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SECURITIES AND EXCHANGE COMMISSION

FORM 10-K

FOR ANNUAL AND TRANSITION REPORTS
PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934

Commission file number 0-26088

PACIFIC AEROSPACE & ELECTRONICS, INC.

                     Registrant’s telephone number, including area code: (509) 667-9600

Securities registered pursuant to Section 12(g) of the Act:
common stock, $0.001 par value
(Title of class)

Common Stock Purchase Warrants
(Title of class)

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. Yes [X]  No [  ]

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]

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The aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant, computed by reference to the price at which the common equity was last sold, or the average bid and ask price of such common equity on the NASD Over-the-Counter Bulletin Board as of November 29, 2002, was approximately $8,537,000.

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes [  ]  No [X]

The number of shares outstanding of the Registrant’s common stock, $0.001 par value per share, as of August 21, 2003 was 24,779,209 shares.

DOCUMENTS INCORPORATED BY REFERENCE: None.

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PART I

ITEM 1.       DESCRIPTION OF BUSINESS

Overview

We are an engineering and manufacturing company with operations in the United States and the United Kingdom. We design, manufacture and sell components and subassemblies used in technically demanding environments. Products that we produce primarily for the aerospace, defense and transportation industries include machined, cast and formed metal parts and subassemblies, using aluminum, titanium, magnesium and other metals. Products that we produce primarily for the defense, electronics, telecommunications and medical industries include components such as hermetically sealed electrical connectors, instrument packages and ceramic capacitors, filters and feedthroughs. Our customers include global leaders in all of these industries.

In March 2002, we completed the exchange portion of a capital restructuring (the “Exchange”). In accordance with an exchange agreement (the “Exchange Agreement”), holders (the “Noteholders”) of all of our then outstanding 11 1/4% senior subordinated notes due 2005 (the “Subordinated Notes”) exchanged $63.7 million aggregate principal amount of the Subordinated Notes, together with accrued interest thereon, for shares of our common stock, shares of our Series C Convertible Preferred Stock (“Series C Preferred Stock”) and approximately $15.0 million in aggregate principal amount of 10% pay-in-kind senior subordinated notes (the “PIK Notes”). The Series C Preferred Stock automatically converted (the “Automatic Conversion”) into 4,865,820,023 shares of our common stock following shareholder approval of an increase in the number of our authorized shares of common stock. Following the conversion of the Series C Preferred Stock, the Company’s shareholders approved an amendment to the Articles of Incorporation providing for a 200 to 1 reverse split of the Company’s common stock, with a proportionate reduction in the Company’s authorized common stock (the “Reverse Split”). The Reverse Split did not affect the par value of the common stock.

As a result of the Exchange, the Noteholders now beneficially own approximately 97.5% of our outstanding shares of common stock on a fully-diluted basis. In addition to exchanging our Subordinated Notes as described above, we also entered into a new five-year senior secured loan (the “Senior Loan”) represented by new senior secured notes (the “Senior Notes”, and the holder thereof, the “Senior Noteholders). The Senior Notes were issued at a discount so that the proceeds of that loan totaled approximately $22.0 million. The Senior Notes will accrete through May 1, 2007 to a principal amount of $36.0 million and will bear interest on the fully accreted amount at 5% per annum beginning on the date of the exchange. We used $16.2 million of the proceeds from the Senior Notes to pay off principal and accrued interest on our then outstanding 21% senior secured loan. The remaining proceeds were used for working capital, to pay the fees and costs of the restructuring and for other general corporate purposes.

References in this Form 10-K to the Company include Pacific Aerospace & Electronics, Inc., and its subsidiaries. Our headquarters is located at 430 Olds Station Road, Third Floor, Wenatchee, Washington 98801, and our telephone number is (509) 667-9600. This Annual Report on Form 10-K relates to the fiscal year ended May 31, 2003. The description of the Company’s business in this report focuses on the operations as they were organized as of May 31, 2003. Pacific Aerospace & Electronics, Inc.’s predecessor, PCT Holdings, Inc., a Nevada corporation (“PCTH”) was incorporated in 1995. In 1996, PCTH merged into the Company, with the Company as the surviving entity, in order to reincorporate under the laws of the State of Washington.

Our Internet website address is http://www.pcth.com. We make our periodic reports and other filings available through our website, free of charge, as soon as practical after they are filed with or furnished to the Securities and Exchange Commission. Readers should note that the contents of our website are not

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incorporated into our Securities and Exchange Commission reports, nor should any part of that website be considered a part of any such report for any purpose.

