0.57 | ) |      | $ | (3.60 | )
|Interest                        |  |      | 0.83  |   |      |   | 0.47  |  
|Tax benefit                     |  |      | (0.30 | ) |      |   | (2.36 | )
|Depreciation and amortization   |  |      | 0.78  |   |      |   | 1.07  |  
|                                |  |      |       |   |      |   |       |  
|EBITDA                          |  | $    | 0.74  |   |      | $ | (4.42 | )
|                                |  |      |       |   |      |   |       |  

The Company presents Earnings Before Interest, Taxes, Depreciation and Amortization, more commonly referred to as
EBITDA, because its management uses the measure to evaluate the Companys performance and to allocate resources. In addition, EBITDA is used as one of the components to calculate the Companys debt covenants. The Company believes EBITDA is
also an important gauge used by commercial banks, investment banks, other financial institutions, and current and potential investors to approximate its cash generation capability. Accordingly, the Company has included EBITDA as part of this report.
The depreciation and amortization amounts used in the



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##### Table of Contents

EBITDA calculation are those that were recorded in the consolidated statements of operations in this report. Due to the
long-term nature of much of the Companys business, the depreciation and amortization amounts recorded in the consolidated statements of operations will not directly match the change in accumulated depreciation and amortization reflected on the
Companys consolidated balance sheets. This is a result of the capitalization of depreciation expense on long-term contracts into work-in-process inventory. EBITDA is not a measure of financial performance under generally accepted accounting
principles (GAAP) and should not be considered as a substitute for or superior to other measures of financial performance reported in accordance with GAAP. EBITDA as presented herein may not be comparable to similarly titled measures
reported by other companies.

The table below presents the highlights in revenue by operating segment for the three months ended September 30, 2006
and 2005 excluding the results of discontinued operations.

(In Millions)



|             |  |      |       |   |      |   |       |        |  |   |          |   |  |      |  
|------------ |  | ---- | ----- | - | ---- | - | ----- | ------ |  | - | -------- | - |  | ---- | -
|             |  | 2006 |       |   | 2005 |   |       | Change |  |   | % Change |  
|GSS          |  | $    | 18.67 |   |      | $ | 18.04 |        |  | $ | 0.63     |   |  | 3.5  | %
|CSS          |  |      | 16.75 |   |      |   | 9.12  |        |  |   | 7.63     |   |  | 83.7 | %
|MCS          |  |      | 3.02  |   |      |   | 2.66  |        |  |   | 0.36     |   |  | 13.5 | %
|Eliminations |  |      | (0.10 | ) |      |   | (0.09 | )      |  |   | (0.01    | ) |  |      |  
|             |  |      |       |   |      |   |       |        |  |   |          |   |  |      |  
|Total        |  | $    | 38.34 |   |      | $ | 29.73 |        |  | $ | 8.61     |   |  | 29.0 | %
|             |  |      |       |   |      |   |       |        |  |   |          |   |  |      |  

Without regard to operating segments, the Companys mix of revenue between government and commercial
customers was approximately 44% commercial and 56% government in 2006 and 31% commercial and 69% government in 2005.

GSS revenue remained flat during the
third quarter of 2006 with a slight increase of $0.6 million, or 3.5%, from third quarter revenue in 2005. GSS delivered one additional aircraft during the third quarter of 2006, as compared to the same quarter of 2005, under the KC-135 Programmed
Depot Maintenance (PDM) program. However, fewer non-routine maintenance and repairs were performed during the third quarter of 2006 causing a decrease in program revenue of $1.1 million when compared to third quarter of 2005, offset by
increased parts sales of $0.5 million. The second P-3 aircraft under the basic PDM contract with the US Navy was delivered in the third quarter of 2006 and generated revenue of $1.1 million. Additional non-routine maintenance was performed under
this program producing $1.0 million in revenue. This contract was obtained in late 2005 and there were no related deliveries as of September 30, 2005. Unscheduled depot level maintenance (UDLM) is a repair falling outside the PDM
cycle. UDLM revenue for all C-130 aircraft decreased slightly for the three-month period ended September 30, 2006, when compared to the same period in 2005. UDLM for C-130 Air Force aircraft generated an additional $2.2 million for the
three-month period ended September 30, 2006, for which there was no comparable revenue in the third quarter of 2005. Offsetting the increase in the C-130 Air Force program revenue was a decrease in revenue of $2.3 million from the delivery of a
C-130 UDLM Coast Guard aircraft during the third quarter of 2005, for which there was no comparable deliveries during the same period of 2006.

CSS revenue
increased $7.6 million during the third quarter of 2006 when compared to the same quarter in 2005 as a result of increased cargo conversions and increased inductions for maintenance, repair and overhaul (MRO) services. During the third
quarter of 2006, CSS delivered one cargo conversion producing $2.7 million in additional revenue when compared to the same period in 2005. The cargo conversion was performed under a subcontract by TAECO, a China-based company. There were no cargo
conversion deliveries for the three-month period ended September 30, 2005. Also, increased inductions from our largest commercial MRO customers generated $4.9 million of additional CSS revenue for the three months ended September 30, 2006,
when compared to the same period of 2005. Revenue during the third quarter of 2005 was substantially lower than historical levels due to the bankruptcy of our largest commercial customer and a lockout of unionized employees at the Dothan, Alabama,
facility.

MCS revenue increased 13.5%, or $0.4 million, in the third quarter of 2006 compared to revenue for the same period in 2005. Financial data
relating to the MCS represents work on U.S. government launch vehicle programs at Space Vector Corporation. Revenue and related costs from Pemco Engineers Inc., a manufacturer of high precision machined parts and other aircraft components, have been
excluded. Substantially all of the assets and the operations of Pemco Engineers were sold in October 2006 and have been presented as discontinued operations as of September 30, 2006.



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##### Table of Contents

All related 2006 and 2005 financial data for Pemco Engineers is reported separately as income from discontinued
operations, net of tax.

Consolidated cost of sales increased $5.4 million, or 19.3%, to $33.3 million during the third quarter of 2006 as a result of the
higher revenue base. Cost of sales was 86.8% and 93.8% of revenue the third quarter of 2006 and 2005, respectively. Gross profit was significantly impacted by the results of CSS which experienced positive gross profit of $2.9 million for the third
quarter of 2006 as a result of the TAECO cargo conversion and an increase in MRO services performed for our largest two commercial customers. The additional MRO services and the cargo conversion in the third quarter of 2006, compared with operating
results in the third quarter of 2005 which included the impact of the lockout of the Companys union employees in Dothan, resulted in a $3.2 million increase of CSS gross profit for the third quarter of 2006. Gross profit at GSS was negatively
impacted by charges related to the Navy P-3 program totaling $0.9 million in the third quarter of 2006 when compared to the same period in 2005. Because the Navy P-3 program was contracted in late 2005, there were no comparable charges during the
third quarter 2005.

Selling, General and Administrative (SG&A) expenses decreased $0.7 million, or 12.0%, to $5.1 million in 2006. As a
percentage of sales, SG&A expenses decreased to 13.3% in 2006 from 19.5% in 2005. The decrease in SG&A expense as a percentage of sales was primarily caused by the higher sales volume at CSS and expense controls implemented throughout the
Company.

The Company also recorded a $1.5 million provision for doubtful accounts during the third quarter of 2005 related to the Chapter 11 bankruptcy
filing by our largest commercial customer. The Companys claim to the $1.5 million of accounts receivable related to the bankruptcy was sold in the third quarter of 2006 for $0.6 million.

