##### Table of Contents

---

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---

FORM 10-Q



---



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

For the Quarterly Period Ended June 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



---

PEMCO
AVIATION GROUP, INC.

(Exact name of registrant as specified in its charter)



---



|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|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 August 10, 2006
|Common Stock, $.0001 par value |  | 4,126,200                     



---



---

##### Table of Contents

INDEX

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES



|                              |  |                                                                                                  |  |     
|----------------------------- |  | ------------------------------------------------------------------------------------------------ |  | ----
|                              |  |                                                                                                  |  | PAGE
|PART I. FINANCIAL INFORMATION |  |                                                                                                 
|                              |  |                                                                                                 
|Item 1.                       |  | Financial Statements (Unaudited)                                                                 |  | 1   
|                              |  |                                                                                                 
|                              |  | Consolidated Balance SheetsJune 30, 2006 (Unaudited) and December 31, 2005                       |  | 2   
|                              |  |                                                                                                 
|                              |  | Unaudited Consolidated Statements of OperationsFor The Three Months Ended June 30, 2006 and 2005 |  | 3   
|                              |  |                                                                                                 
|                              |  | Unaudited Consolidated Statements of OperationsFor The Six Months ended June 30, 2006 and 2005   |  | 4   
|                              |  |                                                                                                 
|                              |  | Unaudited Consolidated Statements of Cash FlowsFor The Six Months ended June 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            |  | 20  
|                              |  |                                                                                                 
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                                       |  | 31  
|                              |  |                                                                                                 
|Item 4.                       |  | Controls and Procedures                                                                          |  | 31  
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                                 
|                              |  |                                                                                                 
|Item 1.                       |  | Legal Proceedings                                                                                |  | 33  
|                              |  |                                                                                                 
|Item 1A.                      |  | Risk Factors                                                                                     |  | 33  
|                              |  |                                                                                                 
|Item 3.                       |  | Defaults upon Senior Securities                                                                  |  | 38  
|                              |  |                                                                                                 
|Item 4.                       |  | Submission of Matters to a Vote of Security Holders                                              |  | 38  
|                              |  |                                                                                                 
|Item 6.                       |  | Exhibits                                                                                         |  | 39  
|                              | 
|SIGNATURES                    |  | 40                                                                                              



---

##### Table of Contents

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

(In Thousands)



|                                               |  |              |         |   |                  |   |         |  
|---------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                               |  | June 30,2006 |         |   | December 31,2005 |  
|                                               |  | Unaudited    |         |   |                  |  
|Current assets:                                |  |              |         |   |                  |   |         |  
|Cash and cash equivalents                      |  | $            | 93      |   |                  | $ | 26      |  
|Accounts receivable, net                       |  |              | 28,043  |   |                  |   | 20,852  |  
|Inventories, net                               |  |              | 17,589  |   |                  |   | 20,953  |  
|Deferred income taxes                          |  |              | 3,310   |   |                  |   | 4,083   |  
|Prepaid expenses and other                     |  |              | 1,568   |   |                  |   | 1,925   |  
|                                               |  |              |         |   |                  |   |         |  
|Total current assets                           |  |              | 50,603  |   |                  |   | 47,839  |  
|                                               |  |              |         |   |                  |   |         |  
|Machinery, equipment and improvements at cost: |  |              |         |   |                  |   |         |  
|Machinery and equipment                        |  |              | 34,738  |   |                  |   | 34,154  |  
|Leasehold improvements                         |  |              | 30,412  |   |                  |   | 29,975  |  
|Construction-in-process                        |  |              | 597     |   |                  |   | 265     |  
|                                               |  |              |         |   |                  |   |         |  
|                                               |  |              | 65,747  |   |                  |   | 64,394  |  
|Less accumulated depreciation and amortization |  |              | (41,378 | ) |                  |   | (39,392 | )
|                                               |  |              |         |   |                  |   |         |  
|Net machinery, equipment and improvements      |  |              | 24,369  |   |                  |   | 25,002  |  
|                                               |  |              |         |   |                  |   |         |  
|Other non-current assets:                      |  |              |         |   |                  |   |         |  
|Deposits and other                             |  |              | 2,677   |   |                  |   | 2,322   |  
|Deferred income taxes                          |  |              | 11,493  |   |                  |   | 11,042  |  
|Related party receivable                       |  |              | 513     |   |                  |   | 503     |  
|Intangible pension asset                       |  |              | 8,476   |   |                  |   | 8,476   |  
|Intangible assets, net                         |  |              | 187     |   |                  |   | 104     |  
|                                               |  |              |         |   |                  |   |         |  
|                                               |  |              | 23,346  |   |                  |   | 22,447  |  
|                                               |  |              |         |   |                  |   |         |  
|Total assets                                   |  | $            | 98,318  |   |                  | $ | 95,288  |  
|                                               |  |              |         |   |                  |   |         |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



1



---

##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

LIABILITIES AND STOCKHOLDERS EQUITY

(In Thousands, Except Common Share Information)



|                                                                                                                                                        |  |              |         |   |                  |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                        |  | June 30,2006 |         |   | December 31,2005 |  
|                                                                                                                                                        |  | Unaudited    |         |   |                  |  
|Current liabilities:                                                                                                                                    |  |              |         |   |                  |   |         |  
|Current portion of long-term debt                                                                                                                       |  | $            | 31,537  |   |                  | $ | 25,126  |  
|Current portion of pension liability                                                                                                                    |  |              | 11,019  |   |                  |   | 11,019  |  
|Accounts payable - trade                                                                                                                                |  |              | 12,138  |   |                  |   | 12,058  |  
|Accrued health and dental                                                                                                                               |  |              | 979     |   |                  |   | 1,158   |  
|Accrued liabilities - payroll related                                                                                                                   |  |              | 6,258   |   |                  |   | 5,724   |  
|Accrued liabilities - other                                                                                                                             |  |              | 4,343   |   |                  |   | 4,855   |  
|Customer deposits in excess of cost                                                                                                                     |  |              | 3,399   |   |                  |   | 6,443   |  
|                                                                                                                                                        |  |              |         |   |                  |   |         |  
|Total current liabilities                                                                                                                               |  |              | 69,673  |   |                  |   | 66,383  |  
|                                                                                                                                                        |  |              |         |   |                  |   |         |  
|Long-term debt, less current portion                                                                                                                    |  |              | 1,969   |   |                  |   | 1,973   |  
|Long-term pension benefit liability                                                                                                                     |  |              | 11,151  |   |                  |   | 13,139  |  
|Other long-term liabilities                                                                                                                             |  |              | 2,627   |   |                  |   | 2,254   |  
|                                                                                                                                                        |  |              |         |   |                  |   |         |  
|Total liabilities                                                                                                                                       |  |              | 85,420  |   |                  |   | 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, 4,123,485 and 4,113,659 outstanding at June 30, 2006 and December 31,
2005, respectively |  |              | 1       |   |                  |   | 1       |  
|Additional paid-in capital                                                                                                                              |  |              | 14,023  |   |                  |   | 13,188  |  
|Retained earnings                                                                                                                                       |  |              | 29,418  |   |                  |   | 28,894  |  
|Treasury stock, at cost  413,398 shares at June 30, 2006 and December 31, 2005, respectively                                                           |  |              | (8,623  | ) |                  |   | (8,623  | )
|Accumulated other comprehensive loss: Minimum pension liability                                                                                         |  |              | (21,921 | ) |                  |   | (21,921 | )
|                                                                                                                                                        |  |              |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                              |  |              | 12,898  |   |                  |   | 11,539  |  
|                                                                                                                                                        |  |              |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                              |  | $            | 98,318  |   |                  | $ | 95,288  |  
|                                                                                                                                                        |  |              |         |   |                  |   |         |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



2



---

##### 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 EndedJune 30, 2006 |        |   | ThreeMonths EndedJune 30, 2005 |  
|Net sales                                    |  | $                              | 49,647 |   |                                | $ | 38,599 |  
|Cost of sales                                |  |                                | 42,955 |   |                                |   | 33,633 |  
|                                             |  |                                |        |   |                                |   |        |  
|Gross profit                                 |  |                                | 6,692  |   |                                |   | 4,966  |  
|                                             |  |                               
|Selling, general and administrative expenses |  |                                | 5,731  |   |                                |   | 5,728  |  
|Reversal of provision for doubtful accounts  |  |                                | (638   | ) |                                |   |       |  
|                                             |  |                                |        |   |                                |   |        |  
|Income/(loss) from operations                |  |                                | 1,599  |   |                                |   | (762   | )
|                                             |  |                               
|Other income                                 |  |                                |       |   |                                |   | 650    |  
|Interest expense                             |  |                                | (854   | ) |                                |   | (466   | )
|                                             |  |                                |        |   |                                |   |        |  
|Income/(loss) before income taxes            |  |                                | 745    |   |                                |   | (578   | )
|Income tax expense/(benefit)                 |  |                                | 300    |   |                                |   | (210   | )
|                                             |  |                                |        |   |                                |   |        |  
|Net income/(loss)                            |  | $                              | 445    |   |                                | $ | (368   | )
|                                             |  |                                |        |   |                                |   |        |  
|Net income/(loss) per common share:          |  |                                |        |   |                                |   |        |  
|Basic                                        |  | $                              | 0.11   |   |                                | $ | (0.09  | )
|Diluted                                      |  | $                              | 0.10   |   |                                | $ | (0.09  | )
|                                             |  |                               
|Weighted average common shares outstanding:  |  |                                |        |   |                                |   |        |  
|Basic                                        |  |                                | 4,121  |   |                                |   | 4,105  |  
|Diluted                                      |  |                                | 4,252  |   |                                |   | 4,105  |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



