| PEMCO AVIATION GROUP INC Item 1A Risk Factors RISK FACTORS THAT MAY AFFECT FUTURE PERFORMANCE You should carefully consider the following risk factors, in addition to the other information contained in this report, in your evaluation of us, and our financial condition |
| Numerous risk factors, including potentially the risk factors described in this section, could cause material harm to the Company’s business and impair the value of its Common Stock |
| The Company is Heavily Dependent on US Government Contracts |
| Approximately 61prca, 68prca and 69prca of our revenues in 2005, 2004 and 2003, respectively, were derived from US Government contracts |
| US Government contracts expose us to a number of risks, including: • Unpredictable contract or project terminations, • Reductions in government funds available for our projects due to government policy changes, budget cuts and contract adjustments, • Disruptions in scheduled workflow due to untimely delivery of equipment and components necessary to perform government contracts, • Penalties arising from post award contract audits, and • Final cost audits in which the value of our contracts may be reduced and may take a substantial number of years to be completed |
| In addition, substantially all of our government backlog scheduled for delivery can be terminated at the convenience of the US Government since orders are often placed well before delivery, and our contracts typically provide that orders may be terminated with limited or no penalties |
| If we are unable to address any of the above risks, our business could be materially harmed and the value of our Common Stock could be impaired |
| A small number of our contracts account for a significant percentage of its revenues |
| Contracts with the US Government comprised 61prca, 68prca and 69prca of our revenues during 2005, 2004, and 2003, respectively |
| The USAF KC-135 program in and of itself comprised 47prca, 60prca, and 65prca of our total revenues in 2005, 2004, and 2003, respectively, and a contract with Northwest Airlines comprised 22prca, 22prca, and 15prca of our total revenues during these same respective time periods |
| During 2003, a contract with GECAS comprised 11prca of our total revenues |
| Termination of a contract, a dispute over compliance with contract terms, a disruption of any of these contracts (including option years not being exercised), or the inability of us to renew or replace any of these contracts when they expire, could materially harm our business and impair the value of our Common Stock |
| The Company submitted a proposal as a subcontractor/partner with Boeing LSS for the KC-135 program |
| The Company expects the award announcement to occur later in 2006 |
| Under the current contract, the Company expects to induct KC-135 aircraft through the end of the US Government’s fiscal year ending September 30, 2007 |
| If the Company’s Customers Experience Financial or Other Difficulties, the Company’s Business Could Be Materially Harmed |
| A number of our commercial customers, including Northwest Airlines, which represented 22prca of our revenues in 2005, have in the past and may in the future experience significant financial difficulties, including bankruptcy |
| Many of these customers face risks that are similar to those encountered by the Company, including risks associated with market conditions, competition, government regulations, and the ability to obtain sufficient capital |
| There can be no assurance that our customers will be successful in managing these risks |
| If our customers do not successfully manage these risks, it could impair our ability to generate revenues, collect amounts due from these customers, and materially harm our business |
| Northwest Airlines filed a petition for Chapter 11 bankruptcy |
| As a result, we recorded charges of dlra1dtta5 million to provide for pre-petition Northwest Airlines receivables |
| The Company Faces Risks from Downturns in the Domestic and Global Economies |
| The domestic and global economies have experienced downturns that have had significant effects on markets that we serve, particularly the airline industry |
| We cannot predict the depth or duration of such downturns, and our ability to increase or maintain its revenues and operating results may be impaired as a result of negative general economic conditions |
| Further, because current domestic and global economic conditions and economies are extremely uncertain, it is difficult to estimate the growth in various parts of the economy, including the markets in which we participate |
| Because parts of our budgeting and forecasting are reliant on estimates of growth in the markets it serves, the current economic uncertainty renders estimates of future revenues and expenditures even more difficult than usual to formulate |
| The future direction of the overall domestic and global economies could have a significant impact on our overall financial performance and impair the value of our Common Stock |
| The Company’s Markets are Highly Competitive and Some of its Competitors Have Greater Resources than the Company |
| The aircraft maintenance and modification services industry is highly competitive, and we expect that the competition will continue to intensify |
| Some of our competitors are larger and more established 16 ______________________________________________________________________ [45]Table of Contents companies with strategic advantages, including greater financial resources and greater name recognition |
| In addition, we are facing increased competition from entities located outside of the United States and entities that are affiliated with commercial airlines |
