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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 June 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 August 16, 2004
|Common Stock, $.0001 par value |  | 4,076,334                     



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PART I. FINANCIAL INFORMATION



Item 1. Financial Statements



PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS



ASSETS

(In Thousands)



|                                               |  |                       |         |   |                  |   |         |  
|---------------------------------------------- |  | --------------------- | ------- | - | ---------------- | - | ------- | -
|                                               |  | June 30,2004Unaudited |         |   | December 31,2003 |  
|Current assets:                                |  |                       |         |   |                  |   |         |  
|Cash                                           |  | $                     | 385     |   |                  | $ | 3,156   |  
|Accounts receivable, net                       |  |                       | 39,274  |   |                  |   | 35,042  |  
|Inventories, net                               |  |                       | 30,422  |   |                  |   | 25,504  |  
|Deferred income taxes                          |  |                       | 7,596   |   |                  |   | 7,223   |  
|Prepaid expenses and other                     |  |                       | 1,898   |   |                  |   | 1,561   |  
|                                               |  |                       |         |   |                  |   |         |  
|Total current assets                           |  |                       | 79,575  |   |                  |   | 72,486  |  
|                                               |  |                       |         |   |                  |   |         |  
|Machinery, equipment and improvements at cost: |  |                       |         |   |                  |   |         |  
|Machinery and equipment                        |  |                       | 31,726  |   |                  |   | 31,536  |  
|Leasehold improvements                         |  |                       | 27,465  |   |                  |   | 27,281  |  
|Construction-in-process                        |  |                       | 2,146   |   |                  |   | 988     |  
|                                               |  |                       |         |   |                  |   |         |  
|                                               |  |                       | 61,337  |   |                  |   | 59,805  |  
|Less accumulated depreciation and amortization |  |                       | (35,225 | ) |                  |   | (33,864 | )
|                                               |  |                       |         |   |                  |   |         |  
|Net machinery, equipment and improvements      |  |                       | 26,112  |   |                  |   | 25,941  |  
|                                               |  |                       |         |   |                  |   |         |  
|Other non-current assets:                      |  |                       |         |   |                  |   |         |  
|Deposits and other                             |  |                       | 1,869   |   |                  |   | 1,779   |  
|Related party receivable                       |  |                       | 471     |   |                  |   | 460     |  
|Intangible pension asset                       |  |                       | 4,539   |   |                  |   | 4,539   |  
|Intangible assets, net                         |  |                       | 188     |   |                  |   | 217     |  
|                                               |  |                       |         |   |                  |   |         |  
|                                               |  |                       | 7,067   |   |                  |   | 6,995   |  
|                                               |  |                       |         |   |                  |   |         |  
|Total assets                                   |  | $                     | 112,754 |   |                  | $ | 105,422 |  
|                                               |  |                       |         |   |                  |   |         |  



The accompanying notes
are an integral part

of these consolidated statements.



-1-



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS



LIABILITIES AND STOCKHOLDERS EQUITY

(In Thousands, Except Common Share Information)



|                                                                                                                                                   |  |                       |         |   |                  |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------- |  | --------------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                                                   |  | June 30,2004Unaudited |         |   | December 31,2003 |  
|Current liabilities:                                                                                                                               |  |                       |         |   |                  |   |         |  
|Current portion of long-term debt                                                                                                                  |  | $                     | 1,233   |   |                  | $ | 1,255   |  
|Current portion of pension liability                                                                                                               |  |                       | 8,281   |   |                  |   | 8,612   |  
|Accounts payable                                                                                                                                   |  |                       | 5,979   |   |                  |   | 1,849   |  
|Accounts payable - accrued                                                                                                                         |  |                       | 4,955   |   |                  |   | 6,696   |  
|Accrued health and dental                                                                                                                          |  |                       | 1,229   |   |                  |   | 1,141   |  
|Accrued liabilities - payroll related                                                                                                              |  |                       | 9,196   |   |                  |   | 7,951   |  
|Accrued liabilities - other                                                                                                                        |  |                       | 7,214   |   |                  |   | 9,210   |  
|Customer deposits in excess of cost                                                                                                                |  |                       | 6,919   |   |                  |   | 7,679   |  
|                                                                                                                                                   |  |                       |         |   |                  |   |         |  
|Total current liabilities                                                                                                                          |  |                       | 45,006  |   |                  |   | 44,393  |  
|                                                                                                                                                   |  |                       |         |   |                  |   |         |  
|Long-term debt, less current portion                                                                                                               |  |                       | 28,434  |   |                  |   | 20,299  |  
|Long-term pension benefit liability                                                                                                                |  |                       | 13,473  |   |                  |   | 15,575  |  
|Other long-term liabilities                                                                                                                        |  |                       | 2,243   |   |                  |   | 2,180   |  
|                                                                                                                                                   |  |                       |         |   |                  |   |         |  
|Total liabilities                                                                                                                                  |  |                       | 89,156  |   |                  |   | 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, 4,076,334 and 4,044,164 issued at June 30, 2004 and December 31, 2003,
respectively |  |                       | 1       |   |                  |   | 1       |  
|Additional paid-in capital                                                                                                                         |  |                       | 12,302  |   |                  |   | 10,077  |  
|Retained earnings                                                                                                                                  |  |                       | 38,419  |   |                  |   | 38,504  |  
|Treasury stock, at cost  411,998 shares at June 30, 2004 and 359,723 at December 31, 2003, respectively                                           |  |                       | (8,585  | ) |                  |   | (7,043  | )
|Accumulated other comprehensive income (loss)                                                                                                      |  |                       |         |   |                  |   |         |  
|Net unrealized gain on investments                                                                                                                 |  |                       | 165     |   |                  |   | 140     |  
|Minimum pension liability                                                                                                                          |  |                       | (18,704 | ) |                  |   | (18,704 | )
|                                                                                                                                                   |  |                       |         |   |                  |   |         |  
|Total stockholders equity                                                                                                                         |  |                       | 23,598  |   |                  |   | 22,975  |  
|                                                                                                                                                   |  |                       |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                                         |  | $                     | 112,754 |   |                  | $ | 105,422 |  
|                                                                                                                                                   |  |                       |         |   |                  |   |         |  



The accompanying notes
are an integral part

of these consolidated statements.



-2-



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

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



|                                              |  |                                |        |   |                                |   |       
|--------------------------------------------- |  | ------------------------------ | ------ | - | ------------------------------ | - | ------
|                                              |  | ThreeMonths EndedJune 30, 2004 |        |   | ThreeMonths EndedJune 30, 2003
|Net sales                                     |  | $                              | 43,515 |   |                                | $ | 47,253
|Cost of sales                                 |  |                                | 37,761 |   |                                |   | 36,133
|                                              |  |                                |        |   |                                |   |       
|Gross profit                                  |  |                                | 5,754  |   |                                |   | 11,120
|                                              |  |                               
|Selling, general, and administrative expenses |  |                                | 7,298  |   |                                |   | 7,456 
|                                              |  |                                |        |   |                                |   |       
|Income (loss) from operations                 |  |                                | (1,544 | ) |                                |   | 3,664 
|                                              |  |                               
|Interest                                      |  |                                | 277    |   |                                |   | 230   
|                                              |  |                                |        |   |                                |   |       
|Income (loss) before income taxes             |  |                                | (1,821 | ) |                                |   | 3,434 
|Income tax expense (benefit)                  |  |                                | (701   | ) |                                |   | 1,305 
|                                              |  |                                |        |   |                                |   |       
|Net income (loss)                             |  | $                              | (1,120 | ) |                                | $ | 2,129 
|                                              |  |                                |        |   |                                |   |       
|Net income (loss) per common share:           |  |                                |        |   |                                |   |       
|Basic                                         |  | $                              | (0.28  | ) |                                | $ | 0.53  
|Diluted                                       |  | $                              | (0.28  | ) |                                | $ | 0.49  
|                                              |  |                               
|Weighted average common shares outstanding:   |  |                                |        |   |                                |   |       
|Basic                                         |  |                                | 4,064  |   |                                |   | 4,043 
|Diluted                                       |  |                                | 4,064  |   |                                |   | 4,377 



The accompanying notes
are an integral part

of these consolidated statements.