3



---

##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

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



|                                             |  |                              |        |   |                              |   |        |  
|-------------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | - | ------ | -
|                                             |  | SixMonths EndedJune 30, 2006 |        |   | SixMonths EndedJune 30, 2005 |  
|Net sales                                    |  | $                            | 87,290 |   |                              | $ | 82,647 |  
|Cost of sales                                |  |                              | 73,781 |   |                              |   | 69,497 |  
|                                             |  |                              |        |   |                              |   |        |  
|Gross profit                                 |  |                              | 13,509 |   |                              |   | 13,150 |  
|                                             |  |                             
|Selling, general and administrative expenses |  |                              | 11,762 |   |                              |   | 11,533 |  
|Reversal of provision for doubtful accounts  |  |                              | (638   | ) |                              |   |       |  
|                                             |  |                              |        |   |                              |   |        |  
|Income from operations                       |  |                              | 2,385  |   |                              |   | 1,617  |  
|                                             |  |                             
|Other income                                 |  |                              |       |   |                              |   | 650    |  
|Interest expense                             |  |                              | (1,509 | ) |                              |   | (908   | )
|                                             |  |                              |        |   |                              |   |        |  
|Income before income taxes                   |  |                              | 876    |   |                              |   | 1,359  |  
|Income tax expense                           |  |                              | 352    |   |                              |   | 568    |  
|                                             |  |                              |        |   |                              |   |        |  
|Net income                                   |  | $                            | 524    |   |                              | $ | 791    |  
|                                             |  |                              |        |   |                              |   |        |  
|Net income per common share:                 |  |                              |        |   |                              |   |        |  
|Basic                                        |  | $                            | 0.13   |   |                              | $ | 0.19   |  
|Diluted                                      |  | $                            | 0.12   |   |                              | $ | 0.18   |  
|                                             |  |                             
|Weighted average common shares outstanding:  |  |                              |        |   |                              |   |        |  
|Basic                                        |  |                              | 4,120  |   |                              |   | 4,105  |  
|Diluted                                      |  |                              | 4,300  |   |                              |   | 4,389  |  

The accompanying notes are an integral part

of these audited consolidated financial statements.



4



---

##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                                                            |  |                              |        |   |                              |   |        |  
|------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | - | ------ | -
|                                                                                            |  | SixMonths EndedJune 30, 2006 |        |   | SixMonths EndedJune 30, 2005 |  
|Cash flows from operating activities:                                                       |  |                              |        |   |                              |   |        |  
|Net income                                                                                  |  | $                            | 524    |   |                              | $ | 791    |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Adjustments to reconcile net income to net cash (used in)/provided by operating activities: |  |                              |        |   |                              |   |        |  
|Depreciation and amortization of machinery, equipment and leasehold improvements            |  |                              | 1,917  |   |                              |   | 1,714  |  
|Amortization of intangible assets                                                           |  |                              | 136    |   |                              |   | 19     |  
|Provision for deferred income taxes                                                         |  |                              | 352    |   |                              |   | 568    |  
|Funding over pension cost                                                                   |  |                              | (1,988 | ) |                              |   | (1,702 | )
|Reversal of provision for doubtful accounts                                                 |  |                              | (638   | ) |                              |   |       |  
|Loss on disposals of machinery and equipment                                                |  |                              | 2      |   |                              |   | 79     |  
|Provision for losses on contracts-in-process                                                |  |                              | (2,958 | ) |                              |   | 1,920  |  
|Stock based compensation                                                                    |  |                              | 710    |   |                              |   |       |  
|Realized gain on deferred compensation plan investments                                     |  |                              |       |   |                              |   | (340   | )
|Changes in assets and liabilities:                                                          |  |                              |        |   |                              |   |        |  
|Accounts receivable, trade                                                                  |  |                              | (6,553 | ) |                              |   | 13,507 |  
|Inventories                                                                                 |  |                              | 6,407  |   |                              |   | (7,454 | )
|Prepaid expenses and other                                                                  |  |                              | 357    |   |                              |   | (202   | )
|Deposits and other                                                                          |  |                              | (365   | ) |                              |   | (315   | )
|Customer deposits in excess of cost                                                         |  |                              | (3,044 | ) |                              |   | 4,656  |  
|Accounts payable and accrued liabilities                                                    |  |                              | 295    |   |                              |   | (7,265 | )
|                                                                                            |  |                              |        |   |                              |   |        |  
|Total adjustments                                                                           |  |                              | (5,370 | ) |                              |   | 5,185  |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Net cash (used in)/provided by operating activities                                         |  |                              | (4,846 | ) |                              |   | 5,976  |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Cash flows from investing activities:                                                       |  |                              |        |   |                              |   |        |  
|Capital expenditures                                                                        |  |                              | (1,371 | ) |                              |   | (1,532 | )

The accompanying notes are an integral part

of these audited consolidated financial statements.



5



---

##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                    |  |                              |       |   |                              |   |        |  
|--------------------------------------------------- |  | ---------------------------- | ----- | - | ---------------------------- | - | ------ | -
|                                                    |  | SixMonths EndedJune 30, 2006 |       |   | SixMonths EndedJune 30, 2005 |  
|Cash flows from financing activities:               |  |                              |       |   |                              |   |        |  
|Proceeds from exercise of stock options             |  |                              | 95    |   |                              |   | 39     |  
|Net change under revolving credit facility          |  |                              | 2,270 |   |                              |   | (6,602 | )
|Principal payments under long-term debt             |  |                              | (863  | ) |                              |   | (515   | )
|Borrowings under long-term debt                     |  |                              | 5,000 |   |                              |   |       |  
|Payment of debt issuance costs                      |  |                              | (218  | ) |                              |   | (2     | )
|                                                    |  |                              |       |   |                              |   |        |  
|Net cash provided by/(used in) financing activities |  |                              | 6,284 |   |                              |   | (7,080 | )
|                                                    |  |                              |       |   |                              |   |        |  
|Net change in cash and cash equivalents             |  |                              | 67    |   |                              |   | (2,806 | )
|                                                    |  |                              |       |   |                              |   |        |  
|Cash and cash equivalents, beginning of period      |  |                              | 26    |   |                              |   | 3,354  |  
|                                                    |  |                              |       |   |                              |   |        |  
|Cash and cash equivalents, end of period            |  | $                            | 93    |   |                              | $ | 548    |  
|                                                    |  |                              |       |   |                              |   |        |  
|Supplemental disclosure of cash flow information:   |  |                              |       |   |                              |   |        |  
|Cash paid/(received) during the period for:         |  |                              |       |   |                              |   |        |  
|Interest                                            |  | $                            | 1,264 |   |                              | $ | 908    |  
|                                                    |  |                              |       |   |                              |   |        |  
|Income taxes                                        |  | $                            | (301  | ) |                              | $ | 115    |  
|                                                    |  |                              |       |   |                              |   |        |  

The accompanying notes are an integral part

of these unaudited consolidated financial statements.



6



---

##### Table of Contents

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of and for the Quarters Ended

June 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 June 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
in the six month period ended June 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 Option Plan (defined below),
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 income (loss) per share calculations for the three-month
and six-month periods ended June 30, 2006 and 2005:

(All numbers in thousands, except income per share)



|                                    |  |                                |       |                                |   |       |                              |  |                              |       |  |   |      
|----------------------------------- |  | ------------------------------ | ----- | ------------------------------ | - | ----- | ---------------------------- |  | ---------------------------- | ----- |  | - | -----
|                                    |  | ThreeMonths EndedJune 30, 2006 |       | ThreeMonths EndedJune 30, 2005 |   |       | SixMonths EndedJune 30, 2006 |  | SixMonths EndedJune 30, 2005
|Net income (loss)                   |  | $                              | 445   |                                | $ | (368  | )                            |  | $                            | 524   |  | $ | 791  
|Weighted average shares             |  |                                | 4,121 |                                |   | 4,105 |                              |  |                              | 4,120 |  |   | 4,105
|Basic net income (loss) per share   |  | $                              | 0.11  |                                | $ | (0.09 | )                            |  | $                            | 0.13  |  | $ | 0.19 
|Dilutive securities                 |  |                                | 131   |                                |   |      |                              |  |                              | 180   |  |   | 284  
|Diluted weighted average shares     |  |                                | 4,252 |                                |   | 4,105 |                              |  |                              | 4,300 |  |   | 4,389
|Diluted net income (loss) per share |  | $                              | 0.10  |                                | $ | (0.09 | )                            |  | $                            | 0.12  |  | $ | 0.18 

Options to purchase 763,206 and 465,333 shares of Common Stock related to the three months ended
June 30, 2006 and 2005, respectively, and options to purchase 558,881 and 272,333 shares of Common Stock related to the six months ended June 30, 2006 and 2005, respectively, were excluded from the computation of diluted net income (loss)
per share because the option exercise price was greater than the average market price of the shares.



7



---

##### Table of Contents

4.STOCK OPTIONS

On May 14, 2003, the Companys stockholders approved amendments to the Companys Nonqualified 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 330,000 at June 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.



