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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, 2007,

or



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

For the Transition Period From  To
.

Commission file number: 0-13829



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PEMCO AVIATION GROUP, INC.

(Exact name of registrant as specified in its charter)



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



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

205-592-0011

(Registrants telephone number, including area code)



---

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

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

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

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

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



|                               |  |                               
|------------------------------ |  | ------------------------------
|Class                          |  | Outstanding at August 13, 2007
|Common Stock, $.0001 par value |  | 4,126,200                     



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INDEX

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES



|                              |  |                                                                                                   |  |   
|----------------------------- |  | ------------------------------------------------------------------------------------------------- |  | --
|                              |  | PAGE                                                                                             
|PART I. FINANCIAL INFORMATION |  |                                                                                                  
|                              |  |                                                                                                  
|Item 1.                       |  | Financial Statements (Unaudited)                                                                  |  | 1 
|                              |  |                                                                                                  
|                              |  | Consolidated Balance Sheets June 30, 2007 (Unaudited) and December 31, 2006                       |  | 1 
|                              |  |                                                                                                  
|                              |  | Unaudited Consolidated Statements of Operations For The Three Months Ended June 30, 2007 and 2006 |  | 3 
|                              |  |                                                                                                  
|                              |  | Unaudited Consolidated Statements of Operations For The Six Months Ended June 30, 2007 and 2006   |  | 4 
|                              |  |                                                                                                  
|                              |  | Unaudited Consolidated Statements of Cash Flows For The Six Months Ended June 30, 2007 and 2006   |  | 5 
|                              |  |                                                                                                  
|                              |  | Notes to Consolidated Financial Statements                                                        |  | 7 
|                              |  |                                                                                                  
|Item 2.                       |  | Managements Discussion and Analysis of Financial Condition and Results of Operations             |  | 27
|                              |  |                                                                                                  
|Item 3.                       |  | Quantitative and Qualitative Disclosures about Market Risk                                        |  | 44
|                              |  |                                                                                                  
|Item 4.                       |  | Controls and Procedures                                                                           |  | 45
|                              | 
|PART II. OTHER INFORMATION    |  |                                                                                                  
|                              |  |                                                                                                  
|Item 1.                       |  | Legal Proceedings                                                                                 |  | 47
|                              |  |                                                                                                  
|Item 1A.                      |  | Risk Factors                                                                                      |  | 47
|                              |  |                                                                                                  
|Item 4.                       |  | Submission of Matters to a Vote of Security Holders                                               |  | 53
|                              |  |                                                                                                  
|Item 6.                       |  | Exhibits                                                                                          |  | 53
|                              | 
|SIGNATURES                    |  | S1                                                                                               



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##### Table of Contents

PART I. FINANCIAL INFORMATION



|Item 1. | Financial Statements
|------- | --------------------

PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

ASSETS

(In Thousands)



|                                               |  |              |         |   |                  |   |         |  
|---------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                               |  | June 30,2007 |         |   | December 31,2006 |  
|                                               |  | (Unaudited)  |         |   |                  |  
|Current assets:                                |  |              |         |   |                  |   |         |  
|Cash and cash equivalents                      |  | $            | 42      |   |                  | $ | 23      |  
|Accounts receivable, net                       |  |              | 26,605  |   |                  |   | 27,668  |  
|Inventories, net                               |  |              | 16,500  |   |                  |   | 14,465  |  
|Deferred income taxes                          |  |              | 4,014   |   |                  |   | 3,288   |  
|Prepaid expenses and other                     |  |              | 1,144   |   |                  |   | 1,794   |  
|Assets of discontinued operations              |  |              | 9       |   |                  |   | 9       |  
|                                               |  |              |         |   |                  |   |         |  
|Total current assets                           |  |              | 48,314  |   |                  |   | 47,247  |  
|                                               |  |              |         |   |                  |   |         |  
|Machinery, equipment and improvements at cost: |  |              |         |   |                  |   |         |  
|Machinery and equipment                        |  |              | 31,801  |   |                  |   | 31,630  |  
|Leasehold improvements                         |  |              | 31,074  |   |                  |   | 30,913  |  
|Construction-in-process                        |  |              | 104     |   |                  |   | 217     |  
|                                               |  |              |         |   |                  |   |         |  
|                                               |  |              | 62,979  |   |                  |   | 62,760  |  
|Less accumulated depreciation and amortization |  |              | (41,314 | ) |                  |   | (39,922 | )
|                                               |  |              |         |   |                  |   |         |  
|Net machinery, equipment and improvements      |  |              | 21,665  |   |                  |   | 22,838  |  
|                                               |  |              |         |   |                  |   |         |  
|Other non-current assets:                      |  |              |         |   |                  |   |         |  
|Deposits and other                             |  |              | 3,152   |   |                  |   | 2,684   |  
|Deferred income taxes                          |  |              | 12,441  |   |                  |   | 14,199  |  
|Related party receivable                       |  |              | 429     |   |                  |   | 524     |  
|Intangible assets, net                         |  |              | 72      |   |                  |   | 260     |  
|Assets of discontinued operations              |  |              | 834     |   |                  |   | 834     |  
|                                               |  |              |         |   |                  |   |         |  
|Total other non-current assets                 |  |              | 16,928  |   |                  |   | 18,501  |  
|                                               |  |              |         |   |                  |   |         |  
|Total assets                                   |  | $            | 86,907  |   |                  | $ | 88,586  |  
|                                               |  |              |         |   |                  |   |         |  

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



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

LIABILITIES AND STOCKHOLDERS EQUITY

(In Thousands, Except Share Information)



|                                                                                                                            |  |              |         |   |                  |   |         |  
|--------------------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                                                                                            |  | June 30,2007 |         |   | December 31,2006 |  
|                                                                                                                            |  | (Unaudited)  |         |   |                  |  
|Current liabilities:                                                                                                        |  |              |         |   |                  |   |         |  
|Current portion of long-term debt                                                                                           |  | $            | 27,861  |   |                  | $ | 28,760  |  
|Current portion of pension and post-retirement liabilities                                                                  |  |              | 81      |   |                  |   | 81      |  
|Accounts payable - trade                                                                                                    |  |              | 14,789  |   |                  |   | 14,849  |  
|Accrued health and dental                                                                                                   |  |              | 914     |   |                  |   | 871     |  
|Accrued liabilities - payroll related                                                                                       |  |              | 5,710   |   |                  |   | 5,485   |  
|Accrued liabilities - other                                                                                                 |  |              | 2,063   |   |                  |   | 3,529   |  
|Customer deposits in excess of cost                                                                                         |  |              | 3,491   |   |                  |   | 3,648   |  
|Liabilities of discontinued operations                                                                                      |  |              | 37      |   |                  |   | 37      |  
|                                                                                                                            |  |              |         |   |                  |   |         |  
|Total current liabilities                                                                                                   |  |              | 54,946  |   |                  |   | 57,260  |  
|                                                                                                                            |  |              |         |   |                  |   |         |  
|Long-term debt, less current portion                                                                                        |  |              | 1,828   |   |                  |   | 1,786   |  
|Long-term pension and post-retirement liabilities                                                                           |  |              | 17,555  |   |                  |   | 19,510  |  
|Other long-term liabilities                                                                                                 |  |              | 3,095   |   |                  |   | 2,650   |  
|                                                                                                                            |  |              |         |   |                  |   |         |  
|Total liabilities                                                                                                           |  |              | 77,424  |   |                  |   | 81,206  |  
|                                                                                                                            |  |              |         |   |                  |   |         |  
|Commitments and contingencies (Note 9)                                                                                      |  |              |         |   |                  |   |         |  
|Stockholders equity:                                                                                                       |  |              |         |   |                  |   |         |  
|Preferred Stock, $0.0001 par value, 5,000,000 shares authorized, none outstanding                                           |  |              |        |   |                  |   |        |  
|Common Stock, $0.0001 par value, 12,000,000 shares authorized, 4,126,200 outstanding at June 30, 2007 and December 31,
2006 |  |              | 1       |   |                  |   | 1       |  
|Additional paid-in capital                                                                                                  |  |              | 14,926  |   |                  |   | 14,345  |  
|Retained earnings                                                                                                           |  |              | 30,935  |   |                  |   | 29,413  |  
|Treasury stock, at cost  413,398 shares at June 30, 2007 and December 31, 2006                                             |  |              | (8,623  | ) |                  |   | (8,623  | )
|Accumulated other comprehensive loss:                                                                                       |  |              |         |   |                  |   |         |  
|Pension and post-retirement liabilities                                                                                     |  |              | (27,756 | ) |                  |   | (27,756 | )
|                                                                                                                            |  |              |         |   |                  |   |         |  
|Total stockholders equity                                                                                                  |  |              | 9,483   |   |                  |   | 7,380   |  
|                                                                                                                            |  |              |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                                  |  | $            | 86,907  |   |                  | $ | 88,586  |  
|                                                                                                                            |  |              |         |   |                  |   |         |  

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



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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 30,2007 |        | ThreeMonths EndedJune 30,2006 |  
|Net sales                                             |  | $                             | 53,176 |                               | $ | 48,480 |  
|Cost of sales                                         |  |                               | 45,899 |                               |   | 41,759 |  
|                                                      |  |                               |        |                               |   |        |  
|Gross profit                                          |  |                               | 7,277  |                               |   | 6,721  |  
|Selling, general and administrative expenses          |  |                               | 5,169  |                               |   | 5,433  |  
|Reversal of provision for doubtful accounts           |  |                               |       |                               |   | (638   | )
|                                                      |  |                               |        |                               |   |        |  
|Operating income                                      |  |                               | 2,108  |                               |   | 1,926  |  
|Interest expense                                      |  |                               | 1,058  |                               |   | 829    |  
|                                                      |  |                               |        |                               |   |        |  
|Income from continuing operations before income taxes |  |                               | 1,050  |                               |   | 1,097  |  
|Income tax expense                                    |  |                               | 424    |                               |   | 434    |  
|                                                      |  |                               |        |                               |   |        |  
|Income from continuing operations                     |  |                               | 626    |                               |   | 663    |  
|Loss from discontinued operations, net of tax         |  |                               |       |                               |   | (218   | )
|                                                      |  |                               |        |                               |   |        |  
|Net income                                            |  | $                             | 626    |                               | $ | 445    |  
|                                                      |  |                               |        |                               |   |        |  
|                                                      |  |                              
|Net income per common share:                          |  |                               |        |                               |   |        |  
|Basic income from continuing operations               |  | $                             | 0.15   |                               | $ | 0.16   |  
|Basic income (loss) from discontinued operations      |  | $                             |       |                               | $ | (0.05  | )
|Basic net income per share                            |  | $                             | 0.15   |                               | $ | 0.11   |  
|Diluted income from continuing operations             |  | $                             | 0.15   |                               | $ | 0.16   |  
|Diluted income (loss) from discontinued operations    |  | $                             |       |                               | $ | (0.05  | )
|Diluted net income per share                          |  | $                             | 0.15   |                               | $ | 0.10   |  
|                                                      |  |                              
|Weighted average common shares outstanding:           |  |                               |        |                               |   |        |  
|Basic                                                 |  |                               | 4,126  |                               |   | 4,121  |  
|Diluted                                               |  |                               | 4,189  |                               |   | 4,252  |  

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



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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 30,2007 |         | SixMonths EndedJune 30,2006 |  
|Net sales                                             |  | $                           | 105,580 |                             | $ | 85,135 |  
|Cost of sales                                         |  |                             | 90,038  |                             |   | 71,987 |  
|                                                      |  |                             |         |                             |   |        |  
|Gross profit                                          |  |                             | 15,542  |                             |   | 13,148 |  
|Selling, general and administrative expenses          |  |                             | 10,808  |                             |   | 11,013 |  
|Reversal of provision for doubtful accounts           |  |                             |        |                             |   | (638   | )
|                                                      |  |                             |         |                             |   |        |  
|Operating income                                      |  |                             | 4,734   |                             |   | 2,773  |  
|Interest expense                                      |  |                             | 2,059   |                             |   | 1,459  |  
|                                                      |  |                             |         |                             |   |        |  
|Income from continuing operations before income taxes |  |                             | 2,675   |                             |   | 1,314  |  
|Income tax expense                                    |  |                             | 1,153   |                             |   | 519    |  
|                                                      |  |                             |         |                             |   |        |  
|Income from continuing operations                     |  |                             | 1,522   |                             |   | 795    |  
|Loss from discontinued operations, net of tax         |  |                             |        |                             |   | (271   | )
|                                                      |  |                             |         |                             |   |        |  
|Net income                                            |  | $                           | 1,522   |                             | $ | 524    |  
|                                                      |  |                             |         |                             |   |        |  
|                                                      |  |                            
|Net income per common share:                          |  |                             |         |                             |   |        |  
|Basic income from continuing operations               |  | $                           | 0.37    |                             | $ | 0.19   |  
|Basic income (loss) from discontinued operations      |  | $                           |        |                             | $ | (0.07  | )
|Basic net income per share                            |  | $                           | 0.37    |                             | $ | 0.13   |  
|Diluted income from continuing operations             |  | $                           | 0.37    |                             | $ | 0.18   |  
|Diluted income (loss) from discontinued operations    |  | $                           |        |                             | $ | (0.06  | )
|Diluted net income per share                          |  | $                           | 0.37    |                             | $ | 0.12   |  
|                                                      |  |                            
|Weighted average common shares outstanding:           |  |                             |         |                             |   |        |  
|Basic                                                 |  |                             | 4,126   |                             |   | 4,120  |  
|Diluted                                               |  |                             | 4,142   |                             |   | 4,300  |  

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



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                                                              |  |                             |        |   |                             |   |        |  
|--------------------------------------------------------------------------------------------- |  | --------------------------- | ------ | - | --------------------------- | - | ------ | -
|                                                                                              |  | SixMonths EndedJune 30,2007 |        |   | SixMonths EndedJune 30,2006 |  
|Cash flows from operating activities:                                                         |  |                             |        |   |                             |   |        |  
|Net income                                                                                    |  | $                           | 1,522  |   |                             | $ | 524    |  
|                                                                                              |  |                             |        |   |                             |   |        |  
|                                                                                              |  |                            
|Adjustments to reconcile net income to net cash provided by / (used in) operating activities: |  |                             |        |   |                             |   |        |  
|Depreciation and amortization of machinery, equipment and leasehold improvements              |  |                             | 1,682  |   |                             |   | 1,917  |  
|Amortization of intangible assets                                                             |  |                             | 188    |   |                             |   | 136    |  
|Provision for deferred income taxes                                                           |  |                             | 1,032  |   |                             |   | 352    |  
|Funding in excess of pension cost                                                             |  |                             | (1,955 | ) |                             |   | (1,988 | )
|Provision for (reversal of) losses on receivables                                             |  |                             | 148    |   |                             |   | (638   | )
|Loss on disposals of machinery and equipment                                                  |  |                             | 28     |   |                             |   | 2      |  
|Provision for inventory valuation                                                             |  |                             | 329    |   |                             |   |       |  
|Reversal of losses on contracts-in-process                                                    |  |                             | (166   | ) |                             |   | (2,958 | )
|Stock based compensation expense                                                              |  |                             | 581    |   |                             |   | 710    |  
|                                                                                              |  |                            
|Changes in assets and liabilities:                                                            |  |                             |        |   |                             |   |        |  
|Accounts receivable, trade                                                                    |  |                             | 915    |   |                             |   | (6,553 | )
|Inventories                                                                                   |  |                             | (2,198 | ) |                             |   | 6,407  |  
|Prepaid expenses and other                                                                    |  |                             | 650    |   |                             |   | 357    |  
|Deposits and other                                                                            |  |                             | (373   | ) |                             |   | (365   | )
|Customer deposits in excess of cost                                                           |  |                             | (157   | ) |                             |   | (3,044 | )
|Accounts payable and accrued liabilities                                                      |  |                             | (813   | ) |                             |   | 295    |  
|                                                                                              |  |                             |        |   |                             |   |        |  
|Total adjustments                                                                             |  |                             | (109   | ) |                             |   | (5,370 | )
|                                                                                              |  |                             |        |   |                             |   |        |  
|Net cash provided by / (used in) operating activities                                         |  |                             | 1,413  |   |                             |   | (4,846 | )
|                                                                                              |  |                             |        |   |                             |   |        |  
|                                                                                              |  |                            
|Cash flows from investing activities:                                                         |  |                             |        |   |                             |   |        |  
|Capital expenditures                                                                          |  |                             | (434   | ) |                             |   | (1,371 | )
|                                                                                              |  |                             |        |   |                             |   |        |  
|Net cash used in investing activities                                                         |  |                             | (434   | ) |                             |   | (1,371 | )
|                                                                                              |  |                             |        |   |                             |   |        |  