-3-



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF OPERATIONS

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



|                                              |  |                              |        |   |                              |   |       
|--------------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | - | ------
|                                              |  | SixMonths EndedJune 30, 2004 |        |   | SixMonths EndedJune 30, 2003
|Net sales                                     |  | $                            | 86,762 |   |                              | $ | 82,922
|Cost of sales                                 |  |                              | 72,169 |   |                              |   | 65,297
|                                              |  |                              |        |   |                              |   |       
|Gross profit                                  |  |                              | 14,593 |   |                              |   | 17,625
|                                              |  |                             
|Selling, general, and administrative expenses |  |                              | 14,229 |   |                              |   | 12,626
|                                              |  |                              |        |   |                              |   |       
|Income (loss) from operations                 |  |                              | 364    |   |                              |   | 4,999 
|                                              |  |                             
|Interest                                      |  |                              | 502    |   |                              |   | 449   
|                                              |  |                              |        |   |                              |   |       
|Income (loss) before income taxes             |  |                              | (138   | ) |                              |   | 4,550 
|Income tax expense (benefit)                  |  |                              | (53    | ) |                              |   | 1,728 
|                                              |  |                              |        |   |                              |   |       
|Net income (loss)                             |  | $                            | (85    | ) |                              | $ | 2,822 
|                                              |  |                              |        |   |                              |   |       
|Net income (loss) per common share:           |  |                              |        |   |                              |   |       
|Basic                                         |  | $                            | (0.02  | ) |                              | $ | 0.70  
|Diluted                                       |  | $                            | (0.02  | ) |                              | $ | 0.64  
|                                              |  |                             
|Weighted average common shares outstanding:   |  |                              |        |   |                              |   |       
|Basic                                         |  |                              | 4,055  |   |                              |   | 4,040 
|Diluted                                       |  |                              | 4,055  |   |                              |   | 4,381 



The accompanying notes
are an integral part

of these consolidated statements



-4-



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                                                            |  |                              |        |   |                              |   |        |  
|------------------------------------------------------------------------------------------- |  | ---------------------------- | ------ | - | ---------------------------- | - | ------ | -
|                                                                                            |  | SixMonths EndedJune 30, 2004 |        |   | SixMonths EndedJune 30, 2003 |  
|Cash flows from operating activities:                                                       |  |                              |        |   |                              |   |        |  
|Net income                                                                                  |  | $                            | (85    | ) |                              | $ | 2,822  |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Adjustments to reconcile net income to net cash (used in) provided by operating activities: |  |                              |        |   |                              |   |        |  
|Depreciation and amortization                                                               |  |                              | 1,830  |   |                              |   | 1,788  |  
|Provision for deferred income taxes                                                         |  |                              | (906   | ) |                              |   | 1,728  |  
|Funding over pension cost                                                                   |  |                              | (2,433 | ) |                              |   | (1,722 | )
|Provision for losses on receivables                                                         |  |                              | 49     |   |                              |   | 21     |  
|Provision for inventory valuation                                                           |  |                              | 39     |   |                              |   |       |  
|Gain (loss) on disposal of fixed assets                                                     |  |                              | 10     |   |                              |   |       |  
|Provision for losses on contracts-in-process                                                |  |                              | (1,749 | ) |                              |   | (1,577 | )
|Income tax benefit from exercise of non-qualified stock options                             |  |                              | 202    |   |                              |   | 121    |  
|Changes in assets and liabilities:                                                          |  |                              |        |   |                              |   |        |  
|Related party receivable                                                                    |  |                              | (11    | ) |                              |   | (25    | )
|Accounts receivable, net                                                                    |  |                              | (4,281 | ) |                              |   | (5,511 | )
|Inventories                                                                                 |  |                              | (4,957 | ) |                              |   | (6,925 | )
|Prepaid expenses and other                                                                  |  |                              | (337   | ) |                              |   | (298   | )
|Deposits and other                                                                          |  |                              | (90    | ) |                              |   | (219   | )
|Customer deposits in excess of cost                                                         |  |                              | (1,173 | ) |                              |   | 3,610  |  
|Accounts payable and accrued liabilities                                                    |  |                              | 4,422  |   |                              |   | 4,815  |  
|Other non-current liabilities                                                               |  |                              | 63     |   |                              |   | 216    |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Total adjustments                                                                           |  |                              | (9,322 | ) |                              |   | (3,978 | )
|                                                                                            |  |                              |        |   |                              |   |        |  
|Net cash used in operating activities                                                       |  |                              | (9,407 | ) |                              |   | (1,156 | )
|                                                                                            |  |                              |        |   |                              |   |        |  
|Cash flows from investing activities:                                                       |  |                              |        |   |                              |   |        |  
|Capital expenditures                                                                        |  |                              | (1,932 | ) |                              |   | (3,883 | )
|                                                                                            |  |                              |        |   |                              |   |        |  
|Net cash used in investing activities                                                       |  |                              | (1,932 | ) |                              |   | (3,883 | )
|                                                                                            |  |                              |        |   |                              |   |        |  
|Cash flows from financing activities:                                                       |  |                              |        |   |                              |   |        |  
|Proceeds from exercise of stock options                                                     |  |                              | 2,022  |   |                              |   | 67     |  
|Purchase of treasury stock                                                                  |  |                              | (1,542 | ) |                              |   | (136   | )
|Net change under revolving credit facility                                                  |  |                              | 6,801  |   |                              |   | 2,714  |  
|Principal payments under long-term debt                                                     |  |                              | (510   | ) |                              |   | (239   | )
|Borrowings under long term debt                                                             |  |                              | 1,797  |   |                              |   |       |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Net cash provided by financing activities                                                   |  |                              | 8,568  |   |                              |   | 2,406  |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Net decrease in cash                                                                        |  |                              | (2,771 | ) |                              |   | (2,633 | )
|                                                                                            |  |                              |        |   |                              |   |        |  
|Cash, beginning of period                                                                   |  |                              | 3,156  |   |                              |   | 2,795  |  
|                                                                                            |  |                              |        |   |                              |   |        |  
|Cash, end of period                                                                         |  | $                            | 385    |   |                              | $ | 162    |  
|                                                                                            |  |                              |        |   |                              |   |        |  



The accompanying notes
are an integral part

of these consolidated statements



-5-



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of and for the Quarters Ended

June 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 June 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.