Nine months ended September 30, 2006

Versus nine months
ended September 30, 2005

The table below presents major highlights from the nine months ended September 30, 2006 and 2005 excluding the
results of discontinued operations, except for Net loss.

(In Millions)



|                                                      |  |      |        |   |      |   |        |        |  |        |  
|----------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | ------ |  | ------ | -
|                                                      |  | 2006 |        |   | 2005 |   |        | Change | 
|Revenue                                               |  | $    | 123.48 |   |      | $ | 109.86 |        |  | 12.4   | %
|Gross profit                                          |  |      | 18.22  |   |      |   | 14.10  |        |  | 29.2   | %
|Operating income/(loss) from continuing operations    |  |      | 2.97   |   |      |   | (3.62  | )      |  | 182.0  | %
|Income/(loss) from continuing operations before taxes |  |      | 0.71   |   |      |   | (4.33  | )      |  | 116.4  | %
|Income/(loss) from continuing operations              |  |      | 0.41   |   |      |   | (2.61  | )      |  | 115.7  | %
|Net loss                                              |  |      | (0.02  | ) |      |   | (2.96  | )      |  | 99.3   | %
|EBITDA                                                |  |      | 5.55   |   |      |   | (0.22  | )      |  | 2622.7 | %

EBITDA for the nine months ended September 30, 2006 and 2005 excluding the results of discontinued operations
was calculated using the following approach:

(In Millions)



|                                         |  |      |      |      |   |       |  
|---------------------------------------- |  | ---- | ---- | ---- | - | ----- | -
|                                         |  | 2006 |      | 2005 |  
|Income/(loss) from continuing operations |  | $    | 0.41 |      | $ | (2.61 | )
|Interest                                 |  |      | 2.26 |      |   | 1.35  |  
|Tax expense/(benefit)                    |  |      | 0.30 |      |   | (1.72 | )
|Depreciation and amortization            |  |      | 2.58 |      |   | 2.76  |  
|                                         |  |      |      |      |   |       |  
|EBITDA                                   |  | $    | 5.55 |      | $ | (0.22 | )
|                                         |  |      |      |      |   |       |  



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##### Table of Contents

The table below presents the highlights in revenue by operating segment for the nine months ended September 30, 2006
and 2005 excluding the results of discontinued operations.

(In Millions)



|             |  |      |        |   |      |   |        |        |  |          |       |  |      |  
|------------ |  | ---- | ------ | - | ---- | - | ------ | ------ |  | -------- | ----- |  | ---- | -
|             |  | 2006 |        |   | 2005 |   |        | Change |  | % Change |      
|GSS          |  | $    | 65.34  |   |      | $ | 58.70  |        |  | $        | 6.64  |  | 11.3 | %
|CSS          |  |      | 49.72  |   |      |   | 43.62  |        |  |          | 6.10  |  | 14.0 | %
|MCS          |  |      | 8.65   |   |      |   | 7.83   |        |  |          | 0.82  |  | 10.5 | %
|Eliminations |  |      | (0.23  | ) |      |   | (0.29  | )      |  |          | 0.06  |  |      |  
|             |  |      |        |   |      |   |        |        |  |          |       |  |      |  
|Total        |  | $    | 123.48 |   |      | $ | 109.86 |        |  | $        | 13.62 |  | 12.4 | %
|             |  |      |        |   |      |   |        |        |  |          |       |  |      |  

Without regard to operating segments, the Companys mix of revenue between government and commercial
customers was approximately 40% commercial and 60% government in the first nine months of fiscal year 2006 and 40% commercial and 60% government in the first nine months of fiscal year 2005.

GSS revenue increased $6.6 million for the nine-month period ended September 30, 2006 versus the nine-month period ended September 30, 2005. The number of
aircraft for which routine and non-routine maintenance was performed in conjunction with the KC-135 PDM program was comparable to the first nine months of 2005. The KC-135 program generated an additional $4.9 million in revenue when compared to the
nine-months period ended September 30, 2005, due to additional parts sales of $2.5 million and an increase in the contract prices. This increase was partially offset, however, by the completion of the Coast Guard C-130 contract in early 2006 which
resulted in a decrease in revenue of $3.6 million during the first nine months of 2006 as compared to the first nine months of 2005. The C-130 UDLM Air Force aircraft contract generated $3.7 million in revenue for the nine-month period ended
September 30, 2006, for which there was no comparable revenue for the nine-month period ended September 30, 2005. The first two P-3 aircraft under the basic PDM contract with the US Navy were delivered in the first three quarters of 2006
and generated revenue of $1.7 million. Additional non-routine maintenance was performed under this program producing $1.5 million in revenue. This contract was obtained in late 2005 and there were no related deliveries as of September 30, 2005.

CSS delivered two additional cargo conversions during the first nine months of 2006 when compared to the same period in 2005 generating an additional $6.1
million in revenue. One cargo conversion was performed under a subcontract by TAECO. MRO revenues during the first nine months of 2006 were comparable to the first nine months of 2005. Revenue of $0.8 million related to settlement of a Request for
Equitable Adjustment (REA) claim, described in Note 10 of the Financial Statements, was also recognized during the first nine months of 2006 for which there was no comparable revenue during the same period of 2005.

Revenue at the MCS increased $0.8 million, or 10.5%, in the first nine months of 2006 versus the first nine months of 2005. Revenue at Space Vector increased due to
additional work on U.S. government launch vehicle programs. Revenue and related costs from Pemco Engineers have been excluded. Substantially all of the assets and the operations of Pemco Engineers were sold in October 2006 and have been presented as
discontinued operations as of September 30, 2006. All related 2006 and 2005 financial data for Pemco Engineers is reported separately as income from discontinued operations, net of tax.

Consolidated cost of sales increased $9.5 million, or 9.9%, to $105.3 million during the first nine months of 2006 primarily as a result of the higher revenue base. Cost
of sales was 85.2% and 87.2% of revenue for the nine months ended September 30, 2006 and 2005, respectively. Cost of sales was negatively impacted by the delivery of two Coast Guard aircraft during the first quarter of 2006 for which no profit
or loss was recognized due to the provisions for losses being recorded in 2005. Gross profit was negatively impacted by charges related to the Navy P-3 program totaling $1.1 million in the first nine months of 2006 as a result of starting this new
program. Because the first Navy P-3 induction occurred in late 2005, there were no comparable charges during the first nine months of 2005. As a percentage of sales, cost of sales was positively impacted by $0.8 million of revenue from the
settlement of the REA claim for which the related cost of sales was recognized in periods prior to 2005. Gross profit was significantly impacted by the results of CSS which experienced positive gross profit of $8.9 million for the first nine months
of 2006. The two additional cargo conversions and decreases in production cost rates per hour in 2006 coupled with the 2005 lockout of union employees in Dothan resulted in a $3.9 million increase of CSS gross profit for the nine-month period ended
September 30, 2006, when compared to the same period in 2005. In addition, CSS recorded a $0.4 million positive adjustment in the



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##### Table of Contents

estimated cost to settle the Falcon Air claim due to additional regulatory approval granted during the second quarter of
2006. Gross profit for MCS increased to 35.4% of revenue in 2006 as compared to 27.9% of revenue in 2005 due to increases in revenue and tight expense controls.

SG&A expenses decreased $0.3 million, or 2.0%, to $15.9 million in 2006. As a percentage of sales, SG&A expenses decreased to 12.9% in 2006 from 14.7% in 2005. The decrease in SG&A expense as a percentage of sales was primarily
caused by the higher sales volume at CSS and expense controls implemented throughout the Company.