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



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

UNAUDITED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In Thousands)



|                                                    |  |   |       |   |  |   |       |  
|--------------------------------------------------- |  | - | ----- | - |  | - | ----- | -
|Cash flows from financing activities:               |  |   |       |   |  |   |       |  
|Proceeds from exercise of stock options             |  | $ |      |   |  | $ | 95    |  
|Net change under revolving credit facility          |  |   | (97   | ) |  |   | 2,270 |  
|Borrowings under long-term debt                     |  |   |      |   |  |   | 5,000 |  
|Principal payments under long-term debt             |  |   | (863  | ) |  |   | (863  | )
|Payment of debt issuance costs                      |  |   |      |   |  |   | (218  | )
|                                                    |  |   |       |   |  |   |       |  
|Net cash (used in) provided by financing activities |  |   | (960  | ) |  |   | 6,284 |  
|                                                    |  |   |       |   |  |   |       |  
|                                                    |  |  
|Net increase in cash and cash equivalents           |  |   | 19    |   |  |   | 67    |  
|                                                    |  |   |       |   |  |   |       |  
|Cash and cash equivalents, beginning of period      |  |   | 23    |   |  |   | 26    |  
|                                                    |  |   |       |   |  |   |       |  
|Cash and cash equivalents, end of period            |  | $ | 42    |   |  | $ | 93    |  
|                                                    |  |   |       |   |  |   |       |  
|Supplemental disclosure of cash flow information:   |  |   |       |   |  |   |       |  
|Cash paid / (received) during the period for:       |  |   |       |   |  |   |       |  
|Interest                                            |  | $ | 1,937 |   |  | $ | 1,264 |  
|                                                    |  |   |       |   |  |   |       |  
|Income taxes                                        |  | $ | 59    |   |  | $ | (301  | )
|                                                    |  |   |       |   |  |   |       |  

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



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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

As of and for the Quarters Ended

June 30, 2007 and 2006

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 six month period ended June 30, 2007 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 2006 Annual Report on Form 10-K.

The Company historically had
three operating segments: its Government Services Segment (GSS), its Commercial Services Segment (CSS), and its 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.

On September 30, 2006, the Company sold the assets and operations of Pemco Engineers, Inc., which are presented in these consolidated
financial statements as discontinued operations. Pemco Engineers was previously included in the MCS segment. In the fourth quarter of 2006, the Board of Directors approved a plan to divest the Companys subsidiary Space Vector Corporation. In
May 2007, the Company reversed its decision to sell Space Vector, which had been previously included in discontinued operations in the Companys Annual Report on Form 10-K for the Fiscal Year Ended December 31, 2006 and the Companys
Quarterly Report on Form 10-Q for the Quarter Ended March 31, 2007. Space Vector is presented in these consolidated financial statements as part of the Companys continuing operations because the Company reversed its decision to sell Space
Vector.

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; collection of accounts receivable; funding requirements associated with the Companys defined benefit pension plan; settlements of various claims; and
potential divestitures. The Company anticipates that cash flow generated from operations or by consummating potential strategic



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divestitures will be sufficient to fund capital expenditures and make scheduled payments on debt obligations for the next twelve months. The ability to
generate positive cash flow from operations during the last six months of 2007 will be affected by whether or not the Company wins the KC-135 contract award from the U.S. Air Force. The anticipated sale of the CSS business in 2007 will have a
significantly positive impact on the Companys financial condition and liquidity.

2. NET INCOME PER SHARE

Computation of basic and diluted earnings from continuing operations per share for the three-month and six-month periods ended June 30, 2007 and 2006
is as follows:

(In Thousands, Except Share and Per Share Information)



|                                         |  |                                |       |                   |       |                   |   |       |  
|---------------------------------------- |  | ------------------------------ | ----- | ----------------- | ----- | ----------------- | - | ----- | -
|For the Three Months Ended June 30, 2007 |  | IncomefromContinuingOperations |       | SharesOutstanding |       | EarningsPer Share |  
|Basic earnings and per share amounts     |  | $                              | 626   |                   | 4,126 |                   | $ | 0.15  |  
|Dilutive shares                          |  |                                |      |                   | 63    |                   |   |      |  
|                                         |  |                                |       |                   |       |                   |   |       |  
|Diluted earnings and per share amounts   |  | $                              | 626   |                   | 4,189 |                   | $ | 0.15  |  
|                                         |  |                                |       |                   |       |                   |   |       |  
|                                         |  |                                |      
|For the Three Months Ended June 30, 2006 |  | IncomefromContinuingOperations |       | SharesOutstanding |       | EarningsPer Share |  
|Basic earnings and per share amounts     |  | $                              | 663   |                   | 4,121 |                   | $ | 0.16  |  
|Dilutive shares                          |  |                                |      |                   | 131   |                   |   |      |  
|                                         |  |                                |       |                   |       |                   |   |       |  
|Diluted earnings and per share amounts   |  | $                              | 663   |                   | 4,252 |                   | $ | 0.16  |  
|                                         |  |                                |       |                   |       |                   |   |       |  
|                                         |  |                                |      
|For the Six Months Ended June 30, 2007   |  | IncomefromContinuingOperations |       | SharesOutstanding |       | EarningsPer Share |  
|Basic earnings and per share amounts     |  | $                              | 1,522 |                   | 4,126 |                   | $ | 0.37  |  
|Dilutive shares                          |  |                                |      |                   | 16    |                   |   |      |  
|                                         |  |                                |       |                   |       |                   |   |       |  
|Diluted earnings and per share amounts   |  | $                              | 1,522 |                   | 4,142 |                   | $ | 0.37  |  
|                                         |  |                                |       |                   |       |                   |   |       |  
|                                         |  |                                |      
|For the Six Months Ended June 30, 2006   |  | IncomefromContinuingOperations |       | SharesOutstanding |       | EarningsPer Share |  
|Basic earnings and per share amounts     |  | $                              | 795   |                   | 4,120 |                   | $ | 0.19  |  
|Dilutive shares                          |  |                                |      |                   | 180   |                   |   | (0.01 | )
|                                         |  |                                |       |                   |       |                   |   |       |  
|Diluted earnings and per share amounts   |  | $                              | 795   |                   | 4,300 |                   | $ | 0.18  |  
|                                         |  |                                |       |                   |       |                   |   |       |  



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Options to purchase 982,374 and 763,206 shares of Common Stock related to the three months ended
June 30, 2007 and 2006, respectively, and options to purchase 1,080,039 and 558,881 shares of Common Stock related to the six months ended June 30, 2007 and 2006, respectively, were excluded from the computation of diluted net income per
share because the option exercise price was greater than the average market price of the shares.



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3. INVENTORIES

Inventories as of June 30, 2007 and December 31, 2006 consisted of the following:

(In Thousands)



|                                              |  |              |        |   |                  |   |         |  
|--------------------------------------------- |  | ------------ | ------ | - | ---------------- | - | ------- | -
|                                              |  | June 30,2007 |        |   | December 31,2006 |  
|Work in process                               |  | $            | 16,070 |   |                  | $ | 25,468  |  
|Raw materials and supplies                    |  |              | 12,807 |   |                  |   | 12,188  |  
|Finished goods                                |  |              | 786    |   |                  |   | 786     |  
|                                              |  |              |        |   |                  |   |         |  
|Total                                         |  |              | 29,663 |   |                  |   | 38,442  |  
|Less reserves for obsolete inventory          |  |              | (3,689 | ) |                  |   | (3,360  | )
|Less milestone payments and customer deposits |  |              | (9,474 | ) |                  |   | (20,617 | )
|                                              |  |              |        |   |                  |   |         |  
|Total inventories                             |  | $            | 16,500 |   |                  | $ | 14,465  |  
|                                              |  |              |        |   |                  |   |         |  

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

4. DEBT

Debt as of June 30, 2007 and December 31, 2006 consisted of the following:

(In Thousands)



|                                                                                                                 |  |              |         |   |                  |   |         |  
|---------------------------------------------------------------------------------------------------------------- |  | ------------ | ------- | - | ---------------- | - | ------- | -
|                                                                                                                 |  | June 30,2007 |         |   | December 31,2006 |  
|Revolving Credit Facility; interest at LIBOR plus 3.00% (8.32% at June 30, 2007)                                 |  | $            | 21,758  |   |                  | $ | 21,855  |  
|Bank Term Loan; interest at LIBOR plus 3.00% (8.32% at June 30, 2007)                                            |  |              | 500     |   |                  |   | 1,000   |  
|Treasury Stock Term Loan; interest at LIBOR plus 3.00% (8.32% at June 30, 2007)                                  |  |              | 359     |   |                  |   | 719     |  
|Airport Authority Term Loan; interest at BMA plus 0.36% (3.89% at June 30, 2007)                                 |  |              | 1,960   |   |                  |   | 1,960   |  
|Special Value Bond Fund, LLC, a related party; interest fixed at 15%                                             |  |              | 5,000   |   |                  |   | 5,000   |  
|Capital Lease Obligations; interest from 5.0% to 11.0%, collateralized by security interest in certain equipment |  |              | 112     |   |                  |   | 12      |  
|                                                                                                                 |  |              |         |   |                  |   |         |  
|Total long-term debt                                                                                             |  |              | 29,689  |   |                  |   | 30,546  |  
|Less portion reflected as current                                                                                |  |              | (27,861 | ) |                  |   | (28,760 | )
|                                                                                                                 |  |              |         |   |                  |   |         |  
|Long term-debt, net of current portion                                                                           |  | $            | 1,828   |   |                  | $ | 1,786   |  
|                                                                                                                 |  |              |         |   |                  |   |         |  



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On December 16, 2002, the Company entered into a Credit Agreement with Wachovia Bank and Compass
Bank (the Credit Agreement) that provides for a Revolving Credit Facility and a Bank Term Loan. During 2003, 2004 and 2005, the Company and its lenders entered into a series of amendments to the Credit Agreement that adjusted the
maturity dates and commitment levels. Until the Credit Agreement was amended and restated on October 12, 2006 (see below), the interest on the Revolving Credit Facility was computed at LIBOR plus 2.00% to 2.75%, based on the ratio of adjusted
funded debt to earnings before interest, taxes, depreciation and amortization, each as defined in the Credit Agreement.

On
February 15, 2006, the Credit Agreement was amended to establish financial covenants for 2006. The covenants established a minimum adjusted tangible net worth for each quarter, minimum earnings before tax beginning June 30, 2006, and a
fixed charge coverage ratio for the year ending December 31, 2006. As discussed below, the debt covenants were further amended on October 12, 2006. The Company was in compliance with all debt covenants at June 30, 2007.

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



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



| |  |  | Maintained the maximum principal amount of the Revolving Credit Facility at $28.0 million;
| | - |  | ------------------------------------------------------------------------------------------



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



| |  |  | Provided for an increase in the borrowing base by increasing eligible Work-in-Process Inventory, as defined in the Amended Credit Agreement, from 50% to 65%; and
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Changed the interest rate on the Revolving Credit Facility to a rate ranging from LIBOR plus 1.5% to LIBOR plus 6.0% (8.32% at June 30, 2007), determined based
on quarterly earnings before interest, taxes, deprecation and amortization (EBITDA), as defined in the Amended Credit Agreement, and established new debt covenants as follows:
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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

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, 2007. Additional availability under the Revolving Credit Facility at June 30, 2007 was $4.1 million.

The Bank Term Loan matures on December 31, 2007 and bears interest at LIBOR plus 2.25% to 3.00% (8.32% at June 30, 2007), determined by the
ratio of adjusted funded debt to earnings before interest, taxes, depreciation and amortization as each is defined in the Credit Agreement. The loan is payable in 60 monthly installments of $83,333 plus interest.

The Treasury Stock Term Loan matures on December 31, 2007 and bears interest at LIBOR plus 3.00% (8.32% at June 30, 2007). The loan is payable
in 31 monthly installments of $59,890.

The Airport Authority Term Loan was originated on November 26, 2002, has a term of 15 years,
and bears interest at the Bond Market Association (BMA) rate plus 0.36% (3.89% at June 30, 2007). The amount outstanding under the Airport Authority Term Loan at June 30, 2007 was approximately $2.0 million and is payable in 14
annual installments of approximately $180,000. A Letter of Credit supports the Airport Authority Term Loan and has a fee of 1.0% per year based on the outstanding loan balance with a five-year term.

On February 15, 2006, the Company entered into a Note Purchase Agreement with Silver Canyon Services, Inc. (Silver Canyon), pursuant to
which the Company issued to Silver Canyon a senior secured note in the principal amount of $5.0 million (the Note). The Note accrues interest at an annual rate of 15%, which is payable quarterly in arrears. The Company may, at its
election, redeem the Note at a price equal to 100% of the principal amount then outstanding, together with accrued and unpaid interest thereon. The Note is subordinate to any debt incurred by the Company under the Amended Credit Agreement with
Wachovia Bank and Compass Bank. The Note contains customary events of default consistent with the events of default defined in the Amended Credit Agreement with Wachovia Bank and Compass Bank. The payment of all outstanding principal, interest and
other amounts owing under the Note may be declared immediately due and payable upon the occurrence of an event of default, subject to certain standstill provisions with Wachovia and Compass. On July 31, 2006, the Note was purchased by Special
Value Bond Fund, LLC, which is managed by Tennenbaum Capital Partners, LLC, a related party of the Company. The Note Purchase Agreement was amended on July 31, 2007 to extend the maturity date of the Note to February 15, 2009.

During the six months ended Jan. 30, 2007, the Company acquired machinery and equipment of approximately $103,000 under a capital lease obligation.



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

Principal maturities of debt as of June 30, 2007 over the next five years and in
the aggregate thereafter are as follows:

(In Thousands)



|           |  |   |       
|---------- |  | - | ------
|Current    |  | $ | 27,861
|1-3 years  |  |   | 588   
|3-5 years  |  |   | 540   
|Thereafter |  |   | 700   
|           |  |   |       
|           |  | $ | 29,689
|           |  |   |       

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

As of June 30, 2007, the Company was in compliance with all its covenants in the Amended Credit Agreement; however, there can be no assurances that
the Company will satisfy all of the debt covenants in the future or that the availability under the Revolving Credit Facility will be sufficient to continue its operations. If the Company violates any of the debt covenants, all debt may become
immediately due and payable. If additional financing is needed, the Companys negative results of operations in prior years and the current lack of a long-term KC-135 contract will likely make it more difficult and expensive for the Company to
raise additional capital that may be necessary to continue its operations. If the Company cannot raise adequate funds on acceptable terms, or at all, its business could be materially harmed.



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5. INCOME TAXES

In June 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation (FIN) No. 48 Accounting for Uncertainty in Income Taxes  an interpretation of FASB Statement
109. FIN 48 establishes a single model to address accounting for uncertain tax positions. FIN 48 clarifies the accounting for income taxes by prescribing a minimum recognition threshold a tax position is required to meet before being
recognized in the financial statements. FIN 48 also provides guidance on derecognition, measurement, classification, interest and penalties, accounting in interim periods, disclosure and transition.