(In thousands except per share information)



|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  
|------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ------------------------------ | - | ----- | ---------------------------- |  | - | ---------------------------- | - |  | - | ------ | -
|                                                                    |  | ThreeMonths EndedJune 30, 2004 |        |   | ThreeMonths EndedJune 30, 2003 |   |       | SixMonths EndedJune 30, 2004 |  |   | SixMonths EndedJune 30, 2003 |  
|Net income (loss)  as reported                                     |  | $                              | (1,120 | ) |                                | $ | 2,129 |                              |  | $ | (85                          | ) |  | $ | 2,822  |  
|Stock based compensation under fair value method, net of tax effect |  |                                | (141   | ) |                                |   | (182  | )                            |  |   | (1,167                       | ) |  |   | (1,158 | )
|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  
|Net income (loss)  pro forma                                       |  | $                              | (1,261 | ) |                                | $ | 1,947 |                              |  | $ | (1,252                       | ) |  | $ | 1,664  |  
|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  
|Net income (loss) per share, basic  as reported                    |  | $                              | (0.28  | ) |                                | $ | 0.53  |                              |  | $ | (0.02                        | ) |  | $ | 0.70   |  
|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  
|Net income (loss) per share, diluted  as reported                  |  | $                              | (0.28  | ) |                                | $ | 0.49  |                              |  | $ | (0.02                        | ) |  | $ | 0.64   |  
|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  
|Net income (loss) per share, basic  pro forma                      |  | $                              | (0.31  | ) |                                | $ | 0.48  |                              |  | $ | (0.31                        | ) |  | $ | 0.41   |  
|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  
|Net income (loss) per share, diluted  pro forma                    |  | $                              | (0.31  | ) |                                | $ | 0.44  |                              |  | $ | (0.31                        | ) |  | $ | 0.38   |  
|                                                                    |  |                                |        |   |                                |   |       |                              |  |   |                              |   |  |   |        |  



-6-



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3.INVENTORIES



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



(In thousands)



|                                              |  |              |         |   |                  |   |         |  
|--------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                              |  | June 30,2004 |         |   | December 31,2003 |  
|Work in process                               |  | $            | 39,666  |   |                  | $ | 31,679  |  
|Finished goods                                |  |              | 2,046   |   |                  |   | 2,058   |  
|Raw materials and supplies                    |  |              | 11,931  |   |                  |   | 9,677   |  
|                                              |  |              |         |   |                  |   |         |  
|Total                                         |  |              | 53,643  |   |                  |   | 43,414  |  
|Less reserves                                 |  |              | (2,512  | ) |                  |   | (2,473  | )
|Less milestone payments and customer deposits |  |              | (20,709 | ) |                  |   | (15,437 | )
|                                              |  |              |         |   |                  |   |         |  
|                                              |  | $            | 30,422  |   |                  | $ | 25,504  |  
|                                              |  |              |         |   |                  |   |         |  



A substantial portion
of the above inventories relate to U.S. Government contracts or sub-contracts. The company receives milestone payments on the majority of its U.S. Government contracts. The title to all inventories on which the company receives milestone payments is
vested in the customer to the extent of the deposit balance.



4.NET
INCOME (LOSS) PER SHARE



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



-7-



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The following table represents the net income (loss) per share calculations for the three-month and
six-month periods ended June 30, 2004 and 2003:



(All numbers
in thousands, except income per share)



|                                    |  |                                |        |   |                                  |   |                              |  |   |                              |   |  |   |      
|----------------------------------- |  | ------------------------------ | ------ | - | -------------------------------- | - | ---------------------------- |  | - | ---------------------------- | - |  | - | -----
|                                    |  | ThreeMonths EndedJune 30, 2004 |        |   | Three Months Ended June 30, 2003 |   | SixMonths EndedJune 30, 2004 |  |   | SixMonths EndedJune 30, 2003
|Net income (loss)                   |  | $                              | (1,120 | ) |                                  | $ | 2,129                        |  | $ | (85                          | ) |  | $ | 2,822
|Weighted average shares             |  |                                | 4,064  |   |                                  |   | 4,043                        |  |   | 4,055                        |   |  |   | 4,040
|Basic net income (loss) per share   |  | $                              | (0.28  | ) |                                  | $ | 0.53                         |  | $ | (0.02                        | ) |  | $ | 0.70 
|Dilutive securities: options        |  |                                |       |   |                                  |   | 334                          |  |   |                             |   |  |   | 341  
|Diluted weighted average shares     |  |                                | 4,064  |   |                                  |   | 4,377                        |  |   | 4,055                        |   |  |   | 4,381
|Diluted net income (loss) per share |  | $                              | (0.28  | ) |                                  | $ | 0.49                         |  | $ | (0.02                        | ) |  | $ | 0.64 



Options to purchase
204,833 and approximately 217,000 shares of common stock related to June 30, 2004 and 2003, respectively, were excluded from the computation of diluted net income (loss) per share because the option exercise price was greater than the average market
price of the shares.



5.DEBT



Debt as of June 30, 2004 and December 31, 2003 consists of the following:



(In thousands)



|                                                                                                                 |  |              |        |   |                  |   |        |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------ | ------ | - | ---------------- | - | ------ | -
|                                                                                                                 |  | June 30,2004 |        |   | December 31,2003 |  
|Revolving credit facility; Interest at LIBOR plus 2.50% (3.78% at June 30, 2004)                                 |  | $            | 21,792 |   |                  | $ | 14,966 |  
|Bank Term Loan; Interest at LIBOR plus 2.75% (4.03% at June 30, 2004)                                            |  |              | 3,500  |   |                  |   | 4,000  |  
|Airport Authority Term Loan; Interest at BMA plus 0.36% (1.33% at June 30, 2004)                                 |  |              | 2,500  |   |                  |   | 2,500  |  
|Treasury Stock Term Loan; Interest at LIBOR plus 3.00% (4.52% at June 30, 2004)                                  |  |              | 1,797  |   |                  |   |       |  
|Capital Lease Obligations; Interest from 8.4% to 11.0%, collateralized by security interest in certain equipment |  |              | 78     |   |                  |   | 88     |  
|                                                                                                                 |  |              |        |   |                  |   |        |  
|Total long-term debt                                                                                             |  |              | 29,667 |   |                  |   | 21,554 |  
|Less portion reflected as current                                                                                |  |              | (1,233 | ) |                  |   | (1,255 | )
|                                                                                                                 |  |              |        |   |                  |   |        |  
|Long term-debt, net of current portion                                                                           |  | $            | 28,434 |   |                  | $ | 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 borrowing capacity under the Revolving Credit Facility from $20.0 million to $25.0 million



-8-



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and extended the maturity date from December 16, 2004 to December 16, 2005. The Revolving Credit Facility
bears interest at 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 million to $27 million. Borrowing availability under the revolving credit facility is tied to percentages of eligible accounts receivable and inventories. The company had borrowings of
approximately $21.8 million outstanding under the Revolving Credit Facility at June 30, 2004. Remaining borrowing capacity available under the revolving credit facility at June 30, 2004, based upon the calculation that defines the borrowing base,
totaled approximately $5.2 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.



On May 22, 2004, the company amended the Credit Agreement to create a line of credit for the repurchase of the companys common stock (Treasury
Stock Term Loan). The company may draw upon the Treasury Stock Term Loan 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 June 30, 2004 of $1.8 million compared to a -0- balance at December 31, 2003. The loan will be repaid in equal monthly installments over 31 months commencing on May 22, 2005.



The Airport Authority Term Loan was originated on November 26, 2002, has a
term of 15 years, and bears interest at the Bond Market Association (BMA) plus 0.36%. The amount outstanding under the Airport Authority Term Loan at June 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 five-year term.



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



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



(In Thousands)



|                    |  |   |       
|------------------- |  | - | ------
|Current             |  | $ | 1,233 
|One to three years  |  |   | 25,724
|Three to five years |  |   | 1,110 
|Thereafter          |  |   | 1,600 
|                    |  |   |       
|                    |  | $ | 29,667
|                    |  |   |       



A significant portion
of the debt maturing during the one to three year period listed above relates to the expiration of the two-year term of the Revolving Credit Facility, as amended. The company expects that it will renew the agreement for an additional two-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, which limit or prohibit the company from
incurring additional indebtedness, disposing of assets, merging with other entities, declaring dividends, or making capital expenditures in excess of certain amounts in any fiscal year. Additionally, the company is required to maintain various
financial ratios and minimum net worth amounts.