Business Strengths

Significant Customer Base

We have a diverse international customer base, which includes many of the world’s leading companies in their industries. Our customers over the past year have included Advanced Bionics Corporation, Aeronautical Macchi Manufacturing Corporation (“Aermacchi”), Agilent Technologies, Inc., BAE SYSTEMS plc (“BAE Systems”), Goodrich Corporation’s Aerostructures Group (“Goodrich,” formerly known as BFGoodrich Company), The Boeing Company (“Boeing”), European Aeronautic Defence and Space Company N.V. (“EADS”), GKN Westland Aerospace, Inc. (“GKN Westland”), Honeywell International Inc., Lockheed Martin Corporation, Northrup Grumman Corporation (“Northrup”), Vought Aircraft Industries, Inc. (“Vought,” formerly Northrup Grumman Corporation’s commercial aerostructures group), Parker Hannifan Corporation, Raytheon Company (“Raytheon”), Rolls-Royce plc (“Rolls-Royce”), and TRW Inc.

Strong Technology Position

We utilize specialized manufacturing techniques, advanced materials science, integrated design, process engineering, and proprietary technologies or processes in the design and manufacture of our products. We currently own 23 U.S. patents, 4 non-U.S. patents, and 4 pending patent applications in non-U.S. jurisdictions, and we use a combination of patented technology, trade secrets and other proprietary technology in the manufacture of our state-of-the-art electronic components and packages. We also have a broad base of expertise in precision machining. Our European Operations have specialized expertise in casting aluminum and magnesium products using sand and investment casting techniques and its licensed “Sophia Process” casting technology. We also have expertise in superplastic forming of titanium sheet and stretch forming of aluminum sheet. We are continually working to develop new proprietary technologies, and, in addition to the numerous patents that we own or have pending, we maintain an ongoing program of evaluating and protecting our proprietary rights and processes.

Strong Position in Major Aerospace and Defense Programs

We supply components, parts and assemblies to Boeing for various commercial aircraft construction programs and to members of the Airbus consortium for Airbus’ A318-A321, A330/340, and A380 commercial aircraft construction programs. In addition, we participate in major defense and military aircraft programs in the U.S. and Europe including components for the U.S. made F-15, F-18, F-22 and Apache Longbow and the European made Eurofighter.

Diversity of Product Offerings and Capabilities

We design and manufacture a broad range of precision cast, formed, machined, finished, and fabricated metal products, as well as a broad range of specialized electronics components and sub-assemblies. We collaborate with many of our customers to develop products that meet specific design or customization requests. We believe that one of our key strengths is our ability to provide integrated design and manufacturing solutions to our customers. We also believe that our experience and capabilities in providing specialty processes and working with the changing needs of our customers will allow us to

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respond to changing market trends in the industries that we already serve and responding to the needs of customers in new markets.

Strategies

Our objective is to be a world class aerospace and electronics component manufacturer that generates profitable growth by integrating manufacturing processes, introducing new products and technologies, and developing new customers in targeted markets. We believe that pursuing the following business strategies will enable us to increase market penetration, create operating efficiencies, and enhance our competitive position.

Offer Complete Solutions

We have continued to vertically consolidate our manufacturing processes, with the goal of improving operating efficiencies and increasing profit margins. A key component of this strategy is to use our expertise in advanced materials science and in the manufacture and assembly of precision products to identify new products, services, technologies and markets and to provide customers with integrated design and assembly capabilities. We believe commercial aircraft manufacturers, defense contractors, and leading manufacturers in other industries will continue to move toward purchasing from a smaller number of suppliers that can supply more integrated systems and pre-assembled parts. By producing products that integrate our various areas of expertise, we hope to improve our profit margins and position ourselves to capture a larger share of our customers’ total product requirements.

Diversify Customer Base

We believe that two keys to our long-term success will be diversification of our customer base and expansion of our proprietary technologies into new markets. We have always believed that our proprietary technologies give us advantages that many of our competitors do not have. We do not just make parts based on a drawing – we are able to provide design, modeling and prototyping services to our customers as well. We are expanding outside of our historical markets into new industries, such as the fuel cell, fiber optic, power supply and advanced medical products industries. As a result of these efforts, we have reduced our reliance on the cyclical aerospace industry, allowing us to become an important part of emerging industries.

