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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the Quarterly Period Ended September 30, 2004, or



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



For the Transition Period From  To
.



Commission file number: 0-13829



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PEMCO AVIATION GROUP, INC.

(Exact name of registrant as specified in its charter)



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



|                                           |  |           
|------------------------------------------ |  | ----------
|1943 North 50thStreet, Birmingham,
Alabama |  | 35212     
|(Address of principal executive offices)   |  | (Zip Code)



205-592-0011

(Registrants telephone number, including area code)



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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 registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). ̈Yes    x  No



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



|                               |  |                                 
|------------------------------ |  | --------------------------------
|Class                          |  | Outstanding at November 15, 2004
|Common Stock, $.0001 par value |  | 4,171,743                       



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PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS



ASSETS

(In thousands)



|                                               |  |                              |         |   |                   |   |         |  
|---------------------------------------------- |  | ---------------------------- | ------- | - | ----------------- | - | ------- | -
|                                               |  | September 30, 2004 Unaudited |         |   | December 31, 2003 |  
|Current assets:                                |  |                              |         |   |                   |   |         |  
|Cash                                           |  | $                            | 767     |   |                   | $ | 3,156   |  
|Accounts receivable, net                       |  |                              | 31,549  |   |                   |   | 35,042  |  
|Inventories, net                               |  |                              | 32,887  |   |                   |   | 25,504  |  
|Deferred income taxes                          |  |                              | 7,633   |   |                   |   | 7,223   |  
|Prepaid expenses and other                     |  |                              | 2,275   |   |                   |   | 1,561   |  
|                                               |  |                              |         |   |                   |   |         |  
|Total current assets                           |  |                              | 75,111  |   |                   |   | 72,486  |  
|                                               |  |                              |         |   |                   |   |         |  
|Machinery, equipment and improvements at cost: |  |                              |         |   |                   |   |         |  
|Machinery and equipment                        |  |                              | 34,342  |   |                   |   | 31,536  |  
|Leasehold improvements                         |  |                              | 27,765  |   |                   |   | 27,281  |  
|Construction-in-process                        |  |                              | 265     |   |                   |   | 988     |  
|                                               |  |                              |         |   |                   |   |         |  
|                                               |  |                              | 62,372  |   |                   |   | 59,805  |  
|Less accumulated depreciation and amortization |  |                              | (36,121 | ) |                   |   | (33,864 | )
|                                               |  |                              |         |   |                   |   |         |  
|Net machinery, equipment and improvements      |  |                              | 26,251  |   |                   |   | 25,941  |  
|                                               |  |                              |         |   |                   |   |         |  
|Other non-current assets:                      |  |                              |         |   |                   |   |         |  
|Deposits and other                             |  |                              | 1,880   |   |                   |   | 1,779   |  
|Related party receivable                       |  |                              | 476     |   |                   |   | 460     |  
|Intangible pension asset                       |  |                              | 4,539   |   |                   |   | 4,539   |  
|Intangible assets, net                         |  |                              | 153     |   |                   |   | 217     |  
|                                               |  |                              |         |   |                   |   |         |  
|                                               |  |                              | 7,048   |   |                   |   | 6,995   |  
|                                               |  |                              |         |   |                   |   |         |  
|Total assets                                   |  | $                            | 108,410 |   |                   | $ | 105,422 |  
|                                               |  |                              |         |   |                   |   |         |  



The accompanying notes
are an integral part of these consolidated statements.



Page 2



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

LIABILITIES AND STOCKHOLDERS EQUITY

(In thousands, except common share information)



|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ---------------------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                             |  | September 30, 2004 Unaudited |         |   | December 31, 2003 |  
|Current liabilities:                                                                                                                                         |  |                              |         |   |                   |   |         |  
|Current portion of long-term debt                                                                                                                            |  | $                            | 1,221   |   |                   | $ | 1,255   |  
|Current portion of pension liability                                                                                                                         |  |                              | 8,047   |   |                   |   | 8,612   |  
|Accounts payable                                                                                                                                             |  |                              | 7,456   |   |                   |   | 1,849   |  
|Accounts payable - accrued                                                                                                                                   |  |                              | 5,598   |   |                   |   | 6,696   |  
|Accrued health and dental                                                                                                                                    |  |                              | 1,224   |   |                   |   | 1,141   |  
|Accrued liabilities - payroll related                                                                                                                        |  |                              | 9,986   |   |                   |   | 7,951   |  
|Accrued liabilities - other                                                                                                                                  |  |                              | 5,135   |   |                   |   | 9,210   |  
|Customer deposits in excess of cost                                                                                                                          |  |                              | 4,465   |   |                   |   | 7,679   |  
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|Total current liabilities                                                                                                                                    |  |                              | 43,132  |   |                   |   | 44,393  |  
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|Long-term debt                                                                                                                                               |  |                              | 27,245  |   |                   |   | 20,299  |  
|Long-term pension liability                                                                                                                                  |  |                              | 11,563  |   |                   |   | 15,575  |  
|Other long-term liabilities                                                                                                                                  |  |                              | 2,244   |   |                   |   | 2,180   |  
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|Total liabilities                                                                                                                                            |  |                              | 84,184  |   |                   |   | 82,447  |  
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|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, 4,097,344 and 4,044,164 outstanding at September 30, 2004 and December 31,
2003, respectively |  |                              | 1       |   |                   |   | 1       |  
|Additional paid-in capital                                                                                                                                   |  |                              | 12,690  |   |                   |   | 10,077  |  
|Retained earnings                                                                                                                                            |  |                              | 38,698  |   |                   |   | 38,504  |  
|Treasury stock, at cost  413,398 and 359,723 shares at September 30, 2004 and December 31, 2003, respectively                                               |  |                              | (8,623  | ) |                   |   | (7,043  | )
|Accumulated other comprehensive income (loss)                                                                                                                |  |                              |         |   |                   |   |         |  
|Net unrealized gain on investments                                                                                                                           |  |                              | 164     |   |                   |   | 140     |  
|Minimum pension liability                                                                                                                                    |  |                              | (18,704 | ) |                   |   | (18,704 | )
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|Total stockholders equity                                                                                                                                   |  |                              | 24,226  |   |                   |   | 22,975  |  
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  
|Total liabilities and stockholders equity                                                                                                                   |  | $                            | 108,410 |   |                   | $ | 105,422 |  
|                                                                                                                                                             |  |                              |         |   |                   |   |         |  



The accompanying notes
are an integral part of these consolidated statements.



Page 3



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except net income
per common share information)



|                                              |  |                                      |        |                                      |   |        |  
|--------------------------------------------- |  | ------------------------------------ | ------ | ------------------------------------ | - | ------ | -
|                                              |  | Three Months Ended September 30,2004 |        | Three Months Ended September 30,2003 |  
|Net sales                                     |  | $                                    | 54,911 |                                      | $ | 44,095 |  
|Cost of sales                                 |  |                                      | 45,914 |                                      |   | 31,438 |  
|                                              |  |                                      |        |                                      |   |        |  
|Gross profit                                  |  |                                      | 8,997  |                                      |   | 12,657 |  
|                                              |  |                                     
|Selling, general, and administrative expenses |  |                                      | 8,194  |                                      |   | 6,563  |  
|                                              |  |                                      |        |                                      |   |        |  
|Income from operations                        |  |                                      | 803    |                                      |   | 6,094  |  
|                                              |  |                                     
|Interest                                      |  |                                      | 351    |                                      |   | 224    |  
|Insurance recovery                            |  |                                      |       |                                      |   | (527   | )
|                                              |  |                                      |        |                                      |   |        |  
|Income before income taxes                    |  |                                      | 452    |                                      |   | 6,397  |  
|Income tax expense                            |  |                                      | 174    |                                      |   | 2,430  |  
|                                              |  |                                      |        |                                      |   |        |  
|Net income                                    |  | $                                    | 278    |                                      | $ | 3,967  |  
|                                              |  |                                      |        |                                      |   |        |  
|Net income per common share:                  |  |                                      |        |                                      |   |        |  
|Basic                                         |  | $                                    | 0.07   |                                      | $ | 0.98   |  
|Diluted                                       |  | $                                    | 0.06   |                                      | $ | 0.91   |  
|                                              |  |                                     
|Weighted average common shares outstanding:   |  |                                      |        |                                      |   |        |  
|Basic                                         |  |                                      | 4,138  |                                      |   | 4,043  |  
|Diluted                                       |  |                                      | 4,360  |                                      |   | 4,368  |  



The accompanying notes
are an integral part of these consolidated statements.