Notwithstanding the covenants mentioned above which 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.



6.STOCKHOLDERS EQUITY



Holders of stock options under the companys
Non-Qualified Stock Option Plan exercised options for approximately 84,445 and 17,000 shares, respectively, of the companys common stock during the three months ended June 30, 2004 and 2003. The company recorded both the exercise price and a
tax benefit totaling approximately $2.3 million and $270,000, respectively, to additional paid in capital during the second quarter of 2004 and 2003.



7.EMPLOYEE BENEFIT PLANS



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



-10-



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



|                                   |  |                                |        |   |                                  |   |        |                              |  |   |                              |   |  |   |        |  
|---------------------------------- |  | ------------------------------ | ------ | - | -------------------------------- | - | ------ | ---------------------------- |  | - | ---------------------------- | - |  | - | ------ | -
|                                   |  | ThreeMonths EndedJune 30, 2004 |        |   | Three Months Ended June 30, 2003 |   |        | SixMonths EndedJune 30, 2004 |  |   | SixMonths EndedJune 30, 2003 |  
|Service cost                       |  | $                              | 642    |   |                                  | $ | 577    |                              |  | $ | 1,284                        |   |  | $ | 1,154  |  
|Interest cost                      |  |                                | 1,792  |   |                                  |   | 1,849  |                              |  |   | 3,584                        |   |  |   | 3,698  |  
|Expected return on plan assets     |  |                                | (2,190 | ) |                                  |   | (2,138 | )                            |  |   | (4,380                       | ) |  |   | (4,276 | )
|Amortization of prior service cost |  |                                | 169    |   |                                  |   | 218    |                              |  |   | 338                          |   |  |   | 436    |  
|Amortization of net (gain) loss    |  |                                | 268    |   |                                  |   | 44     |                              |  |   | 536                          |   |  |   | 88     |  
|                                   |  |                                |        |   |                                  |   |        |                              |  |   |                              |   |  |   |        |  
|Net pension cost                   |  | $                              | 681    |   |                                  | $ | 550    |                              |  | $ | 1,362                        |   |  | $ | 1,100  |  
|                                   |  |                                |        |   |                                  |   |        |                              |  |   |                              |   |  |   |        |  



8.CONTINGENCIES



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



A Significant Portion of the Companys Revenue is Derived From a Few of its Customers- A small number of the companys customers account
for a significant percentage of its revenues. The KC-135 program comprised 57% and 67% of the companys total revenues during the six month periods ended June 30, 2004 and 2003, respectively. The companys two largest programs generated
approximately 84% and 83% of its revenues during the second quarters of 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.



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 of
three Boeing 737



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aircraft to Quick Change configuration by the company 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. The New York Court has ordered mediation in the matter. On March 24, 2004, the Circuit Court of Dale County, Alabama denied a motion filed by GECAS to dismiss or stay
the proceedings. GECAS has subsequently paid in full charges owed on four of the six aircraft. Management believes that the results of this claim will not have a material impact on the companys financial position or results of operations.



ACC Capital Corporation (ACC Capital) claims the
company improperly terminated leases for computer hardware and software in November of 2002. The company filed a Declaratory Judgment action on February 4, 2003 in the U. S. District Court, Northern District of Alabama to substantiate the
companys end-of-term option to purchase. ACC Capital filed an action in Utah state court on March 17, 2003, which was subsequently removed to federal court on the companys motion. The parties settled the case on May 28, 2004.



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 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 and all briefs filed. Arguments were heard by the Court



-12-



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on March 18, 2004 and the company awaits the Courts decision. 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
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 Management believes will not 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 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. The companys subsequent site characterization report was approved by the EPA and the Alabama Department of Environmental Management (ADEM) on July 30, 2004. The additional sampling schedule is being
determined. 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 $74,000 and $100,000 related to the Phase II Plan at June 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



-13-



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$441,000, of which the company has paid approximately $367,000 as of June 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. Management believes that compliance with environmental regulations will not have a material impact on the companys financial position or results of operations.



9. 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 intercompany profit is not material. The company does not allocate income taxes to segments.



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



-14-



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



(In Thousands)



|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ | --- |  | - | ------------ | - |  | - | ------- | -
|Three Months Ended June 30, 2004          |  | GSS |        |   | CSS |   |        | MCS |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 26,289 |   |     | $ | 9,996  |     |  | $ | 1,701        |   |  | $ | 37,986  |  
|Revenues from external foreign customers  |  |     |        |   |     |   | 5,375  |     |  |   | 154          |   |  |   | 5,529   |  
|Inter-company revenues                    |  |     | 1      |   |     |   | 3,445  |     |  |   | 150          |   |  |   | 3,596   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 26,290 |   |     |   | 18,816 |     |  |   | 2,005        |   |  |   | 47,111  |  
|Elimination                               |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (3,596  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 43,515  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  | $   | 3,885  |   |     | $ | 2,476  |     |  | $ | (607         | ) |  | $ | 5,754   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Segment operating income (loss)           |  | $   | (1,349 | ) |     | $ | 379    |     |  | $ | (574         | ) |  | $ | (1,544  | )
|Interest expense                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 277     |  
|Income tax benefit                        |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (701    | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Net income (loss)                         |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | (1,120  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 74,050 |   |     | $ | 33,612 |     |  | $ | 5,092        |   |  | $ | 112,754 |  
|Depreciation/amortization                 |  |     | 818    |   |     |   | 337    |     |  |   | 117          |   |  |   | 1,272   |  
|Capital Additions                         |  |     | 1,175  |   |     |   | 207    |     |  |   | 4            |   |  |   | 1,386   |  
|                                          |  |     |        |  
|Three Months Ended June 30, 2003          |  | GSS |        |   | CSS |   |        | MCS |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 34,276 |   |     | $ | 11,317 |     |  | $ | 1,428        |   |  | $ | 47,021  |  
|Revenues from external foreign customers  |  |     |        |   |     |   | 160    |     |  |   | 72           |   |  |   | 232     |  
|Inter-company revenues                    |  |     | 2      |   |     |   | 549    |     |  |   | 508          |   |  |   | 1,059   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 34,278 |   |     |   | 12,026 |     |  |   | 2,008        |   |  |   | 48,312  |  
|Elimination                               |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (1,059  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 47,253  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  | $   | 12,963 |   |     | $ | (928   | )   |  | $ | (915         | ) |  | $ | 11,120  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Segment operating income (loss)           |  | $   | 7,753  |   |     | $ | (2,912 | )   |  | $ | (1,177       | ) |  | $ | 3,664   |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 230     |  
|Income taxes                              |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 1,305   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Net income                                |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 2,129   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 67,693 |   |     | $ | 32,473 |     |  | $ | 5,874        |   |  | $ | 106,040 |  
|Depreciation/amortization                 |  |     | 712    |   |     |   | 384    |     |  |   | 59           |   |  |   | 1,155   |  
|Capital Additions                         |  |     | 272    |   |     |   | 1,104  |     |  |   | 5            |   |  |   | 1,381   |  