8



---

##### Table of Contents

The following table summarizes stock option activity for the six months ended June 30, 2006:



|                                    |  |                |   |  |                                         |      
|----------------------------------- |  | -------------- | - |  | --------------------------------------- | -----
|                                    |  | Shares         |   |  | Weighted averageexercise price pershare
|                                    |  | (In Thousands) |   |  |                                        
|Outstanding as of December 31, 2005 |  | 1,054          |   |  | $                                       | 20.42
|Granted                             |  | 79             |   |  |                                         | 17.42
|Exercised                           |  | (10            | ) |  |                                         | 9.70 
|Forfeited/Expired                   |  | (30            | ) |  |                                         | 27.57
|                                    |  |                |   |  |                                         |      
|Outstanding as of June 30, 2006     |  | 1,093          |   |  |                                         | 20.11
|                                    |  |                |   |  |                                         |      
|Exercisable as of June 30, 2006     |  | 1,023          |   |  | $                                       | 19.80
|                                    |  |                |   |  |                                         |      

The weighted average remaining term for outstanding stock options was 6.14 years at June 30,
2006. The aggregate intrinsic value at June 30, 2006 was approximately $336,000 for stock options outstanding and $336,000 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 $95,000 and $41,000 during the first six months of 2006 and 2005, respectively. The intrinsic value related to the exercise of stock options was approximately $78,000 during the first six 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 $710,000 and $0 for the first six months of
fiscal 2006 and 2005, respectively.



9



---

##### Table of Contents

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)



|                                                                    |  |                              |      |  
|------------------------------------------------------------------- |  | ---------------------------- | ---- | -
|                                                                    |  | SixMonths EndedJune 30, 2005 |     
|Net income  as reported                                            |  | $                            | 791  |  
|Stock based compensation under fair value method, net of tax effect |  |                              | (555 | )
|                                                                    |  |                              |      |  
|Net income  pro forma                                              |  | $                            | 236  |  
|                                                                    |  |                              |      |  
|Net income per share, basic  as reported                           |  | $                            | 0.19 |  
|                                                                    |  |                              |      |  
|Net income per share, diluted  as reported                         |  | $                            | 0.18 |  
|                                                                    |  |                              |      |  
|Net income per share, basic  pro forma                             |  | $                            | 0.06 |  
|                                                                    |  |                              |      |  
|Net income per share, diluted  pro forma                           |  | $                            | 0.05 |  
|                                                                    |  |                              |      |  

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 binominal method and the following weighted-average assumptions:



|                        |  |               |  |      
|----------------------- |  | ------------- |  | -----
|                        |  | 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 will
be 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 June 30,
2006, approximately $516,000 of unrecognized stock compensation related to unvested awards (net of estimated forfeitures) is expected to be recognized over a weighted-average period of 1.1 years.



10



---

##### Table of Contents

5.INVENTORIES

Inventories as of June 30, 2006 and December 31, 2005 consist of the following:

(In Thousands)



|                                              |  |              |         |   |                  |   |         |  
|--------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                              |  | June 30,2006 |         |   | December 31,2005 |  
|Work in process                               |  | $            | 24,589  |   |                  | $ | 24,805  |  
|Finished goods                                |  |              | 1,768   |   |                  |   | 2,542   |  
|Raw materials and supplies                    |  |              | 12,897  |   |                  |   | 12,752  |  
|                                              |  |              |         |   |                  |   |         |  
|Total                                         |  |              | 39,254  |   |                  |   | 40,099  |  
|Less reserves for obsolete inventory          |  |              | (4,771  | ) |                  |   | (3,977  | )
|Less milestone payments and customer deposits |  |              | (16,894 | ) |                  |   | (15,169 | )
|                                              |  |              |         |   |                  |   |         |  
|                                              |  | $            | 17,589  |   |                  | $ | 20,953  |  
|                                              |  |              |         |   |                  |   |         |  

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.

6.DEBT

Debt as of June 30, 2006 and December 31, 2005 consists of the following:

(In Thousands)



|                                                                                                                 |  |              |         |   |                  |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                                                                                 |  | June 30,2006 |         |   | December 31,2005 |  
|Revolving Credit Facility; interest at LIBOR plus 2.75%(7.86% at June 30, 2006)                                  |  | $            | 23,770  |   |                  | $ | 21,500  |  
|Bank Term Loan; interest at LIBOR plus 3.00%(8.11% at June 30, 2006)                                             |  |              | 1,500   |   |                  |   | 2,000   |  
|Treasury Stock Term Loan; interest at LIBOR plus 3.00%(8.11% at June 30, 2006)                                   |  |              | 1,078   |   |                  |   | 1,437   |  
|Airport Authority Term Loan; interest at BMA plus 0.36%(4.08% at June 30, 2006)                                  |  |              | 2,140   |   |                  |   | 2,140   |  
|Senior Secured Note; interestfixed at 15%                                                                        |  |              | 5,000   |   |                  |   |        |  
|Capital Lease Obligations; interest from 5.0% to 11.0%, collateralized by security interest in certain equipment |  |              | 18      |   |                  |   | 22      |  
|                                                                                                                 |  |              |         |   |                  |   |         |  
|Total long-term debt                                                                                             |  |              | 33,506  |   |                  |   | 27,099  |  
|Less portion reflected as current                                                                                |  |              | (31,537 | ) |                  |   | (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



11



---

##### Table of Contents

adjusted the maturity dates and commitment levels. 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 to October 15, 2006 and to reduce the commitment amount to $28.0 million. The
Revolving Credit Facility bears interest 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 (7.86% at June 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 $23.8 million outstanding under the Revolving Credit Facility at June 30, 2006. The Company is actively discussing the refinance of this facility. There is no assurance that it will conclude such
refinance.

The Bank Term Loan has a term of five years and bears interest at LIBOR plus 2.25% to 3.00% (8.11% at June 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 original principal amount of $5.0 million is payable in 60 monthly installments of
$83,333 plus interest, which began on January 31, 2003.

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) through May 22, 2005. The Treasury Stock Term Loan bears interest at LIBOR plus 3.00% (8.11% at June 30, 2006). The
Company had an outstanding balance under the Treasury Stock Term Loan at June 30, 2006 of $1.1 million. The loan is payable in equal monthly installments over 31 months, which began on May 22, 2005.

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% (4.08 % at June 30, 2006). The amount outstanding under the Airport Authority Term Loan at June 30, 2006 was $2.1 million and is payable in 14 annual installments of approximately $180,000, which began on September 30,
2004. 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 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 by Silver Canyon 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 June 30, 2006, over the next five years and in the aggregate thereafter are as follows:

(In Thousands)



|           |  |   |       
|---------- |  | - | ------
|Current    |  | $ | 31,537
|1-3 years  |  |   | 370   
|3-5 years  |  |   | 360   
|Thereafter |  |   | 1,239 
|           |  |   |       
|           |  | $ | 33,506
|           |  |   |       



12



---

##### Table of Contents

A significant portion (over $28.0 million) of the 2006 maturity of debt listed above relates to the
scheduled expiration of the Revolving Credit Facility on October 15, 2006. The Company has contacted other lenders about obtaining additional financing. There can be no assurances that the maturity date of the Revolving Credit Facility will be
extended or additional financing will be obtained. If additional financing is obtained, the Company may elect to pay down the facility prior to the scheduled maturity.

Our negative results of operations in 2005 and the lack of a long-term KC-135 contract will likely make it more difficult and expensive for the Company to raise additional capital that may be necessary to continue our
operations. If the Company cannot raise adequate funds on acceptable terms, the business could be materially harmed.

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. 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 new 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.

The Company was not in compliance with the minimum earnings before tax covenant as of June 30, 2006 and no waiver of default has been obtained. As a result, our lenders may request payment of all debts
outstanding at any time. The Company is continuing to work with the lenders on a waiver and an extension of the maturity date. The Company also has contacted other lenders about obtaining additional financing. If the Company is unable to obtain
additional financing, extend the Credit Agreement or comply with the covenants in the future and the lenders do not grant waivers, the outstanding borrowings under the Credit Agreement may continue to be immediately due and payable and certain
interest rates will increase.

7.STOCKHOLDERS EQUITY

Holders of stock options under the Companys Option Plan exercised options for 2,999 and 2,200 shares, respectively, of the Companys Common
Stock during the three months ended June 30, 2006 and 2005. The Company recorded the exercise price of the options, net of any tax benefit, totaling approximately $33,000 and $44,000, respectively, to Additional Paid-In Capital during the
second quarter of 2006 and 2005 relating to these exercises.



13



---

##### Table of Contents

8. DEFERRED COMPENSATION PLAN

The Company has a deferred compensation arrangement for its Chief Executive Officer, which 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 securities, and do not include Company Common Stock. During the first quarter of 2005, the Company liquidated the assets in the rabbi
trust 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
resulted 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 six months ended June 30, 2005. The fair market values of the assets in the rabbi trust at June 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 plan were $2.4 million and $2.0 million at June 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 EndedJune 30, 2006 |        |   | ThreeMonths EndedJune 30, 2005 |   |        | SixMonths EndedJune 30, 2006 |  |   | SixMonths EndedJune 30, 2005 |  
|Service cost                       |  | $                              | 728    |   |                                | $ | 660    |                              |  | $ | 1,457                        |   |  | $ | 1,320  |  
|Interest cost                      |  |                                | 1,870  |   |                                |   | 1,774  |                              |  |   | 3,739                        |   |  |   | 3,548  |  
|Expected return on plan assets     |  |                                | (2,266 | ) |                                |   | (2,218 | )                            |  |   | (4,532                       | ) |  |   | (4,436 | )
|Amortization of prior service cost |  |                                | 314    |   |                                |   | 151    |                              |  |   | 628                          |   |  |   | 302    |  
|Amortization of net loss           |  |                                | 611    |   |                                |   | 506    |                              |  |   | 1,222                        |   |  |   | 1,012  |  
|                                   |  |                                |        |   |                                |   |        |                              |  |   |                              |   |  |   |        |  
|Net pension cost                   |  | $                              | 1,257  |   |                                | $ | 873    |                              |  | $ | 2,514                        |   |  | $ | 1,746  |  
|                                   |  |                                |        |   |                                |   |        |                              |  |   |                              |   |  |   |        |  

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.