Page 4



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except net income
per common share information)



|                                              |  |                                     |         |                                      |   |         |  
|--------------------------------------------- |  | ----------------------------------- | ------- | ------------------------------------ | - | ------- | -
|                                              |  | Nine Months Ended September 30,2004 |         | Nine Months Ended September 30, 2003 |  
|Net sales                                     |  | $                                   | 141,674 |                                      | $ | 127,017 |  
|Cost of sales                                 |  |                                     | 118,084 |                                      |   | 96,735  |  
|                                              |  |                                     |         |                                      |   |         |  
|Gross profit                                  |  |                                     | 23,590  |                                      |   | 30,282  |  
|                                              |  |                                    
|Selling, general, and administrative expenses |  |                                     | 22,423  |                                      |   | 19,189  |  
|                                              |  |                                     |         |                                      |   |         |  
|Income from operations                        |  |                                     | 1,167   |                                      |   | 11,093  |  
|                                              |  |                                    
|Interest                                      |  |                                     | 853     |                                      |   | 673     |  
|Insurance recovery                            |  |                                     |        |                                      |   | (527    | )
|                                              |  |                                     |         |                                      |   |         |  
|Income before income taxes                    |  |                                     | 314     |                                      |   | 10,947  |  
|Income tax expense                            |  |                                     | 121     |                                      |   | 4,158   |  
|                                              |  |                                     |         |                                      |   |         |  
|Net income                                    |  | $                                   | 193     |                                      | $ | 6,789   |  
|                                              |  |                                     |         |                                      |   |         |  
|Net income per common share:                  |  |                                     |         |                                      |   |         |  
|Basic                                         |  | $                                   | 0.05    |                                      | $ | 1.68    |  
|Diluted                                       |  | $                                   | 0.04    |                                      | $ | 1.55    |  
|                                              |  |                                    
|Weighted average common shares outstanding:   |  |                                     |         |                                      |   |         |  
|Basic                                         |  |                                     | 4,083   |                                      |   | 4,041   |  
|Diluted                                       |  |                                     | 4,461   |                                      |   | 4,376   |  



The accompanying notes
are an integral part of these consolidated statements.



Page 5



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)



|                                                                                            |  |                                    |        |   |                                   |   |        |  
|------------------------------------------------------------------------------------------- |  | ---------------------------------- | ------ | - | --------------------------------- | - | ------ | -
|                                                                                            |  | Nine Months EndedSeptember 30,2004 |        |   | NineMonths EndedSeptember 30,2003 |  
|Cash flows from operating activities:                                                       |  |                                    |        |   |                                   |   |        |  
|Net income                                                                                  |  | $                                  | 193    |   |                                   | $ | 6,789  |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Adjustments to reconcile net income to net cash (used in) provided by operating activities: |  |                                    |        |   |                                   |   |        |  
|Depreciation and amortization                                                               |  |                                    | 2,659  |   |                                   |   | 2,761  |  
|Provision for deferred income taxes                                                         |  |                                    | (942   | ) |                                   |   | 4,158  |  
|Funding in excess of pension cost                                                           |  |                                    | (4,577 | ) |                                   |   | (7,882 | )
|Amortization of intangible asset                                                            |  |                                    | 107    |   |                                   |   | 123    |  
|Provision for losses on contracts in process                                                |  |                                    | 2,176  |   |                                   |   | 2,718  |  
|Changes in assets and liabilities:                                                          |  |                                    |        |   |                                   |   |        |  
|Related party receivable                                                                    |  |                                    | (16    | ) |                                   |   | (30    | )
|Accounts receivable, net                                                                    |  |                                    | 3,443  |   |                                   |   | (1,596 | )
|Inventories                                                                                 |  |                                    | (7,383 | ) |                                   |   | (8,476 | )
|Prepaid expenses and other                                                                  |  |                                    | (714   | ) |                                   |   | (742   | )
|Customer deposits in excess of cost                                                         |  |                                    | (3,214 | ) |                                   |   | (3,130 | )
|Deposits and other                                                                          |  |                                    | 375    |   |                                   |   | (260   | )
|Accounts payable and accrued liabilities                                                    |  |                                    | 910    |   |                                   |   | 5,133  |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Total adjustments                                                                           |  |                                    | (7,176 | ) |                                   |   | (7,223 | )
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Net cash (used in) provided by operating activities                                         |  |                                    | (6,983 | ) |                                   |   | (434   | )
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Cash flows from investing activities:                                                       |  |                                    |        |   |                                   |   |        |  
|Capital expenditures                                                                        |  |                                    | (2,967 | ) |                                   |   | (4,072 | )
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Net cash used in investing activities                                                       |  |                                    | (2,967 | ) |                                   |   | (4,072 | )
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Cash flows from financing activities:                                                       |  |                                    |        |   |                                   |   |        |  
|Proceeds from exercise of stock options                                                     |  |                                    | 2,259  |   |                                   |   | 252    |  
|Purchase of treasury stock                                                                  |  |                                    | (1,580 | ) |                                   |   | (255   | )
|Net borrowings under revolving credit facility                                              |  |                                    | 5,889  |   |                                   |   | 3,965  |  
|Borrowings under long-term debt                                                             |  |                                    | 1,767  |   |                                   |   | 395    |  
|Principal payments under long-term debt                                                     |  |                                    | (774   | ) |                                   |   | (833   | )
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Net cash provided by (used in) financing activities                                         |  |                                    | 7,561  |   |                                   |   | 3,524  |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Net decrease in cash                                                                        |  |                                    | (2,389 | ) |                                   |   | (982   | )
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Cash, beginning of period                                                                   |  |                                    | 3,156  |   |                                   |   | 2,795  |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Cash, end of period                                                                         |  | $                                  | 767    |   |                                   | $ | 1,813  |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Supplemental disclosure of cash flow information:                                           |  |                                    |        |   |                                   |   |        |  
|Cash paid during the period for:                                                            |  |                                    |        |   |                                   |   |        |  
|Interest                                                                                    |  | $                                  | 853    |   |                                   | $ | 440    |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  
|Income taxes                                                                                |  | $                                  | 709    |   |                                   | $ |       |  
|                                                                                            |  |                                    |        |   |                                   |   |        |  



The accompanying notes
are an integral part of these consolidated statements.



Page 6



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of and for the Quarters Ended

September 30, 2004 and 2003



1. CONSOLIDATED FINANCIAL STATEMENTS



The interim consolidated financial statements have been prepared by Pemco Aviation Group, Inc. (the Company) following the requirements of the
Securities and Exchange Commission for interim reporting, and are unaudited. In the opinion of management, all adjustments necessary for a fair presentation are reflected in the interim financial statements. Such adjustments are of a normal and
recurring nature. The results of operations for the period ended September 30, 2004 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 2003 Annual Report on Form 10-K.



2. STOCK OPTIONS



The
Company uses the fair value method for stock options granted for services rendered by non-employees in accordance with SFAS No. 123 Accounting for Stock Based Compensation.



The Company uses the intrinsic value method prescribed by Accounting Principles Board Opinion No. 25 Accounting for
Stock Issued to Employees, for stock option grants to individuals defined as employees. Accordingly, no compensation expense is recognized for options granted at or above the fair market value of the underlying stock on the grant date. The
following table illustrates what the effect on net income and earnings per share would have been if the Company had applied the fair value recognition provisions of FASB Statement No. 123 to stock options granted to employees.



Page 7



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(In thousands except per share information)



|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  
|-------------------------------------------------------------------------------------- |  | ----------------------------------- | ---- | - | ----------------------------------- | - | ----- | ---------------------------------- |  | - | ---------------------------------- | - |  | - | ------ | -
|                                                                                       |  | ThreeMonths Ended September 30,2004 |      |   | ThreeMonths Ended September 30,2003 |   |       | NineMonths Ended September 30,2004 |  |   | NineMonths Ended September 30,2003 |  
|Net Income  as reported                                                               |  | $                                   | 278  |   |                                     | $ | 3,967 |                                    |  | $ | 193                                |   |  | $ | 6,789  |  
|Stock based compensation under fair value method, net of tax effect using 38% tax rate |  |                                     | (182 | ) |                                     |   | (136  | )                                  |  |   | (1,339                             | ) |  |   | (1,149 | )
|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  
|Net income  pro forma                                                                 |  | $                                   | 96   |   |                                     | $ | 3,831 |                                    |  | $ | (1,146                             | ) |  | $ | 5,640  |  
|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  
|Net income per share, basic  as reported                                              |  | $                                   | 0.07 |   |                                     | $ | 0.98  |                                    |  | $ | 0.05                               |   |  | $ | 1.68   |  
|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  
|Net income per share, diluted  as reported                                            |  | $                                   | 0.06 |   |                                     | $ | 0.91  |                                    |  | $ | 0.04                               |   |  | $ | 1.55   |  
|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  
|Net income per share, basic  pro forma                                                |  | $                                   | 0.02 |   |                                     | $ | 0.95  |                                    |  | $ | (0.28                              | ) |  | $ | 1.40   |  
|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  
|Net income per share, diluted  pro forma                                              |  | $                                   | 0.02 |   |                                     | $ | 0.88  |                                    |  | $ | (0.26                              | ) |  | $ | 1.29   |  
|                                                                                       |  |                                     |      |   |                                     |   |       |                                    |  |   |                                    |   |  |   |        |  



3. INVENTORIES



Inventories as of September 30, 2004 and December 31, 2003 consist of the
following:



(In thousands)



|                                              |  |                    |         |   |                   |   |         |  
|--------------------------------------------- |  | ------------------ | ------- | - | ----------------- | - | ------- | -
|                                              |  | September 30, 2004 |         |   | December 31, 2003 |  
|Work in process                               |  | $                  | 37,407  |   |                   | $ | 31,679  |  
|Finished goods                                |  |                    | 2,154   |   |                   |   | 2,058   |  
|Raw materials and supplies                    |  |                    | 13,608  |   |                   |   | 9,677   |  
|                                              |  |                    |         |   |                   |   |         |  
|Total                                         |  |                    | 53,169  |   |                   |   | 43,414  |  
|Less reserves                                 |  |                    | (2,755  | ) |                   |   | (2,473  | )
|Less milestone payments and customer deposits |  |                    | (17,527 | ) |                   |   | (15,437 | )
|                                              |  |                    |         |   |                   |   |         |  
|                                              |  | $                  | 32,887  |   |                   | $ | 25,504  |  
|                                              |  |                    |         |   |                   |   |         |  



The Company receives
deposits from certain customers based on milestones in the maintenance process. The title to all inventory on which the Company receives these payments is vested in the customer to the extent of the deposit balance.