-15-



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



(In Thousands)



|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|----------------------------------------- |  | --- | ------ | - | --- | - | ------ | --- |  | - | ------------ | - |  | - | ------- | -
|Six Months Ended June 30, 2004            |  | GSS |        |   | CSS |   |        | MCS |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 55,881 |   |     | $ | 21,146 |     |  | $ | 3,126        |   |  | $ | 80,153  |  
|Revenues from external foreign customers  |  |     |        |   |     |   | 6,260  |     |  |   | 349          |   |  |   | 6,609   |  
|Inter-company revenues                    |  |     | (9     | ) |     |   | 3,568  |     |  |   | 307          |   |  |   | 3,866   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 55,872 |   |     |   | 30,974 |     |  |   | 3,782        |   |  |   | 90,628  |  
|Elimination                               |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (3,866  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 86,762  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  | $   | 12,556 |   |     | $ | 2,815  |     |  | $ | (778         | ) |  | $ | 14,593  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Segment operating income (loss)           |  | $   | 2,373  |   |     | $ | (1,171 | )   |  | $ | (838         | ) |  | $ | 364     |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 502     |  
|Income tax benefit                        |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (53     | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Net income (loss)                         |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | (85     | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 74,050 |   |     | $ | 33,612 |     |  | $ | 5,092        |   |  | $ | 112,754 |  
|Depreciation/amortization                 |  |     | 1,518  |   |     |   | 630    |     |  |   | 163          |   |  |   | 2,311   |  
|Capital Additions                         |  |     | 1,211  |   |     |   | 666    |     |  |   | 55           |   |  |   | 1,932   |  
|                                          |  |     |        |  
|Six Months Ended June 30, 2003            |  | GSS |        |   | CSS |   |        | MCS |  |   | Consolidated |  
|Revenues from external domestic customers |  | $   | 56,267 |   |     | $ | 20,643 |     |  | $ | 3,325        |   |  | $ | 80,235  |  
|Revenues from external foreign customers  |  |     |        |   |     |   | 2,486  |     |  |   | 201          |   |  |   | 2,687   |  
|Inter-company revenues                    |  |     | 100    |   |     |   | 592    |     |  |   | 640          |   |  |   | 1,332   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total segment revenues                    |  |     | 56,367 |   |     |   | 23,721 |     |  |   | 4,166        |   |  |   | 84,254  |  
|Elimination                               |  |     |        |   |     |   |        |     |  |   |              |   |  |   | (1,332  | )
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Total Revenue                             |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 82,922  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Gross profit                              |  | $   | 20,012 |   |     | $ | (1,446 | )   |  | $ | (941         | ) |  | $ | 17,625  |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Segment operating income (loss)           |  | $   | 11,397 |   |     | $ | (4,984 | )   |  | $ | (1,414       | ) |  | $ | 4,999   |  
|Interest expense                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 449     |  
|Income taxes                              |  |     |        |   |     |   |        |     |  |   |              |   |  |   | 1,728   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Net income                                |  |     |        |   |     |   |        |     |  |   |              |   |  | $ | 2,822   |  
|                                          |  |     |        |   |     |   |        |     |  |   |              |   |  |   |         |  
|Assets                                    |  | $   | 67,693 |   |     | $ | 32,473 |     |  | $ | 5,874        |   |  | $ | 106,040 |  
|Depreciation/amortization                 |  |     | 1,206  |   |     |   | 596    |     |  |   | 111          |   |  |   | 1,913   |  
|Capital Additions                         |  |     | 2,018  |   |     |   | 1,814  |     |  |   | 51           |   |  |   | 3,883   |  



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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 Income will not directly match the change in accumulated depreciation and amortization reflected on the companys Consolidated Balance Sheets. This is a result of the capitalization of depreciation costs on
long-term contracts into work-in-process.



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



|                                                                                                          |  |      |       |      |   |      
|--------------------------------------------------------------------------------------------------------- |  | ---- | ----- | ---- | - | -----
|Three Months Ended June 30                                                                                |  | 2004 |       | 2003
|Change in Accumulated Depreciation and Amortization Reflected on the Consolidated Statement of Cash Flows |  | $    | 915   |      | $ | 1,048
|Net Depreciation and Amortization (Capitalized Into) or Removed from Work-in-Process                      |  |      | 357   |      |   | 107  
|                                                                                                          |  |      |       |      |   |      
|Depreciation and Amortization Recorded in Cost of Goods Sold Upon Delivery of Aircraft                    |  | $    | 1,272 |      | $ | 1,155
|                                                                                                          |  |      |       |      |   |      
|                                                                                                          |  |     
|Six Months Ended June 30                                                                                  |  | 2004 |       | 2003
|Change in Accumulated Depreciation and Amortization Reflected on the Consolidated Statement of Cash Flows |  | $    | 1,840 |      | $ | 1,788
|Net Depreciation and Amortization (Capitalized Into) or Removed from Work-in-Process                      |  |      | 471   |      |   | 125  
|                                                                                                          |  |      |       |      |   |      
|Depreciation and Amortization Recorded in Cost of Goods Sold Upon Delivery of Aircraft                    |  | $    | 2,311 |      | $ | 1,913
|                                                                                                          |  |      |       |      |   |      



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



INTRODUCTION



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



OVERVIEW



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



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RESULTS OF OPERATIONS



Three months ended June 30, 2004

Versus three months ended June
30, 2003



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



(In $Millions)



|                           |  |      |      |   |      |   |        |  |        |   
|-------------------------- |  | ---- | ---- | - | ---- | - | ------ |  | ------ | --
|                           |  | 2004 |      |   | 2003 |   | Change | 
|Revenue                    |  | $    | 43.5 |   |      | $ | 47.3   |  | (8.0   | )%
|Gross Profit               |  |      | 5.8  |   |      |   | 11.1   |  | (47.7  | )%
|Operating income (loss)    |  |      | (1.5 | ) |      |   | 3.7    |  | (140.5 | )%
|Income (loss) before taxes |  |      | (1.8 | ) |      |   | 3.4    |  | (152.9 | )%
|Net income (loss)          |  |      | (1.1 | ) |      |   | 2.1    |  | (152.4 | )%
|EBITDA                     |  |      | (0.2 | ) |      |   | 4.8    |  | (104.2 | )%



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



|                            |  |      |      |   |      |   |    
|--------------------------- |  | ---- | ---- | - | ---- | - | ---
|                            |  | 2004 |      |   | 2003
|Net income (loss)           |  | $    | (1.1 | ) |      | $ | 2.1
|Interest                    |  |      | 0.3  |   |      |   | 0.2
|Taxes                       |  |      | (0.7 | ) |      |   | 1.3
|Depreciation & Amortization |  |      | 1.3  |   |      |   | 1.2
|                            |  |      |      |   |      |   |    
|EBITDA                      |  | $    | (0.2 | ) |      | $ | 4.8
|                            |  |      |      |   |      |   |    



The company presents Earnings Before
Interest, Taxes, Depreciation and Amortization, more commonly referred to as EBITDA, because its management uses the measure to evaluate the companys performance and to allocate resources. In addition, EBITDA is used as one of the components
to calculate the companys debt covenants. The company believes EBITDA is also an important gauge used by commercial banks, investment banks, other financial institutions, and current and potential investors to approximate its cash generation
capability. Accordingly, the company has included EBITDA as part of this report. The Depreciation and Amortization amounts used in the EBITDA calculation are those that were recorded in the Consolidated Statements of Operations in this report. Due
to the long-term nature of much of the companys business, the Depreciation and Amortization amounts recorded in the Consolidated Statements of Income will not directly match the change in Accumulated Depreciation and Amortization reflected on
the companys Consolidated Balance Sheets. This is a result of the capitalization of depreciation expense on long-term contracts into work-in-process. EBITDA is not a measure of financial



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performance under generally accepted accounting principles and should not be considered as a substitute for or superior
to other measures of financial performance reported in accordance with GAAP. EBITDA as presented herein may not be comparable to similarly titled measures reported by other companies.