The Company also recorded a $1.5 million provision for
doubtful accounts during the third quarter of 2005 related to the Chapter 11 bankruptcy filing by our largest commercial customer. During the second quarter of 2006, the Company reversed $0.6 million of the $1.5 million provision to reflect the net
realizable value of the receivables based on purchase offers from unrelated third parties. The Company sold the accounts receivable related to the Chapter 11 bankruptcy during the third quarter of 2006 for $0.6 million.

In the second quarter of 2005, the Company recorded a gain of $0.65 million on the assignment of a lease located at the St. Petersburg-Clearwater International Airport.

LIQUIDITY AND CAPITAL RESOURCES

The table below presents the major indicators of financial condition and liquidity.

(In Thousands, except
debt to equity)



|                                                                |  |                   |         |   |                  |   |         |        |  |   |        |  
|--------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | - | ------- | ------ |  | - | ------ | -
|                                                                |  | September 30,2006 |         |   | December 31,2005 |   |         | Change | 
|Cash and cash equivalents                                       |  | $                 | 74      |   |                  | $ | 26      |        |  | $ | 48     |  
|Working capital                                                 |  |                   | (20,437 | ) |                  |   | (17,945 | )      |  |   | (2,492 | )
|Current portion of long-term debt and capital lease obligations |  |                   | 31,220  |   |                  |   | 25,126  |        |  |   | 6,094  |  
|Long-term debt and capital lease obligations                    |  |                   | 1,969   |   |                  |   | 1,973   |        |  |   | (4     | )
|Stockholders equity                                            |  |                   | 12,497  |   |                  |   | 11,539  |        |  |   | 958    |  
|Debt to equity                                                  |  |                   | 2.66    |   |                  |   | 2.35    |        |  |   | 0.31   |  

The Companys primary sources of liquidity and capital resources include cash flows from operations and
borrowing capability through commercial lenders, including unused borrowing capacity on existing revolving credit agreements. Principal factors affecting the Companys liquidity and capital resources position include, but are not limited to,
the following: results of operations; expansions and contractions in the industries in which the Company operates; funding requirements associated with the Companys defined benefit pension plan; timing of federal income tax payments;
transactions under the Companys stock repurchase plan; and potential acquisitions and divestitures.

Working Capital

As discussed below, the Company was in violation of various debt covenant ratios during 2006 and 2005. Our ability to meet current and future payment obligations is
dependent upon our ability to improve operating performance, obtain additional financing from current or alternative lenders, or a combination of the above items. The lenders waived all defaults of debt covenants through June 30, 2006. There
can be no assurances that the Company will satisfy all debt covenants in the future or that the availability under the Revolving Credit Facility will be sufficient to continue operations. If the Company violates the debt covenants, all debt may
become due and payable. If additional financing is needed, the Companys results of operations in 2006 and 2005 and the lack of a long-term KC-135 contract will likely make it more difficult and expensive, if not impossible, for the Company to
raise additional capital that may be necessary to continue its operations. If the Company cannot raise adequate funds on acceptable terms, the business could be materially harmed.



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##### Table of Contents

Cash Flow Overview

Operating activities used $4.4 million of cash from continuing operations during the nine months ended September 30, 2006 and provided $11.7 million of cash during the same period of 2005. Cash of $1.6 million and $2.9 million was used
during the first nine months of 2006 and 2005, respectively, for capital expenditures. The Company contributed $8.6 million and $6.0 million during 2006 and 2005, respectively, to fund its pension plan. The Company used $1.3 million and $1.1 million
during each of 2006 and 2005 to fund principal payments of long-term debt. On December 16, 2002, the Company entered into a Credit Agreement with Wachovia Bank and Compass Bank (the Credit Agreement) that provides for a revolving
credit facility and a term loan (the Revolving Credit Facility and Bank Term Loan, respectively). The Company borrowed $2.4 million under the Revolving Credit Facility during the first nine months of 2006 and used $11.0
million during the first nine months of 2005 to reduce borrowings under the Revolving Credit Facility. On February 15, 2006, the Company incurred $5.0 million of additional debt with Silver Canyon Services, Inc. (Silver Canyon),
related to a note the Company issued to Silver Canyon in the principal amount of $5.0 million (the Note). On July 31, 2006, the Silver Canyon debt was purchased by the Special Value Bond Fund, LLC which is managed by Tennenbaum
Capital Partners, LLC, a related party of the Company. A substantial amount of cash was used in the first nine months of 2006 due to an increase in accounts receivable at GSS and CSS. New programs and customers during 2006 contributed to the
increase in accounts receivable. In the first nine months of 2005, the decrease in accounts receivable provided $17.8 million in cash due to the timing of deliveries of aircraft. There were substantially fewer aircraft delivered in the fourth
quarter of 2005 versus the fourth quarter of 2004, which caused collection of receivables to decrease in 2006 when compared to 2005.

Future Capital
Requirements

The Company has three large potential capital requirements in 2006: required minimum funding of the defined benefit pension plan, current
maturities of long-term debt and capital expenditures.

The Company maintains a defined benefit pension plan (the Plan), which covers
substantially all employees at its Birmingham and Dothan, Alabama facilities. The Plans assets consist primarily of equity mutual funds, bond mutual funds, hedge funds and cash equivalents. These assets are exposed to various risks, such as
interest rate, credit, and overall market volatility. As a result of unfavorable investment returns related to the Plan in 2001 and 2002, partially offset by favorable returns in 2003 and 2004, coupled with substantially lower interest rates, the
Plan was under-funded by approximately $26.3 million at December 31, 2005. Pursuant to minimum funding requirements of ERISA, the Company expects to contribute approximately $11.0 million to the Plan during 2006, of which the Company has made
contributions of approximately $8.6 million through September 30, 2006.

Current maturities of debt at September 30, 2006 and December 31,
2005 totaled $31.2 million and $25.1 million, respectively. As discussed more extensively below, current maturities of debt at September 30, 2006 and December 31, 2005 included all amounts owed under the Revolving Credit Facility due to
the expiration of the Credit Agreement on August 31, 2007.

The Company has begun an initiative to improve hanger facilities for the GSS in
Birmingham. The Company completed the renovation of two bays and other facility upgrades in Birmingham during 2005. Future upgrades and additional facility improvements will depend on new business and availability of resources. The Company has
obtained commitments from local state, county and city governments to fund certain capital improvements contingent upon winning the KC-135 contract recompete and achieving other required benchmarks. At September 30, 2006, the Company had
approximately $0.1 million in construction-in-process, primarily related to facility upgrades at GSS expected to be completed during 2006. The Company anticipates total capital expenditures of $1.5 to $2.5 million during 2006.

Revolving Credit Facility

The Company and its primary lenders,
Wachovia Bank and Compass Bank, previously entered into a series of amendments to the Credit Agreement dated December 16, 2002, that affect the Revolving Credit Facility that is made available to the Company under the Credit Agreement. On
May 7, 2004, the Company amended the Credit Agreement to temporarily increase the Revolving Credit Facility from a commitment of $25.0 million to $27.0 million. On August 1, 2004, the Company amended the Credit Agreement to extend until
December 31, 2004 the



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##### Table of Contents

temporary increase of the commitment under the Revolving Credit Facility to up to $27.0 million. On November 5,
2004, the Company amended the Credit Agreement to temporarily increase the Revolving Credit Facility from a commitment of $27.0 million to $33.0 million. On December 22, 2004, the Company amended the Credit Agreement to extend the Revolving
Credit Facility maturity date from December 16, 2005 to April 30, 2006. On April 30, 2005, the Company amended the Credit Agreement to extend the $33.0 million Revolving Credit Facility commitment to June 30, 2006. On
June 28, 2005, the Credit Agreement was amended to extend the Revolving Credit Facility maturity date from April 30, 2006 to October 15, 2006, and to reduce the commitment amount to $28.0 million.