4. GOVERNMENT CLAIMS



The Company, as a U.S. Government contractor, utilizes the U.S.
Governments Request for Equitable Adjustment (REA) process as provided by the Federal Acquisition Regulation when it seeks to recover costs from the Government due to Government caused delays, errors in specifications and designs, contract
terminations, change orders in dispute or unapproved as to both scope and price, or other causes of unanticipated additional costs.



Page 8



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The Company recognizes revenue on these claims if: (1) there is a legal basis for the claim, (2) the
additional costs are caused by circumstances that were unforeseen at the contract date, (3) the costs associated with the claim are identifiable or otherwise determinable in view of the work performed, and (4) the evidence supporting the claim is
objective and verifiable. The amount of revenue recognized is managements most reliable estimate of the amount it will be able to realize based upon the claim. The total amount of these claims is approximately $6.3 million. During the second
quarter of 2003, the Company recognized $1.4 million of revenue associated with claims pertaining to two of its contracts with the U.S. Government. The adjustment during the second quarter brought the amount the Company had recorded as revenue to
$1.7 million. There has been no additional recognition of revenue on these claims during 2004.



5. NET INCOME PER SHARE



Basic net income per share was computed by dividing net income by the weighted average number of shares of common stock outstanding during the applicable period. Diluted net income per share was computed by dividing net income by the
weighted average number of shares of common stock and the dilutive effects of the shares awarded under the Companys Non-Qualified Stock Option Plan, based on the treasury stock method using an average fair market value of the stock during the
applicable periods.



The following table represents the net
income per share calculations for the three-month and nine-month periods ended September 30, 2004 and 2003:



(In thousands, except income per share)



|                                |  |                                    |       |                                    |   |                                   |  |                                   |       |  |   |      
|------------------------------- |  | ---------------------------------- | ----- | ---------------------------------- | - | --------------------------------- |  | --------------------------------- | ----- |  | - | -----
|                                |  | ThreeMonths EndedSeptember 30,2004 |       | ThreeMonths EndedSeptember 30,2003 |   | NineMonths EndedSeptember 30,2004 |  | NineMonths EndedSeptember 30,2003
|Net income                      |  | $                                  | 278   |                                    | $ | 3,967                             |  | $                                 | 193   |  | $ | 6,789
|Weighted average shares         |  |                                    | 4,138 |                                    |   | 4,043                             |  |                                   | 4,083 |  |   | 4,041
|Basic net income per share      |  | $                                  | 0.07  |                                    | $ | 0.98                              |  | $                                 | 0.05  |  | $ | 1.68 
|Dilutive securities: options    |  |                                    | 222   |                                    |   | 325                               |  |                                   | 378   |  |   | 335  
|Diluted weighted average shares |  |                                    | 4,360 |                                    |   | 4,368                             |  |                                   | 4,461 |  |   | 4,376
|Diluted net income per share    |  | $                                  | 0.06  |                                    | $ | 0.91                              |  | $                                 | 0.04  |  | $ | 1.55 



Options to purchase
approximately 225,333 and 217,000 shares of common stock at September 30, 2004 and 2003, respectively, were excluded from the computation of diluted net income per share because the option exercise price was greater than the average market price of
the shares.



Page 9



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6. DEBT



Debt as of September 30, 2004 and December 31, 2003 consisted of the following:



(In thousands)



|                                                                                                                   |  |                    |        |   |                   |   |        |  
|------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------ | - | ----------------- | - | ------ | -
|                                                                                                                   |  | September 30, 2004 |        |   | December 31, 2003 |  
|Revolving Credit Facility; interest at LIBOR plus 2.75% (4.50% at September 30, 2004)                              |  | $                  | 20,855 |   |                   | $ | 14,966 |  
|Bank Term Loan; interest at LIBOR plus 3.00% (4.75% at September 30, 2004)                                         |  |                    | 3,250  |   |                   |   | 4,000  |  
|Treasury Stock Term Loan; Interest at LIBOR plus 3.00% (4.87% at September 30, 2004)                               |  |                    | 1,797  |   |                   |   |       |  
|Airport Authority Term Loan; interest at BMA plus 0.36% (1.76% at September 30, 2004)                              |  |                    | 2,500  |   |                   |   | 2,500  |  
|Capital Lease Obligations; interest from 9.07% to 10.00%, collateralized by security interest in certain equipment |  |                    | 64     |   |                   |   | 88     |  
|                                                                                                                   |  |                    |        |   |                   |   |        |  
|Total long-term debt                                                                                               |  |                    | 28,466 |   |                   |   | 21,554 |  
|Less portion reflected as current                                                                                  |  |                    | (1,221 | ) |                   |   | (1,255 | )
|                                                                                                                   |  |                    |        |   |                   |   |        |  
|Long term-debt, net of current portion                                                                             |  | $                  | 27,245 |   |                   | $ | 20,299 |  
|                                                                                                                   |  |                    |        |   |                   |   |        |  



On December 16, 2002,
the Company executed a Credit Agreement that provides for a revolving credit facility and a term loan (the Revolving Credit Facility and Bank Term Loan, respectively). The Revolving Credit Facility had an original term of two
years. The Company amended the Credit Agreement on December 16, 2003, increasing the borrowing capacity under the Revolving Credit Facility from $20.0 million to $25.0 million and extending the maturity date from December 16, 2004 to December 16,
2005. The Revolving Credit Facility bears interest at the London Interbank Offer Rate (LIBOR) plus 2.00% to 2.75%, determined based on the ratio of adjusted funded debt to earnings before interest, taxes, depreciation and amortization, each as
defined in the Credit Agreement.



On May 7, 2004, the Company
amended the Credit Agreement to increase the revolving credit facility from a borrowing base of $25.0 million to $27.0 million. Borrowing availability under the Revolving Credit Facility is tied to percentages of eligible accounts receivable and
inventories. The Company had borrowings of approximately $20.9 million outstanding under the Revolving Credit Facility at September 30, 2004. Remaining borrowing capacity available under the facility at September 30, 2004, based on the calculation
that defines borrowing base, totaled approximately $6.1 million.



The Bank Term Loan has a term of 5 years and bears interest at LIBOR plus 2.25% to 3.00%, 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 January 31, 2003.



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On May 22, 2004, 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 may draw upon the Treasury Stock Term Loan in the amount of up to $5.0 million through May 22, 2005, and the borrowings may be used to make
purchases of the Companys common stock from any person who is not or has never been an affiliate of the Company or any other person approved by lender parties at their discretion. The Treasury Stock Term Loan can be drawn in increments of
$100,000 and bears interest at LIBOR plus 3.00%. The Company had an outstanding balance under the Treasury Stock Term Loan at September 30, 2004 of $1.8 million. The loan will be repaid in equal monthly installments over 31 months commencing on May
22, 2005.



The Airport Authority Term Loan originated on
November 26, 2002, has a term of 15 years, and bears interest at the Bond Market Association (BMA) rate plus 0.36%. The amount outstanding under the Airport Authority Term Loan at September 30, 2004 was $2.5 million and will be repaid over 14 annual
installments of approximately $180,000 commencing on September 30, 2004. A Letter of Credit supports the Airport Authority Term Loan and has a fee of 1.0% per year with a 5-year term.



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



As of September 30, 2004, principal maturities of debt were
as follows:



(In thousands)



|           |  |   |       
|---------- |  | - | ------
|Current    |  | $ | 1,221 
|1-3 years  |  |   | 25,011
|3-5 years  |  |   | 794   
|Thereafter |  |   | 1,440 
|           |  |   |       
|           |  | $ | 28,466
|           |  |   |       



A significant portion
of the 2005 maturity of debt listed above relates to the expiration of the 2-year term of the Revolving Credit Facility, as amended. The Company expects that it will renew the agreement for an additional 2-year term on December 16, 2004, and
continue to do so each year, although there can be no assurances in that regard. Notwithstanding this intended continuous renewal of the Revolving Credit Facility, the Company may elect to pay down the facility out of proceeds from the results of
operations, or other potential financing sources, prior to the scheduled maturity.



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



Page 11



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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.



Notwithstanding the covenants mentioned above that limit or prohibit the Company from incurring additional indebtedness, the Company does have certain assets that are not covered by these limitations or prohibitions
that could possibly be used to secure additional financing.