Industry Overview

Aerospace

The airline industry is in the middle of the worst downturn in recent aviation history. The industry experienced negative growth in 2001 and no growth in 2002. For several of the preceding years, the commercial aerospace industry had been in decline as airlines sought to reduce costs, and the defense industry had experienced substantial force reductions and corresponding declines in military spending. The commercial aerospace trend is expected to continue in 2003 due to the current political climate and threat of contagious viruses. Demand for aerospace components is closely related to delivery and use rates for commercial aircraft. Delivery and use rates are in turn directly related to the actual and projected volume of passenger and freight traffic, average aircraft age, and global fleet size. The Boeing 2003 Current Market Outlook forecasts that worldwide economic growth will average 3.2% per year over the next 20 years, this economic growth will translate into 5.1% per year in airline passenger traffic growth and 6.4% per year in cargo traffic growth. Boeing also forecasts that this growth will create a demand that will more than double the world aircraft fleet over the next 20 years, where one-fourth of the market for

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new commercial jets can be thought of as replacement for older in-service airplanes, and the remaining three-quarters for accommodation of both passenger and cargo traffic growth.

As in other transportation segments, aircraft manufacturers and defense contractors have been aggressively searching for ways to improve the quality and reduce the cost of their manufactured products. One major area of focus has been the manner in which they work with their supply base. Aircraft manufacturers and defense contractors have increasingly become product designers and assemblers rather than vertically integrated manufacturers. As a result, these manufacturers are outsourcing component manufacturing to independent suppliers, seeking to benefit from an independent supplier’s lower cost structure and specialized manufacturing knowledge. Suppliers that demonstrate an ability to effectively deliver a high quality product on the required delivery schedule at a reasonable cost will benefit from this shift. In addition, commercial aircraft manufacturers are tending, and defense contractors are being strongly encouraged by the U.S. Department of Defense, to purchase from suppliers that can supply more integrated systems and pre-assembled parts. These shifts are leading to a consolidation in the supply base. Certain segments of the aerospace supply base are already consolidated, such as engines, avionics and landing gear. Other segments, however, including structural components and electronics, remain fragmented. We believe that this trend toward consolidation presents an opportunity for suppliers with the financial and management resources to meet their customers’ needs.

Electronics

Growth in the high reliability electronics industry has historically been fueled by several factors, including the rapid pace of technological advancement and development of new defense and satellite products. The growth in demand by these sophisticated customers has induced manufacturers to create more complex designs of lighter, more efficient configurations and higher levels of performance. Additionally, international demand for advanced electronics components is growing rapidly as these new developments enter the arena of available solutions.

The electronics industry is experiencing a dynamic period of mergers and acquisitions, with BAE Systems buying a Lockheed Martin Sanders division, Raytheon acquiring Hughes divisions, Northrop Grumman purchasing Litton Guidance & Controls, and DRS purchasing Texas Instruments divisions, to list a few. Each of these transactions offered the Company new opportunities to experience expanded positive exposure within our technology niche. Many of these industry leaders are involved with the Company in multi-year programs.

Products, Processes and Markets

Our products, manufacturing processes and markets in fiscal 2003, and the industry segments in which we operated during fiscal 2003, are summarized below.

For financial information about operational segments and geographic areas, see “Notes to Consolidated Financial Statements – Note 5” in the Company’s consolidated financial statements for May 31, 2003.

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The following chart shows the percentage of total revenue from each business unit for the past three fiscal years.

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U.S. Operations

          Electronic Components

In Wenatchee, Washington, our Electronic Components business unit designs and produces lightweight, hermetically sealed electronics housings and components for the space, medical, energy and military markets. Utilizing proprietary sealants such as our Kryoflex® ceramic and other patented and proprietary technologies, the unit is known as a supplier of some of the most durable products on the market today. Applications include many high profile projects, such as the International Space Station, the Javelin Missile, the Longbow Missile, the F-15, F-18 and F-22 current production military aircraft, the THAD Missile and the Joint Strike Fighter aircraft.

Utilizing our proprietary and patented ceramic joining technologies, we have developed and continue to develop innovative solutions for components used in a number of medical applications. For example, we make components that are used in implantable neuro-stimulators for the management of such maladies as incontinence, epilepsy, Hodgkins disease, loss of muscle control, and chronic pain. Other medical component applications that incorporate our products include a zirconia/titanium housing for a cochlear implant device, implantable defibrillator components, a left ventricular assist device, and artificial heart components.