For the six months ended June 30, 2006, the Company violated a debt covenant requiring the Company to achieve income before income taxes of $1.0 million. The
Company obtained a waiver from the lender for the debt covenant violation for the six-month period ended June 30, 2006. During each quarter of 2005, the Company violated the fixed charge coverage ratio covenant under the Revolving Credit
Facility due to losses incurred by the Company during 2005. As of September 30, 2005, the Company violated the adjusted tangible net worth covenant. On March 31, 2005, the Company obtained a waiver from the lender for the fixed charge
coverage ratio covenant violation with respect to the first quarter of 2005 and the fourth quarter of 2004. The Credit Agreement was amended to revise the calculation of the fixed charge coverage ratio for the second and third quarters of 2005 to
use annualized 2005 results rather than total results of the past four quarters, and to increase the adjusted tangible net worth covenant from approximately $30.0 million to $33.5 million. On August 11, 2005, the Company obtained a waiver from
the lender for the fixed charge coverage ratio covenant violation with respect to the second and third quarters of 2005. The Credit Agreement was amended to revise the calculation of the fixed charge coverage ratio for the fourth quarter of 2005,
decreasing the required ratio of operating income to fixed charges from 1.2 to 1.0 and increasing the adjusted tangible net worth covenant from approximately $33.5 million to $38.5 million. As of December 31, 2005, the Company was in violation
of the fixed charge coverage ratio and the adjusted tangible net worth ratio. The Company obtained a waiver from the lender for all debt covenant violations through December 31, 2005. On February 15, 2006, the Credit Agreement was amended
to establish financial covenants for 2006. The covenants established a minimum adjusted tangible net worth for each quarter, minimum earnings before tax beginning June 30, 2006, and a fixed charge coverage ratio for the year ending
December 31, 2006. As discussed below, the debt covenants were amended on October 12, 2006.

On October 12, 2006, the Company entered into
an Amended and Restated Credit Agreement (Amended Credit Agreement) with its lenders. The Amended Credit Agreement:



| |  |  | extended the maturity date of the Revolving Credit Facility to August 31, 2007,
| | - |  | -------------------------------------------------------------------------------



| |  |  | maintained the maximum principal amount of the Revolving Credit Facility at $28.0 million including any unused letters of credit,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | provided for an increase in the maximum principal amount of the Revolving Credit Facility to $31.0 million if the Company is awarded the new KC-135 contract,
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | provided for an increase in the borrowing base by increasing eligible Work-in-Process Inventory from 50% to 65%,
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | changed the interest rate on the Revolving Credit Facility to a rate ranging from LIBOR plus 1.5% to LIBOR plus 6.0% determined on quarterly earnings before interest, taxes,
depreciation and amortization (EBITDA) as defined in the Amended Credit Agreement, and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | established new debt covenants as follows:
| | - |  | ------------------------------------------



| | i) | Beginning with the quarter ending December 31, 2006, a fixed charge coverage ratio of not less than 1.0 to 1.0, to be tested at each quarter-end thereafter on a cumulative
basis commencing October 1, 2006 and ending on the last day of the respective quarter-end.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | ii) | At all times, maintain a ratio of adjusted liabilities to adjusted tangible net worth of not more than 2.5 to 1.0.
| | --- | ------------------------------------------------------------------------------------------------------------------



| | iii) | Achieve a cumulative EBITDA of not less than $400,000 for the period from September 1, 2006 to September 30, 2006; $2.85 million for the period from September 1, 2006
to December 31, 2006; $3.75 million for the period from September 1, 2006 to March 31, 2007; and $6.0 million for the period from September 1, 2006 to June 30, 2007.
| | ---- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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Bank Term Loan

The
Bank Term Loan has a term of five years and bears interest at LIBOR plus 2.25% to 3.00%, determined based on the ratio of adjusted funded debt to EBITDA, as defined in the Credit Agreement. The principal amount under the loan is $5.0 million, which
is payable in 60 monthly installments of $83,333 plus interest, which began January 31, 2003. The Company had an outstanding balance under the Bank Term Loan at September 30, 2006 of $1.3 million.

Treasury Stock Term Loan

On May 22, 2003, the Company amended
the Credit Agreement to include a term loan that could be used for the repurchase of the Companys Common Stock (Treasury Stock Term Loan). The Company was permitted to draw upon the Treasury Stock Term Loan up to $5.0 million
through May 22, 2005, and the borrowings could be used to make purchases of the Companys Common Stock from any person who is not and has never been an affiliate of the Company, or any other person approved by lender parties at their
discretion. The Treasury Stock Term Loan could be drawn in increments of $100,000 and bears interest at LIBOR plus 3.00% (8.33% at September 30, 2006). The Company had an outstanding balance under the Treasury Stock Term Loan at
September 30, 2006 of $0.9 million. The loan is being repaid in equal monthly installments over 31 months which began on May 22, 2005.

Airport Authority Term Loan

The Company executed a loan agreement during the fourth quarter of 2002 to borrow up to $2.5 million from the
Dothan-Houston County Airport Authority to finance its hanger expansion at the facility. The hanger expansion was completed during the first quarter of 2003. The loan is backed by a letter of credit with the Companys primary lender and carries
a variable interest rate, which was 3.90% at September 30, 2006. The Company had an outstanding balance under the Airport Authority Term Loan at September 30, 2006 of $2.1 million.

Senior Secured Debt

As described above, on February 15, 2006,
the Company entered into a note purchase agreement with Silver Canyon, pursuant to which the Company issued to Silver Canyon a senior secured Note in the principal amount of $5.0 million. The principal amount of the Note becomes due and payable on
the earlier of (i) February 15, 2007, or (ii) the date on which amounts outstanding under the Companys Revolving Credit Facility with Wachovia Bank and Compass Bank become due and payable. The Note accrues interest at an annual
rate of 15%, which is payable quarterly in arrears commencing March 1, 2006. The Company may, at its election, redeem the Note at a price equal to 100% of the principal amount then outstanding, together with accrued and unpaid interest thereon.
The Note is subordinate to any debt incurred by the Company under the Credit Agreement. The Note contains customary events of default consistent with the events of default defined in the thirteenth amendment of the Credit Agreement with Wachovia and
Compass on February 15, 2006. The payment of all outstanding principal, interest and other amounts owed under the Note may be declared immediately due and payable by the lender upon the occurrence of an event of default, subject to certain
standstill provisions with Wachovia and Compass. On July 31, 2006, the Silver Canyon debt was purchased by the Special Value Bond Fund, LLC, which is managed by Tennenbaum Capital Partners, LLC, a related party of the Company.

Funding Sources

The Company plans to finance its capital
expenditures, working capital and liquidity requirements through the most advantageous sources of capital available to the Company at the time, which may include the sale of equity or debt securities through public offerings or
private placements, obtaining additional debt through secured or unsecured borrowings and the reinvestment of proceeds from the disposition of assets. The Company believes that its internally generated liquidity, together with access to
external capital resources, will be sufficient to satisfy existing commitments and plans for at least the next twelve months. The Company could elect, or could be required, to raise additional funds during that period, and the Company may
need to raise additional capital in the future. Additional capital may not be available at all, or may not be available on terms favorable to the Company. Any additional issuance of equity or equity-linked securities may result in
substantial dilution to the Companys stockholders. The Company is continually monitoring and reevaluating its level of investment in all of its operations, as well as the financing sources available to achieve its
goals in each business area.