The table below presents the highlights in revenue by operating segment from the three months ended June 30, 2004 and 2003.



(In $Millions)



|             |  |      |   |  |      |   |  |        |   |  |          |   
|------------ |  | ---- | - |  | ---- | - |  | ------ | - |  | -------- | --
|             |  | 2004 |   |  | 2003 |   |  | Change |   |  | % Change |   
|GSS          |  | 26.3 |   |  | 34.3 |   |  | (8.0   | ) |  | (23.3    | )%
|CSS          |  | 18.8 |   |  | 12.0 |   |  | 6.8    |   |  | 56.7     | % 
|MCS          |  | 2.0  |   |  | 2.0  |   |  |       |   |  | 0.0      | % 
|Eliminations |  | (3.6 | ) |  | (1.1 | ) |  | (2.5   | ) |  | 227.3    | % 
|             |  |      |   |  |      |   |  |        |   |  |          |   
|Total        |  | 43.5 |   |  | 47.2 |   |  | (3.7   | ) |  | (7.8     | )%
|             |  |      |   |  |      |   |  |        |   |  |          |   



Without regard to operating segments,
the companys mix of revenue between government and commercial customers was approximately 38% commercial and 62% government in 2004 and 26% commercial and 74% government in 2003.



GSS revenue decreased $8.0 million primarily as a result of lower sales under the KC-135 Programmed Depot Maintenance (PDM)
program of approximately $10.0 million which was offset by sales related to C-130 contracts of approximately $2.0 million. During the second quarter of 2004, the GSS delivered four PDM aircraft compared to ten PDM deliveries during the same period
of 2003. The lower than expected PDM deliveries were due to implementation of changes in the production process designed to improve flow days.



The increase in the CSS revenue of $6.8 million was attributable to an increase in commercial Maintenance, Repair, and Overhaul (MRO) services to its largest
customer of approximately $9.6 million and increased intercompany sales of KC-135 flight controls of $2.5 million. These increases were partially offset by a decrease in 737 cargo conversion work of $2.3 million, and a decrease in other MRO services
of approximately $3.0 million.



Revenue at the MCS remained flat at $2.0
million in the second quarter of 2004 versus the second quarter of 2003. Revenues at the MCS consist of flight termination and other launch systems for the three months ended June 30, 2004 versus the close out of two government programs for the
period ended June 30, 2003. Revenue related to sales of high precision machined parts and other aircraft components remained relatively flat during the second quarter of 2004 compared to the second quarter of 2003.



Cost of sales increased to $37.8 million during the second quarter of 2004 from $36.1 million
in the second quarter of 2003 due to several factors. At the GSS, losses of approximately $2.0 million associated with C-130 programs were recognized. Additionally, the GSS incurred professional fees related to improving cycle time and reducing flow
days. Overall, the gross profit percentage of the



-19-



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company decreased during this same period to 13.2% in 2004 from 23.5% in 2003. Gross profit at the GSS decreased to 14.8%
from 37.8% during the same period. Gross profit at the CSS improved to approximately 13.2% during the second quarter of 2004 from approximately (8.2)% during the same period of 2003. Cost of sales at the CSS during the second quarter of 2003
included training and learning curve costs related to work begun on new types of aircraft.



Selling, general and administrative (SG&A) expense decreased to $7.3 million in the second quarter of 2004 from $7.5 million during the second quarter of 2003. Included in the SG&A for the quarter
was a charge of $0.9 million related to the purchase of treasury stock upon the exercise of certain stock options. Without this adjustment, SG&A for the second quarter would have been $1.1 million lower than the prior year. This SG&A
decrease relates to lower sales in GSS, which capitalizes SG&A expense and relieves those costs from work in process as aircraft are sold.



Interest expense held relatively constant at approximately $0.3 million during the second quarter of 2004 and 2003.



The company recorded income taxes at an effective rate of 38.5% and 38.0% during the second
quarter of 2004 and 2003, respectively.



Six months ended June 30, 2004

Versus six months ended June 30, 2003



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



(In $millions)



|                           |  |      |   |  |      |  |        |   
|-------------------------- |  | ---- | - |  | ---- |  | ------ | --
|                           |  | 2004 |   |  | 2003 |  | Change |   
|Revenue                    |  | 86.8 |   |  | 82.9 |  | 4.7    | % 
|Gross profit               |  | 14.6 |   |  | 17.6 |  | (17.0  | )%
|Operating income           |  | 0.4  |   |  | 5.0  |  | (92.0  | )%
|Income (loss) before taxes |  | (0.1 | ) |  | 4.6  |  | (102.2 | )%
|Net income (loss)          |  | (0.1 | ) |  | 2.8  |  | (103.6 | )%
|EBITDA                     |  | 2.6  |   |  | 6.8  |  | (61.8  | )%



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



(In
$millions)



|                            |  |      |   |  |     
|--------------------------- |  | ---- | - |  | ----
|                            |  | 2004 |   |  | 2003
|Net income (loss)           |  | (0.1 | ) |  | 2.8 
|Interest                    |  | 0.5  |   |  | 0.5 
|Taxes                       |  | (0.1 | ) |  | 1.7 
|Depreciation & Amortization |  | 2.3  |   |  | 1.9 
|                            |  |      |   |  |     
|EBITDA                      |  | 2.6  |   |  | 6.8 
|                            |  |      |   |  |     



-20-



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The table below presents the highlights in Revenue by Operating Segment from the six months ended June 30, 2004 and 2003.



(In $millions)



|             |  |      |   |  |      |   |  |        |   |  |          |   
|------------ |  | ---- | - |  | ---- | - |  | ------ | - |  | -------- | --
|             |  | 2004 |   |  | 2003 |   |  | Change |   |  | % Change |   
|GSS          |  | 55.9 |   |  | 56.4 |   |  | (0.5   | ) |  | (0.9     | )%
|CSS          |  | 31.0 |   |  | 23.7 |   |  | 7.3    |   |  | 30.8     | % 
|MCS          |  | 3.8  |   |  | 4.2  |   |  | (0.4   | ) |  | (9.5     | )%
|Eliminations |  | (3.9 | ) |  | (1.3 | ) |  | (2.6   | ) |  | 200.0    | % 
|             |  |      |   |  |      |   |  |        |   |  |          |   
|Total        |  | 86.8 |   |  | 83.0 |   |  | 3.8    |   |  | 4.6      | % 
|             |  |      |   |  |      |   |  |        |   |  |          |   



Without regard to operating segments,
the companys mix of revenue between government and commercial customers was approximately 34% commercial and 66% government in the first six months of fiscal year 2004 and 29% commercial and 71% government in the first six months of fiscal
year 2003.



GSS revenue remained relatively flat at a $0.5 million decrease for
the six month period ended June 30, 2004 versus the six month period ended June 30, 2003. Revenues under the KC-135 (PDM) program decreased by $5.0 million which was offset by sales related to a new C-130 contract of approximately $5.5 million.
During the first six months of 2004, the GSS delivered 11 PDM aircraft compared to 15 PDM deliveries during the same period of 2003.



The increase in the CSS revenue of $7.3 million was attributable to an increase in commercial MRO services to its largest customer of approximately $13.3 million and
increased intercompany sales of KC-135 flight controls of $2.8 million. These increases were partially offset by a decrease of 737 cargo conversion work of $2.3 million, and a decrease in Other MRO Customers of $6.5 million.



Revenue at the MCS decreased $0.4 million in the first six months of 2004 versus the first
six months of 2003 primarily as a result of the close out of two government programs during 2003, partially offset by increased sales related to flight termination systems program. Revenue related to sales of high precision machined parts and other
aircraft components remained relatively flat during the first six months of 2004 compared to the first six months of 2003.