| Our competition for military aircraft maintenance includes Boeing Aerospace Support Center, Lockheed-Martin Aircraft and Logistics Center, L-3 Communications, and various military depots |
| Our competition for outsourced commercial work in the United States consists of the Goodrich Airframe Services Division, Timco Aviation Services, and Singapore Technologies (which includes Mobile Aerospace Engineering, San Antonio Aerospace, and Dalfort Aerospace) |
| If we are unable to compete effectively against any of these entities it could materially harm our business and impair the value of our Common Stock |
| Our continuing efforts to increase revenue and improve operating results and stockholder value includes seeking sales opportunities in international markets |
| During 2005 and 2004, foreign sales comprised 4prca and 3prca of total revenues, respectively, though such sales could comprise an increasingly larger percentage of revenues in the future |
| We believe there are a number of factors inherent in these markets that may expose us to significantly greater risk than domestic markets, including: foreign exchange exposure local economic and market conditions, less regulation of patents or other safeguards of intellectual property, potential political unrest, difficulty in collecting receivables, and inability to rely on local government aid to enforce standard business practices |
| These factors, or others we have not currently identified, could materially harm our business and impair the value of our Common Stock |
| The Company is a Party to Legal Proceedings that could be Costly to Resolve |
| The Company may be exposed to legal claims relating to the services it provides |
| The Company is currently a party to several legal proceedings, including breach of contract claims and claims based on the Company’s employment practices |
| While the Company maintains insurance covering many risks from its business, the insurance may not cover all relevant claims or may not provide sufficient coverage |
| If the Company’s insurance coverage does not cover all costs resulting from these claims, an adverse determination on these claims could materially harm the Company’s business and impair the value of its Common Stock |
| The Company Could Incur Significant Costs and Expenses Related to Environmental Problems |
| Various federal, state, and local laws and regulations require property owners or operators to pay for the costs of removal or remediation of hazardous or toxic substances located on a property |
| For example, there are stringent legal requirements applicable to the stripping, cleaning, and painting of aircraft |
| We have previously paid penalties to the EPA for violations of these laws and regulations, and we may be required to pay additional penalties or remediation costs in the future |
| These laws and regulations also impose liability on persons who arrange for the disposal or treatment of hazardous or toxic substances at another location for the costs of removal or remediation of these hazardous substances at the disposal or treatment facility |
| Further, these laws and regulations often impose liability regardless of whether the entity arranging for the disposal ever owned or operated the disposal facility |
| As operators of properties and as potential arrangers for hazardous substance disposal, we may be liable under the laws and regulations for removal or remediation costs, governmental penalties, property damage, and related expenses |
| Payment of any of these costs and expenses could materially harm our business and impair the value of our Common Stock |
| 17 ______________________________________________________________________ [46]Table of Contents The Company May Not Be Able to Hire and Retain a Sufficient Number of Qualified Employees |
| Our success and growth will depend on our ability to continue to attract and retain skilled personnel |
| Competition for qualified personnel in the aircraft maintenance and modification services industry has been intense |
| Any failure to attract and retain qualified personnel could materially harm our business and impair the value of our Common Stock |
| Failure to negotiate new collective bargaining agreements in the future with unionized employees could materially harm our business |
| Our growth strategy requires continued access to capital |
| From time to time, we may require additional financing to enable it to: • Finance unanticipated working capital requirements, • Develop or enhance existing services, • Respond to competitive pressures, • Acquire complementary businesses, • Acquire additional treasury stock, or • Fund obligations under our defined benefit pension plans |
| We cannot provide assurance that, if it needs to raise additional funds, such funds will be available on favorable terms, or at all |
| If we cannot raise adequate funds on acceptable terms, our business could be materially harmed and the value of our Common Stock impaired |
| Evolving industry standards and changing customer requirements characterize the aircraft maintenance and modification services industry |
| The introduction of new aircraft embodying new technologies and the emergence of new industry standards could render our existing services obsolete and cause us to incur significant development and labor costs |
| Failure to introduce new services and enhancements to our existing services in response to changing market conditions or customer requirements could materially harm our business and impair the value of our Common Stock |
| The Company’s Trust for its Defined Benefit Plan is Under-Funded and Subject to Financial Market Forces |
| We maintain the Plan, which covers substantially all employees at its Birmingham and Dothan, Alabama facilities |