14



---

##### Table of Contents

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 46% and 43% of the Companys total revenues during the six-month periods ended June 30, 2006 and 2005,
respectively. The Companys two largest programs generated approximately 57% and 70% of its revenues during the second quarters of 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 contracts when they expire, could have a material adverse effect on the Companys business, financial position or results of
operations. The Company is submitting 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.

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 and trial has been set for
October 30, 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.



15



---

##### Table of Contents

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 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 have agreed to mediation which is to take place August 30 and 31, 2006. 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 June 30, 2006. The Company recorded liabilities of approximately $100,000 related to the Phase II Plan at both June 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



16



---

##### Table of Contents

(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 the that paint chips were
disposed of by the contract services provider, Philips Service Company, beginning in 1997. Philips Service Company filed for bankruptcy in 2003. 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). GSS, located in Birmingham, Alabama, provides aircraft maintenance and modification services for government and military customers. 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. 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 not material. 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. CSS and MCS may generate revenues from governmental entities or programs and GSS may generate revenues from commercial entities.



17



---

##### Table of Contents

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

(In Thousands)



|                                          |  |     |        |   |     |   |        |  |              |       |  |   |        |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ |  | ------------ | ----- |  | - | ------ | -
|Three Months Ended June 30, 2006          |  | GSS |        |   | CSS |   | MCS    |  | Consolidated |      
|Revenues from external domestic customers |  | $   | 24,538 |   |     | $ | 15,849 |  | $            | 3,998 |  | $ | 44,385 |  
|Revenues from external foreign customers  |  |     |       |   |     |   | 5,049  |  |              | 213   |  |   | 5,262  |  
|Inter-company revenues                    |  |     | 101    |   |     |   | 11     |  |              | 62    |  |   | 174    |  
|                                          |  |     |        |   |     |   |        |  |              |       |  |   |        |  
|Total segment revenues                    |  |     | 24,639 |   |     |   | 20,909 |  |              | 4,273 |  |   | 49,821 |  
|Elimination                               |  |     |        |   |     |   |        |  |              |       |  |   | (174   | )
|                                          |  |     |        |   |     |   |        |  |              |       |  |   |        |  
|Total revenue                             |  |     |        |   |     |   |        |  |              |       |  | $ | 49,647 |  
|                                          |  |     |        |   |     |   |        |  |              |       |  |   |        |  
|Gross profit                              |  | $   | 2,348  |   |     | $ | 3,131  |  | $            | 1,213 |  | $ | 6,692  |  
|Segment operating income                  |  |     | (109   | ) |     |   | 1,450  |  |              | 258   |  |   | 1,599  |  
|Other income                              |  |     |        |   |     |   |        |  |              |       |  |   |       |  
|Interest expense                          |  |     |        |   |     |   |        |  |              |       |  |   | (854   | )
|Income tax expense                        |  |     |        |   |     |   |        |  |              |       |  |   | (300   | )
|                                          |  |     |        |   |     |   |        |  |              |       |  |   |        |  
|Net income                                |  |     |        |   |     |   |        |  |              |       |  | $ | 445    |  
|                                          |  |     |        |   |     |   |        |  |              |       |  |   |        |  
|Assets                                    |  |     | 50,855 |   |     |   | 37,989 |  |              | 9,474 |  | $ | 98,318 |  
|Depreciation/amortization                 |  |     | 465    |   |     |   | 422    |  |              | 93    |  |   | 980    |  
|Capital additions                         |  |     | 579    |   |     |   | 37     |  |              | 7     |  |   | 623    |  



|                                          |  |     |        |   |     |   |        |  |   |              |   |  |   |        |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ |  | - | ------------ | - |  | - | ------ | -
|Three Months Ended June 30, 2005          |  | GSS |        |   | CSS |   | MCS    |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 19,196 |   |     | $ | 13,390 |  | $ | 4,064        |   |  | $ | 36,650 |  
|Revenues from external foreign customers  |  |     |       |   |     |   | 1,775  |  |   | 174          |   |  |   | 1,949  |  
|Inter-company revenues                    |  |     |       |   |     |   | 718    |  |   | (2           | ) |  |   | 716    |  
|                                          |  |     |        |   |     |   |        |  |   |              |   |  |   |        |  
|Total segment revenues                    |  |     | 19,196 |   |     |   | 15,883 |  |   | 4,236        |   |  |   | 39,315 |  
|Elimination                               |  |     |        |   |     |   |        |  |   |              |   |  |   | (716   | )
|                                          |  |     |        |   |     |   |        |  |   |              |   |  |   |        |  
|Total revenue                             |  |     |        |   |     |   |        |  |   |              |   |  | $ | 38,599 |  
|                                          |  |     |        |   |     |   |        |  |   |              |   |  |   |        |  
|Gross profit                              |  | $   | 1,613  |   |     | $ | 2,307  |  | $ | 1,046        |   |  | $ | 4,966  |  
|Segment operating income (loss)           |  |     | (1,025 | ) |     |   | 179    |  |   | 84           |   |  |   | (762   | )
|Other income                              |  |     |        |   |     |   |        |  |   |              |   |  |   | 650    |  
|Interest expense                          |  |     |        |   |     |   |        |  |   |              |   |  |   | (466   | )
|Income tax benefit                        |  |     |        |   |     |   |        |  |   |              |   |  |   | 210    |  
|                                          |  |     |        |   |     |   |        |  |   |              |   |  |   |        |  
|Net loss                                  |  |     |        |   |     |   |        |  |   |              |   |  | $ | (368   | )
|                                          |  |     |        |   |     |   |        |  |   |              |   |  |   |        |  
|Assets                                    |  | $   | 52,289 |   |     | $ | 37,925 |  | $ | 6,089        |   |  | $ | 96,303 |  
|Depreciation/amortization                 |  |     | 400    |   |     |   | 388    |  |   | 39           |   |  |   | 827    |  
|Capital additions                         |  |     | 275    |   |     |   | 82     |  |   | 179          |   |  |   | 536    |  



18



---

##### Table of Contents

The following table presents information about segment profit or loss for the six months ended June 30, 2006 and
2005:

(In Thousands)



|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|----------------------------------------- |  | --- | ------ | --- | - | ------ |  | ------------ | ----- |  | - | ------ | -
|Six Months Ended June 30, 2006            |  | GSS |        | CSS |   | MCS    |  | Consolidated |      
|Revenues from external domestic customers |  | $   | 46,568 |     | $ | 26,373 |  | $            | 7,477 |  | $ | 80,418 |  
|Revenues from external foreign customers  |  |     |       |     |   | 6,566  |  |              | 306   |  |   | 6,872  |  
|Inter-company revenues                    |  |     | 101    |     |   | 24     |  |              | 273   |  |   | 398    |  
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Total segment revenues                    |  |     | 46,669 |     |   | 32,963 |  |              | 8,056 |  |   | 87,688 |  
|Elimination                               |  |     |        |     |   |        |  |              |       |  |   | (398   | )
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Total revenue                             |  |     |        |     |   |        |  |              |       |  | $ | 87,290 |  
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Gross profit                              |  | $   | 5,270  |     | $ | 5,929  |  | $            | 2,310 |  | $ | 13,509 |  
|Segment operating income                  |  |     | 637    |     |   | 1,676  |  |              | 72    |  |   | 2,385  |  
|Other income                              |  |     |        |     |   |        |  |              |       |  |   |       |  
|Interest expense                          |  |     |        |     |   |        |  |              |       |  |   | (1,509 | )
|Income tax expense                        |  |     |        |     |   |        |  |              |       |  |   | (352   | )
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Net income                                |  |     |        |     |   |        |  |              |       |  | $ | 524    |  
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Assets                                    |  |     | 50,855 |     |   | 37,989 |  |              | 9,474 |  | $ | 98,318 |  
|Depreciation/amortization                 |  |     | 863    |     |   | 862    |  |              | 192   |  |   | 1,917  |  
|Capital additions                         |  |     | 1,178  |     |   | 151    |  |              | 42    |  |   | 1,371  |  



|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|----------------------------------------- |  | --- | ------ | --- | - | ------ |  | ------------ | ----- |  | - | ------ | -
|Six Months Ended June 30, 2005            |  | GSS |        | CSS |   | MCS    |  | Consolidated |      
|Revenues from external domestic customers |  | $   | 40,661 |     | $ | 30,501 |  | $            | 7,250 |  | $ | 78,412 |  
|Revenues from external foreign customers  |  |     |        |     |   | 3,801  |  |              | 434   |  |   | 4,235  |  
|Inter-company revenues                    |  |     |       |     |   | 1,145  |  |              | 106   |  |   | 1,251  |  
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Total segment revenues                    |  |     | 40,661 |     |   | 35,447 |  |              | 7,790 |  |   | 83,898 |  
|Elimination                               |  |     |        |     |   |        |  |              |       |  |   | (1,251 | )
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Total revenue                             |  |     |        |     |   |        |  |              |       |  | $ | 82,647 |  
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Gross profit                              |  | $   | 5,423  |     | $ | 5,423  |  | $            | 2,304 |  | $ | 13,150 |  
|Segment operating income                  |  |     | 528    |     |   | 781    |  |              | 308   |  |   | 1,617  |  
|Other income                              |  |     |        |     |   |        |  |              |       |  |   | 650    |  
|Interest expense                          |  |     |        |     |   |        |  |              |       |  |   | (908   | )
|Income tax expense                        |  |     |        |     |   |        |  |              |       |  |   | (568   | )
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Net income                                |  |     |        |     |   |        |  |              |       |  | $ | 791    |  
|                                          |  |     |        |     |   |        |  |              |       |  |   |        |  
|Assets                                    |  | $   | 52,289 |     | $ | 37,925 |  | $            | 6,089 |  | $ | 96,303 |  
|Depreciation/amortization                 |  |     | 792    |     |   | 857    |  |              | 84    |  |   | 1,733  |  
|Capital additions                         |  |     | 1,133  |     |   | 191    |  |              | 208   |  |   | 1,532  |  

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. New 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.