7.
STOCKHOLDERS EQUITY



Holders of stock options
under the Companys Non-Qualified Stock Option Plan exercised options for 22,410 shares of the Companys common stock during the three months ended September 30, 2004 and options for 5,663 shares during the same period of 2003. The Company
recorded both the exercise price and a tax benefit to Additional Paid-In Capital, totaling approximately $237,000 during the third quarter of 2004 and $90,000 during the third quarter of 2003. During the nine months ended September 30, 2004, holders
of Stock Options under the Companys Non-Qualified Stock Option Plan exercised options for 106,855 shares of the Companys common stock, adding with its associated tax benefit, approximately $2.3 million to Additional Paid-In Capital.
During the same period ended September 30, 2003 holders of stock options exercised options for 22,375 shares of the Companys common stock, adding with its associated tax benefit, approximately $360,000 to Additional Paid-In Capital. The
average price of the stock options exercised for the nine months ended September 30, 2004 was $21.14. In addition, there was approximately $300,000 in permanent tax benefit that was included in Additional Paid-In Capital related to stock option
exercises.



8. 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 regarding pension plans.



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



|                                   |  |                                    |        |   |                                       |   |        |                                   |  |   |                                    |   |  |   |        |  
|---------------------------------- |  | ---------------------------------- | ------ | - | ------------------------------------- | - | ------ | --------------------------------- |  | - | ---------------------------------- | - |  | - | ------ | -
|                                   |  | ThreeMonths EndedSeptember 30,2004 |        |   | Three Months Ended September 30, 2003 |   |        | NineMonths EndedSeptember 30,2004 |  |   | NineMonths Ended September 30,2003 |  
|Service cost                       |  | $                                  | 642    |   |                                       | $ | 577    |                                   |  | $ | 1,926                              |   |  | $ | 1,731  |  
|Interest cost                      |  |                                    | 1,792  |   |                                       |   | 1,849  |                                   |  |   | 5,376                              |   |  |   | 5,547  |  
|Expected return on plan assets     |  |                                    | (2,190 | ) |                                       |   | (2,138 | )                                 |  |   | (6,570                             | ) |  |   | (6,414 | )
|Amortization of prior service cost |  |                                    | 169    |   |                                       |   | 218    |                                   |  |   | 507                                |   |  |   | 654    |  
|Amortization of net (gain) loss    |  |                                    | 268    |   |                                       |   | 44     |                                   |  |   | 804                                |   |  |   | 132    |  
|                                   |  |                                    |        |   |                                       |   |        |                                   |  |   |                                    |   |  |   |        |  
|Net pension cost                   |  | $                                  | 681    |   |                                       | $ | 550    |                                   |  | $ | 2,043                              |   |  | $ | 1,650  |  
|                                   |  |                                    |        |   |                                       |   |        |                                   |  |   |                                    |   |  |   |        |  



9. 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 materially adverse effect on the Companys consolidated results of operations, financial position or cash flows.



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 approximately 70% and 56% of the Companys total revenues for the nine-month periods ended September 30, 2004 and 2003, respectively. The Companys two largest
programs generated approximately 83% and 80% of its revenues during the nine-month periods ended September 30, 2004 and 2003, 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 materially harm the Companys business and impair the value of its common stock.



Page 13



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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 the Company filed an appeal with the 11thCircuit
Court of Appeals for determination on certain procedural issues on October 31, 2001. The parties have subsequently entered into arbitration and discovery is ongoing. Management believes that the results of this claim will not have a material impact
on the Companys financial position or results of operations.



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, GECAS filed suit 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 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 six aircraft. The New York Court ordered mediation in the matter. Mediation took place on October 6, 2004, but was unsuccessful in bringing
resolution. Trial has been set in Dale County, Alabama for February 14, 2005. Management believes that the results of this claim will not have a material impact on the Companys financial position or results of operations.



On November 9, 1994 the Company was awarded the contract to perform standard
depot level maintenance (SDLM) and engineering design work (Executive Transport) on the 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s) with the Navy totaling over $4,945,000 plus interest. The claims included 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 (ASBCA), which consolidated the SDLM, Executive Transport and EDLM appeals into one case for litigation purposes. Discovery is currently in process.



Employment Lawsuits



In December 1999, the Company and its Pemco Aeroplex subsidiary were served with a purported class action in the U.S. District Court, Northern District of
Alabama, seeking



Page 14



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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 million. On July 27, 2000 the U.S. District Court determined that
the group would not be certified as a class and 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. On June 28, 2002 a jury determined that there was no hostile work environment with regard to any of the 22 plaintiffs in the original case and granted verdicts for the Company. 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 has petitioned the
11thCircuit to rehear the case en banc. 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 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 of Pemco Aeroplex are also pending in Alabama state court. The Company believes that no one of these claims is material to the Company as a whole 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.



The Company and its subsidiaries
are also parties to other non-employment related litigation, the results of which are not expected to be material to 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



Page 15



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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 and well installation has been completed. 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 recorded liabilities of approximately $56,000 and $100,000 related to the Phase II Plan at September 30, 2004 and December 31, 2003, respectively, which are included in accrued liabilities  other on the
accompanying Consolidated Balance Sheets. The Company anticipates the total costs of the Phase II Plan to be approximately $474,000, of which the Company has paid approximately $418,000 as of September 30, 2004. 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.



The Company is required to comply with environmental regulations at the federal, state and local levels. These requirements apply especially to the
stripping, cleaning and painting of aircraft. The requirements to comply with environmental regulations have not had, and are not expected to have, a material effect on the Companys financial position or results of operations.



10. SEGMENT INFORMATION



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



The accounting policies of the segments are the same as those described in the summary of significant accounting policies in
the Companys 2003 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 inter-company profit is eliminated. The Company does not allocate income taxes to segments.



The Companys reportable segments are strategic business units that offer different products and services. They are managed separately because each
business requires different



Page 16



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operating and marketing strategies. The CSS and MCS segments may generate revenues from governmental
entities and the GSS segment may generate revenues from commercial entities.



The following table presents information about segment profit or loss for the three months ended September 30, 2004 and 2003:



(In thousands)



|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|----------------------------------------- |  | --- | ------ | --- | - | ------ | --- |  | - | ------------ | - |  | - | ------- | -
|Three Months Ended September 30, 2004     |  | GSS |        | CSS |   |        | MCS |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 36,406 |     | $ | 15,958 |     |  | $ | 1,529        |   |  | $ | 53,893  |  
|Revenues from external foreign customers  |  |     |        |     |   | 938    |     |  |   | 80           |   |  |   | 1,018   |  
|Inter-company revenues                    |  |     |       |     |   | 293    |     |  |   | 54           |   |  |   | 347     |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 36,406 |     |   | 17,189 |     |  |   | 1,663        |   |  |   | 55,258  |  
|Elimination                               |  |     |        |     |   |        |     |  |   |              |   |  |   | (347    | )
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |     |   |        |     |  |   |              |   |  | $ | 54,911  |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  |     | 6,928  |     |   | 2,578  |     |  |   | (509         | ) |  |   | 8,997   |  
|Segment operating income (loss)           |  |     | 4,203  |     |   | (2,855 | )   |  |   | (545         | ) |  |   | 803     |  
|Interest expense                          |  |     |        |     |   |        |     |  |   |              |   |  |   | 351     |  
|Income taxes                              |  |     |        |     |   |        |     |  |   |              |   |  |   | 174     |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Net income                                |  |     |        |     |   |        |     |  |   |              |   |  | $ | 278     |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 63,276 |     | $ | 39,716 |     |  | $ | 5,418        |   |  | $ | 108,410 |  
|Depreciation/amortization                 |  |     | 925    |     |   | 395    |     |  |   | 50           |   |  |   | 1,370   |  
|Capital Additions                         |  |     | 815    |     |   | 206    |     |  |   | 14           |   |  |   | 1,035   |  
|                                          |  |     |        |    
|Three Months Ended September 30, 2003     |  | GSS |        | CSS |   |        | MCS |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 34,138 |     | $ | 7,757  |     |  | $ | 1,621        |   |  | $ | 43,516  |  
|Revenues from external foreign customers  |  |     |        |     |   | 473    |     |  |   | 106          |   |  |   | 579     |  
|Inter-company revenues                    |  |     | 6      |     |   | 563    |     |  |   | 140          |   |  |   | 709     |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 34,144 |     |   | 8,793  |     |  |   | 1,867        |   |  |   | 44,804  |  
|Elimination                               |  |     |        |     |   |        |     |  |   |              |   |  |   | (709    | )
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |     |   |        |     |  |   |              |   |  | $ | 44,095  |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  |     | 14,221 |     |   | (1,292 | )   |  |   | (272         | ) |  |   | 12,657  |  
|Segment operating income (loss)           |  |     | 8,534  |     |   | (1,865 | )   |  |   | (575         | ) |  |   | 6,094   |  
|Interest expense                          |  |     |        |     |   |        |     |  |   |              |   |  |   | 224     |  
|Insurance claim                           |  |     |        |     |   |        |     |  |   |              |   |  |   | (527    | )
|Income taxes                              |  |     |        |     |   |        |     |  |   |              |   |  |   | 2,430   |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Net income                                |  |     |        |     |   |        |     |  |   |              |   |  | $ | 3,967   |  
|                                          |  |     |        |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 70,114 |     | $ | 30,004 |     |  | $ | 5,541        |   |  | $ | 105,659 |  
|Depreciation/amortization                 |  |     | 656    |     |   | 286    |     |  |   | 57           |   |  |   | 999     |  
|Capital Additions                         |  |     | 292    |     |   | 158    |     |  |   | 11           |   |  |   | 461     |  