| The Plan’s assets consist primarily of equity mutual funds, bond mutual funds, hedge funds, and cash equivalents |
| These assets are exposed to various risks, such as interest rate, credit, and overall 18 ______________________________________________________________________ [47]Table of Contents market volatility |
| As a result of unfavorable investment returns related to the Plan during 2001 and 2002, partially offset by favorable returns in 2003, 2004 and 2005, coupled with an increase in actuarial liability resulting from lower interest rates and the terms of new collective bargaining agreements entered into in 2005, the Plan was under-funded by approximately dlra26dtta3 million at December 31, 2005 |
| Any further losses on the Plan’s assets may lead to an increase in the amount of the shortfall |
| In 2006, we expect that the minimum required contribution will be approximately dlra11dtta0 million |
| Unless and until the Plan under-funding is remedied sufficiently, the making of minimum required contributions may adversely affect our liquidity and cash flow, which could materially harm our business and impair the value of our Common Stock |
| Our Credit Agreement contains covenants that restrict, among other things, our ability to borrow money, make particular types of investments, sell assets, merge or consolidate, or make acquisitions |
| Our Credit Agreement also requires us to maintain specified financial ratios |
| Our ability to meet these financial ratios can be affected by events beyond our control, and there can be no assurance that we will be able to meet these ratios |
| For example, during certain quarters of 2005 and 2004, we violated the fixed charge coverage ratio covenant and the adjusted tangible net worth covenant |
| Waivers or amendments to the Credit Agreement were obtained when the covenant violations occurred |
| As of December 31, 2005, we were in violation of the fixed charge coverage ratio and the adjusted tangible net worth ratio |
| We have obtained a waiver from the lender for all debt covenant violations through December 31, 2005 |
| If we are unable to comply with the covenants in the future and the lenders do not grant a waiver or amend the Credit Agreement, the outstanding borrowings under the Credit Agreement may become immediately due and payable and certain interest rates will increase |
| On February 15, 2006, we entered into a note purchase agreement with Silver Canyon Services, Inc |
| (“Silver Canyon”), pursuant to which we issued to Silver Canyon a senior secured note in the principal amount of dlra5dtta0 million |
| The note with Silver Canyon is subordinate to any debt incurred by us under the revolving credit facility with Wachovia and Compass |
| The note contains customary events of default consistent with the defined events of default established by the thirteenth amendment of the Credit Agreement with Wachovia Bank and Compass Bank (“Wachovia” and “Compass”) on February 15, 2006 |
| The payment of all outstanding principal, interest and other amounts owing under the note may be declared immediately due and payable by Silver Canyon upon the occurrence of an event of default, subject to certain standstill provisions with Wachovia and Compass |
| We may be unable to locate other lenders at comparable interest rates if an event of default occurs |
| We have also pledged substantially all of our assets to secure the debt under its Credit Agreement with Wachovia and Compass and the subordinated debt with Silver Canyon |
| If the amounts outstanding under the Credit Agreement or the note with Silver Canyon were accelerated, the lenders could proceed against those assets |
| Any event of default, therefore, could have a material adverse effect on our business and impair the value of our Common Stock |
| Our agreements with its customers generally contain terms designed to limit its exposure to potential product liability claims |
| We also maintain a product liability insurance policy for its business |
| However, our 19 ______________________________________________________________________ [48]Table of Contents insurance may not cover all relevant claims or may not provide sufficient coverage |
| If our insurance coverage does not cover all costs resulting from future product liability claims, these claims could materially harm our business and impair the value of our Common Stock |
| The aircraft maintenance and modification services industry is subject to extensive regulatory and legal compliance requirements that result in significant costs |
| The FAA from time to time issues directives and other regulations relating to the maintenance and modification of aircraft that require significant expenditures |
| Regulatory changes could materially harm our business by making its current services less attractive or obsolete, or increasing the opportunity for additional competition |
| Changes in, or the failure to comply with, applicable regulations could materially harm our business and impair the value of our Common Stock |
| The Company Has Implemented Anti-Takeover Provisions that Could Prevent an Acquisition of Its Business at a Premium Price |
| Some of the provisions of our certificate of incorporation and bylaws could discourage, delay or prevent an acquisition of our business at a premium price |
| These provisions: • Permit the Board of Directors to increase its own size and fill the resulting vacancies, • Provide for a board comprised of three classes of directors with each class serving a staggered three-year term, • Authorize the issuance of preferred stock in one or more series, and • Prohibit stockholder action by written consent |
| In addition, Section 203 of the Delaware General Corporation Law imposes restrictions on mergers and other business combinations between us and any holder of 15prca or more of our Common Stock |