Cost of sales increased to $72.2 million during the first six months of 2004 from $65.3 million in the first six months of 2003, due partially to an increase in revenue.
Other factors include GSS loss reserves, which were recorded, associated with C-130 programs of $2.7 million associated with learning curve costs on this relatively new program. Additionally, professional fees related to improving productivity and
cost associated with projects to improve material flow to the aircraft, including point of use supply programs. Overall, the gross profit percentage of the company decreased during this same period to 16.8% in the first six months of 2004 from 21.3%
in the first six months of 2003.



-21-



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Gross profit at the GSS declined to 22.5% in the first six months of 2004 from 35.5% in the first six months of 2003.
Gross profit at the CSS improved to approximately 9.1% during the first six months of 2004 from approximately (7.0)% during the same period of 2003. Cost of sales at the CSS during the first six months of 2003 included training and learning curve
costs related to work begun on new types of aircraft. Such costs included a $0.9 million charge for estimated losses on contracts-in-process. There were no comparable costs at the CSS during the first half of 2004.



SG&A expense increased to $14.2 million for the six month period ended June 30, 2004 from
$12.6 million during the six month period ended June 30, 2003. Included in the SG&A for the quarter was a charge of $0.9 million related to the purchase of treasury stock upon the exercise of certain stock options. The company also recorded
accounting and legal charges of approximately $1.6 million during the first quarter of 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 held relatively constant at approximately
$0.5 million during the first half of 2004 and $0.4 during the first six months of 2003.



The company recorded income taxes at an effective rate of 38.5% and 38.0% during the first six months of 2004 and 2003, respectively.



LIQUIDITY AND CAPITAL RESOURCES



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



(In $thousands except long term debt to equity)



|                                             |  |             |  |                  |  |        |        |  
|-------------------------------------------- |  | ----------- |  | ---------------- |  | ------ | ------ | -
|                                             |  | June30,2004 |  | December 31,2003 |  | Change |       
|Cash                                         |  | 385         |  | 3,156            |  | $      | (2,771 | )
|Working capital                              |  | 34,569      |  | 28,093           |  |        | 6,476  |  
|Revolving credit facility                    |  | 21,792      |  | 14,966           |  |        | 6,826  |  
|Long term debt and capital lease obligations |  | 6,642       |  | 5,333            |  |        | 1,309  |  
|Shareholders equity                         |  | 23,598      |  | 22,975           |  |        | 623    |  
|Long term debt to equity                     |  | 1.20        |  | 0.88             |  |        | 0.32   |  



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



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Operating activities used $9.4 million of cash during the six months ended June 30, 2004. Operating activities used $1.3
million of cash during the same period of 2003. Cash of $1.9 million and $3.9 million was used during the quarters ended June 30, 2004 and 2003, respectively, for capital expenditures.



At June 30, 2004 the company had additional borrowing capacity of $5.2 million under its Revolving 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 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, partially offset by favorable returns in 2003, coupled with substantially lower interest rates, the Plan was under-funded by approximately $26.5 million
at December 31, 2003. Pursuant to ERISA funding requirements, the company expects to make contributions of approximately $8.6 million to the Plan during 2004, of which the company has made contributions of approximately $3.9 million through June 30,
2004.



In January 2003, the company began projects to improve its information
system infrastructure. These projects included an upgrade to its enterprise software at GSS and a conversion to the enterprise software and upgrades to hardware at the CSS, altogether expected to cost approximately $1.5 million. The company
anticipates costs to complete these projects during 2004 to be approximately $0.9 million. The company currently has no other material capital projects underway.



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 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. 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.



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TRADING ACTIVITIES



The company has not engaged in trading activities or in trading non-exchange traded contracts. As of June 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 Part I of this Report.



RELATED PARTY TRANSACTIONS



On April 23, 2002, the company loaned its current President and Chief Executive Officer approximately $0.4 million under the terms of a Promissory Note. The Promissory
Note carries a fixed interest rate of 5% per annum and is payable within 60 days of the President and Chief Executive Officers termination of employment with the company. Any change in this related party receivable relates to interest
accumulated during the period.



CRITICAL ACCOUNTING POLICIES AND ESTIMATES



The companys significant accounting policies are disclosed in Note
1 of Notes to Consolidated Financial Statements in the companys 2003 Annual Report on Form 10-K. The preparation of financial statements in conformity with generally accepted accounting principles requires that management use judgments to make
estimates and assumptions that affect the amounts reported in the financial statements. As a result, there is some risk that reported financial results could have been materially different had different methods, assumptions, and estimates been used.



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



Revenue Recognition



Revenue at the companys GSS is derived principally from aircraft maintenance and modification services performed under contracts or subcontracts with government and military customers. These contracts generally
provide for a fixed price component and a time-and-material component based on estimated labor hours at fixed hourly rates. Milestone billings and costs related to work performed under fixed price arrangements are accumulated on the balance sheet
during the period of performance, and revenue and associated costs are recognized when the aircraft is delivered. An aircraft is considered delivered when work is substantially complete and accepted by the customer. Revenue related to work performed
under time-and-material components of a contract is recognized upon completion of all performance obligations in accordance with the contract and acceptance by the customer. Such work is performed and completed throughout the PDM process.



Revenue at the companys CSS is derived principally from aircraft
maintenance, modification, and conversion programs under contracts with the owners and operators of large commercial airlines. The CSS recognizes revenue and associated costs for all work performed under such contracts as deliveries are made.



-24-



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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.



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.



Deferred Taxes



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



Inventory Reserves



The company regularly estimates the degree of technological obsolescence in its inventories and provides inventory reserves on that basis. Though the company believes it has adequately provided for any such declines
in inventory value to date, any unanticipated change in technology or potential decertification due to failure to meet design specification could significantly affect the value of the companys inventories and thereby adversely affect gross
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.



Reserve for Warranty Expenses



The company provides warranties on certain work performed for a given time period, in
accordance with the terms of each specific contract. The company provides a reserve for anticipated warranty claims based on historical experience, current warranty trends, and specific warranty terms. This reserve is managements best estimate
of anticipated costs related to aircraft that were under warranty at June 30, 2004. Periodic adjustments to the reserve will be made as events occur that indicate changes are necessary. The liability for warranty reserves was approximately $776,000
and $816,000 at June 30, 2004 and December 31, 2003, respectively.



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Pension and Postretirement Plans



The company maintains pension plans covering a majority of its employees and retirees, and postretirement benefit plans for retirees that
include health care benefits and life insurance coverage (see Item 8. Financial Statements and Supplementary Data in Note 9 of Notes to Financial Statements for additional details). For financial reporting purposes, net periodic pension and other
postretirement benefit costs (income) are calculated based upon a number of actuarial assumptions including a discount rate for plan obligations, assumed rate of return on pension plan assets, assumed annual rate of compensation increase for plan
employees, and an annual rate of increase in the per capita costs of covered postretirement healthcare benefits. Each of these assumptions is based upon the companys judgment, considering all known trends and uncertainties. Actual asset
returns for the company pension plans significantly below the companys assumed rate of return would result in lower net periodic pension income (or higher expense) in future years. Actual annual rates of increase in the per capita costs of
covered postretirement healthcare benefits above assumed rates of increase would result in higher net periodic postretirement benefit costs in future years.



Contingencies



As further discussed in Note 10 of Notes to 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. However, a settlement or an adverse resolution of
one or more of these matters may result in the payment of significant costs and damages that could have a material adverse effect on the companys business, financial condition, results of operations, and cash flows.