The Company adopted the provisions of FIN 48 on January 1, 2007. Upon adoption, the Company recognized no adjustment in the amount of unrecognized tax
benefits. As of the date of adoption, the Company had no unrecognized tax benefits. The Companys policy is to recognize interest and penalties that would be assessed in relation to the settlement value of unrecognized tax benefits as a
component of income tax expense. The Company has recognized no interest or penalties since the adoption of FIN 48.

The Company and its
subsidiaries are subject to U.S. federal income tax as well as income tax in multiple state jurisdictions. With few exceptions, the Company is no longer subject to U.S. federal income tax examinations for years before 2003. However, to the extent
allowed by law, the tax authorities may have the right to examine prior periods where net operating losses were generated and carried forward, and make adjustments up to the amount of the net operating loss carryforward amount.

The Company is not currently under Internal Revenue Service (IRS), state or local tax examinations.

6. STOCK OPTIONS

On May 14, 2003, the
Companys stockholders approved amendments to the Companys Nonqualified Stock Option Plan (the Stock Option Plan), pursuant to which a maximum aggregate of 2,000,000 shares of Common Stock have been reserved for grants to key
personnel. The Stock Option Plan expires by its terms on September 8, 2009. The Companys Incentive Stock Option and Appreciation Rights Plan expired during the fiscal year 2000, with outstanding options under that plan being combined with
the Stock Option Plan. Options available to be granted under the Stock Option Plan amounted to approximately 230,000 at June 30, 2007. Options granted under the Stock Option Plan become exercisable over staggered periods and expire ten years
after the date of grant. Certain option awards provide for accelerated vesting if there is a change of control (as defined in the Stock Option Plan)

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



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The following table summarizes stock option activity for the six months ended June 30, 2007:



|                                    |  |                       |   |  |                                          |      
|----------------------------------- |  | --------------------- | - |  | ---------------------------------------- | -----
|                                    |  | Shares (In Thousands) |   |  | Weighted averageexercise price per share
|Outstanding as of December 31, 2006 |  | 1,071                 |   |  | $                                        | 20.29
|Granted                             |  | 202                   |   |  |                                          | 8.35 
|Exercised                           |  |                      |   |  |                                          |     
|Forfeited/Expired                   |  | (79                   | ) |  |                                          | 19.43
|                                    |  |                       |   |  |                                          |      
|Outstanding as of June 30, 2007     |  | 1,194                 |   |  |                                          | 18.33
|                                    |  |                       |   |  |                                          |      
|Exercisable as of June 30, 2007     |  | 1,099                 |   |  |                                          | 19.02
|                                    |  |                       |   |  |                                          |      

The weighted average remaining term for outstanding stock options was 6.0 years at June 30,
2007. The aggregate intrinsic value at June 30, 2007 was $522,312 for stock options outstanding and $403,557 for stock options exercisable. The intrinsic value for stock options is calculated based on the exercise price of the underlying awards
and the market price of our common stock as of the reporting date.

Proceeds received from the exercise of stock options were approximately
$-0- and $95,000 during the first six months of 2007 and 2006, respectively. The intrinsic value related to the exercise of stock options was approximately $-0- and $78,000 for the first six month of 2007 and 2006, respectively, which are deductible
for tax purposes. However, these tax benefits were not realized due to existing unused net operating loss carryforwards. The pre-tax compensation cost for stock-based employee compensation was approximately $581,000 and $710,000 for the first six
months of 2007 and 2006, respectively.

The fair value of the options granted during the six months ended June 30, 2007 and 2006 was
estimated on the date of grant using the binominal method and the following weighted-average assumptions:



|                        |  |                               |   |  |                               |  
|----------------------- |  | ----------------------------- | - |  | ----------------------------- | -
|                        |  | Six Months EndedJune 30, 2007 |   |  | Six Months EndedJune 30, 2006 |  
|Risk-free interest rate |  | 4.54                          | % |  | 4.84% - 4.88                  | %
|Expected volatility     |  | 60                            | % |  | 59                            | %
|Expected term (years)   |  | 4.38                          |   |  | 4.2                           |  
|Dividend yield          |  | 0                             | % |  | 0                             | %
|Exercise Factor         |  | 2.00                          |   |  | 2.00                          |  
|Post-Vest %             |  | 5.04                          | % |  | 6.51                          | %

The options pricing model used to calculate the fair value of the options granted requires the
input of subjective assumptions that will usually have a significant impact on the fair value estimated.



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SFAS No. 123(R) requires the recognition of stock-based compensation for the number of awards that
are ultimately expected to vest. As a result, for most awards, recognized stock compensation was reduced for estimated forfeitures prior to vesting primarily based on historical annual forfeiture rates of approximately 10%. Estimated forfeitures
will be reassessed in subsequent periods and may change based on new facts and circumstances. As of June 30, 2007, approximately $323,000 of unrecognized stock compensation related to unvested awards (net of estimated forfeitures) is expected
to be recognized over a weighted-average period of 1.6 years.

Holders of stock options under the Companys Stock Option Plan exercised
options for 2,999 and 9,826 shares of the Companys Common Stock during the three and six months ended June 30, 2006, respectively. The Company recorded increases to additional paid-in capital of approximately $33,000 and $125,000 related
to the exercise price and a tax benefit of approximately $1,800 and $30,000 during the three and six months ended June 30, 2006, respectively. There were no stock options exercised during the three or six months ended June 30, 2007.

7. DEFERRED COMPENSATION PLAN

The
Company has a deferred compensation arrangement for its Chief Executive Officer, which generally provides for payments upon retirement, death or termination of employment. The Company funds the deferred compensation liability by making contributions
to a rabbi trust. The contributions are invested in U.S. treasury bills, and do not include Company Common Stock. The fair market values of the assets in the rabbi trust at June 30, 2007 and December 31, 2006 were $2.9 million and $2.4
million, respectively, and are reflected in the deposits and other line item in the accompanying consolidated balance sheets. The deferred compensation liability is adjusted, with a corresponding charge or credit to compensation cost, to reflect
changes in the fair market value of the compensation liability. The amounts accrued under this plan were $2.9 million and $2.4 million at June 30, 2007 and December 31, 2006, respectively, and are reflected in other long-term liabilities
in the accompanying consolidated balance sheets.

8. EMPLOYEE BENEFIT PLANS

The Company has a defined benefit pension plan (the Pension 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 under federal laws and regulations concerning pensions.

During the six months
ended June 30, 2007, the Company made contributions to the Pension Plan totaling $4.6 million. The Company expects to contribute approximately $6.5 million to the Pension Plan during the remainder of 2007.



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Components of the Pension Plans net periodic pension cost included in continuing operations were as
follows:

(In Thousands)



|                                   |  |                               |        |   |                               |   |        |                             |  |   |                             |   |  |   |        |  
|---------------------------------- |  | ----------------------------- | ------ | - | ----------------------------- | - | ------ | --------------------------- |  | - | --------------------------- | - |  | - | ------ | -
|                                   |  | ThreeMonths EndedJune 30,2007 |        |   | ThreeMonths EndedJune 30,2006 |   |        | SixMonths EndedJune 30,2007 |  |   | SixMonths EndedJune 30,2006 |  
|Service cost                       |  | $                             | 751    |   |                               | $ | 728    |                             |  | $ | 1,502                       |   |  | $ | 1,457  |  
|Interest cost                      |  |                               | 1,964  |   |                               |   | 1,870  |                             |  |   | 3,928                       |   |  |   | 3,739  |  
|Expected return on plan assets     |  |                               | (2,444 | ) |                               |   | (2,266 | )                           |  |   | (4,888                      | ) |  |   | (4,532 | )
|Amortization of prior service cost |  |                               | 333    |   |                               |   | 314    |                             |  |   | 666                         |   |  |   | 628    |  
|Amortization of net loss           |  |                               | 729    |   |                               |   | 611    |                             |  |   | 1,458                       |   |  |   | 1,222  |  
|                                   |  |                               |        |   |                               |   |        |                             |  |   |                             |   |  |   |        |  
|Net pension cost                   |  | $                             | 1,333  |   |                               | $ | 1,257  |                             |  | $ | 2,666                       |   |  | $ | 2,514  |  
|                                   |  |                               |        |   |                               |   |        |                             |  |   |                             |   |  |   |        |  

9. CONTINGENCIES

United States Government Contracts

The Company, as a U.S. Government contractor and sub-contractor,
is subject to audits, reviews, and investigations by the government related to its negotiation and performance of government contracts and its accounting for such contracts. Failure to comply with applicable U.S. Government standards by a contractor
may result in suspension from eligibility for award of any new government contracts and a guilty plea or conviction may result in debarment from eligibility for awards. The government may, in certain cases, also terminate existing contracts, recover
damages, and impose other sanctions and penalties. On April 19, 2007, the Company was served with a subpoena from the Office of the Inspector General, Department of Defense. The subpoena requests certain information related to non-routine
maintenance services and billings on the KC-135 PDM subcontract with Boeing Corporation. The Company has no knowledge regarding the basis or objective of the investigation, nor any reason to believe there will be a material adverse outcome; however,
it is unable at this point to estimate the potential impact of this matter, if any, upon the Company's financial position or results of operations.

Concentrations

A small number of the Company's customers account for a significant percentage of its revenues. The KC-135
program comprised 25% and 47% of the Companys total revenues from continuing operations during the six-month periods ended June 30,



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2007 and 2006, respectively. The Companys four largest programs generated approximately 74% and 70% of its revenues during the first six months of 2007
and 2006, respectively. Termination or a disruption in these contracts or the inability of the Company to renew or replace these contracts, could have a materially adverse effect on the Companys financial position and results of operations.

In May 2005, the U.S. Air Force decided to re-compete the KC-135 PDM program. The Company submitted a proposal to the USAF as a
subcontractor/partner with Boeing LSS for the KC-135 program. On June 6, 2006, the Company was notified by Boeing that Boeing was terminating a Memorandum of Agreement (MOA) among Boeing, L3/IS Integrated Systems (L3)
and the Companys Birmingham, Alabama subsidiary, Pemco Aeroplex, Inc. Under the previously announced MOA, the companies had agreed on a teaming arrangement to compete for the KC-135 PDM program. In the termination notice, Boeing asserted that
it received notice of an amendment to the request for proposal for the KC-135 program reducing the requested quantities of aircraft, and that the reduction would be so unfavorable to Boeing that further participation in the program pursuant to the
MOA would no longer be practical or financially viable. The Company and Boeing are currently teamed on the KC-135 Bridge Contract through the government fiscal year ending September 30, 2007, which remains unaffected by the termination. The
Company submitted a proposal as a prime contractor for the KC-135 PDM program in September 2006. An award announcement is expected before the end of the third quarter of 2007. If the Companys proposal for the KC-135 PDM program is
unsuccessful, or if the award is significantly delayed, it could have a material effect on the Companys financial condition, 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 by the Company of three Boeing 737 aircraft to Quick Change configuration was defective, limiting the commercial use of the aircraft. The parties were able to subsequently settle the case following consecutive
mediation efforts. On March 14, 2007, the Companys insurer agreed to pay $3.0 million and the Company was absolved of any requirements to provide services on these aircraft. A final settlement agreement was executed by all parties on
April 20, 2007. As a result of amendments to the settlement agreement the Company reduced the estimated cost of the settlement by $1.0 million in 2006 of which $0.4 million was recorded in the second quarter of 2006.

On January 16, 2004, the Company filed a complaint in the Circuit Court of Dale County, Alabama against GE Capital Aviation Services, Inc.
(GECAS) for monies owed for modification and maintenance services provided on six 737-300 aircraft, all of which were re-delivered to GECAS during 2003 and are in service. On January 20, 2004, the Company received service of a suit
filed against the Companys Pemco



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World Air Services, Inc. subsidiary in New York state court, claiming breach of contract with regard to two of the aircraft re-delivered. On March 5,
2004, the Company filed a motion to dismiss the claim filed in the New York state court, which was denied. On March 24, 2004, the Circuit Court of Dale County, Alabama denied a motion filed by GECAS to dismiss or stay the proceedings. GECAS has
subsequently paid in full charges owed on four of the six aircraft. The New York Court ordered mediation in the matter. Mediation took place on October 6, 2004, but was unsuccessful in bringing resolution. The case was again mediated on
October 6, 2006 without success. On October 16, 2006, the Court granted the Company partial summary judgment as to two of the five GECAS counterclaims. Discovery was completed on June 15, 2007, but a trial date has not been set.
Management believes that the results of the claim by GECAS will not have a material impact on the Companys financial position or results of operations.

On November 9, 1994, the Company was awarded a contract to perform standard depot level maintenance (SDLM) and engineering design work (Executive Transport) on an H-3 helicopter. In 2002,
the Company filed three separate Requests for Equitable Adjustment (REA) with the Navy. The claims included entitlement to additional sums due to severe funding issues and lack or delay of required support in materials, equipment and
engineering data for the H-3 program. The case was settled in May 2006 with the government agreeing to pay $1.85 million to the Company in settlement of all three claims. The Company recorded $0.8 million of revenue related to the settlement during
the first quarter of 2006. The Company paid $0.2 million in legal fees related to this settlement in the first quarter of 2006, which is reflected in selling, general and administrative expenses on the Consolidated Statement of Operations.
Approximately $1.0 million of revenue related to the claim had been recognized in periods prior to 2005.

Employment Lawsuits

In December 1999, the Company and Pemco Aeroplex were served with a purported class action in the U.S. District Court, Northern
District of Alabama, seeking declaratory, injunctive relief, and other compensatory and punitive damages based upon alleged unlawful employment practices of race discrimination and racial harassment by the Companys managers, supervisors, and
other employees. The complaint sought damages in the amount of $75 million. On July 27, 2000, the U.S. District Court determined that the group would not be certified as a class since the plaintiffs withdrew their request for class
certification. The Equal Employment Opportunity Commission (EEOC) subsequently filed a parallel case. The Court denied consolidation of the cases for trial purposes but provided for consolidated discovery. On June 28, 2002, a jury
determined that there was no hostile work environment in the original case and granted verdicts for the Company with regard to all 22 plaintiffs. The Company reached a settlement determination with the EEOC for $0.4 million. The settlement was
approved by the court and a Consent Decree entered on April 16, 2007 in the Northern District of Alabama, Southern Division. During 2006, the Company reversed $0.5 million of accruals related to the settlement of the case with the EEOC. The
Company denies any liability with regard to this case and believes it has taken effective remedial and corrective action, and acted promptly in respect to any specific complaint by an employee.



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Various claims alleging employment discrimination, including race, sex, disability, and age have been
made against the Company and its subsidiaries by current and former employees at its Birmingham and Dothan, Alabama facilities in proceedings before the EEOC and before state and federal courts in Alabama. Workers compensation claims brought
by employees are also pending in Alabama state court. The Company believes that none of these claims, individually or in the aggregate, 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.