The aircraft services industry has been in a consolidation phase generally in recent years. As a consequence, the Company
receives and sometimes initiates inquiries with respect to corporate combinations. The Company has not



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completed any such combinations for a number of years, and there is no assurance that it will be party to such
transactions in the future.

TRADING ACTIVITIES

The
Company has not engaged in trading activities or in trading non-exchange traded contracts. As of September 30, 2006 and 2005, the carrying amounts of the Companys financial instruments were estimated to approximate their fair values, due
to their short-term nature, and variable or market interest rates. The Company has not hedged its interest rate or foreign exchange risks through the use of derivative financial instruments. See Quantitative and Qualitative Disclosures about
Market Risk included in Item 3 of Part I of this Report.

RELATED PARTY TRANSACTIONS

On April 23, 2002, the Company loaned its current President and Chief Executive Officer approximately $0.4 million under the terms of a Promissory Note. The
Promissory Note carries a fixed interest rate of 5.0% per annum and is payable within 60 days of the President and Chief Executive Officers termination of employment with the Company. Any change in this related party receivable relates to
interest accumulated during the period.

As discussed above, on July 31, 2006, the Silver Canyon debt was purchased by the Special Value Bond Fund,
LLC, which is managed by Tennenbaum Capital Partners, LLC, a related party of the Company.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The Companys significant accounting policies are disclosed in Note 1 of the Notes to Consolidated Financial Statements in the Companys 2005 Annual Report
on Form 10-K. The preparation of financial statements in conformity with generally accepted accounting principles requires that management use judgments to make estimates and assumptions that affect the amounts reported in the financial statements.
As a result, there is some risk that reported financial results could have been materially different had different methods, assumptions, and estimates been used.

The Company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity as used in the preparation of its consolidated financial statements:

Revenue Recognition

Revenue at GSS is derived principally from
aircraft maintenance and modification services performed under contracts or subcontracts with government and military customers. GSS recognizes revenue and associated costs under such contracts on the percentage-of-completion method as prescribed by
Statement of Position 81-1 (SOP 81-1), Accounting for Performance of Construction-Type and Certain Production-Type Contracts. These contracts generally provide for routine maintenance and modification services at fixed prices
detailed in the contract. Any non-routine maintenance and modification services are provided based upon estimated labor hours at fixed hourly rates. The Company segments the routine and the non-routine services for purposes of accumulating costs and
recognizing revenue. For routine services, the Company uses the units-of-delivery method as the basis to measure progress toward completion, with revenue recorded based upon the unit sales value stated in the contract and costs of sales recorded
based upon actual unit cost. An aircraft is considered delivered when work is substantially complete and acceptance by the customer has occurred. For non-routine services, the Company uses an output measure based upon units of work performed to
measure progress toward completion, with revenue recorded based upon the stated hourly rates in the contract and costs of sales recorded based upon estimated average costs. The Company considers each task performed for the customer as a unit of work
performed. Revenue and costs of sales are recognized upon completion of all performance obligations in accordance with the contract. Such work is performed and completed throughout the PDM process.

Revenue at CSS is derived principally from aircraft maintenance, modification, and conversion programs under contracts with the owners and operators of large commercial
airlines. CSS recognizes revenue and associated costs for all work performed under such contracts on a percentage-of-completion method, as prescribed by SOP 81-1, using units-of-delivery as the basis to measure progress toward completion. Revenue is
recorded based upon the unit sales value stated in the contract and costs of sales are recorded based upon actual unit cost.

MCS derives a significant
portion of its revenue from cost-reimbursement type contracts accounted for under the principles prescribed by SOP 81-1 and from sales of precision parts and components. Revenue on cost-reimbursable



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contracts is recognized to the extent of costs incurred plus a proportionate amount of estimated fee earned. For certain
other fixed-price contracts, revenue is recognized when performance milestones have been achieved in accordance with contract terms. Revenue related to sales of individual components and parts is recognized upon delivery to the customer, and when
the product price is fixed and determinable and collection of the resulting receivable is reasonably assured.

Contract accounting requires judgment
relative to assessing risks and estimating contract revenues and costs. The Company employs various techniques to project contract revenue and costs which inherently include significant assumptions and estimates. Contract revenues are a function of
the terms of the contract and often bear a relationship to contract costs. Contract costs include labor, material, an allocation of indirect costs, and, in the case of certain government contracts, an allocation of general and administrative costs.
Techniques for estimating contract costs generally impact the Companys proposal processes, including the determination of pricing for routine and non-routine elements of contracts, the evaluation of profitability on contracts, and the timing
and amounts recognized for revenue and cost of sales. The Company provides for losses on uncompleted contracts in the period in which management determines that the estimated total costs under the contract will exceed the estimated total contract
revenues. These estimates are reviewed periodically and any revisions are charged or credited to operations in the period in which the change is determined. An amount equal to contract costs attributable to claims is included in revenues when
realization is probable and the amount can be reasonably estimated. Judgment is required in determining the potential realization of claim revenue and estimating the amounts recoverable. Because of the significance of the judgments and estimates
required in these processes, it is likely that materially different amounts could result from the use of different assumptions or if the underlying conditions were to change. In addition, contracts accounted for under the percentage-of-completion,
units-of-delivery method may result in material fluctuations in revenue and profit margins depending on the timing of delivery and performance, the relative proportion of fixed price, cost reimbursement, and other types of contracts-in-process, and
costs incurred in their performance. For additional information regarding accounting policies the Company has established for recognizing revenue, see Revenue Recognition in Note 1 to the Consolidated Financial Statements in the
Companys 2005 Annual Report on Form 10-K.

Allowance for Doubtful Accounts

The Companys allowance for doubtful accounts is generally recorded on the specific identification method. This method involves subjectivity and generally includes an evaluation of historical experience with the
customer, current relationship with the customer, aging of the receivable, contract terms, discussion with the customer, marketing, and contracts personnel, as well as other available data.

Given the nature of GSSs business and customers, write-offs have historically been nominal. GSS customers are primarily the U.S. Government and more recently
Boeing Corporation. CSS primarily services the commercial airline market, and is therefore more susceptible to collectibility issues. Generally, the Companys services are contract driven, and fees for services performed in accordance with the
agreed upon terms of the contract with the customer are collected. MCSs business involving commercial customers has experienced some collectibility problems; however, historical write-offs have been insignificant to the Companys
operations as a whole.

Inventory Reserves

The Company
regularly estimates the degree of technological obsolescence in its inventories and provides inventory reserves on that basis. Though the Company believes it has adequately provided for any such declines in inventory value to date, any unanticipated
change in technology or potential decertification due to failure to meet design specification could significantly affect the value of the Companys inventories and thereby adversely affect gross profit and results of operations. In addition, an
inability of the Company to accurately forecast its inventory needs related to its warranty and maintenance obligations could adversely affect gross profit and results of operations.

Deferred Taxes

The Company records a valuation allowance to reduce its deferred tax assets to the amount that is
more likely than not to be realized. While the Company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the Company were to determine that
it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the Company determine
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it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred
tax asset would be charged against income in the period such determination was made.

Machinery, Equipment and Improvements and Impairment

Machinery, equipment and leasehold improvements are stated at cost, less accumulated depreciation and amortization. Depreciation and amortization are
computed using the straight-line method over the estimated useful lives. In the case of leasehold improvements, the useful life is the shorter of the lease period or the economic life of the improvements. The Company estimates the useful lives based
on historical experience and expectations of future conditions. Should the actual useful lives be less than estimated, additional depreciation expense or recording a loss on disposal may be required.