The “state of the art” machining capability within the Wenatchee facility allows us to comply with the very precise tolerances (up to 1/10,000 inch) needed for the production of satellite, avionics and missile components. When combined with the application of our proprietary Kryoflex® ceramic sealant, this capability allows us to produce extremely rugged electronic connectors for applications under extreme conditions such as the oil drilling industry’s “down hole” temperatures in excess of 400 degrees Fahrenheit and pressures in excess of 30,000 pounds per square inch. Kryoflex® is available in several formulations that are selected according to the materials to be joined and conditions to be endured.

With our new composite packaging technology, we have undertaken projects for the military radar industry, with current projects in both shipboard and airborne radar applications. Providing the required features of light weight, thermal conductivity and hermeticity, these systems are utilized within the latest Aegis class cruisers, as well as the F-18 and F-22 aircraft, in preference to the traditional materials, which have both higher weight and significantly higher cost.

We also design and manufacture the world’s smallest multilayer discoidal (round) ceramic capacitors and EMI (electro-magnetic interference) filters for the electronics industry. Furthermore, we have released to market a series of high current EMI filters that represent the smallest 25, 50 and 100 amp EMI filters available on the market today. This is a significant advantage to power applications requiring high current and high package density. We also produce components used in the heart pacer industry.

We also produce a wide variety of explosively bonded dissimilar metals, as well as other complex metal forms and conditions. Applications of this explosively bonded technology range from components for surgical instruments, such as endoscopes, to “sputtering targets” utilized for vapor deposition of exotic metals onto critical surfaces such as semiconductor devices, to mirrors for medical and spacecraft uses. One major application for these products is in the maritime industry, where they provide a solution to the ageless problem of galvanic corrosion. Utilizing explosive metal forming, we produce components for jet aircraft engines, rocket nozzle components for the Space Shuttle, and complex aircraft chassis components. We are the only known U.S. source for explosive metal forming at this time. Shock hardening (a type of work hardening) of metals is another one of our important processes. Products made by this process include railroad intersection components that are hardened to extend their service life, and cutting teeth for tunnel boring machines.

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Our proprietary and patented technologies provide technical solutions to difficulties faced by high-tech manufacturers that are challenged by extreme environmental conditions, such as in the fuel cell and implantable medical products industries. We focus on providing solutions in the areas of diffusion bonding, ceramic/metals joining, exotic metals composites, interconnect stability, and thermal stress distribution with biocompatible materials. In the fuel cell area, we are developing processes for the assembly of fuel cells stacks, heat exchangers and fuel reformers for pem and solid-oxide fuel cells. Our zirconia-metal fusion technology has also been applied to the manufacture of a solid-oxide electrolyzer for use in space exploration. Additional research is being performed on planar fuel cell stacks. We have used our zirconia-metal fusion technology to assist a manufacturer of neurostimulator devices in overcoming technological barriers. We have produced a number of composite electronic enclosures and have U.S. patent protection for this technology. This technology allows us to produce lighter, more durable electronics packages with improved thermal conductivity.

During the past several years, we have made significant progress in the area of labor-reducing automation. Fully automatic testing stations and computerized numerical control (“CNC”) turning stations are in use in our manufacturing and machining facilities today due to this in house development program.

The Electronic Components business unit holds a certificate of registration to the ISO 9001 standard and to the AS 9000 standard. The ISO 9001 and the AS 9000 standards are internationally recognized certifications of quality. AS 9000 is the more demanding aerospace quality management system standard. The registration process requires a company to: (1) document and implement a quality management system that meets or exceeds all of the requirements of the standards, (2) choose an accredited registrar (in our case, TUV Essen), (3) have a full quality management system audit conducted by an accredited registrar, and (4) identify and correct any issues that arise during the audit. We also have received a number of military and industry qualification ratings.

          Machining Components

Our Machining Components business unit operates a precision machine shop in Wenatchee, Washington that produces precision machined components, structural parts and assemblies principally from aluminum, titanium, stainless steel and explosively bonded metals. We manufacture machined and sheet metal parts and assemblies that are used for primary and secondary flight components within aircraft. We use CNC machining cells to manufacture particularly complex components and assembly housings and also provide value-added services such as painting and electroplating. Our products are machined and assembled either to customer specifications or according to an engineering and tooling design developed by us to suit our customer’s particular needs. All products are inspected and tested at various stages of production using non-destructive methods such as X-ray, ultrasound, manual and computerized measuring instruments, eddy current, and dyes before the products are passed for shipment to the customer. We often supply our precision machined parts on a “just in time to point of use” basis. This unit also supplies key machined components to our Electronic Components business unit.