Environmental Compliance

In December
1997, the Company received an inspection report from the Environmental Protection Agency (EPA) documenting the results of an inspection at the Birmingham, Alabama facility. The report cited various violations of environmental laws. The
Company has taken actions to correct the items raised by the inspection. On December 21, 1998, the Company and the EPA entered into a Consent Agreement and Consent Order (CACO) resolving the complaint and compliance order. As part
of the CACO, the Company agreed to assess a portion of the Birmingham facility for possible contamination by certain constituents and remediate such contamination as necessary. During 1999, the Company drilled test wells and took samples under its
Phase I Site Characterization Plan. These samples were forwarded to the EPA in 1999. A Phase II Site Characterization Plan (Phase II Plan) was submitted to the EPA in 2001 upon receiving the agencys response to the 1999 samples.
The Phase II Plan was approved in January 2003, wells installed and favorable sampling events recorded. The Company compiled the results and submitted a revised work plan to the agency which was accepted on July 30, 2004. The Media
Clean-Up Standard Report, as required, was submitted to the EPA in January 2005. On April 17, 2007 the Company received notice from the EPA that the Media Clean-Up Standard Report was disapproved. The Company has been given a 120-day period to
submit an updated report consistent with the federal and state regulations enacted or revised since the original submittal in 2005, but has requested, and anticipates receiving an extension for submittal. 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 $100,000 related to the Phase II Plan at both June 30, 2007 and December 31, 2006, 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 $550,000, of which the Company had paid approximately $450,000 as of June 30, 2007. 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.



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In March 2005, Pemco Aeroplex received notice from the South Carolina Department of Health and
Environmental Control (DHEC) that it was believed to be a potentially responsible party (PRP) with regard to contamination found on the Philips Service Corporation (PSC) site located in Rock Hill, South Carolina.
Pemco was listed as a PRP due to alleged use by the Company of contract services in disposal of hazardous substances. The Company joined a large group of existing PRP notification recipients in retaining environmental counsel. The Company believes
it is possible that paint chips were disposed of with this contractor beginning in 1997. PSC filed for bankruptcy in 2003. It is noted that contamination seems to be primarily linked to a diesel fuel tank leak whereby over 200,000 gallons of diesel
product were lost or released into the environment at the Rock Hill site. The database of manifests located on-site at PSC has been reviewed and the waste-in compilations have been completed, but remain subject to revision. The PRP group continues
to increase. It is believed that the Companys potential liability will not exceed $50,000. The Company believes it is adequately insured in this matter. Management believes that the resolution of the above matter will not have a material
impact on the Companys financial position or results of operations.

In June 2007, Pemco Aeroplex received a request from the United
States Environmental Protection Agency (USEPA) to provide certain information about any dealings Pemco Aeroplex, Inc. or its predecessors, had with, or shipments of waste made to a company named Performance Advantage. Performance Advantage operated
a fuel blending and recycling facility in Weogufka, Alabama, until the early 1990s, at which time it closed. That facility has been identified by USEPA as a CERCLA/Superfund Site based on testing performed indicating contamination on site.
USEPA has identified Pemco Aeroplex as a potentially responsible party (PRP) for the costs of investigating and cleaning up the site. USEPA has informed Pemco Aeroplex that it believes the shipments of waste to Performance Advantage were made by the
Companys predecessor, Hayes International, in the early 1980s. Pemco purchased Hayes International in 1988.

The Company has
been unable to locate any documents remaining in its possession, custody or control reflecting any such dealings by its predecessor. However, the Company, through its outside counsel, has been able to confirm that Hayes did ship paint/solvent waste
and spent aviation fuel to Performance Advantage in approximately 1982 and 1983. The exact number of drums or quantity of material and the dates of such shipments are not known. The Company has responded to USEPAs information request and now
waits for receipt of information from USEPA on the nature of the contamination and cleanup at the site, the anticipated cost and identification of other PRPs. Due to the uncertain nature of the foregoing, we are unable to assess or estimate the
potential liability, if any.

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



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10. SEGMENT INFORMATION

The Company has three reportable segments: GSS, CSS and 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, which is comprised of Space Vector
Corporation, is 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.

The accounting policies of the segments are the same as those described in the summary of significant accounting policies in the Company's 2006 Annual
Report on Form 10-K. The Company evaluates performance based on total (external and inter-segment) revenues, gross profits and operating income. The Company accounts for inter-segment sales and transfers as if the sales or transfers were to third
parties. The amount of intercompany profit is eliminated. The Company does not allocate income taxes to segments.

The Company's reportable
segments are strategic business units that offer different products and services. They are managed separately because each business requires different operating and marketing strategies. Although CSS primarily services the commercial sector, they
may, at times, generate revenues from government entities or programs. Similarly, the GSS may also cross sectors and generate revenue from the commercial sector.



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The following table presents information about segment profit or loss for the three months ended
June 30, 2007 and 2006, excluding discontinued operations:

(In Thousands)



|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |        |  
|--------------------------------- |  | --- | ------ | - | --- | - | ------ |  | - | -------------------- | - |  | ------------ | ------ | - |  | - | ------ | -
|Three Months Ended June 30, 2007  |  | GSS |        |   | CSS |   | MCS    |  |   | UnallocatedCorporate |   |  | Consolidated |       
|Revenues from domestic customers  |  | $   | 15,776 |   |     | $ | 26,298 |  | $ | 3,403                |   |  |              |        |   |  | $ | 45,477 |  
|Revenues from foreign customers   |  |     |       |   |     |   | 7,699  |  |   |                     |   |  |              |       |   |  |   | 7,699  |  
|Inter-company revenues            |  |     | 8      |   |     |   |       |  |   |                     |   |  |              |       |   |  |   | 8      |  
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |        |  
|Total segment revenues            |  |     | 15,784 |   |     |   | 33,997 |  |   | 3,403                |   |  |              |       |   |  |   | 53,184 |  
|Elimination                       |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   | (8     | )
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |        |  
|Total revenue                     |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  | $ | 53,176 |  
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |        |  
|Gross profit                      |  | $   | 646    |   |     | $ | 6,109  |  | $ | 522                  |   |  | $            |       |   |  | $ | 7,277  |  
|Segment operating income / (loss) |  |     | (1,186 | ) |     |   | 4,005  |  |   | (199                 | ) |  |              | (512   | ) |  |   | 2,108  |  
|Interest expense                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   | (1,058 | )
|Income tax expense                |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   | (424   | )
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |        |  
|Net income                        |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  | $ | 626    |  
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |        |  
|Assets                            |  | $   | 31,513 |   |     | $ | 27,336 |  | $ | 6,051                |   |  | $            | 21,164 |   |  | $ | 86,064 |  
|Depreciation/amortization         |  |     | 419    |   |     |   | 358    |  |   | 48                   |   |  |              | 36     |   |  |   | 861    |  
|Capital additions                 |  |     | 246    |   |     |   | 11     |  |   | 169                  |   |  |              |       |   |  |   | 426    |  



|                                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|--------------------------------- |  | --- | ------ | - | --- | - | ------ |  | -------------------- | ----- |  | ------------ | ------ | - |  | - | ------ | -
|Three Months Ended June 30, 2006  |  | GSS |        |   | CSS |   | MCS    |  | UnallocatedCorporate |       |  | Consolidated |       
|Revenues from domestic customers  |  | $   | 24,538 |   |     | $ | 15,849 |  | $                    | 3,044 |  | $            |       |   |  | $ | 43,431 |  
|Revenues from foreign customers   |  |     |       |   |     |   | 5,049  |  |                      |      |  |              |       |   |  |   | 5,049  |  
|Inter-company revenues            |  |     | 101    |   |     |   | 11     |  |                      |      |  |              |       |   |  |   | 112    |  
|                                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Total segment revenues            |  |     | 24,639 |   |     |   | 20,909 |  |                      | 3,044 |  |              |       |   |  |   | 48,592 |  
|Elimination                       |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   | (112   | )
|                                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Total revenue                     |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  | $ | 48,480 |  
|                                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Gross profit                      |  | $   | 2,348  |   |     | $ | 3,131  |  | $                    | 1,242 |  | $            |       |   |  | $ | 6,721  |  
|Segment operating income / (loss) |  |     | (109   | ) |     |   | 1,450  |  |                      | 721   |  |              | (136   | ) |  |   | 1,926  |  
|Interest expense                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   | (829   | )
|Income tax expense                |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   | (434   | )
|                                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Net Income                        |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  | $ | 663    |  
|                                  |  |     |        |   |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Assets                            |  | $   | 39,211 |   |     | $ | 24,887 |  | $                    | 5,217 |  | $            | 26,629 |   |  | $ | 95,944 |  
|Depreciation/amortization         |  |     | 465    |   |     |   | 422    |  |                      | 38    |  |              |       |   |  |   | 925    |  
|Capital additions                 |  |     | 579    |   |     |   | 37     |  |                      | 7     |  |              |       |   |  |   | 623    |  



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The following table presents information about segment profit or loss for the six months ended
June 30, 2007 and 2006, excluding discontinued operations:

(In Thousands)



|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |         |  
|--------------------------------- |  | --- | ------ | - | --- | - | ------ |  | - | -------------------- | - |  | ------------ | ------ | - |  | - | ------- | -
|Six Months Ended June 30, 2007    |  | GSS |        |   | CSS |   | MCS    |  |   | UnallocatedCorporate |   |  | Consolidated |       
|Revenues from domestic customers  |  | $   | 35,359 |   |     | $ | 52,724 |  | $ | 4,997                |   |  | $            |       |   |  | $ | 93,080  |  
|Revenues from foreign customers   |  |     |       |   |     |   | 12,500 |  |   |                     |   |  |              |       |   |  |   | 12,500  |  
|Inter-company revenues            |  |     | 54     |   |     |   |       |  |   |                     |   |  |              |       |   |  |   | 54      |  
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |         |  
|Total segment revenues            |  |     | 35,413 |   |     |   | 65,224 |  |   | 4,997                |   |  |              |       |   |  |   | 105,634 |  
|Elimination                       |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   | (54     | )
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |         |  
|Total revenue                     |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  | $ | 105,580 |  
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |         |  
|Gross profit                      |  | $   | 3,256  |   |     | $ | 11,268 |  | $ | 918                  |   |  | $            | 100    |   |  | $ | 15,542  |  
|Segment operating income / (loss) |  |     | (431   | ) |     |   | 6,423  |  |   | (384                 | ) |  |              | (874   | ) |  |   | 4,734   |  
|Interest expense                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   | (2,059  | )
|Income taxes                      |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   | (1,153  | )
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |         |  
|Net income                        |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  | $ | 1,522   |  
|                                  |  |     |        |   |     |   |        |  |   |                      |   |  |              |        |   |  |   |         |  
|Assets                            |  | $   | 31,513 |   |     | $ | 27,336 |  | $ | 6,051                |   |  | $            | 21,164 |   |  | $ | 86,064  |  
|Depreciation/amortization         |  |     | 812    |   |     |   | 721    |  |   | 76                   |   |  |              | 73     |   |  |   | 1,682   |  
|Capital additions                 |  |     | 291    |   |     |   | 70     |  |   | 169                  |   |  |              | 7      |   |  |   | 537     |  



|                                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|--------------------------------- |  | --- | ------ | --- | - | ------ |  | -------------------- | ----- |  | ------------ | ------ | - |  | - | ------ | -
|Six Months Ended June 30, 2006    |  | GSS |        | CSS |   | MCS    |  | UnallocatedCorporate |       |  | Consolidated |       
|Revenues from domestic customers  |  | $   | 46,568 |     | $ | 26,373 |  | $                    | 5,628 |  | $            |       |   |  | $ | 78,569 |  
|Revenues from foreign customers   |  |     |       |     |   | 6,566  |  |                      |      |  |              |       |   |  |   | 6,566  |  
|Inter-company revenues            |  |     | 101    |     |   | 24     |  |                      |      |  |              |       |   |  |   | 125    |  
|                                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Total segment revenues            |  |     | 46,669 |     |   | 32,963 |  |                      | 5,628 |  |              |       |   |  |   | 85,260 |  
|Elimination                       |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   | (125   | )
|                                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Total revenue                     |  |     |        |     |   |        |  |                      |       |  |              |        |   |  | $ | 85,135 |  
|                                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Gross profit                      |  | $   | 5,270  |     | $ | 5,929  |  | $                    | 1,949 |  | $            |       |   |  | $ | 13,148 |  
|Segment operating income / (loss) |  |     | 637    |     |   | 1,676  |  |                      | 704   |  |              | (244   | ) |  |   | 2,773  |  
|Interest expense                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   | (1,459 | )
|Income taxes                      |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   | (519   | )
|                                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Net income                        |  |     |        |     |   |        |  |                      |       |  |              |        |   |  | $ | 795    |  
|                                  |  |     |        |     |   |        |  |                      |       |  |              |        |   |  |   |        |  
|Assets                            |  | $   | 39,211 |     | $ | 24,887 |  | $                    | 5,217 |  | $            | 26,629 |   |  | $ | 95,944 |  
|Depreciation/amortization         |  |     | 863    |     |   | 862    |  |                      | 73    |  |              |       |   |  |   | 1,798  |  
|Capital additions                 |  |     | 1,178  |     |   | 151    |  |                      | 18    |  |              |       |   |  |   | 1,347  |  



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11. DISCONTINUED OPERATIONS

On September 30, 2006, the Company sold the assets of its subsidiary, Pemco Engineers, Inc., which had previously been included in the MCS segment. In accordance with SFAS No. 144,Accounting for
the Impairment or Disposal of Long-Lived Assets, this business unit is reported as discontinued operations and, accordingly, income and losses from discontinued operations have been reported separately from continuing operations. Net sales and
loss from discontinued operations for the three- and six month periods ended June 30, 2007 and 2006 were as follows:

(In Thousands)



|                                                      |  |                    |   |              |                  |       |              |  |              |   |  |   |       |  
|----------------------------------------------------- |  | ------------------ | - | ------------ | ---------------- | ----- | ------------ |  | ------------ | - |  | - | ----- | -
|                                                      |  | Three Months Ended |   |              | Six Months Ended |      
|                                                      |  | June 30,2007       |   | June 30,2006 |                  |       | June 30,2007 |  | June 30,2006 |  
|Net Sales from discontinued operations                |  | $                  |  |              | $                | 1,230 |              |  | $            |  |  | $ | 2,428 |  
|                                                      |  |                    |   |              |                  |       |              |  |              |   |  |   |       |  
|Loss before income taxes from discontinued operations |  | $                  |  |              | $                | (352  | )            |  | $            |  |  | $ | (438  | )
|Income tax benefit from discontinued operations       |  |                    |  |              |                  | (134  | )            |  |              |  |  |   | (167  | )
|                                                      |  |                    |   |              |                  |       |              |  |              |   |  |   |       |  
|Loss from discontinued operations                     |  | $                  |  |              | $                | (218  | )            |  | $            |  |  | $ | (271  | )
|                                                      |  |                    |   |              |                  |       |              |  |              |   |  |   |       |  

Included within the results from discontinued operations is an allocation of interest expense.
Interest expense allocated to discontinued operations was approximately $25,000 and $50,000 for the three- and six month periods ended June 30, 2006, respectively. There was no allocation of interest expense for the three- and six month periods
ended June 30, 2007.

To conform with this presentation, all prior periods have been reclassified. As a result, the assets and
liabilities of the discontinued operations have been reclassified on the balance sheet from the historical classifications and presented under the captions assets of discontinued operations and liabilities of discontinued
operations, respectively.