Page 17



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The following table presents information about segment profit or loss for the nine months ended September
30, 2004 and 2003:



(In thousands)



|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ | --- |  | - | ------------ | - |  | - | ------- | -
|Nine Months Ended September 30, 2004      |  | GSS |        |   | CSS |   |        | MCS |  |   | Consolidated |  
|                                          |  |     |        |  
|Revenues from external domestic customers |  | $   | 92,286 |   |     | $ | 37,105 |     |  | $ | 4,657        |   |  | $ | 134,048 |  
|Revenues from external foreign customers  |  |     |        |   |     |   | 7,197  |     |  |   | 429          |   |  |   | 7,626   |  
|Inter-company revenues                    |  |     | (9     | ) |     |   | 3,862  |     |  |   | 360          |   |  |   | 4,213   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 92,277 |   |     |   | 48,164 |     |  |   | 5,446        |   |  |   | 145,887 |  
|Elimination                               |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (4,213  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 141,674 |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  |     | 19,467 |   |     |   | 5,409  |     |  |   | (1,286       | ) |  |   | 23,590  |  
|Segment operating income (loss)           |  |     | 6,576  |   |     |   | (4,026 | )   |  |   | (1,383       | ) |  |   | 1,167   |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 853     |  
|Income taxes                              |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 121     |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Net income                                |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 193     |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 63,276 |   |     | $ | 39,716 |     |  | $ | 5,418        |   |  | $ | 108,410 |  
|Depreciation/amortization                 |  |     | 2,442  |   |     |   | 1,026  |     |  |   | 213          |   |  |   | 3,681   |  
|Capital Additions                         |  |     | 2,025  |   |     |   | 872    |     |  |   | 70           |   |  |   | 2,967   |  
|                                          |  |     |        |  
|Nine Months Ended September 30, 2003      |  | GSS |        |   | CSS |   |        | MCS |  |   | Consolidated |  
|                                          |  |     |        |  
|Revenues from external domestic customers |  | $   | 90,404 |   |     | $ | 28,401 |     |  | $ | 4,945        |   |  | $ | 123,750 |  
|Revenues from external foreign customers  |  |     |        |   |     |   | 2,960  |     |  |   | 307          |   |  |   | 3,267   |  
|Inter-company revenues                    |  |     | 107    |   |     |   | 1,155  |     |  |   | 780          |   |  |   | 2,042   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 90,511 |   |     |   | 32,516 |     |  |   | 6,032        |   |  |   | 129,059 |  
|Elimination                               |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (2,042  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 127,017 |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  |     | 34,372 |   |     |   | (2,888 | )   |  |   | (1,202       | ) |  |   | 30,282  |  
|Segment operating income (loss)           |  |     | 19,931 |   |     |   | (6,848 | )   |  |   | (1,990       | ) |  |   | 11,093  |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 673     |  
|Insurance claim                           |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (527    | )
|Income taxes                              |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 4,158   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Net income                                |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 6,789   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 70,114 |   |     | $ | 30,004 |     |  | $ | 5,541        |   |  | $ | 105,659 |  
|Depreciation/amortization                 |  |     | 1,862  |   |     |   | 882    |     |  |   | 168          |   |  |   | 2,912   |  
|Capital Additions                         |  |     | 1,935  |   |     |   | 2,347  |     |  |   | 62           |   |  |   | 4,344   |  



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Due to the long-term nature of much of the Companys business, the depreciation and amortization amounts recorded in
the Consolidated Statements of Operations will not directly match the change in accumulated depreciation and amortization reflected on the Companys Consolidated Balance Sheets. This is a result of the capitalization of costs on long-term
contracts into Work-in-Process.



The following tables reconcile the effect of
this capitalization of costs for the nine months ended September 30, 2004 and 2003:



(In thousands)



|                                                                                                          |  |      |       |      |   |      
|--------------------------------------------------------------------------------------------------------- |  | ---- | ----- | ---- | - | -----
|Nine Months Ended September 30                                                                            |  | 2004 |       | 2003
|Change in Accumulated Depreciation and Amortization Reflected on the Consolidated Statement of Cash Flows |  | $    | 2,659 |      | $ | 2,761
|Net Depreciation and Amortization (Capitalized Into) or Removed from Work-in-Process                      |  |      | 1,022 |      |   | 151  
|                                                                                                          |  |      |       |      |   |      
|Depreciation and Amortization Recorded in Cost of Goods Sold Upon Delivery of Aircraft                    |  | $    | 3,681 |      | $ | 2,912
|                                                                                                          |  |      |       |      |   |      



11. RECENTLY ISSUED ACCOUNTING
PRONOUNCEMENTS



In November 2002, the Financial Accounting
Standards Board (FASB) issued Interpretation No. (FIN) 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Others, which is effective for guarantees issued
or modified after December 31, 2002. FIN 45 elaborates on the existing disclosure requirements for most guarantees, including loan guarantees such as standby letters of credit. It also clarifies that at the time a Company issues a guarantee, the
Company must recognize an initial liability for the fair value, or market value, of the obligations it assumes under the guarantee and must disclose that information in its interim and annual financial statements. The provisions related to
recognizing a liability at inception of the guarantee for the fair value of the guarantors obligations do not apply to product warranties or to guarantees accounted for as derivatives. The adoption of FIN 45 in the first quarter 2003 did not
have a significant impact on the Companys consolidated results of operations or financial position.



In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of
Accounting Research Bulletin 51, Consolidation of Financial Statements, which addresses consolidation of variable interest entities (VIE) by business enterprises. FIN 46 requires immediate consolidation of VIEs created after
January 31, 2003, and the compliance of older entities in the first fiscal year or interim period ending after December 15, 2003. The Company has determined that there is no impact to the financial statements or the consolidated results of
operations related to FIN 46.



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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.



Three months ended September 30, 2004

Versus three months ended September 30, 2003



The table below presents major highlights from the quarters ended September 30, 2004 and 2003.



(In millions)



|                    |  |      |      |      |   |        |  |       |   
|------------------- |  | ---- | ---- | ---- | - | ------ |  | ----- | --
|                    |  | 2004 |      | 2003 |   | Change | 
|Revenue             |  | $    | 54.9 |      | $ | 44.1   |  | 24.5  | % 
|Gross Profit        |  |      | 9.0  |      |   | 12.7   |  | (29.1 | )%
|Operating income    |  |      | 0.8  |      |   | 6.1    |  | (86.9 | )%
|Income before taxes |  |      | 0.5  |      |   | 6.4    |  | (92.2 | )%
|Net income          |  |      | 0.3  |      |   | 4.0    |  | (92.5 | )%
|EBITDA              |  |      | 2.3  |      |   | 7.6    |  | (69.7 | )%



EBITDA for the quarters ended
September 30, 2004 and 2003 was calculated using the following approach:



(In millions)



|                            |  |      |     |      |   |    
|--------------------------- |  | ---- | --- | ---- | - | ---
|                            |  | 2004 |     | 2003
|Net Income                  |  | $    | 0.3 |      | $ | 4.0
|Interest                    |  |      | 0.4 |      |   | 0.2
|Taxes                       |  |      | 0.2 |      |   | 2.4
|Depreciation & Amortization |  |      | 1.4 |      |   | 1.0
|                            |  |      |     |      |   |    
|EBITDA                      |  | $    | 2.3 |      | $ | 7.6
|                            |  |      |     |      |   |    



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, the Company believes EBITDA is an important
gauge used by commercial banks, investment banks, other financial institutions, and current and potential investors, to approximate its cash generation capability. The Company has accordingly included EBITDA as part of this report. The Depreciation
and Amortization amounts



Page 20



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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 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 costs on long-term contracts into Work-in-Process. 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 Revenue by Operating Segment from the three months
ended September 30, 2004 and 2003.



(In millions)



|             |  |      |      |   |      |   |      |        |  |      |          |  |       |   
|------------ |  | ---- | ---- | - | ---- | - | ---- | ------ |  | ---- | -------- |  | ----- | --
|             |  | 2004 |      |   | 2003 |   |      | Change |  |      | % Change | 
|GSS          |  | $    | 36.3 |   |      | $ | 34.1 |        |  | 2.2  |          |  | 6.5   | % 
|CSS          |  |      | 17.2 |   |      |   | 8.8  |        |  | 8.4  |          |  | 95.5  | % 
|MCS          |  |      | 1.7  |   |      |   | 1.9  |        |  | (0.2 | )        |  | (10.5 | )%
|Eliminations |  |      | (0.3 | ) |      |   | (0.7 | )      |  |      |          |  |       |   
|             |  |      |      |   |      |   |      |        |  |      |          |  |       |   
|Total        |  | $    | 54.9 |   |      | $ | 44.1 |        |  | 10.8 |          |  | 24.5  | % 
|             |  |      |      |   |      |   |      |        |  |      |          |  |       |   



Without regard to operating segments,
the Companys mix of business between government and commercial customers was 34.0% commercial and 66.0% government in 2004 and 21.7% commercial and 78.3% government in 2003.