The Company reviews machinery, equipment and improvements for impairment whenever there is an indication that their carrying amount may not be recoverable and performs
impairment tests on groups of assets that have separately identifiable cash flow. The Company compares the carrying amount of the assets with the undiscounted expected future cash flows to determine if an impairment exists. If an impairment exists,
assets classified as held and used are written down to fair value and are depreciated over their remaining useful life, while assets classified as held for sale are written down to fair value less cost to sell. The actual fair value may differ from
the estimate.

Pension and Postretirement Plans

The
Company maintains pension plans covering a majority of its employees and retirees, and postretirement benefit plans for retirees that include health care benefits and life insurance coverage. For financial reporting purposes, net periodic pension
and other postretirement benefit costs (income) are calculated based upon a number of actuarial assumptions including a discount rate for plan obligations, assumed rate of return on pension plan assets, assumed annual rate of compensation increase
for plan employees, and an annual rate of increase in the per capita costs of covered postretirement healthcare benefits. Each of these assumptions is based upon the Companys judgment, considering all known trends and uncertainties. Actual
asset returns for the Company pension plans significantly below the Companys assumed rate of return would result in lower net periodic pension income (or higher expense) in future years. Actual annual rates of increase in the per capita costs
of covered postretirement healthcare benefits above assumed rates of increase would result in higher net periodic postretirement benefit costs in future years.

Warranties

The Company provides warranties covering workmanship and materials under its PDM and MRO maintenance contracts that generally
range from six to 18 months after an aircraft is delivered, depending on the specific terms of each contract. The Company provides warranties under its cargo conversion contracts that generally range from approximately three to ten years from the
date of aircraft delivery on structure, electrical systems and other components directly associated with the conversion system and one year from the date of aircraft delivery on workmanship and materials related to general maintenance performed
concurrent with the conversion. The Company provides a reserve for anticipated warranty claims based on historical experience, current warranty trends, and specific warranty terms. Periodic adjustments to the reserve are made as events occur that
indicate changes are necessary.

Insurance Reserves

The Company is currently self-insured for employee medical coverage and has a large deductible for workers compensation claims. The Company records a liability for the ultimate settlement of claims incurred as of the balance sheet
date based upon estimates provided by the companies that administer the claims on the Companys behalf. The Company also reviews historical payment trends and identified specific claims in determining the reasonableness of the reserve.
Adjustments to the reserve are made when the facts and circumstances of the underlying claims change. Should the actual settlement of the medical or workers compensation claims be greater than estimated, additional expense will be recorded.

Contingencies

The Company has been involved, and may
continue to be involved, in various legal proceedings arising out of the conduct of its business including litigation with customers, employment related lawsuits, purported class actions, and



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actions brought by governmental authorities. The Company has, and will continue to, vigorously defend itself and to
assert available defenses with respect to these matters. Where necessary, the Company has accrued an estimate of the probable cost of resolutions of these proceedings based upon consultation with outside counsel and assuming various strategies. A
settlement or an adverse resolution of one or more of these matters may result in the payment of significant costs and damages that could have a material adverse effect on the Companys financial position or results of operations.

BACKLOG

The following table
presents the Companys backlog at September 30, 2006 and December 31, 2005:

(In Thousands)



|                |  |                   |        |                  |   |       
|--------------- |  | ----------------- | ------ | ---------------- | - | ------
|Customer Type   |  | September 30,2006 |        | December 31,2005
|U.S. Government |  | $                 | 41,808 |                  | $ | 45,536
|Commercial      |  |                   | 31,169 |                  |   | 24,012
|                |  |                   |        |                  |   |       
|Total           |  | $                 | 72,977 |                  | $ | 69,548
|                |  |                   |        |                  |   |       

The $3.7 million reduction in government backlog was related to decreases in the KC-135 program at GSS offset by
increases in the P-3 program. The GSS backlog decreased approximately $2.5 million when compared to December 31, 2005 primarily due to fewer KC-135 aircraft in work and the termination of the Coast Guard C-130 program. Backlog was positively
impacted by the addition of seven P-3 aircraft at September 30, 2006 versus two at December 31, 2005. Backlog in government programs at the MCS decreased $1.2 million during this same period due to decreased awards related to U.S.
government launch vehicle programs.

Total commercial backlog increased $7.2 million. The increase in backlog at the CSS is due primarily to a contract for
aircraft conversion work in Dothan, Alabama and in China. Backlog at the CSS increased due to the addition of a major commercial customer.

Overall, the
mix of backlog shifted from 65% U.S. Government and 35% commercial at December 31, 2005 to 57% U.S. Government and 43% commercial at September 30, 2006. The shift to commercial from U.S. Government results primarily from the increase in
backlog at the CSS described above.

The Company includes sub-contracts for government work in its U.S. Government backlog category.

CONTINGENCIES

See Note 10 to the Consolidated Financial Statements.

The Companys Forward-Looking Statements May Prove to be Wrong.

Some of the information under the caption Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Quarterly Report are forward-looking statements
that are entitled to the protection of the safe harbors contained in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements include, but
are not limited to, statements about the Companys plans, objectives, expectations and intentions, award or loss of contracts, anticipated increase in demand for conversions, the outcome of pending or future litigation, compliance with debt
covenants under borrowing arrangements, estimates of backlog and other statements contained in this Quarterly Report that are not historical facts. When used in this Quarterly Report, the words expects, anticipates,
intends, plans, believes, seeks, estimates and similar expressions are generally intended to identify forward-looking statements. Because these forward-looking statements involve risks and
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important factors, including the factors discussed under the caption Risk Factors in this Quarterly Report,
which could cause actual results to differ materially from those expressed or implied by these forward-looking statements. The Company cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date on
which they are made. The Company does not undertake any obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company is exposed to market risk from changes in
interest rates as part of its normal operations. The Company maintains various debt instruments to finance its business operations. The debt consists of fixed and variable rate debt. The variable rate debt is related to the Companys Credit
Agreement, which includes a revolving credit facility and two term loans, all as described in Note 6 to the Consolidated Financial Statements (see Item 1 herein). The Credit Agreements revolving credit facility bears interest at LIBOR
plus 275 basis points (8.08% at September 30, 2006). Each of the term loans under the Credit Agreement bears interest at LIBOR plus 300 basis points (8.33% at September 30, 2006). The Airport Authority Term Loan bears interest at Bond
Market Association (BMA) plus 36 basis points (3.90% at September 30, 2006). Had the interest rate of the variable rate debt increased 100 basis points, net loss would have been increased by approximately $215,000 during the first
nine months of 2006.

Item 4. Controls and Procedures

(a) Evaluation of disclosure controls and procedures.

The Company maintains disclosure controls and procedures designed to provide reasonable assurance of achieving the objective that information in its Exchange Act reports
is recorded, processed, summarized and reported within the time periods specified and pursuant to the requirements of the Securities and Exchange Commissions rules and forms. Disclosure controls and procedures, as defined in Rules 13a-15(e)
and 15d-15(e) under the Exchange Act, include controls and procedures designed to ensure that information required to be disclosed by the Company in the reports filed or submitted under the Exchange Act is accumulated and communicated to the
Companys management, including the Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. It should be noted that any system of controls, however well designed and
operated, can provide only reasonable, and not absolute, assurance that the objectives of the system are met.