19



---

##### 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 revenue 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 June 30, 2006

Versus three months ended June 30, 2005

The table below presents major highlights from the three months ended June 30, 2006 and 2005.

(In Millions)



|                           |  |      |       |      |   |       |        |  |       |  
|-------------------------- |  | ---- | ----- | ---- | - | ----- | ------ |  | ----- | -
|                           |  | 2006 |       | 2005 |   |       | Change | 
|Revenue                    |  | $    | 49.65 |      | $ | 38.60 |        |  | 28.6  | %
|Gross Profit               |  |      | 6.70  |      |   | 4.97  |        |  | 34.8  | %
|Operating income (loss)    |  |      | 1.60  |      |   | (0.76 | )      |  | 310.5 | %
|Income (loss) before taxes |  |      | 0.75  |      |   | (0.58 | )      |  | 229.3 | %
|Net income (loss)          |  |      | 0.45  |      |   | (0.37 | )      |  | 221.6 | %
|EBITDA                     |  |      | 2.58  |      |   | 0.72  |        |  | 258.3 | %

EBITDA for the quarters ended June 30, 2006 and 2005 was calculated using the following approach:

(In Millions)



|                              |  |      |      |      |   |       |  
|----------------------------- |  | ---- | ---- | ---- | - | ----- | -
|                              |  | 2006 |      | 2005 |  
|Net income (loss)             |  | $    | 0.45 |      | $ | (0.37 | )
|Interest                      |  |      | 0.85 |      |   | 0.47  |  
|Taxes                         |  |      | 0.30 |      |   | (0.21 | )
|Depreciation and Amortization |  |      | 0.98 |      |   | 0.83  |  
|                              |  |      |      |      |   |       |  
|EBITDA                        |  | $    | 2.58 |      | $ | 0.72  |  
|                              |  |      |      |      |   |       |  

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 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



20



---

##### Table of Contents

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 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 June 30, 2006 and
2005.

(In Millions)



|             |  |      |       |   |      |   |       |        |  |          |       |  |      |  
|------------ |  | ---- | ----- | - | ---- | - | ----- | ------ |  | -------- | ----- |  | ---- | -
|             |  | 2006 |       |   | 2005 |   |       | Change |  | % Change |      
|GSS          |  | $    | 24.64 |   |      | $ | 19.20 |        |  | $        | 5.44  |  | 28.3 | %
|CSS          |  |      | 20.91 |   |      |   | 15.88 |        |  |          | 5.03  |  | 31.7 | %
|MCS          |  |      | 4.27  |   |      |   | 4.24  |        |  |          | 0.03  |  | 0.7  | %
|Eliminations |  |      | (0.17 | ) |      |   | (0.72 | )      |  |          | 0.55  |  |      |  
|             |  |      |       |   |      |   |       |        |  |          |       |  |      |  
|Total        |  | $    | 49.65 |   |      | $ | 38.60 |        |  | $        | 11.05 |  | 28.6 | %
|             |  |      |       |   |      |   |       |        |  |          |       |  |      |  

The Companys mix of business between government and commercial customers was approximately 44% commercial
and 56% government in the second quarter of 2006 and 43% commercial and 57% government in the second quarter of 2005.

GSS revenue increased $5.4 million
due to the delivery of two additional KC-135 aircraft pursuant to a contract with the U.S. Air Force and the delivery of one P-3 aircraft under a contract with the U.S. Navy, offset by a reduction in revenue under a contract with the U.S. Coast
Guard. GSS delivered one additional aircraft under the KC-135 Programmed Depot Maintenance (PDM) in the second quarter of 2006 compared to the second quarter of 2005 and one additional KC-135 unscheduled depot level maintenance
(UDLM) in the second quarter of 2006 resulting in a revenue increase of $7.0 million. The first P-3 aircraft for the U.S. Navy was delivered in the second quarter of 2006 and generated additional revenue of $1.0 million. The termination
of the Coast Guard contract resulted in a revenue decrease of $3.0 million versus the second quarter of 2005. In addition, non-routine services performed under the C-130 U.S. Air Force UDLM contract generated an additional $0.4 million of revenue
during the second quarter of 2006.

CSS revenue for the quarter ended June 30, 2006 increased approximately 32%, or $5.0 million, from the quarter
ended June 30, 2005. For the three-month period ended June 30, 2006, delivery of two cargo conversions generated $6.3 million of additional revenue whereas the second quarter of 2005 included no revenue from cargo conversions. Offsetting
the increase in cargo conversion revenue was a decrease in maintenance, repair and overhaul (MRO) revenue of $1.3 million, or 8%, for the three months ended June 30, 2006, when compared to the second quarter 2005.

MCS revenue for the three months ended June 30, 2006 was consistent with that of the same three-month period of 2005. Revenue at Pemco Engineers related to sales of
high precision machined parts and other aircraft components remained relatively flat during the second quarter of 2006 compared to the second quarter of 2005. Revenue at Space Vector related to both the government launch vehicle program and related
engineering design services, which also remained flat during the second quarter of 2006, as compared to the same period of 2005.

Consolidated cost of
sales increased $9.3 million, or 27.7%, to $43.0 million during the second quarter of 2006 as a result of the higher revenue base. As a percentage of revenue, quarter-to-date cost of sales at June 30, 2006 was 86.5% compared to 87.1% during the
second quarter of 2005. Cost of sales at GSS decreased from 91.6% of revenue to 90.5% of revenue primarily due to losses recorded on the U.S. Coast Guard contract during the second quarter of 2005. Cost of sales at CSS decreased from 85.5% of
revenue to 85.0% of revenue primarily due to better profit margins on cargo conversion deliveries and a $0.4 million positive adjustment in the estimated cost to settle the Falcon Air claim due to additional regulatory approval issued during the
second quarter of 2006. Cost of sales at MCS decreased slightly from $3.2 million to $3.1 million.



21



---

##### Table of Contents

Selling, General and Administrative (SG&A) expenses remained consistent at $5.7 million for each of the
second quarters of 2006 and 2005. Expense reductions during the second quarter of 2006 were offset by additional stock-based compensation expenses during the second quarter.

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

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.
Interest expense increased $0.4 million due to increases in the total debt outstanding and increases in variable interest rates on debt compared to the second quarter of 2005.

Six months ended June 30, 2006

Versus six months ended June 30, 2005

The table below presents major highlights from the six months ended June 30, 2006 and 2005.

(In Millions)



|                    |  |      |       |      |   |        |  |       |   
|------------------- |  | ---- | ----- | ---- | - | ------ |  | ----- | --
|                    |  | 2006 |       | 2005 |   | Change | 
|Revenue             |  | $    | 87.29 |      | $ | 82.65  |  | 5.6   | % 
|Gross Profit        |  |      | 13.51 |      |   | 13.15  |  | 2.7   | % 
|Operating income    |  |      | 2.39  |      |   | 1.62   |  | 47.5  | % 
|Income before taxes |  |      | 0.88  |      |   | 1.36   |  | (35.3 | %)
|Net income          |  |      | 0.52  |      |   | 0.79   |  | (34.2 | %)
|EBITDA              |  |      | 4.30  |      |   | 4.00   |  | 7.5   | % 

EBITDA for the six months ended June 30, 2006 and 2005 was calculated using
the following approach:

(In Millions)



|                              |  |      |      |      |   |     
|----------------------------- |  | ---- | ---- | ---- | - | ----
|                              |  | 2006 |      | 2005
|Net income                    |  | $    | 0.52 |      | $ | 0.79
|Interest                      |  |      | 1.51 |      |   | 0.91
|Taxes                         |  |      | 0.35 |      |   | 0.57
|Depreciation and Amortization |  |      | 1.92 |      |   | 1.73
|                              |  |      |      |      |   |     
|EBITDA                        |  | $    | 4.30 |      | $ | 4.00
|                              |  |      |      |      |   |     



22



---

##### Table of Contents

The table below presents the highlights in revenue by operating segment from the six months ended June 30, 2006 and
2005.

(In Millions)



|             |  |      |       |   |      |   |       |        |  |   |          |   |  |      |   
|------------ |  | ---- | ----- | - | ---- | - | ----- | ------ |  | - | -------- | - |  | ---- | --
|             |  | 2006 |       |   | 2005 |   |       | Change |  |   | % Change |  
|GSS          |  | $    | 46.67 |   |      | $ | 40.66 |        |  | $ | 6.01     |   |  | 14.8 | % 
|CSS          |  |      | 32.96 |   |      |   | 35.45 |        |  |   | (2.49    | ) |  | (7.0 | %)
|MCS          |  |      | 8.06  |   |      |   | 7.79  |        |  |   | 0.27     |   |  | 3.5  | % 
|Eliminations |  |      | (0.40 | ) |      |   | (1.25 | )      |  |   | 0.85     |   |  |      |   
|             |  |      |       |   |      |   |       |        |  |   |          |   |  |      |   
|Total        |  | $    | 87.29 |   |      | $ | 82.65 |        |  | $ | 4.64     |   |  | 5.6  | % 
|             |  |      |       |   |      |   |       |        |  |   |          |   |  |      |   

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 six months of 2006 and 46% commercial and 54% government in the first six months of 2005.