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As of June 30, 2007 and December 31, 2006, net assets of discontinued operations, consisted of
the following:

(In Thousands)



|                                          |  |                          |     |                  |   |    
|----------------------------------------- |  | ------------------------ | --- | ---------------- | - | ---
|                                          |  | June 30,2007 (unaudited) |     | December 31,2006
|Prepaid expenses and other current assets |  | $                        | 9   |                  | $ | 9  
|                                          |  |                          |     |                  |   |    
|Total current assets                      |  |                          | 9   |                  |   | 9  
|                                          |  |                          |     |                  |   |    
|Deferred tax asset                        |  |                          | 834 |                  |   | 834
|                                          |  |                          |     |                  |   |    
|Total assets                              |  | $                        | 843 |                  | $ | 843
|                                          |  |                          |     |                  |   |    
|Accounts payable                          |  | $                        | 37  |                  | $ | 37 
|                                          |  |                          |     |                  |   |    
|Total current liabilities                 |  |                          | 37  |                  |   | 37 
|                                          |  |                          |     |                  |   |    
|Total liabilities                         |  |                          | 37  |                  |   | 37 
|                                          |  |                          |     |                  |   |    
|Net assets                                |  | $                        | 806 |                  | $ | 806
|                                          |  |                          |     |                  |   |    

12. SUBSEQUENT EVENT

On July 11, 2007, the Company and Sun Capital Partners, Inc. (Sun Capital) announced they had entered into a Stock Purchase Agreement (the Purchase Agreement) between the Company, WAS
Aviation Services, Inc., an affiliate of Sun Capital (WAS) and Pemco World Air Services, Inc. (PWAS), a wholly owned subsidiary of the Company. Pursuant to the Purchase Agreement, the Company has agreed to sell all of the
outstanding capital stock of PWAS to WAS for an aggregate purchase price of approximately $43.0 million in cash, subject to: (i) a purchase price holdback of up to $1.0 million for potential environmental remediation, (ii) an offset of
$5.75 million for the assumption of certain underfunded pension liabilities and (iii) a potential working capital adjustment. The completion of the transaction, which is currently anticipated to close in the fall of 2007, is subject to the
approval of the Companys stockholders as well as other customary closing conditions.

The Company has agreed, subject to certain
exceptions, to cause a stockholders meeting to be held to consider approval of the Purchase Agreement and the transactions contemplated thereby. The Purchase Agreement contains certain termination rights and provides that if the stockholders of the
registrant fail to approve the transaction, the Company will be required to pay up to $2,500,000 of WASs reasonable out of pocket expenses.

In connection with the Purchase Agreement, Tennenbaum Capital Partners, LLC and certain of its affiliates and Massachusetts Mutual Life Insurance Company and certain of its affiliates have entered into a Voting Agreement with WAS, dated
July 10, 2007. As of July 10, 2007, these stockholders had shared voting power over 2,004,566 shares, or approximately 48.6%, of the Companys outstanding common stock.



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##### Table of Contents

|Item 2. | Management's Discussion and Analysis of Financial Condition and Results of Operations
|------- | -------------------------------------------------------------------------------------

INTRODUCTION

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

OVERVIEW

The Company operates primarily in the
aerospace and defense industry and its principal business is providing aircraft maintenance and modification services to military and commercial customers. The Companys services are 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.

RECENT DEVELOPMENTS

On July 11, 2007, the Company and Sun Capital Partners, Inc. (Sun Capital) announced they had entered into a Stock Purchase Agreement (the Purchase Agreement) between the Company, WAS Aviation Services, Inc., an
affiliate of Sun Capital (WAS) and Pemco World Air Services, Inc. (PWAS), a wholly owned subsidiary of the Company. Pursuant to the Purchase Agreement, the Company has agreed to sell all of the outstanding capital stock of
PWAS to WAS for an aggregate purchase price of approximately $43.0 million in cash, subject to: (i) a purchase price holdback of up to $1.0 million for potential environmental remediation, (ii) an offset of $5.75 million for the assumption
of certain underfunded pension liabilities and (iii) a potential working capital adjustment. The completion of the transaction, which is currently anticipated to close in the fall of 2007, is subject to the approval of the Companys
stockholders as well as other customary closing conditions.

The Company has agreed, subject to certain exceptions, to cause a stockholders meeting to be
held to consider approval of the Purchase Agreement and the transactions contemplated thereby. The Purchase Agreement contains certain termination rights and provides that if the stockholders of the registrant fail to approve the transaction, the
Company will be required to pay up to $2,500,000 of WASs reasonable out of pocket expenses.

In connection with the Purchase Agreement, Tennenbaum
Capital Partners, LLC and certain of its affiliates and Massachusetts Mutual Life Insurance Company and certain of its affiliates have entered into a Voting Agreement with WAS, dated July 10, 2007. As of July 10, 2007, these stockholders
had shared voting power over 2,004,566 shares, or approximately 48.6%, of the Companys outstanding common stock.

RESULTS OF OPERATIONS

Three months ended June 30, 2007 versus three months ended June 30, 2006

The table below presents major highlights from the three months ended June 30, 2007 and 2006.

(In
Millions)



|                                               |  |      |       |      |   |          |  |      |   
|---------------------------------------------- |  | ---- | ----- | ---- | - | -------- |  | ---- | --
|                                               |  | 2007 |       | 2006 |   | % Change | 
|Revenue                                        |  | $    | 53.18 |      | $ | 48.48    |  | 9.7  | % 
|Gross profit                                   |  |      | 7.28  |      |   | 6.72     |  | 8.3  | % 
|Operating income from continuing operations    |  |      | 2.11  |      |   | 1.93     |  | 9.3  | % 
|Income from continuing operations before taxes |  |      | 1.05  |      |   | 1.10     |  | (4.5 | )%
|Income from continuing operations              |  |      | 0.63  |      |   | 0.66     |  | (4.5 | )%
|Net income                                     |  |      | 0.63  |      |   | 0.45     |  | 40.0 | % 
|EBITDA from continuing operations              |  |      | 2.97  |      |   | 2.85     |  | 4.2  | % 

The Company defines operating income from continuing operations, as shown in the above table, as revenue less cost
of sales, less selling, general, and administrative expenses.



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EBITDA from continuing operations for the quarters ended June 30, 2007 and 2006 was calculated using the following
approach:

(In Millions)



|                                  |  |      |      |      |   |     
|--------------------------------- |  | ---- | ---- | ---- | - | ----
|                                  |  | 2007 |      | 2006
|Income from continuing operations |  | $    | 0.63 |      | $ | 0.66
|Interest expense                  |  |      | 1.06 |      |   | 0.83
|Taxes                             |  |      | 0.42 |      |   | 0.43
|Depreciation and Amortization     |  |      | 0.86 |      |   | 0.93
|                                  |  |      |      |      |   |     
|EBITDA from continuing operations |  | $    | 2.97 |      | $ | 2.85
|                                  |  |      |      |      |   |     

The Company presents Earnings Before Interest, Taxes, Depreciation and Amortization, more commonly referred to as
EBITDA, because its management uses the measure to evaluate the Companys performance and to allocate resources. In addition, the Company believes EBITDA is an important gauge used by commercial banks, investment banks, other financial
institutions, and current and potential investors, to approximate its cash generation capability. 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 operations will
not directly match the change in Accumulated Depreciation and Amortization reflected on the Companys consolidated balance sheets. This is a result of the capitalization of depreciation expense on long-term contracts into Work-in-Process.
EBITDA is not a measure of financial performance under generally accepted accounting principles in the United States (GAAP) and should not be considered as a substitute for or superior to other measures of financial performance reported
in accordance with GAAP. EBITDA as presented herein may not be comparable to similarly titled measures reported by other companies.

The table below
presents the highlights in revenue by operating segment for the three months ended June 30, 2007 and 2006.

(In Millions)



|             |  |      |       |      |   |       |        |  |   |          |   |  |       |   
|------------ |  | ---- | ----- | ---- | - | ----- | ------ |  | - | -------- | - |  | ----- | --
|             |  | 2007 |       | 2006 |   |       | Change |  |   | % Change |  
|GSS          |  | $    | 15.78 |      | $ | 24.64 |        |  | $ | (8.86    | ) |  | (36.0 | %)
|CSS          |  |      | 34.00 |      |   | 20.91 |        |  |   | 13.09    |   |  | 62.6  | % 
|MCS          |  |      | 3.40  |      |   | 3.04  |        |  |   | 0.36     |   |  | 11.8  | % 
|Eliminations |  |      |      |      |   | (0.11 | )      |  |   | 0.11     |   |  |       |   
|             |  |      |       |      |   |       |        |  |   |          |   |  |       |   
|Total        |  | $    | 53.18 |      | $ | 48.48 |        |  | $ | 4.70     |   |  | 9.7   | % 
|             |  |      |       |      |   |       |        |  |   |          |   |  |       |   

The $8.9 million decrease in GSS revenue was primarily due to decreases in KC-135 deliveries offset by increased
revenue from U.S. Navy P-3 aircraft and U.S Air Force (USAF) C-130 aircraft. The KC-135 Program Depot Maintenance (PDM) program, which accounted for 22.5% of revenue in the second quarter of 2007 and 44.7% of revenue in the
second quarter of 2006, allows for the Company to provide services on PDM aircraft, drop-in aircraft, and other aircraft related areas. Revenue from the KC-135 program decreased $9.7 million during the second quarter of 2007 versus the second
quarter of 2006. During the second quarter of 2007, the Company delivered three PDM aircraft and no drop-ins, compared to six PDM aircraft and one drop-in during the second quarter of 2006. The Company delivered one P-3 aircraft in the second
quarter of 2007 and 2006. Revenue from



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non-routine work performed on P-3 aircraft increased $0.3 million during the second quarter of 2007 compared to the second quarter of 2006 due to more
aircraft in work. Revenue increased $1.0 million under contracts to perform non-routine maintenance work on USAF C-130 aircraft. Revenue on other U.S. Government programs decreased $0.5 million during the second quarter of 2007 compared to the
second quarter of 2006.

The increase in CSS revenue of $13.1 million was primarily due to increases in cargo conversion revenues of $7.0 million,
increases in maintenance, repair and overhaul (MRO) revenue from Southwest Airlines of $4.7 million, and increases in MRO revenue from Northwest Airlines of $3.5 million, offset by decreases in revenue from various customers of $1.3
million and settlement of the H-3 Request for Equitable Adjustment of $0.8 million in the first quarter of 2006. CSS delivered four cargo conversions during the second quarter of 2007 compared to two during the second quarter of 2006. Two of the
four cargo conversions were performed in mainland China. Southwest Airlines increased the number of aircraft inducted during the second quarter of 2007 versus the second quarter of 2006. Northwest Airlines increased the scope of work on aircraft
inducted in the second quarter of 2007 as compared to the second quarter of 2006. CSS has several customers that provide drop-in aircraft on an inconsistent basis. These drop-in aircraft accounted for a larger percentage of revenue in the second
quarter of 2006.

Gross profit at GSS decreased from $2.3 million to $0.6 million during the second quarter of 2007 compared to the second quarter of 2006.
The decrease is primarily attributable to a decline in deliveries of KC-135 aircraft and losses incurred on the U.S. Navy P-3 program. Gross profit on the KC-135 program decreased $0.6 million during the second quarter of 2007 versus the second
quarter of 2006. The Company recorded losses on the U.S. Navy P-3 program of $1.1 million during the second quarter of 2007 versus losses of $0.5 million during the second quarter of 2006. Selling, general and administrative (SG&A)
expenses decreased $0.6 million during the second quarter of 2007 versus the second quarter of 2006 due to a decrease in the amount of allocated corporate expenses.

Gross profit at CSS increased from $3.1 million during the second quarter of 2006 to $6.1 million during the second quarter of 2007. Additional MRO revenue increased gross profit by $1.8 million in the second quarter
of 2007. Additional cargo conversions increased gross profit by $1.8 million in the second quarter of 2007. Gross profit at CSS in 2006 was positively impacted by the settlement of the H-3 Request for Equitable Adjustment, which resulted in an
increase in revenue of $0.8 million. CSS SG&A expenses decreased $0.2 million to $2.1 million in the second quarter of 2007 from $2.3 million in the second quarter of 2006 due to a reduction of allocated corporate expenses. CSS also recognized a
$0.6 million reversal of a provision for doubtful accounts in the second quarter of 2006.

Gross profit at MCS decreased from $0.7 million during the
second quarter of 2006 to ($0.2) million during the second quarter of 2007 due to the termination of one design services contract for a U.S. Government launch vehicle program and losses on fixed price contracts.

Consolidated Unallocated Corporate SG&A Expenses, Interest Expense and Income Taxes

During the second quarter of 2007, the Company incurred $0.5 million of legal and accounting expenses related to the planned sale of Space Vector Corporation and the sale of CSS. The Company did not allocate these
expenses to its subsidiaries. There were no comparable unallocated corporate expenses in the second quarter of 2006.



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Total interest expense, including discontinued operations, increased to $1.1 million in the second quarter of 2007 from
$0.9 million in the second quarter of 2006. Interest expense increased primarily as a result of higher rates on variable interest rate loans resulting from amending existing credit agreements.

During the second quarter of 2007, the Company recorded income tax expense at an effective rate of 40.4%. During the second quarter of 2006, the Company recorded income
tax expense at an effective rate of 39.6%. The effective income tax rate is affected by the allocation of taxable gains or losses between operations in Alabama and California. Net operating loss carry forwards in California are subject to a deferred
tax valuation allowance. Net operating loss carryforwards for Alabama are expected to be utilized in the current and/or future years.

Six months ended
June 30, 2007 versus six months ended June 30, 2006

The table below presents major highlights from the six months ended June 30, 2007
and 2006.

(In Millions)



|                                               |  |      |        |      |   |          |  |       |  
|---------------------------------------------- |  | ---- | ------ | ---- | - | -------- |  | ----- | -
|                                               |  | 2007 |        | 2006 |   | % Change | 
|Revenue                                        |  | $    | 105.58 |      | $ | 85.14    |  | 24.0  | %
|Gross profit                                   |  |      | 15.54  |      |   | 13.15    |  | 18.2  | %
|Operating income from continuing operations    |  |      | 4.73   |      |   | 2.77     |  | 70.8  | %
|Income from continuing operations before taxes |  |      | 2.68   |      |   | 1.31     |  | 104.6 | %
|Income from continuing operations              |  |      | 1.52   |      |   | 0.80     |  | 90.0  | %
|Net income                                     |  |      | 1.52   |      |   | 0.52     |  | 192.3 | %
|EBITDA from continuing operations              |  |      | 6.41   |      |   | 4.58     |  | 40.0  | %

The Company defines operating income from continuing operations, as shown in the above table, as revenue less cost
of sales, less selling, general, and administrative expenses.

EBITDA from continuing operations for the six months ended June 30, 2007 and 2006 was
calculated using the following approach:

(In Millions)



|                                  |  |      |      |      |   |     
|--------------------------------- |  | ---- | ---- | ---- | - | ----
|                                  |  | 2007 |      | 2006
|Income from continuing operations |  | $    | 1.52 |      | $ | 0.80
|Interest expense                  |  |      | 2.06 |      |   | 1.46
|Taxes                             |  |      | 1.15 |      |   | 0.52
|Depreciation and Amortization     |  |      | 1.68 |      |   | 1.80
|                                  |  |      |      |      |   |     
|EBITDA from continuing operations |  | $    | 6.41 |      | $ | 4.58
|                                  |  |      |      |      |   |     

A description of the Companys use of non-GAAP information is provided in the previous section.



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##### Table of Contents

The table below presents the highlights in revenue by operating segment for the six months ended March 31, 2007 and
2006.