| Compliance with Changing Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses |
| Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations, and Nasdaq Stock Market rules have led to increased administrative costs |
| We are committed to maintaining high standards of corporate governance and public disclosure |
| As a result, we believe that it has invested and will continue to invest reasonably necessary resources to comply with evolving standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities, which could harm our business and impair the value of our Common Stock |
| Insiders Have Substantial Control over the Company and Can Significantly Influence Matters Requiring Stockholder Approval |
| As of December 31, 2005, our executive officers, directors, and affiliates, in the aggregate, beneficially owned approximately 49dtta8prca of our outstanding Common Stock |
| As a result, these stockholders are able to significantly influence matters requiring approval by our stockholders, including the election of 20 ______________________________________________________________________ [49]Table of Contents directors and the approval of mergers or other business combination transactions |
| This control may have the effect of deterring hostile takeovers, delaying or preventing changes in control or changes in management, or limiting the ability of our other stockholders to approve transactions that they may deem to be in their best interests |
| During the audit of the 2003 financial statements, our then independent registered public accounting firm identified the following reportable conditions that together constituted a material weakness in internal control over financial reporting: • lack of appropriate analysis and support for revenue recognition matters, • lack of appropriate analysis and support pertaining to estimates to complete certain contracts made in connection with projecting losses on contracts in a current period, • lack of appropriate analysis and support for inventory accounting matters, and • lack of appropriate analysis and support for the reconciliation of inter-company transactions |
| Additionally, during the audit of the 2004 financial statements, our independent registered public accounting firm identified the following material weaknesses in internal control over financial reporting: • lack of appropriate controls to timely record liabilities for services performed in 2004 for which the invoices were not processed at December 31, 2004, • lack of appropriate analysis and support for inventory matters, • lack of appropriate analysis and support for payroll accruals, • lack of adequate evaluation of leasehold improvements placed in service from 1982 to 2001, and • lack of segregation of duties related to system access controls |
| During the audit of the 2005 financial statements, our independent registered public accounting firm identified the following material weaknesses in internal control over financial reporting: • significant deficiencies in the posting of physical inventory results and in adherence with our inventory costing methodology resulted in a material weakness in controls over inventory at the Pemco Aeroplex subsidiary, and • the process for determining adequate information with regards to estimating costs to complete certain contracts for the purpose of projecting losses on contracts was insufficient |
| Although we have taken and are continuing to undertake a number of initiatives to address these material weaknesses, the existence of a material weakness is an indication that there is more than a remote likelihood that a material misstatement of its financial statements will not be prevented or detected in the current or any future period |
| In addition, we may in the future identify other material weaknesses or significant deficiencies in its internal control over financial reporting that it has not discovered to date |
| 21 ______________________________________________________________________ [50]Table of Contents Furthermore, Section 404 of the Sarbanes-Oxley Act of 2002, with which we must comply in 2007, requires our independent registered public accounting firm to audit both the design and operating effectiveness of its internal controls and management’s assessment of the design and the effectiveness of its internal controls |
| If we are unable to remediate all material weaknesses in sufficient time to permit testing of our documentation and remediation efforts relating to these material weaknesses, our auditors may disclaim an opinion or issue an adverse opinion on the operating effectiveness of our internal controls over financial reporting or on management’s assessment of their effectiveness, when Section 404 becomes applicable to us |
| A disclaimer or an adverse opinion on our internal controls could materially impair the value of our Common Stock |
| Changes in Financial Accounting Standards Related to Stock Option Expenses May Have a Significant Effect on the Company’s Reported Results |
| The FASB issued a revised standard that requires that we record compensation expense in the statement of operations for employee stock options using the fair value method |
| The adoption of the new standard is expected to have a significant effect on our reported earnings, although it will not affect its cash flows, and could adversely impact our ability to provide accurate guidance on future reported financial results due to the variability of the factors used to establish the value of stock options |
| As a result, the adoption of the new standard in the first quarter of 2006 could impair the value of our Common Stock and result in greater stock price volatility |