GSS revenue increased $6.0 million for the six-month period ended June 30, 2006 versus the six-month period ended June 30, 2005. Revenue under the KC-135 PDM contract increased $5.4 million in 2006 compared
to 2005 due to additional material sales of $2.0 million and an increase in revenue from non-routine services due to a reduction in flow days for aircraft under this program. The P-3 aircraft program, which began in the fourth quarter of 2005,
generated additional revenue of $1.2 million. The first P-3 aircraft for the U.S. Navy was delivered in the second quarter of 2006. The termination of the Coast Guard contract resulted in a revenue decrease of $0.9 million versus the first six
months of 2005, due to lower non-routine services performed during 2006.

CSS revenue decreased $2.5 million in 2006 as compared to the first six months of
2005. The decrease was caused by a reduction in MRO revenues during the first six months of 2006. MRO revenue for the six months ended June 30, 2006 decreased $6.5 million. Revenue from the largest customer of CSS decreased $12.0 million, which
decrease was partially offset by additional revenue from new customers of approximately $5.5 million. The delivery of one additional cargo conversion during 2006, as compared to 2005, produced an additional $3.4 million in revenue. The decreases
were further offset by $0.8 million of revenue related to settlement of the H3 Request for Equitable Adjustment (REA) claim described in Note 10 of the Financial Statements.

Revenue at MCS increased 3.5% in the first half of 2006 versus the first half of 2005. Pemco Engineers revenue decreased $0.4 million as shipments of aircraft cargo system parts were lower when compared to the
first six months of 2005. Revenues at Space Vector Corporation increased $0.5 million due to billing adjustments on U.S. government launch vehicle programs.

Consolidated cost of sales increased $4.3 million to $73.8 million during the six-month period ended June 30, 2006, as a result of the higher revenue base. As a percent of revenue, cost of sales for the first six months of 2006 was
84.5%, compared to 84.1% during 2005. Cost of sales at GSS increased from 86.7% of revenue to 88.7% of revenue primarily due to losses recorded on the U.S. Navy P-3 contract of $0.5 million and losses recorded for non-routine services performed
under C-130 U.S. Air Force UDLM contract of $0.8 million. Cost of sales at CSS decreased from 84.7% of revenue to 82.0% of revenue primarily due to better profit margins on cargo conversion deliveries and a $0.4 million positive adjustment in the
estimated cost to settle the Falcon Air claim due to additional regulatory approval issued during the second quarter of 2006. Cost of sales at MCS decreased from 73.7% of revenue to 71.3% of revenue primarily due to an increase in revenue at Space
Vector and a decrease in revenue at Pemco Engineers. Historically, profit margins have been greater at Space Vector than at Pemco Engineers.

SG&A
expenses increased $0.2 million, or 2.0%, to $11.8 million during the first six months of 2006. As a percentage of sales, SG&A expenses decreased to 13.5% in 2006 from 14.0% in 2005, primarily as a result of increased revenue and expense
controls implemented, offset by stock-based compensation expense recorded in 2006.

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



23



---

##### Table of Contents

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. Interest expense increased $0.6 million due to increases in the total debt outstanding and increases in variable interest rates on debt compared to the second quarter of 2005.

LIQUIDITY AND CAPITAL RESOURCES

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

(In Thousands except, debt to equity)



|                                                                |  |              |         |   |                  |   |         |        |  |   |       |  
|--------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | ------ |  | - | ----- | -
|                                                                |  | June 30,2006 |         |   | December 31,2005 |   |         | Change | 
|Cash and cash equivalents                                       |  | $            | 93      |   |                  | $ | 26      |        |  | $ | 67    |  
|Working capital                                                 |  |              | (18,619 | ) |                  |   | (18,544 | )      |  |   | (75   | )
|Current portion of long-term debt and capital lease obligations |  |              | 31,537  |   |                  |   | 25,126  |        |  |   | 6,411 |  
|Long-term debt and capital lease obligations                    |  |              | 1,969   |   |                  |   | 1,973   |        |  |   | (4    | )
|Stockholders equity                                            |  |              | 12,898  |   |                  |   | 11,539  |        |  |   | 1,359 |  
|Debt to equity                                                  |  |              | 2.60    |   |                  |   | 2.35    |        |  |   | 0.25  |  

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 as of June 30, 2006 and December 31, 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 December 31, 2005. The defaults of debt covenants as of June 30, 2006 have not been waived. In addition, our lenders have not extended the October 15, 2006 Revolving Credit Facility maturity date. As a result, our lenders may
request payment of all debts outstanding at any time. The Company is continuing to work with the lenders on a waiver and an extension of the maturity date. The Company also has contacted other lenders about obtaining additional financing. In
addition, there can be no assurances that the maturity date of the Revolving Credit Facility will be extended or additional financing will be obtained. In addition, there can be no assurances that our operating performance will continue to improve,
and we may require additional capital to meet our operating needs. We will continue to monitor our financial results and liquidity position and, if necessary, implement further reductions in expenses and capital expenditures. Our negative results of
operations in 2005 and the lack of a long-term KC-135 contract will likely make it more difficult and expensive for the Company to raise additional capital that may be necessary to continue our operations.

Cash Flow Overview

Operating activities used $4.8 million of cash
during the six months ended June 30, 2006 and provided $6.0 million of cash during the same period of 2005. Cash of $1.4 million and $1.5 million was used during the six-month period ended June 30, 2006 and 2005, respectively, for capital
expenditures. The Company contributed $4.5 million and $3.5 million during the first two quarters of 2006 and 2005, respectively, to fund its pension plan. The Company used $0.9 million and $0.5 million, respectively, during the six-month period
ended June 30, 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



24



---

##### Table of Contents

loan (the Revolving Credit Facility and Bank Term Loan, respectively). The Company borrowed $2.3
million under the Revolving Credit Facility during the first six months of 2006 and used $6.6 million during the first six 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 six 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 six months of 2005, the decrease in accounts receivable provided $13.5 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 $4.5 million through June 30, 2006.

Current maturities of debt at June 30, 2006 and December 31, 2005 totaled $31.5 million and $25.1 million, respectively. As discussed more extensively below, current maturities of debt at December 31,
2005 and June 30, 2006 included all amounts owed under the Revolving Credit Facility due to the expiration of the Credit Agreement on October 15, 2006.

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 improvement contingent upon winning the KC-135 contract recompete and
achieving other required benchmarks. At June 30, 2006, the Company had approximately $0.6 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 $2.5 to $3.5 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 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.



25



---

##### Table of Contents

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. During the first and second quarters of 2005 and the fourth quarter of 2004, the Company violated the fixed charge coverage ratio covenant under the Revolving Credit Facility due to quarterly losses incurred by
the Company during 2005 and 2004. 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 lenders 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 using annualized 2005 results
instead of 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 lenders 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, to decrease the required
ratio of operating income to fixed charges from 1.2 to 1.0 and to increase 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 lenders 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 new 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. The Company was not in compliance with the minimum earnings before tax covenant as of June 30, 2006 and no waiver of default has been obtained. As a result, our lenders may request payment of all debts outstanding at any time. The Company
is continuing to work with the lenders on a waiver and an extension of the maturity date. The Company also has contacted other lenders about obtaining additional financing. If the Company is unable to obtain additional financing, extend the Credit
Agreement or comply with the covenants in the future and the lenders do not grant waivers, the outstanding borrowings under the Credit Agreement may continue to be immediately due and payable and certain interest rates will increase.

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 June 30, 2006 of $1.5 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% (8.11% at June 30, 2006). The Company had an outstanding balance under the Treasury Stock Term Loan at June 30, 2006 of $1.1 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 4.08% at June 30, 2006. The Company had an outstanding
balance under the Airport Authority Term Loan at June 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



26



---

##### Table of Contents

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 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 Silver Canyon 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 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 June 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% 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.



27



---

##### Table of Contents

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.

The 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 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.



28



---

##### Table of Contents

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, discussions 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
that 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.



29



---

##### Table of Contents

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 workers 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 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 June 30, 2006 and December 31, 2005:

(In Thousands)



|                |  |              |        |                  |   |       
|--------------- |  | ------------ | ------ | ---------------- | - | ------
|Customer Type   |  | June 30,2006 |        | December 31,2005
|U.S. Government |  | $            | 39,351 |                  | $ | 45,536
|Commercial      |  |              | 25,971 |                  |   | 24,620
|                |  |              |        |                  |   |       
|Total           |  | $            | 65,322 |                  | $ | 70,156
|                |  |              |        |                  |   |       

The $6.2 million reduction in government backlog was related to decreases at both GSS and MCS. GSS backlog
decreased $4.7 million when compared to the December 31, 2005, balance due primarily to fewer KC-135 aircraft in work and the termination of the Coast Guard C-130 program. GSS backlog at June 30, 2006 was positively impacted by $3.8
million related to the addition of seven P-3 aircraft versus $1.9 million in backlog at December 31, 2005. Backlog in government programs at MCS related to U.S. government launch vehicle programs decreased by $1.4 million from December 31,
2005.