(In Millions)



|             |  |      |        |   |      |   |       |        |  |   |          |   |  |       |   
|------------ |  | ---- | ------ | - | ---- | - | ----- | ------ |  | - | -------- | - |  | ----- | --
|             |  | 2007 |        |   | 2006 |   |       | Change |  |   | % Change |  
|GSS          |  | $    | 35.41  |   |      | $ | 46.67 |        |  | $ | (11.26   | ) |  | (24.1 | )%
|CSS          |  |      | 65.22  |   |      |   | 32.96 |        |  |   | 32.26    |   |  | 97.9  | % 
|MCS          |  |      | 5.00   |   |      |   | 5.63  |        |  |   | (0.63    | ) |  | (11.2 | )%
|Eliminations |  |      | (0.05  | ) |      |   | (0.12 | )      |  |   | 0.07     |   |  |       |   
|             |  |      |        |   |      |   |       |        |  |   |          |   |  |       |   
|Total        |  | $    | 105.58 |   |      | $ | 85.14 |        |  | $ | 20.44    |   |  | 24.0  | % 
|             |  |      |        |   |      |   |       |        |  |   |          |   |  |       |   

The $11.3 million decrease in GSS revenue was primarily due to decreases in KC-135 and Coast Guard C-130
deliveries offset by increased revenue from U.S. Navy P-3 aircraft and U.S Air Force (USAF) C-130 aircraft. The KC-135 Program Depot Maintenance (PDM) program, which accounted for 25.4% of revenue in the first six months of
2007 and 47.1% of revenue in the first six months of 2006, allows for the Company to provide services on PDM aircraft, drop-in aircraft, and other aircraft related areas. Revenue from the KC-135 program decreased $13.3 million during the first six
months of 2007 versus the first six months of 2006. During the first six months of 2007, the Company delivered seven PDM aircraft and no drop-ins, compared to ten PDM aircraft and two drop-ins during first six months of 2006. The Company delivered
two USCG C-130 aircraft during the first six months of 2006 for which there was no comparable revenue in 2007, resulting in a decrease in revenue of $3.5 million. The Company delivered three P-3 aircraft in the first six months of 2007 versus one in
the first six months of 2006, which increased revenue by $1.1 million. Revenue from non-routine work performed on P-3 aircraft increased by $1.1 million during the first six months of 2007 compared to the first six months of 2006 due to more
aircraft in work. Revenue increased by $2.1 million during the first six months of 2007 under contracts to perform non-routine maintenance work on USAF C-130 aircraft. Revenue on other U.S. Government programs increased $0.9 million during the first
six months of 2007 compared to the first six months of 2006.

The increase in CSS revenue of $32.3 million was primarily due to increases in cargo
conversion revenues of $17.1 million, increases in maintenance, repair and overhaul (MRO) revenue from Southwest Airlines of $11.5 million, and increases in MRO revenue from Northwest Airlines of $8.9 million, offset by decreases in
revenue from various customers of $4.4 million and settlement of the H-3 Request for Equitable Adjustment of $0.8 million in the first quarter of 2006. CSS delivered seven cargo conversions during the first six months of 2007 compared to two during
the first six months of 2006. Three of the seven cargo conversions was performed in mainland China. Southwest Airlines increased the number of aircraft inducted during the first six months of 2007 versus the first six months of 2006. Northwest
Airlines increased the scope of work on aircraft inducted in the first six months of 2007 as compared to the first six months of 2006. CSS has several customers that provide drop-in aircraft on an inconsistent basis. These drop-in aircraft accounted
for a larger percentage of revenue in the first six months of 2006.

Gross profit at GSS decreased from $5.3 million to $3.3 million during the first six
months of 2007 compared to the first six months of 2006. The decrease is primarily attributable to higher overhead rates caused by a reduction in man-hours and losses incurred on the U.S. Navy P-3 program. Gross profit on the KC-135 program
decreased $0.6 million during the first six months of 2007 versus the first six months of 2006. The Company recorded losses on the U.S. Navy P-3 program of $1.1 million during the first six months of 2007 versus losses



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of $0.4 million during the first six months of 2006. GSS SG&A expenses decreased by $0.9 million to $3.7 million in the first six months of 2007 from
$4.6 million in the first six months of 2006 due to a reduction in allocated corporate expenses.

Gross profit at CSS increased from $5.9 million during
the first six months of 2006 to $11.3 million during the first six months of 2007. Gross profit during the first half of 2006 was adversely impacted by the lockout of all union employees at the Dothan, Alabama facility, from August 11, 2005 to
October 9, 2005 and the bankruptcy of Northwest Airlines in the third quarter of 2005 as CSS capacity utilization increased back to normal levels. Additional MRO revenue increased gross profit by $3.7 million in the first six months of 2007.
Additional cargo conversions increased gross profit by $2.5 million in the first six months of 2007. Gross profit at CSS in 2006 was also positively affected by the settlement of the H-3 Request for Equitable Adjustment which resulted in an increase
in revenue of $0.8 million. CSS SG&A expenses remained unchanged at $4.9 million in the first six months of 2007 and 2006. CSS also recognized a $0.6 million reversal of a provision for doubtful accounts in the first six months of 2006.

Gross profit at MCS decreased from $0.7 million during the first six months of 2006 to ($0.4) million during the first six months of 2007 due to the
termination of one design services contract for a U.S. Government launch vehicle program and losses on fixed price contracts.

Consolidated Unallocated
Corporate SG&A Expenses, Interest Expense and Income Taxes

During the first six months of 2007, the Company incurred $0.9 million of legal and
accounting expenses related to the planned sale of Space Vector Corporation and the sale of CSS. The Company did not allocate these expenses to its subsidiaries. There were no comparable unallocated corporate expenses in the first six months of
2006.

Total interest expense increased to $2.1 million in the first six months of 2007 from $1.5 million in the first six months of 2006. Interest expense
increased primarily as a result of higher rates on variable interest rate loans resulting from amending existing credit agreements.

During the first six
months of 2007, the Company recorded income tax expense at an effective rate of 43.1%. During the first six months of 2006, the Company recorded income tax expense at an effective rate of 39.5%. The effective income tax rate is affected by the
allocation of taxable gains or losses between operations in Alabama and California. Net operating loss carry forwards for California are subject to a deferred tax valuation allowance. Net operating loss carryforwards for Alabama are expected to be
utilized in the current and/or future years.



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##### Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

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

(In Thousands, Except
Ratios)



|                                                                |  |              |        |   |                  |   |         |        |  |   |       |  
|--------------------------------------------------------------- |  | ------------ | ------ | - | ---------------- | - | ------- | ------ |  | - | ----- | -
|                                                                |  | June 30,2007 |        |   | December 31,2006 |   |         | Change | 
|Cash                                                            |  | $            | 42     |   |                  | $ | 23      |        |  | $ | 19    |  
|Working capital                                                 |  |              | (6,632 | ) |                  |   | (10,013 | )      |  |   | 3,381 |  
|Current portion of long-term debt and capital lease obligations |  |              | 27,861 |   |                  |   | 28,760  |        |  |   | (899  | )
|Stockholders equity                                            |  |              | 9,483  |   |                  |   | 7,380   |        |  |   | 2,103 |  
|Debt to equity ratio                                            |  |              | 2.94   |   |                  |   | 3.90    |        |  |   | (0.96 | )

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 under its Revolving Credit Facility. 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; collection of accounts receivable; funding requirements associated with the Companys defined benefit pension plan; settlements of
various claims; and potential divestitures, including the planned sale of CSS. As discussed below under Funding Sources, the Company anticipates that cash flow generated from operations or by consummating the sale of the CSS will be
sufficient to fund capital expenditures and make scheduled payments on debt obligations for the next twelve months. The ability to generate positive cash flow from operations during the last six months of 2007 will be impacted by whether or not the
Company wins the KC-135 contract award and whether or not the Company consummated the sale of the CSS. A sale of the CSS in 2007 will have a significantly positive impact on the Companys financial condition and liquidity. Additionally, a
deterioration of financial results due to the occurrence of any of the items discussed in Item 1A, Risk Factors, of Part II of the Form 10-Q or in the Companys 2006 Annual Report on Form 10-K, under the heading RISK FACTORS THAT MAY
AFFECT FUTURE PERFORMANCE, or failure to renegotiate the Companys credit facilities could adversely affect its liquidity.

Working Capital

As discussed below, the Company was in violation of various debt covenant ratios at various times during 2006. As a result, the maturity dates under
its Amended Credit Agreement have been fixed at less than one year which has resulted in the classification of most of the debt as current on the consolidated balance sheets. The reclassification of long-term debt to current resulted in negative
working capital at June 30, 2007 and December 31, 2006. The Company was in compliance with all debt covenants at June 30, 2007. The Companys ability to meet current and future payment obligations is dependent upon its ability to
improve operating performance, obtain additional financing from current or alternative lenders, sell the CSS or a combination of the above items. The Company has no current arrangements with respect to sources of additional financing, and its
negative results of operations in prior years and the current lack of a KC-135 contract award will likely make it more difficult and expensive for the Company to raise additional capital that may be necessary to continue its operations. The
Companys ability to continue to borrow funds from its lenders under the Amended Credit Agreement with Wachovia Bank and Compass Bank is dependent on its ability to meet the lenders borrowing conditions at the relevant times.



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In January 2007, the Company engaged advisors to pursue a public offering of 100% of its CSS on the AIM market in London,
or explore the potential sale of CSS. The Company received several indications of interest in purchasing the CSS. The Company also received an offer from Michael E. Tennenbaum, Chairman of the Board of Directors of the Company, to either 1) purchase
the CSS for $30.0 million in cash or 2) provide or cause to be provided to the Company financing on commercially reasonable terms in an amount sufficient to refinance all of the Companys debt. Mr. Tennenbaums offer remains open
until the earlier of April 30, 2008 or the sale of the CSS to a third party. The Board of Directors appointed the Finance Committee to consider Mr. Tennenbaums offer and any other offers which were made. On July 11, 2007, the
Company and Sun Capital Partners, Inc. (Sun Capital) announced they had entered into a Stock Purchase Agreement (the Purchase Agreement) between the Company, WAS Aviation Services, Inc., an affiliate of Sun Capital
(WAS) and Pemco World Air Services, Inc. (PWAS), a wholly owned subsidiary of the Company. Pursuant to the Purchase Agreement, the Company has agreed to sell all of the outstanding capital stock of PWAS to WAS for an
aggregate purchase price of approximately $43.0 million in cash, subject to: (i) a purchase price holdback of up to $1.0 million for potential environmental remediation, (ii) an offset of $5.75 million for the assumption of certain
underfunded pension liabilities and (iii) a potential working capital adjustment. The completion of the transaction, which is currently anticipated to close in the fall of 2007, is subject to the approval of the Companys stockholders as
well as other customary closing conditions. The Company expects the net proceeds from the sale of the CSS to be sufficient to eliminate all of the debt with Wachovia Bank and Compass Bank and provide working capital for GSS, although there can be no
assurances in that regard.

Cash Flow Overview

Operating activities provided $1.4 million during the first six months of 2007, compared to using $4.8 million during the first six months of 2006. Cash payments to fund the Companys defined benefit plan exceeded pension expense by
$2.0 million and $2.0 million in the first six months of 2007 and 2006, respectively. Cash of $0.4 million and $1.4 million was used during the first six months of 2007 and 2006, respectively, for capital expenditures. Financing activities used $1.0
million in the first six months of 2007 and provided $6.3 million in the first six months of 2006. The issuance of additional debt generated $5.0 million of cash in the first six months of 2006. The Company used $0.9 million to reduce long-term debt
during each of the first six months of 2007 and 2006. The Company decreased its borrowing under its Revolving Credit Facility by $0.1 million during the first six months of 2007 and increased its borrowing under its Revolving Credit Facility by $2.3
million during the first six months of 2006.

Future Capital Requirements

The Company has three large potential capital requirements in 2007: required minimum funding of the Pension Plan (noted below), current maturities of debt, and working capital required to fund increases in accounts
receivable, inventory and equipment if GSS is awarded the KC-135 contract.



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The Company maintains a Defined Benefit Pension Plan (the Pension Plan), which covers substantially all
employees at its Birmingham and Dothan, Alabama facilities. The Pension Plans assets consist primarily of equity mutual funds, bond mutual funds, hedge funds and cash equivalents. These assets are exposed to various risks, such as interest
rate, credit, and overall market volatility. As a result of unfavorable investment returns related to the Pension Plan in 2001 and 2002 coupled with lower interest rates, the Pension Plan was under-funded by approximately $18.8 million and $26.3
million at December 31, 2006 and 2005, respectively. The Company made contributions to the Pension Plan totaling approximately $11.0 million during 2006 and expects to contribute $11.1 million to the Pension Plan in 2007. The Company also has a
post-retirement benefit plan to provide health care benefits to retirees between 62 and 65 years of age. The post-retirement benefit plan is funded on a pay-as-you-go basis. Total benefits payable are estimated to be $0.1 million in 2007.

As discussed more extensively below, current maturities of long-term debt totaled $27.9 million and $28.8 million at June 30, 2007 and
December 31, 2006, respectively. All of the current maturities relate to the scheduled expirations of various credit agreements in 2007. The Company expects the net proceeds from the proposed sale of its CSS to be sufficient to eliminate all of
its indebtedness and provide working capital for continued operations, although there can be no assurances in that regard.

In 2004, the Company began an
initiative to improve hangar facilities for GSS in Birmingham. This initiative was suspended pending award of the KC-135 contract. If GSS is awarded the new KC-135 contract, the initiative to improve hangar facilities will resume. Future upgrades
and additional facility improvements will depend on new business and availability of resources.

Capital expenditures for 2007 and beyond have not been
budgeted and are highly dependent upon winning the KC-135 contract for GSS and the proposed sale of the CSS.

Revolving Credit Facility

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



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



| |  |  | Maintained the maximum principal amount of the Revolving Credit Facility at $28.0 million;
| | - |  | ------------------------------------------------------------------------------------------



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



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



| |  |  | Changed the interest rate on the Revolving Credit Facility to a rate ranging from LIBOR plus 1.5% to LIBOR plus 6.0% (8.32% at June 30, 2007), determined based
on
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | quarterly earnings before interest, taxes, deprecation and amortization (EBITDA), as defined in the Amended Credit Agreement, and established new
debt covenants as follows:
| | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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

As of June 30, 2007, the Company was in compliance with all of the covenants in the Amended Credit Agreement; however, there can be no assurances that the Company
will satisfy all of the debt covenants in the future or that the availability under the Revolving Credit Facility will be sufficient to continue its operations. If the Company violates any of the debt covenants, all debt may become immediately due
and payable. If additional financing is needed, the Companys negative results of operations in prior years and the current lack of a long-term KC-135 contract will likely make it more difficult and expensive for the Company to raise additional
capital that may be necessary to continue its operations. If the Company cannot raise adequate funds on acceptable terms, or at all, its business could be materially harmed.

Bank Term Loan

The Bank Term Loan with Wachovia Bank and Compass Bank matures December 31, 2007 and bears
interest at a rate ranging from LIBOR plus 2.25% to LIBOR plus 3.00% (8.32% at June 30, 2007) determined based on the ratio of adjusted funded debt to EBITDA, as defined in the Credit Agreement. The principal amount borrowed under the loan was
$5.0 million, which is payable in 60 monthly installments of $83,333 plus interest, which began January 31, 2003. The Company had an outstanding balance under the Bank Term Loan at June 30, 2007 of $0.5 million.

Treasury Stock Term Loan

On May 22, 2003, the Company amended
the Credit Agreement to include a term loan that could be used for the repurchase of the Companys Common Stock (the Treasury Stock Term Loan). The Company was permitted to draw upon the Treasury Stock Term Loan up to $5.0 million
through May 22, 2005, and the borrowings could be used to make purchases of the Companys Common Stock from any person who is not and has never been an affiliate of the Company, or any other person approved by the lenders at their
discretion. The Treasury Stock Term Loan matures on December 31, 2007 and bears interest at LIBOR plus 3.00% (8.32% at June 30, 2007). The Company had an outstanding balance under the Treasury Stock Term Loan at June 30, 2007 of $0.4
million. The loan is being repaid in equal monthly installments over 31 months which began on May 22, 2005.