The increase in the CSS revenue of $8.4 million was primarily due to an increase of $5.0 million in 737 Cargo Conversion revenue.
Additionally, the CSS increased maintenance revenues on DC-9 and Boeing 737 aircraft from the previous year by $3.4 million. The CSSs primary customer increased the amount of hours worked per aircraft in the period ended September 30, 2004
versus the same period of the previous year.



The $2.2 million increase in the
sales of the GSS was due primarily to increased revenue under several C-130 programs and related material sales of $2.5 million. During the three months ended September 30, 2004 the Company delivered 10 Programmed Depot Maintenance (PDM)
aircraft whereas during the same period in 2003 the Company delivered eight PDM aircraft. The KC-135 PDM programs represented 89% of the revenue of the GSS during the third quarter of 2004 and 99.0% during the same period of 2003.



Revenue in the MCS decreased $0.2 million for the three months ended September 30, 2004
versus the same period in 2003. Sales at the Space Vector subsidiary decreased $0.3 million primarily as a result of concluding work on a targets program. Revenue in the Pemco Engineers subsidiary increased $0.1 million between the two periods.



Page 21



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Cost of sales increased during the third quarter from $31.4 million in 2003 to $45.9 million in 2004, primarily as a
result of the increase in sales between the two periods and productivity nitiatives at the GSS. The cost of sales increase related to the sales volume increase was approximately $7.7 million. The remaining cost of sales increase due to initiatives
at the GSS is described below. Overall, the gross profit percentage of the Company decreased from 28.8% in the third quarter of 2003 to 16.4% in the third quarter of 2004. The percentage decrease is due to several factors. The GSS delivered one
C-130 PDM aircraft during the third quarter of 2004 compared with no such deliveries during the third quarter of 2003. The margin on this delivery was significantly less than the margin on KC-135 PDM deliveries during these periods. The GSS also
delivered several KC-135 PDM aircraft during the third quarter of 2004 with relatively longer flow days than those delivered during the same period of 2003, which generally results from more extensive non-routine as well as routine work and
decreases the Companys margin. An additional loss of $0.4 million on C-130 aircraft was also recorded during the quarter. There were also several initiatives designed to improve long-term productivity at the GSS which contributed to the
reduction in profitability during the quarter. These initiatives include training costs, establishing a point of use material program, overhauling the foreign object and debris control process, and initializing a lean manufacturing project among
other initiatives, most of which required substantial training costs. Coupled with the direct costs of such initiatives, productivity over the short term was negatively impacted by a general learning curve associated with these charges. The decrease
at the GSS was offset somewhat by an increase at the CSS. The CSS improved gross profit by $3.9 million for the period ended September 30 2004 versus 2003. The reasons for this include improved efficiencies on sales to its largest customer and two
cargo conversion sales during the quarter. In addition, the 2004 results for the third quarter include an increase to gross profit for an adjustment related to the CSS warranty reserve of $160,000. The Company reviewed the warranty reserve as of
September 30, 2004 and, based on several factors, including historical claims has adjusted its warranty reserve. Previously, this reserve was based on engineering estimates. However, the Company has increased the level of conversion work over the
last two years and believes that there are now sufficient historical claims on which to base their estimate. This is compared with 2003 gross profit for the third quarter, which includes a positive adjustment to Cost of Sales of $0.7 million
insurance recovery related to a fire in the Companys Dothan, Alabama facility in January 2002. The insurance settlement in the third quarter of 2003 was related to a fire at the Companys Pemco World Air Services facility in Dothan,
Alabama that occurred in February 2002.  The Company determined that there were expenses related to that insurance claim that had been run through cost of sales at the facility as it was being repaired.  Some examples of these included
labor from employees at the facility, paving and landscaping for temporary offices, additional expenses for security, etc.  Once the insurance claim was settled, the Company prepared an analysis of all these costs and recorded the remainder to
Other Income.



Selling, general, and administrative
(SG&A) expenses increased $1.6 million during the third quarter of 2004 compared to the third quarter of 2003. Part of the increase in SG&A expenses is attributable to the increase in revenue in the GSS while the remainder is an
increase of segment SG&A costs. These segment SG&A costs relate to the initiatives discussed above at the GSS and the training costs, overtime and indirect labor associated with those initiatives. In addition, the SG&A costs at the CSS
were increased somewhat due to a system conversion at that segment.



Interest
expense increased by $0.2 million, from $0.2 million during the third quarter of 2003 to $0.4 million during the same period of 2004. This increase was due to a higher average debt balance during the three months ended September 30, 2004 when
compared to the same period in 2003.



In the three-month periods ended
September 30, 2004 and 2003, the Company recorded income tax provisions on a normalized basis at an effective rate of 38.5% and 38.0%, respectively.



Page 22



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Nine months ended September 30, 2004

Versus nine months ended September 30, 2003



The table below presents major highlights from the nine months ended September 30, 2004 and 2003.



(In millions)



|                    |  |      |       |      |   |        |  |       |   
|------------------- |  | ---- | ----- | ---- | - | ------ |  | ----- | --
|                    |  | 2004 |       | 2003 |   | Change | 
|Revenue             |  | $    | 141.7 |      | $ | 127.0  |  | 11.6  | % 
|Gross Profit        |  |      | 23.6  |      |   | 30.3   |  | (22.1 | )%
|Operating income    |  |      | 1.2   |      |   | 11.1   |  | (89.2 | )%
|Income before taxes |  |      | 0.3   |      |   | 10.9   |  | (97.2 | )%
|Net income          |  |      | 0.2   |      |   | 6.8    |  | (97.1 | )%
|EBITDA              |  |      | 4.9   |      |   | 14.6   |  | (66.4 | )%



EBITDA for the nine months ended
September 30, 2004 and 2003 was calculated using the following approach:



(In millions)



|                            |  |   |      |  |   |     
|--------------------------- |  | - | ---- |  | - | ----
|                            |  |   | 2004 |  |   | 2003
|Net Income                  |  | $ | 0.2  |  | $ | 6.8 
|Interest                    |  |   | 0.9  |  |   | 0.7 
|Taxes                       |  |   | 0.1  |  |   | 4.2 
|Depreciation & Amortization |  |   | 3.7  |  |   | 2.9 
|                            |  |   |      |  |   |     
|EBITDA                      |  | $ | 4.9  |  | $ | 14.6
|                            |  |   |      |  |   |     



The table below presents Revenue by
Operating Segment from the nine months ended September 30, 2004 and 2003.



(In millions)



|             |  |      |       |   |      |   |       |        |  |      |          |  |       |   
|------------ |  | ---- | ----- | - | ---- | - | ----- | ------ |  | ---- | -------- |  | ----- | --
|             |  | 2004 |       |   | 2003 |   |       | Change |  |      | % Change | 
|GSS          |  | $    | 92.3  |   |      | $ | 90.5  |        |  | 1.8  |          |  | 2.0   | % 
|CSS          |  |      | 48.2  |   |      |   | 32.5  |        |  | 15.7 |          |  | 48.3  | % 
|MCS          |  |      | 5.4   |   |      |   | 6.0   |        |  | (0.6 | )        |  | (10.0 | )%
|Eliminations |  |      | (4.2  | ) |      |   | (2.0  | )      |  |      |          |  |       |   
|             |  |      |       |   |      |   |       |        |  |      |          |  |       |   
|Total        |  | $    | 141.7 |   |      | $ | 127.0 |        |  | 16.9 |          |  | 13.3  | % 
|             |  |      |       |   |      |   |       |        |  |      |          |  |       |   



Page 23



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Without regard to operating segments, the Companys mix of business between government and commercial customers was
35.2% commercial and 64.8% government in 2004 and 27.0% commercial and 73.0% government in 2003.



The increase in the CSS revenue of $15.7 million was primarily due to an increase in maintenance revenues from its primary customer with DC-9 aircraft of $19.7 million. This was offset somewhat by a decrease of $4.3
million in maintenance on other types of aircraft. Revenues for cargo conversions remained relatively constant for the nine months ended September 30, 2004 at $7.4 million compared with $7.7 million during the same period of 2003.



The $1.8 million increase in the sales of the GSS was due primarily to increased revenue on
new C-130 programs, including the Coast Guard, Air Force and Navy. During the nine months ended September 30, 2004, the Company delivered 21 PDM aircraft whereas during the same period in 2003 the Company delivered 23 PDM aircraft. The Company
completed work on eleven C-130 drop-in aircraft during the nine months ended September 30, 2004 with four corresponding sales on C-130s during the same period in the prior year. The overall decrease of PDM program related sales was offset by
additional C-130 Sales. For the nine months ended September 30, 2004, sales of C-130s were $8.9 million when compared with $0.8 million during the same period for 2003. The KC-135 PDM programs represented 90.0% of the revenue of the GSS during
the first nine months of 2004 and 99.0% during the same period of 2003.