30



---

##### Table of Contents

Total commercial backlog increased $1.4 million. The increase is related directly to a $1.4 million increase in orders at
MCS for high precision machined parts, other aircraft components and engineering services. CSS backlog at June 30, 2006 remained comparable to that as of December 31, 2005, with relatively no change.

Overall, the mix of backlog shifted from 65% U.S. Government and 35% commercial at December 31, 2005, to 60% U.S. Government and 40% commercial at June 30,
2006. The shift to commercial from U.S. Government resulted primarily from the decrease in backlog at GSS 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 uncertainties, there are 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 (7.86% at June 30, 2006). Each of the term loans under the Credit Agreement bears interest at LIBOR plus 300 basis points (8.11% at June 30, 2006). The Airport Authority Term Loan bears interest at BMA plus 36 basis
points (4.08% at June 30, 2006). Had the interest rate of the variable rate debt increased 100 basis points, net income would have decreased by approximately $142,000 during the first six 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.



31



---

##### Table of Contents

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 June 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 June 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 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.



32



---

##### Table of Contents

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 June 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

RISK FACTORS THAT MAY AFFECT FUTURE PERFORMANCE

You should carefully consider the following risk factors, in addition to the other information contained in this report, in your evaluation of us, and our financial
condition. Numerous risk factors, including potentially the risk factors described in this section, could cause material harm to the Companys business and impair the value of its Common Stock.

The Company is Heavily Dependent on U.S. Government Contracts.

Approximately 61%, 68% and 69% of our revenues in 2005, 2004 and 2003, respectively, were derived from U.S. Government contracts. U.S. Government contracts expose us to a number of risks, including:



| |  |  | Unpredictable contract or project terminations,
| | - |  | -----------------------------------------------



| |  |  | Reductions in government funds available for our projects due to government policy changes, budget cuts and contract adjustments,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | Disruptions in scheduled workflow due to untimely delivery of equipment and components necessary to perform government contracts,
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------



| |  |  | Penalties arising from post award contract audits, and
| | - |  | ------------------------------------------------------



| |  |  | Final cost audits in which the value of our contracts may be reduced and may take a substantial number of years to be completed.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------

In addition, substantially all of our government backlog scheduled for delivery can be terminated at the convenience of the U.S. Government since orders are often placed
well before delivery, and our contracts typically provide that orders may be terminated with limited or no penalties. If we are unable to address any of the above risks, our business could be materially harmed and the value of our Common Stock could
be impaired.

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 (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. Pemco intends to submit a proposal as a prime contractor for



33



---

##### Table of Contents

the KC-135 PDM program. Proposals are due in September 2006 and the Company expects an award announcement in late 2006 or early 2007.

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

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. 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 Faces Risks from Downturns in
the Domestic and Global Economies.

The domestic and global economies have experienced downturns that have had significant effects on markets that we
serve, particularly the airline industry. We cannot predict the depth or duration of such downturns, and our ability to increase or maintain our revenues and operating results may be impaired as a result of negative general economic conditions.

Further, because current domestic and global economic conditions and economies are extremely uncertain, it is difficult to estimate the growth in various
parts of the economy, including the markets in which we participate. Because parts of our budgeting and forecasting are reliant on estimates of growth in the markets we serve, the current economic uncertainty renders estimates of future revenues and
expenditures even more difficult than usual to formulate. The future direction of the overall domestic and global economies could have a significant impact on our overall financial performance and impair the value of our Common Stock.

The Companys Markets are Highly Competitive and Some of its Competitors Have Greater Resources than the Company.

The aircraft maintenance and modification services industry is highly competitive, and we expect that the competition will continue to intensify. Some of our competitors
are larger and more established companies with strategic advantages, including greater financial resources and greater name recognition. In addition, we are facing increased competition from entities located outside of the United States and entities
that are affiliated with commercial airlines. Our competition for military aircraft maintenance includes Boeing Aerospace Support Center, Lockheed-Martin Aircraft and Logistics Center, L-3 Communications, and various military depots. Our competition
for outsourced commercial work in the United States consists of the Goodrich Airframe Services Division, Timco Aviation Services, and Singapore Technologies (which includes Mobile Aerospace Engineering, San Antonio Aerospace, and Dalfort Aerospace).
If we are unable to compete effectively against any of these entities it could materially harm our business and impair the value of our Common Stock.

Expansion Into International Markets May Expose the Company to Greater Risks.

Our continuing efforts to increase revenue and improve
operating results and stockholder value includes seeking sales opportunities in international markets. During 2005 and 2004, foreign sales comprised 4% and 3% of total revenues, respectively, though such sales could comprise an increasingly larger
percentage of revenues in the future. We believe there are a number of factors inherent in these markets that may expose us to significantly greater risk than domestic markets, including: foreign exchange exposure, local economic and market
conditions, less regulation of patents or other safeguards of intellectual property, potential political unrest, difficulty in collecting receivables, and inability to rely on local government aid to enforce standard business practices. These
factors, or others we have not currently identified, could materially harm our business and impair the value of our Common Stock.



34



---

##### Table of Contents

The Company is a Party to Legal Proceedings that could be Costly to Resolve.

The Company may be exposed to legal claims relating to the services it provides. The Company is currently a party to several legal proceedings, including breach of
contract claims and claims based on the Companys employment practices. While the Company maintains insurance covering many risks from its business, the insurance may not cover all relevant claims or may not provide sufficient coverage. If the
Companys insurance coverage does not cover all costs resulting from these claims, an adverse determination on these claims could materially harm the Companys business and impair the value of its Common Stock.

The Company Could Incur Significant Costs and Expenses Related to Environmental Problems.

Various federal, state, and local laws and regulations require property owners or operators to pay for the costs of removal or remediation of hazardous or toxic substances located on a property. For example, there are
stringent legal requirements applicable to the stripping, cleaning, and painting of aircraft. We have previously paid penalties to the EPA for violations of these laws and regulations, and we may be required to pay additional penalties or
remediation costs in the future. These laws and regulations also impose liability on persons who arrange for the disposal or treatment of hazardous or toxic substances at another location for the costs of removal or remediation of these hazardous
substances at the disposal or treatment facility. Further, these laws and regulations often impose liability regardless of whether the entity arranging for the disposal ever owned or operated the disposal facility. As operators of properties and as
potential arrangers for hazardous substance disposal, we may be liable under the laws and regulations for removal or remediation costs, governmental penalties, property damage, and related expenses. Payment of any of these costs and expenses could
materially harm our business and impair the value of our Common Stock.

The Company May Not Be Able to Hire and Retain a Sufficient Number of Qualified
Employees.

Our success and growth will depend on our ability to continue to attract and retain skilled personnel. Competition for qualified personnel
in the aircraft maintenance and modification services industry has been intense. Any failure to attract and retain qualified personnel could materially harm our business and impair the value of our Common Stock. Failure to negotiate new collective
bargaining agreements in the future with unionized employees could materially harm our business.

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 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 December 31, 2005. The defaults of debt covenants as of June 30, 2006 have not been waived. In addition, our lenders have not extended the
October 15, 2006 Revolving Credit Facility maturity date. As a result, our lenders may request payment of all debts outstanding at any time. The Company is continuing to work with the lenders on a waiver an extension of the maturity date. The
Company also has contacted other lenders about obtaining additional financing. There can be no assurances that the maturity date of the Revolving Credit Facility will be extended or additional financing will be obtained. In addition, there can be no
assurances that our operating performance will continue to improve, and we may require additional capital to meet our operating needs. Our negative results of operations in 2005 and the lack of a long-term KC-135 contract will likely make it more
difficult and expensive for the Company to raise additional capital that may be necessary to continue our operations.

We cannot provide assurance that, if
we need to raise additional funds, such funds will be available on favorable terms, or at all. If we cannot raise adequate funds on acceptable terms, our business could be materially harmed and the value of our Common Stock impaired.

Failure to Introduce New Services in Response to Technological Advances and Evolving Industry Standards Could Materially Harm the Companys Business.

Evolving industry standards and changing customer requirements characterize the aircraft maintenance and modification services industry. The
introduction of new aircraft embodying new technologies and the emergence of new industry standards could render our existing services obsolete and cause us to incur significant development and labor costs. Failure to introduce new services and
enhancements to our existing services in response to changing market conditions or customer requirements could materially harm our business and impair the value of our Common Stock.



35



---

##### Table of Contents

The Companys Trust for its Defined Benefit Plan is Under-Funded and Subject to Financial Market Forces.

We maintain the Plan, which covers substantially all employees at our 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 during 2001 and 2002, partially offset by favorable returns in 2003, 2004 and 2005, coupled with an increase in actuarial liability resulting from lower interest rates and the terms of new collective bargaining agreements entered into in
2005, the Plan was under-funded by approximately $26.3 million at December 31, 2005. Any further losses on the Plans assets may lead to an increase in the amount of the shortfall. In 2006, we expect that the minimum required
contribution will be approximately $11.0 million. Unless and until the Plan under-funding is remedied sufficiently, the making of minimum required contributions may adversely affect our liquidity and cash flow, which could materially harm our
business and impair the value of our Common Stock. On August 3, 2006, the United States Congress passed the Pension Protection Act of 2006 (Act) which significantly alters pension funding rules in the future. The Act is expected to
become law and is awaiting approval by the President of the United States. The Company is in the process of evaluating the impact of the Act on future funding of its defined benefit plan.