Management carried out an evaluation, with
the participation of the Companys Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Companys disclosure controls and procedures as of September 30, 2006, the end of the period covered by this report.
Based on that evaluation and the issues discussed below, the Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were not effective at the reasonable assurance level
as of September 30, 2006.

(b) Changes in internal control over financial reporting.

In addition to managements evaluation of disclosure controls and procedures as discussed above, in connection with the audits of the Companys financial
statements for the fiscal years ended December 31, 2005 and 2004, we are continuing to review and enhance policies and procedures involving accounting, information systems and monitoring.

During the audit of the 2003 financial statements, the Companys independent registered public accounting firm identified the following reportable conditions that
together constituted a material weakness in internal control over financial reporting involving the incorrect applications of generally accepted accounting principles as a result of personnel in certain areas of the Company who did not have a
full understanding of pertinent accounting and financial reporting principles and as a result of the untimely resolution of errors. The resulting reportable conditions were (i) lack of appropriate analysis and support for revenue recognition
matters; (ii) lack of appropriate analysis and support pertaining to estimates to complete certain contracts made in connection with projecting losses on contracts in a current period; (iii) lack of appropriate analysis and support for
inventory accounting matters; and (iv) lack of appropriate analysis and support for the reconciliation of inter-company transactions.

The Company
implemented the following corrective action plan to remediate the material weakness identified during the audit of the 2003 financial statements: (i) re-evaluated and added staffing and level of expertise; (ii) increased training of its
corporate and accounting staff to heighten awareness among corporate and accounting personnel of generally accepted accounting principles; (iii) established policies and procedures, including



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documentation, designed to enhance coordination and reporting procedures between management and the Companys
accounting staff; (iv) centralized review and monitoring of accounting issues; and (v) re-allocated senior accounting personnel to provide additional on-site supervision of accounting functions.

The corrective action plan was not implemented with sufficient time prior to the audit of the 2004 financial statements to fully remediate the material weakness
identified in 2003. Additionally, during the audit of the 2004 financial statements, the Companys independent registered public accounting firm identified the following material weaknesses in internal control over financial reporting:
(i) the lack of appropriate controls to timely record liabilities for services performed in 2004 for which the invoices were not processed at December 31, 2004; (ii) the lack of appropriate analysis and support for inventory matters;
(iii) the lack of appropriate analysis and support for payroll accruals; (iv) the lack of adequate evaluation of leasehold improvements placed in service from 1982 to 2001; and (v) lack of segregation of duties related to system
access controls. Internal controls related to the reconciliation and reviews of these accounts were not operating sufficiently to detect and correct potential errors to the financial statements. The Company expanded the scope of the corrective
action plan to address all issues identified during the audit of the 2004 financial statements in an effort to remediate the material weaknesses which existed as of December 31, 2004. The corrective actions were part of more comprehensive
improvements in internal controls which included more detailed reviews of the reconciliation process for significant accounts, analysis of existing accounting policies, and increased financial audits by the Companys internal audit staff.

During the audit of the 2005 financial statements, the Companys independent registered public accounting firm identified significant deficiencies in
the posting of physical inventory results and in adherence to the Companys inventory costing methodology which resulted in a material weakness in controls over inventory at the Companys Pemco Aeroplex subsidiary. In addition, the firm
also determined that the process for determining adequate information with regards to estimating costs to complete certain contracts for the purpose of projecting losses on those contracts was insufficient and constituted a material weakness of
internal controls. The comprehensive review of internal controls is continuing throughout 2006 through a program conducted by the corporate accounting and internal audit staff. Additional financial personnel have been added to the corporate
accounting staff to conduct this review and to provide increased oversight of the adherence to financial policies and procedures.

Except as noted above,
there have been no changes to the Companys internal control over financial reporting that occurred during the Companys fiscal quarter ended September 30, 2006 that have materially affected or are reasonably likely to materially
affect the Companys internal control over financial reporting.

PART II OTHER INFORMATION

Item 1. Legal Proceedings

See Note 10 to the Consolidated Financial Statements.

Item 1A. Risk Factors

Our Annual Report on Form 10-K for the year ended December 31, 2005 includes a detailed
discussion of our risk factors under the heading Part I, Item IA. Risk Factors. Set forth below are certain changes from the risk factors previously disclosed in our Annual Report on Form 10-K as a result of events that occurred during
the third quarter of 2006 (and thereafter), including submitting a proposal for the new KC-135 PDM program and entering into an Amended and Restated Credit Agreement with our lenders. Please refer to the risk factors discussed in our Annual Report
on Form 10-K and in our Quarterly Report on Form 10-Q for the second quarter, as well as the other information in this report, for disclosures regarding the risks and uncertainties related to our business. The occurrence of any of the risks
discussed in the Annual Report on Form 10-K or this report could materially harm our business and impair the value of our Common Stock.

A Significant
Portion of the Companys Revenues Is Derived From a Few of Its Contracts.

A small number of our contracts account for a significant percentage of
our revenues. Contracts with the U.S. Government comprised 61%, 68% and 69% of our revenues during 2005, 2004, and 2003, respectively. The USAF KC-135 program in and of itself comprised 47%, 60%, and 65% of our total revenues in 2005, 2004, and
2003, respectively, and a contract with Northwest Airlines comprised 22%, 22%, and 15% of our total revenues during these same respective time periods. During 2003, a contract with GECAS comprised 11% of our total revenues. Termination of a
contract, a dispute over compliance with contract terms, a disruption of any of these contracts



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(including option years not being exercised), or the inability of us to renew or replace any of these contracts when they
expire, could materially harm our business and impair the value of our Common Stock.

In May 2005, the U.S. Air Force decided to re-compete the KC-135 PDM
program. The Company submitted a proposal as a subcontractor/partner with Boeing LSS for the KC-135 program. On June 6, 2006, the Company was notified by Boeing that Boeing was terminating a Memorandum of Agreement (MOA) among
Boeing, L3/IS Integrated Systems (L3) and Pemcos Birmingham, Alabama subsidiary, Pemco Aeroplex, Inc. Under the previously announced MOA, the companies had agreed on a teaming arrangement to compete for the KC-135 PDM program. In
the termination notice, Boeing asserted that it received notice of an amendment to the request for proposal for the KC-135 program reducing the requested quantities of aircraft, and that the reduction is so unfavorable to Boeing that further
participation in the program pursuant to the MOA is no longer practical or financially viable. The Company and Boeing are currently teamed on the KC-135 Bridge Contract through the government fiscal year ending September 30, 2007, which remains
unaffected by the termination. The Company submitted a proposal as a prime contractor for the KC-135 PDM program in September 2006. An award announcement is expected during the first quarter of 2007. If our proposal for the KC-135 PDM program is
unsuccessful, it could materially harm our business and impair the value of our Common Stock.

If the Companys Customers Experience Financial or
Other Difficulties, the Companys Business Could Be Materially Harmed.

A number of our commercial customers, including Northwest Airlines, which
represented 22% of our revenues in 2005, have in the past and may in the future experience significant financial difficulties, including bankruptcy. Many of these customers face risks that are similar to those encountered by the Company, including
risks associated with market conditions, competition, government regulations, and the ability to obtain sufficient capital. There can be no assurance that our customers will be successful in managing these risks. If our customers do not successfully
manage these risks, it could impair our ability to generate revenues, collect amounts due from these customers, and materially harm our business. Northwest Airlines filed a petition for Chapter 11 bankruptcy. As a result, we recorded charges of $1.5
million to provide for pre-petition Northwest Airlines receivables in the third quarter of 2005. During the second quarter of 2006, the Company reversed $0.6 million of the $1.5 million charge to reflect the net realizable value of the receivables
based on purchase offers from unrelated third parties. The Company sold the receivables related to the Chapter 11 bankruptcy filing during the third quarter of 2006 for $0.6 million.