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Senior Secured Debt

On February 15, 2006, the Company entered into a Note Purchase Agreement with Silver Canyon Services, Inc. (Silver Canyon), pursuant to which the Company issued to Silver Canyon a senior secured Note in the principal amount
of $5.0 million (the Note). The principal amount of the Note was to become due and payable on the earlier of (i) February 15, 2007, or (ii) the date on which amounts outstanding under the Companys Revolving Credit
Facility become due and payable. The Note accrues interest at an annual rate of 15%, which is payable quarterly in arrears commencing March 1, 2006. The Company may, at its election, redeem the Note at a price equal to 100% of the principal
amount then outstanding, together with accrued and unpaid interest thereon. The Note is subordinate to any debt incurred by the Company under the Amended Credit Agreement with Wachovia and Compass. The Note contains customary events of default
consistent with the events of default defined in the Amended Credit Agreement. The payment of all outstanding principal, interest and other amounts owed under the Note may be declared immediately due and payable by the lender upon the occurrence of
an event of default, subject to certain standstill provisions. On July 31, 2006, the Note was purchased by Special Value Bond Fund, LLC, which is managed by Tennenbaum Capital Partners, LLC, a related party of the Company. On July 31,
2007, the Company entered into an Amended and Restated Senior Secured Note with Special Value Bond Fund, LLC, in which the maturity date for the principal amount of the Note was extended until February 15, 2009.

Airport Authority Term Loan

The Company executed a loan agreement
during the fourth quarter of 2002 to borrow up to $2.5 million from the Dothan-Houston County Airport Authority to finance its hangar expansion at the facility. The hangar expansion was completed during the first quarter of 2003. The loan is backed
by a letter of credit with the Companys primary lender and carries a variable interest rate, which was 3.89% at June 30, 2007. The Company had an outstanding balance under the Airport Authority Term Loan at June 30, 2007 of $2.0
million, payable in annual installments of $180,000 through September 2017.

Funding Sources

The Company intends to seek funding for the advancement of its strategic goals, including the possible investment in targeted business areas and
acquisitions. 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, including the
proposed sale of the CSS. 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.



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As discussed above, the Company has entered into a Purchase Agreement to sell the CSS. The Company expects the net
proceeds from the sale of the CSS to be sufficient to eliminate all of the debt with Wachovia Bank and Compass Bank and provide working capital for GSS, although there can be no assurances in that regard.

TRADING ACTIVITIES

The Company does not engage in trading activities
or in trading non-exchange traded contracts. As of June 30, 2007 and December 31, 2006, 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 risks through the use of derivative financial instruments. The Company did not have any material foreign exchange risks at June 30, 2007 or December 31, 2006.
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 Ronald A. Aramini, its 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 Mr. Araminis termination of employment with the Company. Any change in this related party receivable relates to
interest accumulated during the period. On March 26, 2007, Mr. Aramini paid all the accumulated interest on the promissory note which totaled $0.1 million.

On December 28, 2006, the Company and Mr. Aramini entered into a Second Amendment, effective December 29, 2006 (the Second Amendment), to the Executive Deferred Compensation Agreement, dated
as of May 3, 2002 (the Deferred Compensation Agreement), between the Company and Mr. Aramini. The Company and Mr. Aramini had previously entered into a First Amendment (the First Amendment) to the Deferred
Compensation Agreement dated as of May 16, 2003.

The Deferred Compensation Agreement, as amended by the First Amendment, provided for an initial
lump-sum contribution of $562,140 by the Company to an associated rabbi trust for the benefit of Mr. Aramini, and, for each of Mr. Araminis 2002, 2003, 2004, 2005, 2006 and 2007 full calendar years of employment, additional lump sum
trust contributions of $287,820, $308,560, $296,000, $324,240, $359,861 and $380,326, respectively, following year-end. Company contributions to the trust are invested by the trustee and are to be disbursed to Mr. Aramini in accordance with the
terms of the Agreement. Pursuant to the Second Amendment, the Companys obligation to make the $380,326 lump sum trust contribution for the 2007 calendar year has been eliminated.

On February 15, 2006, the Company entered into a Note Purchase Agreement with Silver Canyon in order to secure working capital and minimum required pension funding, pursuant to which the Company issued to Silver
Canyon a senior secured note due February 15, 2007 in the principal amount of $5.0 million. On



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July 31, 2006, Silver Canyon assigned the Note Purchase Agreement and sold the Note to Special Value Bond Fund, LLC, which is managed by Tennenbaum
Capital Partners, LLC. Michael E. Tennenbaum is the Senior Partner of Tennenbaum Capital Partners, LLC and is Chairman of the Board of Directors of the Company.

On February 15, 2007, the Company entered into an Amended and Restated Senior Secured Note with Special Value Bond Fund, LLC, pursuant to which the maturity date for the principal amount of the Note was extended the earlier of
(i) February 15, 2008, or (ii) the date on which amounts outstanding under the Companys Revolving Credit Facility become due and payable. In addition, the Company executed Amendment No. 1 to the Note Purchase Agreement with
Special Value Bond Fund, LLC, to confirm a revised maturity date for the Note. On July 31, 2007, the Company entered into an Amended and Restated Senior Secured Note with Special Value Bond Fund, LLC, in which the maturity date for the
principal amount of the Note was extended until February 15, 2009. All other terms and conditions of the Note and the Note Purchase Agreement remain the same.

The Company has received an offer from Michael E. Tennenbaum, Chairman of the Board of Directors of the Company, to either 1) purchase the CSS for $30.0 million in cash or 2) provide or cause to be provided to the Company financing on
commercially reasonable terms in an amount sufficient to refinance all of the Companys debt. Mr. Tennenbaums offer remains open until the earlier of April 30, 2008 or the sale of the CSS to a third party. The Board of Directors
appointed the Finance Committee to consider Mr. Tennenbaums offer and any other offers which were made. On July 11, 2007, the Company and Sun Capital announced they had entered into a Stock Purchase Agreement (the Purchase
Agreement) between the Company, WAS and PWAS, a wholly owned subsidiary of the Company. Pursuant to the Purchase Agreement, the Company has agreed to sell all of the outstanding capital stock of PWAS to WAS for an aggregate purchase price of
approximately $43.0 million in cash, subject to: (i) a purchase price holdback of up to $1.0 million for potential environmental remediation, (ii) an offset of $5.75 million for the assumption of certain underfunded pension liabilities and
(iii) a potential working capital adjustment. The completion of the transaction, which is currently anticipated to close in the fall of 2007, is subject to the approval of the Companys stockholders as well as other customary closing
conditions.

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 2006 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.



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Revenue Recognition

Revenue at the GSS is derived principally from aircraft maintenance and modification services performed under contracts or subcontracts with government and military customers. The Company recognizes revenue and associated costs under such
contracts on the percentage-of-completion method as prescribed by Statement of Position 81-1 (SOP 81-1), Accounting for Performance of Construction-Type and Certain Production-Type Contracts. These contracts generally provide for
routine maintenance and modification services at fixed prices detailed in the contract. Any non-routine maintenance and modification services are provided based upon estimated labor hours at fixed hourly rates. The Company segments the routine and
the non-routine services for purposes of accumulating costs and recognizing revenue. For routine services, the Company uses the units-of-delivery method as the basis to measure progress toward completion, with revenue recorded based upon the unit
sales value stated in the contract and costs of sales recorded based upon actual unit cost. An aircraft is considered delivered when work is substantially complete and acceptance by the customer has occurred by execution of a form DD 250. For
non-routine services, the Company uses an output measure based upon units of work performed to measure progress toward completion, with revenue recorded based upon the stated hourly rates in the contract and costs of sales recorded based upon
estimated average costs. The Company considers each task performed for the customer as a unit of work performed. Revenue and costs of sales are recognized upon completion of all performance obligations in accordance with the contract. Such work is
performed and completed throughout the PDM process.

Revenue at the CSS is derived principally from aircraft maintenance, modification and conversion
programs under contracts with the owners and operators of large commercial airlines. The Company recognizes revenue and associated costs for all work performed under such contracts on a percentage-of-completion method, as prescribed by SOP 81-1,
using units-of-delivery as the basis to measure progress toward completion. Revenue is recorded based upon the unit sales value stated in the contract and costs of sales are recorded based upon actual unit cost. The CSS uses program accounting for
contracts that involve the modification of multiple aircraft, require significant engineering cost, and involve certain learning curve costs that were considered in determining the sales value of the contract. Under program accounting, the total
cost to complete all aircraft under the contract is estimated and charged to cost of sales on a basis consistent with how the revenue is recognized.

MCS
derives a significant portion of its revenue from cost-reimbursement type contracts accounted for under the principles prescribed by SOP 81-1 and from sales of precision parts and components. Revenue on cost-reimbursable contracts is recognized to
the extent of costs incurred plus a proportionate amount of estimated fee earned. For certain other fixed-price contracts, revenue is recognized when performance milestones have been achieved in accordance with contract terms.

Contract accounting requires judgment relative to assessing risks and estimating contract revenues and costs. The Company employs various techniques to project contract
revenue and costs which inherently include significant assumptions and estimates. Contract revenues are a function of the terms of the contract and often bear a relationship to contract costs. Contract costs include labor, material, an allocation of
indirect costs, and, in the case of certain government contracts, an allocation of general and administrative costs. Techniques for estimating contract costs impact the Companys proposal processes, including the determination of pricing for
routine and non-routine elements of contracts, the evaluation of



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profitability on contracts, and the timing and amounts recognized for revenue and cost of sales. The Company provides for losses on uncompleted contracts in
the period in which management determines that the estimated total costs under the contract will exceed the estimated total contract revenues. These estimates are reviewed periodically and any revisions are charged or credited to operations in the
period in which the change is determined. An amount equal to contract costs attributable to claims is included in revenues when realization is probable and the amount can be reasonably estimated. Judgment is required in determining the potential
realization of claim revenue and estimating the amounts recoverable. Because of the significance of the judgments and estimates required in these processes, it is likely that materially different amounts could result from the use of different
assumptions or if the underlying conditions were to change. In addition, contracts accounted for under the percentage-of-completion or units-of-delivery methods may result in material fluctuations in revenue and profit margins depending on the
timing of delivery and performance, the relative proportion of fixed price, cost reimbursement, and other types of contracts-in-process, and costs incurred in their performance. For additional information regarding accounting policies the Company
has established for recognizing revenue, see Revenue Recognition in Note 1 to the Consolidated Financial Statements in the Companys 2006 Annual Report on Form 10-K.

Allowance for Doubtful Accounts

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

Given the nature of the GSS business and customers, write-offs have historically been
nominal. GSS customers are primarily the U.S. Government or its prime contractors. The CSS primarily services the commercial airline market, and is therefore more susceptible to collection issues. The Companys services are contract driven, and
fees for services performed in accordance with the agreed upon terms of the contract with the customer are collected.

Inventory Reserves

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



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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.

Machinery, Equipment and Improvements and Impairment

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

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

Pension and Postretirement Plans

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

In September 2006,
the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 158 (FAS No. 158). As required by FAS No. 158, the Company



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adopted the balance sheet recognition provisions at December 31, 2006 which resulted in the Company recording $6.0 million in accumulated comprehensive
income for amounts that had not been previously recorded in net periodic benefit cost.

Warranties

The Company provides warranties covering workmanship and materials under its PDM and MRO contracts that generally range from 6 to 18 months after an aircraft is
delivered, depending on the specific terms of each contract. The Company provides warranties under its cargo conversion contracts that generally range from approximately 3 to 10 years from the date of aircraft delivery on structure, electrical
systems and other components directly associated with the conversion system and one year from the date of aircraft delivery on workmanship and materials related to general maintenance performed concurrent with the conversion. The Company provides a
reserve for anticipated warranty claims based on historical experience, current warranty trends, and specific warranty terms. Periodic adjustments to the reserve are made as events occur that indicate changes are necessary.

Insurance Reserves

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

Contingencies

As further discussed in Note 9 of Notes to Consolidated Financial Statements, the Company has been involved, and may continue
to be involved, in various legal proceedings arising out of the conduct of its business including litigation with customers, employment related lawsuits, purported class actions, and actions brought by governmental authorities. The Company has, and
will continue to, vigorously defend itself and to assert available defenses with respect to these matters. Where appropriate, the Company has accrued an estimate of the probable cost of resolutions of these proceedings based upon consultation with
outside counsel and assuming various strategies. A settlement or an adverse resolution of one or more of these matters may result in the payment of significant costs and damages that could have a material adverse effect on the Companys
financial position or results of operations.

BACKLOG

Backlog at the GSS decreased from $32.1 million at December 31, 2006 to $24.5 million at June 30, 2007. Approximately $3.9 million of the decrease was the result of fewer KC-135 aircraft in work, totaling five at June 30,
2007 versus seven at December 31, 2006. Backlog



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for the P-3 program decreased $2.9 million due to fewer aircraft in work, totaling three at June 30, 2007 versus six at December 31, 2006. The
reduction in KC-135 aircraft in work at the GSS was partially caused by the reduction in processing time due to improvements in flow days. The Company classifies all work for which the final customer is the U.S. Government as U.S. Government work
whether the work is performed directly or under sub-contract. Backlog at the CSS increased from $31.3 million at June 30, 2006 to $31.4 million at June 30, 2007 due to normal fluctuations in the level of activity.

CONTINGENCIES

See Note 9 to the Consolidated Financial Statements.

FORWARD-LOOKING STATEMENTSCAUTIONARY LANGUAGE

Some of the information under the caption Managements Discussion and Analysis of Financial Condition and Results of Operations and elsewhere in this Quarterly Report are forward-looking statements within the meaning of the
Private Securities Litigation Reform Act of 1995 (set forth in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended). These forward-looking statements include, but are
not limited to, statements about the Companys plans, objectives, expectations and intentions, award or loss of contracts, anticipated increase in demand for conversions, the outcome of pending or future litigation, compliance with debt
covenants under borrowing arrangements, estimates of backlog and other statements contained in this Quarterly Report that are not historical facts. When used in this Quarterly Report, the words expects, anticipates,
intends, plans, believes, seeks, estimates, may, will, should, could and similar expressions are generally intended to identify
forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors discussed under the caption Risk Factors in Item 1A of Part II of this Form 10-Q and under the caption
Factors That May Affect Future Performance in the Companys 2006 Annual Report on Form 10-K, which could cause actual results to differ materially from those expressed or implied by these forward-looking statements. The Company
cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date on which they are made. The Company does not undertake any obligation to update or revise any forward-looking statements.



|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 Amended
Credit Agreement, which includes the Revolving Credit Facility and two term loans, all as described in Note 4 to the Consolidated Financial Statements (see Item 1 of Part I herein). The Amended Credit Agreements Revolving Credit Facility
bears interest at LIBOR plus 300 basis points (8.32% at June 30, 2007). Each of the term loans under the Amended Credit Agreement bears interest at LIBOR plus 300 basis points (8.32% at June 30, 2007). The Airport Authority Term Loan bears
interest at BMA plus 36 basis points (3.89% at June 30, 2007). Had the interest rate of the variable rate debt increased 100 basis points, net income would have decreased by approximately $126,000 and $62,000 during the six months and three
months ended June 30, 2007, respectively.



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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 SEC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, 2007, the end of the period covered by this report. Based on that evaluation and the issues discussed below, the Companys Chief Executive Officer and Chief Financial Officer
concluded that the Companys disclosure controls and procedures were not effective at the reasonable assurance level as of June 30, 2007.



|(b) | Changes in internal control over financial reporting.
|--- | -----------------------------------------------------

In addition
to managements evaluation of disclosure controls and procedures as discussed above, in connection with the audits of the Companys financial statements for the fiscal years ended December 31, 2006 and 2005, we are continuing to
review and enhance policies and procedures involving accounting, information systems and monitoring.

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

During the audit of the 2006 financial statements, the Companys independent registered public accounting firm identified a
material weakness in internal control over financial reporting due to the resignation of the Director of Corporate Accounting and Manager of Financial Reporting in December 2006 which created a lack of resources in the financial



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close and reporting process. In addition, it was noted that the Chief Financial Officer had the ability to make journal entries although no such entries were
made by him during the year ended December 31, 2006. As a result of the lack of financial reporting resources, the Companys independent registered public accounting firm identified miscellaneous audit adjustments. The Company added
temporary resources to compensate for the departure of the accounting personnel.