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

Our 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 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 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 December 31, 2005. The defaults of debt covenants as of June 30, 2006 have not been waived. In addition, our lenders have not extended the October 15, 2006 Revolving Credit Facility maturity date. As a result, our lenders may
request payment of all debts outstanding at any time. The Company is continuing to work with the lenders on a waiver and an extension of the maturity date. The Company also has contacted other lenders about obtaining additional financing. If the
Company is unable to obtain additional financing, extend the Credit Agreement or comply with the covenants in the future and the lenders do not grant waivers, the outstanding borrowings under the Credit Agreement may continue to be immediately due
and payable and certain interest rates will increase, which could materially harm our business and impair the value of our Common Stock.

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 by Silver Canyon 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 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.

We have also pledged substantially all of our assets to secure
the debt under our Credit Agreement with Wachovia and Compass and the subordinated debt with Silver Canyon. If the amounts outstanding under the Credit Agreement or the note with Silver Canyon 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.



36



---

##### Table of Contents

The Company Faces Potential Product Liability Claims.

We may be exposed to legal claims relating to the products we sells or the services we provide. Our agreements with our customers generally contain terms designed to
limit our exposure to potential product liability claims. We also maintain a product liability insurance policy for our business. However, our insurance may not cover all relevant claims or may not provide sufficient coverage. If our insurance
coverage does not cover all costs resulting from future product liability claims, these claims could materially harm our business and impair the value of our Common Stock.

The Companys Business Is Subject to Extensive Government Regulation.

The aircraft maintenance and modification
services industry is subject to extensive regulatory and legal compliance requirements that result in significant costs. The FAA from time to time issues directives and other regulations relating to the maintenance and modification of aircraft that
require significant expenditures. Regulatory changes could materially harm our business by making our current services less attractive or obsolete, or increasing the opportunity for additional competition. Changes in, or the failure to comply with,
applicable regulations could materially harm our business and impair the value of our Common Stock.

The Company Has Implemented Anti-Takeover
Provisions that Could Prevent an Acquisition of Its Business at a Premium Price.

Some of the provisions of our certificate of incorporation and bylaws
could discourage, delay or prevent an acquisition of our business at a premium price. These provisions:



| |  |  | permit the Board of Directors to increase its own size and fill the resulting vacancies,
| | - |  | ----------------------------------------------------------------------------------------



| |  |  | provide for a board comprised of three classes of directors with each class serving a staggered three-year term,
| | - |  | ----------------------------------------------------------------------------------------------------------------



| |  |  | authorize the issuance of preferred stock in one or more series, and
| | - |  | --------------------------------------------------------------------



| |  |  | prohibit stockholder action by written consent.
| | - |  | -----------------------------------------------

In addition,
Section 203 of the Delaware General Corporation Law imposes restrictions on mergers and other business combinations between us and any holder of 15% or more of our Common Stock.

Compliance with Changing Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations, and Nasdaq Stock Market rules have led to increased administrative costs. We are
committed to maintaining high standards of corporate governance and public disclosure. As a result, we believe that we have invested and will continue to invest reasonably necessary resources to comply with evolving standards, and this investment
may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities, which could harm our business and impair the value of our Common Stock.

Insiders Have Substantial Control over the Company and Can Significantly Influence Matters Requiring Stockholder Approval.

As of December 31, 2005, our executive officers, directors, and affiliates, in the aggregate, beneficially owned approximately 49.8% of our outstanding Common Stock.
As a result, these stockholders are able to significantly influence matters requiring approval by our stockholders, including the election of directors and the approval of mergers or other business combination transactions. This control may have the
effect of deterring hostile takeovers, delaying or preventing changes in control or changes in management, or limiting the ability of our other stockholders to approve transactions that they may deem to be in their best interests.

The Company Has Material Weaknesses in Its Internal Control over Financial Reporting.

During the audit of the 2003 financial statements, our then independent registered public accounting firm identified the following reportable conditions that together constituted a material weakness in internal
control over financial reporting:



| |  |  | lack of appropriate analysis and support for revenue recognition matters,
| | - |  | -------------------------------------------------------------------------



37



---

##### Table of Contents

| |  |  | 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,
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | lack of appropriate analysis and support for inventory accounting matters, and
| | - |  | ------------------------------------------------------------------------------



| |  |  | lack of appropriate analysis and support for the reconciliation of inter-company transactions.
| | - |  | ----------------------------------------------------------------------------------------------

Additionally, during the audit of the 2004 financial statements, our independent registered public accounting firm identified the following material weaknesses in internal control over financial reporting:



| |  |  | lack of appropriate controls to timely record liabilities for services performed in 2004 for which the invoices were not processed at December 31, 2004,
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | lack of appropriate analysis and support for inventory matters,
| | - |  | ---------------------------------------------------------------



| |  |  | lack of appropriate analysis and support for payroll accruals,
| | - |  | --------------------------------------------------------------



| |  |  | lack of adequate evaluation of leasehold improvements placed in service from 1982 to 2001, and
| | - |  | ----------------------------------------------------------------------------------------------



| |  |  | lack of segregation of duties related to system access controls.
| | - |  | ----------------------------------------------------------------

During
the audit of the 2005 financial statements, our independent registered public accounting firm identified the following material weaknesses in internal control over financial reporting:



| |  |  | significant deficiencies in the posting of physical inventory results and in adherence with our inventory costing methodology resulted in a material weakness in controls over
inventory at the Pemco Aeroplex subsidiary, and
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the process for determining adequate information with regards to estimating costs to complete certain contracts for the purpose of projecting losses on contracts was insufficient.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Although we have taken and are continuing to undertake a number of initiatives to address these material weaknesses, the existence of a
material weakness is an indication that there is more than a remote likelihood that a material misstatement of our financial statements will not be prevented or detected in the current or any future period. In addition, we may in the future identify
other material weaknesses or significant deficiencies in our internal control over financial reporting that we have not discovered to date.

Furthermore,
Section 404 of the Sarbanes-Oxley Act of 2002, with which we must comply in 2007, requires our auditors to audit both the design and operating effectiveness of our internal controls and managements assessment of the design and the
effectiveness of our internal controls. If we are unable to remediate all material weaknesses in sufficient time to permit testing of our documentation and remediation efforts relating to these material weaknesses, our auditors may disclaim an
opinion or issue an adverse opinion on the operating effectiveness of our internal controls over financial reporting or on managements assessment of their effectiveness, when Section 404 becomes applicable to us. A disclaimer or an
adverse opinion on our internal controls could materially impair the value of our Common Stock.

Changes in Financial Accounting Standards Related to
Stock Option Expenses May Have a Significant Effect on the Companys Reported Results.

The FASB recently issued a revised standard that requires
that we record compensation expense in the statement of operations for employee stock options using the fair value method. The adoption of the new standard is expected to have a significant effect on our reported earnings, although it will not
affect our cash flows, and could adversely impact our ability to provide accurate guidance on future reported financial results due to the variability of the factors used to establish the value of stock options. As a result, the adoption of the new
standard could impair the value of our Common Stock and result in greater stock price volatility.

Item 3. Defaults upon Senior Securities

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. 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 December 31, 2005. The defaults of debt covenants as of June 30, 2006 have not been waived. In addition, our lenders have
not extended



38



---

##### Table of Contents

the October 15, 2006 Revolving Credit Facility maturity date. As a result, our lenders may request payment of all debts outstanding at any time,
including the Revolving Credit Facility, Bank Term Loan, Treasury Stock Term Loan, and Senior Secured Note. The Company is continuing to work with the lenders on a waiver and an extension of the maturity date. The Company also has contacted other
lenders about obtaining additional financing. There can be no assurances that the maturity date of the Revolving Credit Facility will be extended or additional financing will be obtained. In addition, there can be no assurances that our operating
performance will continue to improve, and we may require additional capital to meet our operating needs. Our negative results of operations in 2005 and the lack of a long-term KC-135 contract will likely make it more difficult and expensive for the
Company to raise additional capital that may be necessary to continue our operations.

Item 4. Submission of Matters to a Vote of Security Holders

The Companys Annual Meeting of Stockholders was held on
May 11, 2006. At the meeting, stockholders elected Robert E. Joyal and Michael E. Tennenbaum as Class III directors to serve until 2009.

The number
of votes cast for or withheld for each director nominee was as follows:



|                      |  |           |  |         
|--------------------- |  | --------- |  | --------
|Nominee               |  | For       |  | Withheld
|Robert E. Joyal       |  | 2,980,670 |  | 16,253  
|Michael E. Tennenbaum |  | 2,981,045 |  | 15,878  

Ronald A. Aramini, Harold T. Skip Bowling and Ronald W. Yates continued in office as members of the
Board of Directors with their terms expiring at the 2007 Annual Meeting of Stockholders. Hugh Steven Wilson was appointed as a member of the Board of Directors on March 13, 2006 after the resignation of Mark K. Holdsworth.
Mr. Wilsons term expires at the 2008 Annual Meeting of Stockholders. Thomas C. Richards continued in office as a member of the Board of Directors, with his term expiring at the 2008 Annual Meeting of Stockholders.

Item 6. Exhibits



|              |  |                                                                                                                         
|------------- |  | ------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                             
|              | 
|31            |  | Certifications Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                               
|              | 
|32            |  | Certifications Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.



39



---

##### Table of Contents

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: August 14, 2006 |  | By:                        |  | /s/ Ronald A. Aramini                                            
|                       |  |                            |  | Ronald A. Aramini, President and Chief Executive
Officer         
|                       |  |                            |  | (Principal Executive Officer)                                    
|                       |  |                           
|Dated: August 14, 2006 |  | By:                        |  | /s/ Randall C. Shealy                                            
|                       |  |                            |  | Randall C. Shealy, Sr. Vice President and Chief
Financial Officer
|                       |  |                            |  | (Principal Financial Officer)                                    



40