Revenue in the MCS decreased $0.6 million for the nine months ended September 30, 2004 versus the same period in 2003. Sales at the Space Vector division decreased $0.9 million primarily as a result of concluding work on a targets program.
Revenue in the Pemco Engineers division increased $0.3 million between the two periods.



Cost of sales increased for the nine months ended September 30, 2004 as compared to the same period in 2003 from $96.7 million to $118.1 million, primarily as a result of the increase in sales between the two periods and productivity
nitiatives at the GSS. The cost of sales increase related to the sales volume increase was approximately $11.2 million. The remaining cost of sales increase was due to initiatives at the GSS described below. Overall, the gross profit percentage of
the Company decreased from 23.8% during the nine months ended September 30, 2003 to 16.7% for the same period of 2004. The percentage decrease is attributable to several factors. At the GSS, the KC-135 aircraft delivered during the 2004 were less
profitable on average than those delivered during 2003 as a result of additional overhead incurred. This additional overhead was attributable to several initiatives designed to improve long term productivity. These initiatives include training
costs, establishment of a point of use material program, and a lean manufacturing project. Overall,



Page 24



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gross profit decreased during the nine months ended September 30, 2004 by $14.9 million at the GSS when compared with the
same period during 2003. The gross profit decrease at the GSS was offset somewhat by an increase of gross profit at the CSS. The CSS improved gross profit by $8.3 million for the nine months ended September 30 2004 versus the same period in 2003.
The reasons for this include improved efficiencies on sales to its largest customer and three cargo conversion sales during the nine months ended September 30, 2004. In addition, the 2004 results for the nine months ended September 30, 2004 include
an increase to gross profit for an adjustment related to the CSS warranty reserve of $160,000. The Company reviewed the warranty reserve as of September 30, 2004 and, based on several factors, including historical claims has adjusted its warranty
reserve. Previously, this reserve was based on engineering estimates. However, the Company has increased the level of conversion work over the last two years and believes that there are now sufficient historical claims on which to base their
estimate. This is compared with the nine months ended September 30, 2003 gross profit, which includes a positive adjustment to Cost of Sales of $0.7 million insurance recovery related to a fire in the Companys Dothan, Alabama facility in
January 2002. The insurance settlement in the third quarter of 2003 was related to a fire at the Companys Pemco World Air Services facility in Dothan, Alabama that occurred in February 2002.  The Company determined that there were
expenses related to that insurance claim that had been run through cost of sales at the facility as it was being repaired.  Some examples of these included labor from employees at the facility, paving and landscaping for temporary offices,
additional expenses for security, etc.  Once the insurance claim was settled, the Company prepared an analysis of all these costs and recorded the remainder to Other Income.



SG&A expenses increased $3.2 million between the nine months ended September 30, 2003 and the same period of 2003. The increase is
attributable to several factors including a charge during the second quarter of 0.9 million related to the purchase of treasury stock upon exercise of certain stock options. The Company also recorded approximately $2.5 million in accounting and
legal charges during the nine months ended September 30, 2004 related to the 2003 financial statement audit and the restatement of the Companys financial statements filed in connection with the first three quarters of 2003.



Interest expense increased from $0.7 million during the nine months ended September 30, 2003
to $0.9 million during the same period of 2004. This increase was due to a higher average balance during the nine months ended September 30, 2004 when compared to the same period in 2003.



In the nine-month periods ended September 30, 2004 and 2003, the Company recorded income tax provisions on a normalized basis at an
effective rate of 38.5% and 38.0%, respectively.



Liquidity and Capital
Resources



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



(In thousands except long
term debt to equity)



|                                             |  |                    |        |                   |   |        |  |   |        |  
|-------------------------------------------- |  | ------------------ | ------ | ----------------- | - | ------ |  | - | ------ | -
|                                             |  | September 30, 2004 |        | December 31, 2003 |   | Change | 
|Cash                                         |  | $                  | 767    |                   | $ | 3,156  |  | $ | (2,389 | )
|Working Capital                              |  |                    | 31,979 |                   |   | 28,093 |  |   | 3,886  |  
|Revolving credit facility                    |  |                    | 20,855 |                   |   | 14,966 |  |   | 5,889  |  
|Long term debt and capital lease obligations |  |                    | 6,390  |                   |   | 5,333  |  |   | 1,057  |  
|Stockholders equity                         |  |                    | 24,226 |                   |   | 22,975 |  |   | 1,251  |  
|Long term debt to equity                     |  |                    | 1.12   |                   |   | 0.88   |  |   | 0.24   |  



Page 25



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Operating activities used $7.2 million of cash during the nine months ended September 30, 2004. Operating activities used
$0.3 million of cash during the same period of 2003. The Company received proceeds from the exercise of Company stock options of $2.3 million and $0.3 million during the nine months ended September 30, 2004 and 2003, respectively. Cash of $3.0
million and $4.1 million was used during the nine months ended September 30, 2004 and 2003, respectively, for capital expenditures, and $1.6 million and $0.3 million, respectively, was used for the repurchase of Company common stock.



At September 30, 2003 the Company had additional borrowing capacity of $6.1 million under its
revolving line of credit.



The increase in inventories between December 31,
2003 and September 30, 2004, reflected on the Companys Consolidated Statement of Cash Flows, is due primarily to an increase in raw materials and supplies at both the GSS and CSS.



On May 22, 2004 the Company executed an amendment to its credit agreement to create a $5.0 million line of credit for the repurchase of the
Companys common stock. The credit line may be used to make purchases of the Companys common stock from any person who is not or has never been an affiliate of the Company. The credit line can be drawn in increments of $0.1 million and
carries an interest rate of LIBOR plus 3.0%. The line is to be repaid over 31 months beginning on May 22, 2004. As of the date of this report, the Company had drawn $1.8 million on this new credit facility.



The Company maintains a defined benefit pension plan (the Plan) that covers
substantially all employees at its Birmingham and Dothan, Alabama facilities. The Plans assets consist primarily of stocks, bonds 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, the Plan was under-funded by approximately $26 million at December 31, 2003. Under ERISA rules, the Company has paid the minimum required
contribution in 2004. As of the date of this report, the Company has made contributions of $8.1 million during 2004.



Funding for the advancement of the Companys strategic goals, including possible investments in targeted business areas and acquisitions, is expected to continue.
The Company plans to



Page 26



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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, the incurrence of additional indebtedness 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. 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 September 30, 2004 and 2003, 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 this report.



RELATED PARTY TRANSACTIONS



On April 23, 2002 the Company loaned its current President and Chief Executive Officer $425,000 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 the related party receivable relates to interest accumulated during the period.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



The Companys significant accounting policies are disclosed in Note 1 of Notes to the
Consolidated Financial Statements located in the Companys 2003 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.



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



Revenue Recognition



Revenue at the Companys GSS and CSS
is derived principally under contracts using 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. The nature of
the contract and the types of products and services provided are considered when determining the appropriate accounting for a particular contract. The Companys contracts at the GSS and CSS generally have basic and fixed price elements,
time-and-material elements, or commonly both. The GSS generally segments the basic and fixed price elements and the time-and-material elements for purposes of accumulating costs and recognizing revenue. For basic and fixed price elements of a
contract, the GSS 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. Each
aircraft is considered a unit for purposes of recognizing revenue. For time-and-material elements of a contract, the GSS 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 hour chargeable to the customer as a unit of work performed. Revenue and costs of sales for time-and-material
elements are recognized upon completion of all performance obligations in accordance with the contract and acceptance by the customer. The CSS recognizes revenue and associated costs for both fixed price and time-and-material elements using
units-of-delivery as the basis to measure progress toward completion, and 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 Companys MCS derives a significant portion of its revenue from cost-reimbursement
type contracts 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 fixed price and time-and-material elements of contracts, the
evaluation of profitability on



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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, time-and-material, 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.



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. 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 to income in the period such determination was made.



Inventories



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 margins 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 margin and results of operations.



Pensions



The Company maintains pension plans covering a majority of its employees and retirees, and post-retirement benefit plans for retirees that include health care benefits and life insurance coverage. For financial
reporting purposes, net periodic pension cost (income) and other post-retirement benefit costs are calculated based upon a number of actuarial assumptions including a discount rate



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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 post-retirement 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 post-retirement healthcare benefits above assumed rates of increase would result in higher net periodic post-retirement benefit costs in future years.



Contingencies



As further discussed in Note 9 to the Consolidated Financial Statements, 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, however, may result in the payment of significant costs and damages that could have a material adverse effect on our business, financial condition, results of operations, and cash flows.



BACKLOG



The following table presents the Companys backlog at September 30, 2004 and 2003:



(In thousands)



|                |  |      |        |      |   |        
|--------------- |  | ---- | ------ | ---- | - | -------
|Customer Type   |  | 2004 |        | 2003
|U.S. Government |  | $    | 63,760 |      | $ | 87,490 
|Commercial      |  |      | 12,685 |      |   | 14,010 
|                |  |      |        |      |   |        
|Total           |  | $    | 76,445 |      | $ | 101,500
|                |  |      |        |      |   |        



The reduction in government backlog
was primarily related to the Companys GSS. The GSS decreased its backlog approximately $23.7 million year-over-year. The decrease in the GSS was due to a reduction in the number of aircraft in the backlog, which were 20 in 2004 versus 29 in
2003.