BACKLOG



The following table presents the companys backlog (in thousands of dollars) at June 30, 2004 and June 30, 2003:



|                |  |      |        |      |   |        
|--------------- |  | ---- | ------ | ---- | - | -------
|Customer Type   |  | 2004 |        | 2003
|U.S. Government |  | $    | 68,370 |      | $ | 108,508
|Commercial      |  |      | 14,792 |      |   | 13,587 
|                |  |      |        |      |   |        
|Total           |  | $    | 83,162 |      | $ | 122,095
|                |  |      |        |      |   |        



The reduction in government backlog
was related to decreases in both the U.S. Government GSS and MCS. The GSS decreased backlog approximately $40.1 million year-over-year due primarily to



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lower KC-135 aircraft in work. At June 30, 2003, there were 30 KC-135s in backlog versus 25 at June 30, 2004.
Backlog in government programs at the MCS decreased $0.5 million during this same period due to the unit nearing the completion of one of its existing contracts.



Total commercial backlog increased $1.2 million. Backlog at the CSS increased $1.0 million while backlog in commercial programs at the MCS
increased when compared with the prior year. The increased in backlog at the CSS is due primarily to inputs of aircraft from its largest customer, which is performing more heavy maintenance checks on its aircraft in 2004 compared to 2003.



Overall, the mix of backlog shifted towards commercial from 88.8% government
and 11.2% commercial for the six months ended June 30, 2003 to 82.2% government and 17.8% commercial for the three months ended June 30, 2004. This shift in mix is primarily a result of the large decrease in the U. S. Government backlog noted above.



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



CONTINGENCIES



See Note 8 to the Consolidated Financial Statements.



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



Some of the information under the caption Managements Discussion and Analysis of
Financial Condition and Results of Operations and elsewhere in this Quarterly Report 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 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 2003 Annual Report on Form 10-K,
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 Credit Agreement, which includes a Revolving Credit Facility, the Bank term loan, the Treasury Stock Term Loan and the
Airport Authority Term Loan.



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all as described in Note 5 to the Consolidated Financial Statements. The Credit Agreements revolving credit
facility and the Bank term loan bear interest at LIBOR plus 250 basis points and LIBOR plus 275 basis points, respectively, the Treasury Stock Term Loan at LIBOR plus 300 basis points and the Airport Authority term loan bears interest at BMA plus 36
basis points. These interest rates were 3.78%, 4.03%, 1.33% and 4.52, respectively at June 30, 2004. Had the rate of the variable rate debt increased 100 basis points, net income would have been reduced by approximately $50,000 during the second
quarter.



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Item 4. Controls and Procedures



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



Management carried out an evaluation, with the participation of the companys Chief
Executive Officer and Chief Financial Officer, of the effectiveness of the companys disclosure controls and procedures as of June 30, 2004, the end of the period covered by this Quarterly Report on Form 10-Q. Based on that 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 June 30, 2004.



(b) Changes in internal control over financial reporting. The Company continues to
have a material weakness in internal control over financial reporting involving the incorrect applications of generally accepted accounting principles as a result of personnel in certain areas of the company who did not have a full understanding of
pertinent accounting and financial reporting principles. However during the period covered by this Quarterly Report on Form 10-Q, the company implemented remedial measures to address a material weakness in internal control over financial reporting
identified by the companys independent auditors in connection with their audit of the companys financial statements for the fiscal year ended December 31, 2003. Management believes these measures materially improved the companys
internal control over financial reporting during the quarter. Actions taken included re-evaluating and adding staff and level of expertise, increasing training of corporate and accounting staff to heighten awareness of generally accepted accounting
principles, establishing policies and procedures designed to enhance coordination and reporting procedures between management and the companys accounting staff, centralizing review and monitoring of accounting issues, and allocating senior
accounting personnel to provide additional on-site supervision of accounting functions. The company believes the measures it has taken and additional measures it continues to implement here had, and are reasonably likely to continue to have a
material, positive impact on its internal control over financial reporting in future periods.



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PART II OTHER INFORMATION



Item 1. Legal Proceedings



See Note 8 to the Consolidated Financial Statements.



Item 2. Purchases of Equity Securities



On June 16, the company purchased 52,275 shares of treasury stock from a retired employee. The details of this transaction are below:



ISSUER PURCHASES OF EQUITY SECURITIES



|                                |  |                                |  |                             |       |                                                |        
|------------------------------- |  | ------------------------------ |  | --------------------------- | ----- | ---------------------------------------------- | -------
|Period                          |  | Total Numberof SharesPurchased |  | Average PricePaid Per Share |       | MaximumNumber ofShares that MayYet BePurchased
|April 1, 2004 to April 30, 2004 |  | 0                              |  |                             |      |                                                | 189,176
|May 1, 2004 to May 31, 2004     |  | 0                              |  |                             |      |                                                | 189,176
|June 1, 2004 to June 30, 2004   |  | 52,275                         |  | $                           | 29.50 |                                                | 136,901
|                                |  |                                |  |                             |       |                                                |        
|Total                           |  | 52,275                         |  | $                           | 29.50 |                                                | 136,901
|                                |  |                                |  |                             |       |                                                |        



On May 19, 2003, the Board of
Directors authorized the company to repurchase up to an additional 200,000 shares of its common stock, representing approximately 5% of the companys issued and outstanding shares (new repurchase program). The repurchases are
authorized to be made from time to time through open market purchases, privately negotiated transactions or both, at prices to be determined by the Investment Committee of the Board of Directors. The Board of Directors approved the new repurchase
program after considering current economic market factors and the companys capital position. As of June 30, 2004, the company had acquired 83,099 shares under the new repurchase program.



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



The companys Annual Meeting of Stockholders was held on May 18, 2004. At the meeting,
stockholders elected Ronald A. Aramini, Harold T. Skip Bowling and Ronald W. Yates as Class I directors to serve until 2007 and voted against the companys proposal for the Omnibus Incentive Plan.



The number of votes cast for or against, and abstentions and broker non-votes with respect to
the amendment to the companys Omnibus Incentive Plan were as follows:



|          |  |           |  |         |  |         
|--------- |  | --------- |  | ------- |  | --------
|For       |  | Against   |  | Abstain |  | NotVoted
|1,454,003 |  | 1,677,139 |  | 838     |  | 817,866 



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



|                         |  |           |  |         
|------------------------ |  | --------- |  | --------
|Nominee                  |  | For       |  | Withheld
|Ronald A. Aramini        |  | 3,917,696 |  | 32,150  
|Harold T. Skip Bowling |  | 3,913,546 |  | 36,300  
|Ronald W. Yates          |  | 3,913,546 |  | 36,300  



Mark K. Holdsworth and Thomas C.
Richards continued in office as members of the Board of Directors with their terms expiring at the 2005 Annual Meeting of Stockholders. Robert E. Joyal and Michael E. Tennenbaum continued in office as members of the Board of Directors, with their
terms expiring at the 2006 Annual Meeting of Stockholders.



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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



b.
Reports on Form 8-K



The company filed no
reports on Form 8-K during the quarter ended June 30, 2004.



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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: August 16, 2004 |  | By:                        |  | /s/ Ronald A. Aramini                                                                               
|                       |  |                            |  | Ronald A. Aramini, President and Chief Executive Officer (Principal Executive Officer)              
|                       |  |                           
|Dated: August 16, 2004 |  | By:                        |  | /s/ John R. Lee                                                                                     
|                       |  |                            |  | John R. Lee, Sr. Vice President and Chief Financial Officer (Principal Finance & Accounting Officer)



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