The Company May Need Additional Financing to Maintain Its Business Which May or May Not Be Available.

For the six
months ended June 30, 2006, the Company violated a debt covenant under the Revolving Credit Facility requiring the Company to achieve income before income taxes of $1.0 million. The Company obtained a waiver from the lenders for the debt
covenant violation for the six-month period ended June 30, 2006. During each quarter of 2005, the Company violated the fixed charge coverage ratio covenant under the Revolving Credit Facility due to losses incurred by the Company during 2005.
As of September 30, 2005, the Company violated the adjusted tangible net worth covenant. On March 31, 2005, the Company obtained a waiver from the lender for the fixed charge coverage ratio covenant violation with respect to the first
quarter of 2005 and the fourth quarter of 2004. The Credit Agreement was amended to revise the calculation of the fixed charge coverage ratio for the second and third quarters of 2005 to use annualized 2005 results rather than total results of the
past four quarters, and to increase the adjusted tangible net worth covenant from approximately $30.0 million to $33.5 million. On August 11, 2005, the Company obtained a waiver from the lender for the fixed charge coverage ratio covenant
violation with respect to the second and third quarters of 2005. The Credit Agreement was amended to revise the calculation of the fixed charge coverage ratio for the fourth quarter of 2005, decreasing the required ratio of operating income to fixed
charges from 1.2 to 1.0 and increasing the adjusted tangible net worth covenant from approximately $33.5 million to $38.5 million. As of December 31, 2005, the Company was in violation of the fixed charge coverage ratio and the adjusted
tangible net worth ratio. The Company obtained a waiver from the lender for all debt covenant violations through December 31, 2005. On February 15, 2006, the Credit Agreement was amended to establish financial covenants for 2006. The
covenants established a minimum adjusted tangible net worth for each quarter, minimum earnings before tax beginning June 30, 2006, and a fixed charge coverage ratio for the year ending December 31, 2006.

On October 12, 2006, the Company entered into an Amended and Restated Credit Agreement (Amended Credit Agreement) with its lenders. The Amended Credit
Agreement:



| |  |  | extended the maturity date of the Revolving Credit Facility to August 31, 2007,
| | - |  | -------------------------------------------------------------------------------



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| |  |  | maintained the maximum principal amount of the Revolving Credit Facility at $28.0 million, including any unused letters of credit,
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | provided for an increase in the maximum principal amount of the Revolving Credit Facility to $31.0 million if the Company is awarded the new KC-135 contract,
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | provided for an increase in the borrowing base by increasing eligible Work-in-Process Inventory from 50% to 65%,
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | changed the interest rate charged on the Revolving Credit Facility to LIBOR plus 1.5% to 6.0% determined on quarterly earnings before interest, taxes, depreciation and amortization
(EBITDA) as defined in the Amended Credit Agreement, and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | established new debt covenants as follows:
| | - |  | ------------------------------------------



| | iv) | Beginning with the quarter ending December 31, 2006, a fixed charge coverage ratio of not less than 1.0 to 1.0, to be tested at each quarter-end thereafter on a cumulative
basis commencing October 1, 2006 and ending on the last day of the respective quarter-end.
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | v) | At all times, maintain a ratio of adjusted liabilities to adjusted tangible net worth of not more than 2.5 to 1.0.
| | -- | ------------------------------------------------------------------------------------------------------------------



| | vi) | Achieve a cumulative EBITDA of not less than $400,000 for the period from September 1, 2006 to September 30, 2006; $2.85 million for the period from September 1, 2006
to December 31, 2006; $3.75 million for the period from September 1, 2006 to March 31, 2007; and $6.0 million for the period from September 1, 2006 to June 30, 2007.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

There can be no assurances that the Company will achieve all debt covenants or that the availability under the Revolving Credit Facility will be sufficient for its
continuing operations. If the Company violates the debt covenants, all debt may become due and payable. If additional financing is needed, the Companys results of operations in 2006 and 2005 and the lack of a long-term KC-135 contract will
likely make it more difficult and expensive, if not impossible, for the Company to raise additional capital that may be necessary to continue its operations. If the Company cannot raise adequate funds on acceptable terms, the business could be
materially harmed.

The Companys Amended Credit Agreement Restricts Its Financial and Operational Flexibility and the Company Has Violated Certain
Financial Covenants Under the Previous Credit Agreement.

Our Amended Credit Agreement contains covenants that restrict, among other things, our ability
to borrow money, make particular types of investments, sell assets, merge or consolidate, or make acquisitions. Our Amended Credit Agreement also requires us to maintain specified financial ratios. Our ability to meet these financial ratios can be
affected by events beyond our control, and there can be no assurance that we will be able to meet these ratios. For the six months ended June 30, 2006, the Company violated a debt covenant under the previous Credit Agreement requiring the
Company to achieve income before income taxes of $1.0 million. Our ability to meet current and future payment obligations is dependent upon our ability to improve operating performance, obtain additional financing from current or alternative
lenders, or a combination of the above items. The lenders waived all defaults of debt covenants through June 30, 2006. There can be no assurances that the Company will achieve all debt covenants or that the availability under the Revolving
Credit Facility will be sufficient. If the Company violates the debt covenants, all debt may become due and payable.

On February 15, 2006, we entered
into a note purchase agreement with Silver Canyon, pursuant to which we issued to Silver Canyon a senior secured note in the principal amount of $5.0 million. The note with Silver Canyon is subordinate to any debt incurred by us under the revolving
credit facility with Wachovia and Compass. The note contains customary events of default consistent with the defined events of default established by the thirteenth amendment of the Credit Agreement with Wachovia and Compass on February 15,
2006. The payment of all outstanding principal, interest and other amounts owing under the note may be declared immediately due and payable upon the occurrence of an event of default, subject to certain standstill provisions with Wachovia and
Compass. We may be unable to locate other lenders at comparable interest rates if an event of default occurs. On July 31, 2006, the Senior Secured Debt was purchased by the Special Value Bond Fund, LLC, which is managed by Tennenbaum Capital
Partners, LLC, a related party of the Company.



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We have also pledged substantially all of our assets to secure the debt under our Amended Credit Agreement with Wachovia
and Compass and the subordinated debt with Silver Canyon. If the amounts outstanding under the Amended Credit Agreement or the Note were accelerated, the lenders could proceed against those assets. Any event of default, therefore, could have a
material adverse effect on our business and impair the value of our Common Stock.

Item 6. Exhibits



|              |  |                                                                                                                         
|------------- |  | ------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                             
|31.1          |  | Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                               
|              | 
|32.1          |  | Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Company has duly caused
this Report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                         |  |                            |  |                                          
|------------------------ |  | -------------------------- |  | -----------------------------------------
|                         |  | PEMCO AVIATION GROUP, INC.
|                         |  |                           
|Dated: November 14, 2006 |  | By:                        |  | /s/ Ronald A. Aramini                    
|                         |  |                            |  | Ronald A. Aramini, President             
|                         |  |                            |  | and Chief Executive Officer              
|                         |  |                            |  | (Principal Executive Officer)            
|                         |  |                           
|Dated: November 14, 2006 |  | By:                        |  | /s/ Randall C. Shealy                    
|                         |  |                            |  | Randall C. Shealy, Sr. Vice President and
|                         |  |                            |  | Chief Financial Officer                  
|                         |  |                            |  | (Principal Finance Officer)