Except as noted above, there have been no changes to the Companys
internal control over financial reporting that occurred during the Companys second quarter ended June 30, 2007 that have materially affected or that are reasonably likely to materially affect the Companys internal control over
financial reporting.



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PART II OTHER INFORMATION



|Item 1. | Legal Proceedings
|------- | -----------------

See Note 9 to the Consolidated Financial Statements.



|Item 1A. | Risk Factors
|-------- | ------------

There have been no material changes from the Risk Factors previously disclosed in the
Companys 2006 Annual Report on Form 10-K other than the addition of the risks described below under the heading Risks Related to the Sale of Pemco World Air Services, Inc., the deletion of the risk entitled Failure to Sell
the Commercial Services Business Could Materially Harm the Companys Business and the revisions to the following Risk Factors (the complete text of which is set forth below under the heading Revised Risks):



| |  |  | the Risk Factor entitled The Company is Heavily Dependent on U.S. Government Contracts has been revised to reflect that upon the completion of the sale
of the CSS the Company will be dependent upon U.S. Government contracts for substantially all of its revenue.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Risk Factor entitled A Significant Portion of the Companys Revenues is Derived From a Few of its Contracts, and the Termination or Failure to Renew
Any of Them Could Materially Harm the Companys Business has been revised to reflect that upon completion of the sale of the CSS the Companys dependence upon a small number of contracts for a significant portion of its revenues will
increase.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Risk Factor entitled The Company Could Incur Significant Costs and Expenses Related to Environmental Problems has been revised to reflect that the
Company could be exposed to increased costs and expenses related to environmental problems as a result of the Phase II environmental site assessment which is being conducted in connection with the sale of the CSS.
| | - |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Risk Factor entitled The Company May Need Additional Financing to Maintain its Business Which May or May Not Be Available has been revised to
reflect that we have entered into a stock purchase agreement for the sale of Pemco World Air Services, Inc.
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | The Risk Factor entitled The Amount and Terms of the Companys Indebtedness Restrict the Companys Financial and Operational Flexibility has
been revised to reflect the extension of the maturity date of our indebtedness to Special Value Bond Fund, LLC.
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

Risks Related to the
Sale of Pemco World Air Services, Inc.

Our business may be harmed if the sale of Pemco World Air Services, Inc. disrupts the operations of our
business and prevents us from realizing intended benefits.

The sale of Pemco World Air Services, Inc., and uncertainty connected
with the completion of the sale, may disrupt our business and prevent us from realizing intended benefits as a result of a number of obstacles, such as:



| |  |  | loss of key employees or customers;
| | - |  | -----------------------------------



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| |  |  | failure to adjust or implement our business model;
| | - |  | --------------------------------------------------



| |  |  | additional expenditures required to facilitate this sale; and
| | - |  | -------------------------------------------------------------



| |  |  | the diversion of managements attention from our day-to-day business.
| | - |  | ---------------------------------------------------------------------

To the extent any such risks materialize, this may have a material adverse effect on our business prospects, operating results and financial condition.

Our business may be harmed if changing our name in connection with the sale of Pemco World Air Services, Inc. diminishes our recognizability with
potential customers.

We have operated under the name Pemco for a number of years and believe that we have developed
valuable goodwill with respect to this name. We cannot predict whether changing our name in connection with the sale of Pemco World Air Services, Inc. will diminish our recognizability with potential customers or to what extent such diminished
recognizability may have a material adverse effect on our business prospects, operating results and financial condition.

The failure to complete the
sale of Pemco World Air Services, Inc. may result in a decrease in the market value of our common stock.

The sale of Pemco World
Air Services, Inc. is subject to a number of contingencies, including approval by our stockholders and other customary closing conditions. We cannot predict whether we will succeed in obtaining the approval of our stockholders, or that the other
conditions to closing the sale of Pemco World Air Services, Inc. will be satisfied. As a result, we cannot assure you that the sale of Pemco World Air Services, Inc. will be completed. Further, if the sale is not completed for any reason, we may be
subject to a number of material risks including that we may have difficulty funding our continuing operations or satisfying our existing debt service and pension funding obligations. In the event that the sale of Pemco World Air Services, Inc. is
not completed and such risks do materialize, this may have a material adverse effect on our business prospects, operating results and financial condition and the market value of our common stock may decline

If our stockholders do not approve the sale of Pemco World Air Services, Inc., we will owe a substantial fee to WAS Aviation Services, Inc.

If our stockholders do not approve the sale of Pemco World Air Services, Inc., we will be obligated to reimburse up to $2.5 million of the reasonable
out-of-pocket expenses incurred by WAS Aviation Services, Inc. in connection with the sale of Pemco World Air Services, Inc. This expense is significant and may adversely effect our business prospects, operating results and financial condition

If our stockholders do not approve and authorize the sale of Pemco World Air Services, Inc., there may not be any other offers from potential
acquirers.

If our stockholders do not approve the sale of Pemco World Air Services, Inc., we may seek another strategic
transaction, including the sale of all or part of our business. Although we have had discussions regarding such transactions with various parties in the past, none of these parties may now have an interest in a strategic transaction with us or be
willing to offer a reasonable purchase price.



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We will be unable to compete with the Pemco World Air Services, Inc. business for three years from the date of the
closing.

The stock purchase agreement for the sale of Pemco World Air Services, Inc. includes a non-competition obligation which
lasts for a period of three years from the closing of the sale. Under this provision, we will not be able to engage in the business being sold to WAS Aviation Services, Inc., except with respect to military customers. Additionally, we will not be
able to recruit or solicit employees of Pemco World Air Services, Inc. to terminate their employment for a one year period. These limitations on the scope of our future business operations may adversely effect our business prospects, operating
results and financial condition.

We are obligated to indemnify WAS Aviation Services, Inc. under certain circumstances.

While the representations and warranties in the stock purchase agreement do not survive the closing of the sale of Pemco World Air Services, Inc., we have
agreed to a limited indemnity for any and all losses incurred by WAS Aviation Services, Inc. resulting from:



| |  |  | fraud with respect to any representation or warranty made by us or Pemco World Air Services, Inc. in the stock purchase agreement;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------



| |  |  | certain tax liabilities;
| | - |  | ------------------------



| |  |  | certain potential environmental remediation costs; and
| | - |  | ------------------------------------------------------



| |  |  | losses resulting from the litigation between Pemco World Air Services, Inc. and GE Capital Aviation Services, Inc.
| | - |  | ------------------------------------------------------------------------------------------------------------------

In the event that any such indemnification obligations do arise and are material, this may adversely effect our business prospects, operating results and
financial condition.

Revised Risks

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

Approximately 53%, 61% and 69% of our revenues from continuing operations in 2006, 2005 and
2004, respectively, were derived from U.S. Government contracts. U.S. Government contracts expose us to a number of risks, including:



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



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



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



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



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

In addition, substantially all of the Companys government backlog scheduled for delivery can be terminated at the convenience of the U.S.
Government since orders are often placed well before delivery, and its contracts typically provide that orders may be terminated



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with limited or no penalties. In addition, if the Company successfully completes its sale of Pemco World Air Services, Inc., it will become dependent on U.S.
Government contracts for substantially all of its revenues. If the Company is unable to address any of the above risks, its business could be materially harmed and the value of its Common Stock could be impaired.

A Significant Portion of the Companys Revenues is Derived From a Few of its Contracts, and the Termination or Failure to Renew Any of Them Could Materially
Harm the Companys Business.

A small number of the Companys contracts account for a significant percentage of its revenues. Contracts
with the U.S. Government comprised 53%, 61% and 69% of the Companys revenues from continuing operations during 2006, 2005 and 2004, respectively. The USAF KC-135 program in and of itself comprised 45%, 53% and 62% of the Companys total
revenues from continuing operations in 2006, 2005 and 2004, respectively, and a contract with Northwest Airlines comprised 16%, 24% and 23% of total revenues from continuing operations during these same respective time periods. Also, a contract with
Southwest Airlines comprised 10% of the Companys total revenues from continuing operations in 2006. Termination of a contract, a dispute over compliance with contract terms, a disruption of any of these contracts (including option years not
being exercised), or the inability of the Company to renew or replace any of these contracts when they expire, could materially harm its business and impair the value of its Common Stock. In the event that the Company successfully completes its sale
of Pemco World Air Services, Inc., its dependence on a small number of contracts will be increased as substantially all of its remaining contracts will be with the U.S. Government.

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



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

Various federal, state, and local laws and regulations require property owners or operators to pay for the costs of removal or remediation of hazardous or toxic
substances located on a property. For example, there are stringent legal requirements applicable to the stripping, cleaning, and painting of aircraft. We have previously paid penalties to the EPA for violations of these laws and regulations, and we
may be required to pay additional penalties or remediation costs in the future. These laws and regulations also impose liability on persons who arrange for the disposal or treatment of hazardous or toxic substances at another location for the costs
of removal or remediation of these hazardous substances at the disposal or treatment facility. Further, these laws and regulations often impose liability regardless of whether the entity arranging for the disposal ever owned or operated the disposal
facility. As operators of properties and as potential arrangers for hazardous substance disposal, we may be liable under the laws and regulations for removal or remediation costs, governmental penalties, property damage, and related expenses. In
addition, in conjunction with the proposed sale of Pemco World Air Services, Inc., WAS Aviation Services, Inc. has engaged an environmental consultant to conduct an assessment of potential environmental remediation at our facilities, if any, that
may be required to meet applicable remediation standards. We cannot predict the outcome of this assessment or whether this assessment will reveal the presence of hazardous substances or environmental damage on or off Pemco World Air Services,
Inc.s site that its operations may have caused. If significant environmental remediation is required and stockholder approval of the sale of Pemco World Air Services, Inc. is not obtained, expenses related to such remediation may have a
material adverse effect on our business prospects, operating results and financial condition. If, however, the stock purchase agreement is approved and the transaction closes, WAS Aviation Services, Inc. will bear the risk of the first million of
such losses and we will bear the risk of any such losses in excess of $1.0 million but not to exceed $2.0 million in the aggregate. As a result, WAS Aviation Services, Inc. would be responsible for all losses in excess of $3.0 million. Payment of
any of these costs and expenses could materially harm our business and impair the value of our Common Stock.

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

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



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



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



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



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



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

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



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

iii) Achieve a cumulative EBITDA of not less than $0.4 million for the period from September 1, 2006 to
September 30, 2006; $2.85 million for the period from September 1, 2006 to December 31, 2006; $3.75 million for the period from September 1, 2006 to March 31, 2007; and $6.0 million for the period from September 1, 2006
to June 30, 2007.

There can be no assurances that the Company will satisfy all debt covenants or that the availability under the Revolving Credit
Facility will be sufficient for its continuing operations. If the Company violates the debt covenants, all debt may become due and payable. If additional financing is needed, the Companys negative results of operations in 2005 and 2004 and the
uncertainty of a long-term KC-135 contract will likely make it more difficult and expensive for the Company to raise additional capital that may be necessary to continue its operations. If the Company cannot raise adequate funds on acceptable terms,
or at all, the Companys business could be materially harmed.

The Company has entered into a stock purchase agreement, pursuant to which it will sell
its subsidiary, Pemco World Air Services, Inc., to WAS Aviation Services, Inc. for $43.0 million in cash, subject to: (1) a purchase price holdback of up to $1.0 million and an escrow of up to $1.0 million for potential environmental
remediation; (2) an offset of $5.75 million for the assumption of certain pension underfunding liabilities and (3) a potential working capital adjustment. The Company has also received an offer from Michael E. Tennenbaum, Chairman of the
Board of Directors of the Company, to either 1) purchase the Commercial Services business for $30.0 million in cash or 2) provide or cause to be provided to the Company financing on commercially reasonable terms in an amount sufficient to refinance
all of Pemcos debt. Mr. Tennenbaums offer remains open until the earlier of April 30, 2008 or the sale of the Commercial Services business to a third party. The Board of Directors has appointed the Finance Committee to consider
Mr. Tennenbaums offer and any other offers.

The Amount and Terms of the Companys Indebtedness Restrict the Companys Financial
and Operational Flexibility.

The Companys Amended Credit Agreement contains covenants that restrict, among other things, its ability to
borrow money, make particular types of investments, sell assets, merge or consolidate, or make acquisitions. The Amended Credit Agreement also requires the Company to maintain specified financial ratios. The Companys ability to meet these
financial ratios can be affected by events beyond its control, and there can be no assurance that the Company will be able to meet these ratios. The Company was in violation of various



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debt covenants in 2006 and 2005, for which the Company obtained waivers from its lenders. The Companys ability to meet current and future payment
obligations, and to satisfy its debt covenants, is dependent upon its ability to improve operating performance, obtain additional financing from current or alternative lenders, or a combination of the above items. There can be no assurances that the
Company will satisfy all debt covenants, that it will be able to obtain waivers from its lenders if in violation of such covenants, or that the availability under the Revolving Credit Facility will be sufficient for its continuing operations. If the
Company violates the debt covenants, all debt may become due and payable, which could materially harm its business and impair the value of its Common Stock.

On February 15, 2006, the Company entered into a Note Purchase Agreement with Silver Canyon Services, Inc. (Silver Canyon), pursuant to which it issued to Silver Canyon a senior secured note in the principal amount of $5.0
million (the Note). The Note is subordinate to any debt incurred by the Company under the Amended Credit Agreement with Wachovia Bank and Compass Bank. The Note contains customary events of default consistent with the defined events of
default established under the Amended Credit Agreement. The payment of all outstanding principal, interest and other amounts owing under the Note may be declared immediately due and payable upon the occurrence of an event of default, subject to
certain standstill provisions with Wachovia and Compass. The Company may be unable to locate other lenders at comparable interest rates if an event of default occurs. On July 31, 2006, the Note was purchased by Special Value Bond Fund, LLC,
which is managed by Tennenbaum Capital Partners, LLC, a related party of the Company. The Note Purchase Agreement was amended on July 31, 2007 to change the maturity date of the Note to February 15, 2009.

The Company has pledged substantially all of its assets to secure the debt under the Amended Credit Agreement with Wachovia and Compass and the Note with Special Value
Bond Fund, LLC. If the amounts outstanding under the Amended Credit Agreement or the Note were accelerated, the lenders could proceed against those assets. Any event of default, therefore, could have a material adverse effect on the Companys
business and impair the value of its Common Stock.



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

The Companys Annual Meeting of Stockholders was held
on May 16, 2007. At the meeting, stockholders elected Ronald A. Aramini, Harold T. Skip Bowling and Ronald W. Yates as Class III directors to serve until 2010.

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



|                         |  |           |  |         
|------------------------ |  | --------- |  | --------
|Nominee                  |  | For       |  | Withheld
|Ronald A. Aramini        |  | 3,097,823 |  | 62,582  
|Harold T. Skip Bowling |  | 3,096,873 |  | 63,532  
|Ronald W. Yates          |  | 3,102,986 |  | 57,419  

Thomas C. Richards and Hugh Steven Wilson continued in office as a member of the Board of Directors, with their
terms expiring at the 2008 Annual Meeting of Stockholders. Robert E. Joyal and Michael E. Tannenbaum continued in office as a member of the Board of Directors, with their terms expiring at the 2009 Annual Meeting of Stockholders.



|Item 6. | Exhibits
|------- | --------



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



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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 14, 2007 |  | By:                        |  | /s/ Ronald A. Aramini                                                                                                    
|                       |  |                            |  | Ronald A. Aramini, President and Chief Executive Officer (Principal Executive Officer)                                   
|                       |  |                           
|Dated: August 14, 2007 |  | By:                        |  | /s/ Randall C. Shealy                                                                                                    
|                       |  |                            |  | Randall C. Shealy, Senior Vice President and Chief
Financial Officer (Principal Financial Officer and Accounting Officer)



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