Total commercial backlog decreased $1.3 million. This is primarily due
to the Pemco Engineers segment of the MCS, which accounts for all the backlog reduction. The decrease in Pemco Engineers backlog is a result of a downturn in conversion of aircraft for which the unit produces cargo-handling systems combined with a
decrease in sales of replacement parts for cargo-handling systems on aircraft in service.



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Overall the mix of backlog shifted towards commercial during the two periods moving from 83.4% government and 16.6%
commercial as of September 30, 2004 versus 86.2% government and 13.8% commercial as of September 30, 2003.



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 contains forward-looking
statements. 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, the outcome of pending or future litigation, 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 Factors That May Affect Future Performance in the Companys 2002 Annual Report on Form 10-K/A that 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.



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
revolving line of credit and two term loans as noted in Note 6 to the Consolidated Financial Statements and bears interest at LIBOR plus 2.75% and 3.00% on the Revolving Credit Facility and the Bank Term Loan, respectively, and the BMA rate plus
0.36% on Airport Authority Term Loan. These interest rates were 4.50%, 4.75%, and 1.76%, respectively at September 30, 2003. Had the rate of the variable rate debt increased 100 basis points, net income would have been reduced approximately $50,000
during the quarter and $170,000 year-to-date. The actual fluctuation of interest rates is not determinable; accordingly, actual results of interest rate fluctuations could differ.



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) promulgated under the Exchange Act, include controls and procedures designed to ensure that information required to be disclosed by the Company in the reports we file or submit under the
Exchange Act is accumulated and communicated to our Companys management, including our 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.



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As disclosed in the Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003, in the first
quarter of 2004, the Companys previous independent auditors, Ernst & Young LLP (E&Y), identified four reportable conditions that E&Y believed in the aggregate constituted a material weakness. The reportable conditions were: (i) the
lack of appropriate analysis and support for revenue recognition matters; (ii) the 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) the lack of appropriate analysis and support for inventory accounting matters; and (iv) the lack of appropriate analysis and support for the reconciliation of intercompany transactions.



The Companys Annual Report on Form 10-K for the fiscal year ended December 31, 2003 and
its Quarterly Reports on Form 10-Q for the quarters ended March 31, 2004 and June 30, 2004 each disclosed that the Company has taken significant steps to remediate the four reportable conditions, including (i) adding accounting staff and enhancing
the level of expertise; (ii) increasing training of corporate and accounting staff to heighten awareness of generally accepted accounting principles (GAAP); (iii) establishing policies and procedures designed to enhance coordination and reporting
procedures between management and the Companys accounting staff; (iv) centralizing review and monitoring of accounting issues; and (v) allocating senior accounting personnel to provide additional on-site supervision of accounting functions.



Specifically, the Company implemented the following:



| |  | During the first quarter and the early part of the second quarter of 2004, the Company evaluated the reportable conditions and adopted nine new formal corporate policies related to
the four reportable conditions, including policies addressing revenue recognition, contract loss, and the reconciliation of inventory and intercompany accounts. These new policies, which in the aggregate cover all of the Companys segments,
include:
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 1. | Corporate Intercompany Reconciliation Policy,
| | -- | ---------------------------------------------

| | 2. | Corporate Inventory Reconciliation Policy,
| | -- | ------------------------------------------

| | 3. | Pemco Aeroplex Revenue Recognition Policy,
| | -- | ------------------------------------------

| | 4. | Pemco Aeroplex Contract Loss Policy,
| | -- | ------------------------------------

| | 5. | Pemco World Air Services Revenue Recognition Policy,
| | -- | ----------------------------------------------------

| | 6. | Pemco World Air Services Contract Loss Policy,
| | -- | ----------------------------------------------

| | 7. | Space Vector Revenue Recognition Policy,
| | -- | ----------------------------------------

| | 8. | Space Vector Contract Loss Policy, and
| | -- | --------------------------------------

| | 9. | Pemco Engineers Revenue Recognition Policy.
| | -- | -------------------------------------------



| |  | In furtherance of implementing the new policies described above, in April of 2004, the Company engaged Navigant Consulting, Inc. to independently review those policies as well as
the Companys implementation of them. Navigant focused primarily on revenue recognition and contract loss accruals. The Company gave Navigant access to all necessary personnel for Navigant to evaluate the Companys new policies as well as
other aspects of the Companys disclosure controls and procedures. Subsequently, Navigant provided the Company with several recommendations to further strengthen the Companys disclosure controls and procedures, including (i) using current
productivity to measure future productivity; (ii) revising the Companys spreadsheets used for calculation of loss accrual and estimated time to complete; and (iii) reorganizing and supplementing the data package provided by the segment
controllers to the Corporate Controller regarding each aircraft in work, which the Corporate Controller reviews in connection with his end of quarter review. The Company implemented those recommendations during the second and third quarters of 2004.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | At the end of the first quarter of 2004, the Company, with KPMGs assistance, conducted a training seminar for the Chief Executive Officer, the Chief Financial Officer,
Presidents of the Companys subsidiaries, production personnel and contracts personnel on revenue recognition and the estimation of loss contracts. The seminar provided further education to non-accounting personnel regarding the importance of
revenue recognition and estimates to complete for loss accruals in accordance with GAAP. In addition, accounting personnel met with KPMG on Sections 302 and 404 of the Sarbanes-Oxley Act of 2002, revenue recognition (SAB 101 and SOP 81-1) and
contract loss accruals. The Company has an additional training seminar scheduled in December 2004 with KPMG, which the Companys controllers and others appropriate personnel will be required to attend. The Company intends to conduct similar
seminars on a quarterly basis in the future.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | At the end of the first quarter of 2004, the Company created an eight person disclosure committee consisting of the Companys Corporate Controller, five segment controllers,
the Companys general counsel and one member of the Companys internal audit staff. The disclosure committee, which meets at least once a quarter, assists the Chief Executive Officer and Chief Financial Officer in fulfilling their
responsibility for oversight of the accuracy and timeliness of the disclosures made by the Company by assisting in various tasks, in each case subject to the supervision andoversight of the Chief Executive Officer and Chief Financial Officer. Such
tasks include designing appropriate disclosure controls, monitoring the integrity and effectiveness of the Companys disclosure controls and reviewing and supervising the preparation of the Companys periodic and current reports, proxy
statements, registration statements and any other information filed with the Commission.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | During the third quarter of 2004, the Company hired two additional persons for the positions of Assistant Controller and Inventory Accountant. The new Assistant Controller is a
Certified Public Accountant (CPA), and the new Inventory Accountant has significant inventory control and reconciliation experience. With the most recent additions, the Company now employs six CPAs. Moreover, the Company re-allocated several
employees with significant GAAP experience to different positions within the Company and its subsidiaries to strengthen its human resources and GAAP expertise in appropriate areas. The Company is also committed to hiring an additional GAAP expert at
the corporate level. It plans to do so by the end of the current fiscal year and is currently conducting interviews for that position.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------





Management carried out an evaluation, with the participation of the Companys Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the Companys disclosure controls and procedures as of September 30, 2004, the end of the period covered by the Companys Quarterly Report on Form 10-Q for the quarter
ended September 30, 2004. As part of the evaluation, management evaluated the effectiveness of the remedial steps identified above, and believes that they have effectively remediated the four reportable conditions identified by E&Y. Based on its
overall evaluation, the Companys Chief Executive Officer and Chief Financial Officer concluded that the Companys disclosure controls and procedures were effective at the reasonable assurance level as of September 30, 2004.



(b) Changes in internal control over financial
reporting.



Other than as set forth In Item 4(a) above, there have been no
other material changes in the Companys internal control over financial reporting that have materially affected, or are reasonably likely to materially affect, the Companys internal control over financial reporting.



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PART II OTHER INFORMATION



Item 1. Legal Proceedings



See Note 8 to the Consolidated Financial Statements.



Item 6. Exhibits and Reports on Form 8-K.



a. Exhibits



|   |  |                                                                                                                          |  |    
|-- |  | ------------------------------------------------------------------------------------------------------------------------ |  | ---
|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. |  | (*)

---

|(*) | Filed herewith
|--- | --------------



b. Reports on Form 8-K

|
|

Form 8-K dated October 12 and filed October 18, 2004  Change in Registrants
Certifying Accountant.



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SIGNATURES



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



PEMCO AVIATION
GROUP, INC.



|                         |  |     |  |                                         
|------------------------ |  | --- |  | ----------------------------------------
|Dated: November 15, 2004 |  | By: |  | /s/ Ronald A. Aramini                   
|                         |  |     |  | Ronald A. Aramini, President            
|                         |  |     |  | and Chief Executive Officer             
|                         |  |     |  | (Principal Executive Officer)           
|                         |  |    
|Dated: November 15, 2004 |  | By: |  | /s/ John R. Lee                         
|                         |  |     |  | John R. Lee, Sr. Vice President and     
|                         |  |     |  | Chief Financial Officer                 
|                         |  |     |  | (Principal Finance & Accounting Officer)



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