Historically, we have supplied nearly all of our products from this business unit to the commercial aerospace and defense industries. As a result, our sales and profitability have been significantly, and often adversely, affected by fluctuations in these industries. As a result, we believe it is important to diversify our product offerings. With that goal in mind, during fiscal 2003, the Machining Components unit sold its rights and responsibilities for its Boeing Statement of Work to an independent third party. We also sold inventory, tooling and certain intangible assets related to the Boeing Statement of Work. This sale will help us focus our resources on industries other than commercial aerospace such as the medical and semiconductor equipment industries. We continue to look for ways to offer our capabilities to leaders in these and other new markets.

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Our operations are DI-9000A Boeing approved. Our Wenatchee, Washington operations have also been audited and have received certificates of registration to the ISO 9002 and AS 9000 standards. We have won numerous quality and service awards from our customers.

European Operations

          Metal Forming

At our Welwyn Garden City and Birmingham facilities in England, our European Operations unit’s Metal Forming business unit uses hot and cold metal forming technologies to manufacture titanium and aluminum assemblies and details for the commercial aerospace and defense industries. We also perform finishing, welding, brazing and riveting processes on our parts. Testing of products is done using non-destructive techniques and in-house X-ray facilities. Interactive discussions with customers enable us to closely match component design to the most suitable forming process. We are approved to the ISO 9002 standard.

Hot and Superplastic Forming of Titanium. Our Welwyn Garden City facility specializes in hot and superplastic forming of titanium, and we believe it has the largest independent capability in the European Union for that process. Unlike most sheet metal materials, titanium and its alloys are extremely difficult to form in a cold condition. To overcome this, we have developed a variety of hot forming processes, including hot die forming, hot brake press forming, superplastic forming, gas blow forming, and hot circular stretch-forming. These processes maximize weight savings, maintain structural integrity, minimize cost, and enable designers to manipulate the developing alloys into complex shapes. The forming equipment consists of a range of 21 hot forming and superplastic forming presses with tonnage from 150 to 1,500 tons. Most forming tools are machined from oxidation resistant nickel chrome steel castings weighing up to four tons. We design the necessary tooling using our in-house pattern facility. We also have the capability to chemically mill three-dimensional components in titanium. We market our hot-formed titanium products primarily to the commercial aircraft, helicopter and military aircraft markets. Our titanium products include jet engine nacelle bulkhead components, airframe and engine details, and erosion shields for helicopters. Our titanium products are included on the Airbus model A318-321, A330/340, and A380 aircraft, the Boeing model 737 aircraft, the Bombardier Dash 8-400 aircraft, the Embraer 135 and 145 aircraft, and the Dornier 728 aircraft.

Cold Forming of Aluminum Alloys. At our Birmingham facility, we specialize in stretch and cold forming of aluminum alloys used for aircraft skin panels, leading edges and acoustic panel liners. Stretch forming is a process well suited to producing aircraft skin panels and leading edges. Specialized equipment in the Birmingham facility has the capability to form sheets up to 8 feet wide and up to 13 feet long, and can apply stretching loads of up to 700 tons. Most tools are machined from oxidation-resistant stainless steel castings, and forming dies up to four tons can be handled. Using this tooling together with specialist gripper jaws and rotational platen, the division can stretch-form aluminum alloys into a wide variety of shapes and sizes. Our capabilities extend from design to completion, including tooling design and manufacture, forming, chemical milling, trimming, assembly, and quality control. We market our formed aluminum alloy products primarily to the aerospace industry.

          Metal Casting

In Rochester, Worcester and Sittingbourne, England, our European Operations’ Metal Casting business unit manufactures aluminum investment castings and aluminum and magnesium precision sand castings. We are approved to the ISO 9002 standard.

Precision Investment Casting. At our Worcester, England facility, we manufacture aluminum investment casting products, including aircraft and defense system components such as electronic enclosures, aircraft

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engine outer guide vanes, navigation lights, wing tip fences, winglet components, duct stators, and heads up display units. At our Rochester, England facility, we manufacture aircraft components such as pressure tight fuel connectors. The versatility, accuracy and replicability of the investment casting process provides many advantages over more traditional methods of machining and fabricating metal products from solid components. The investment casting process uses a metal die manufactured to required specifications. Our precision tooling capabilities permit production of metal dies that incorporate a variety of details and features. A die can be reused to produce the required number of parts without degradation to the original die. Our production of the die gives the customer an incentive to order additional units of the part from us.

Sophia Process Investment Casting. The continual pursuit of product improvement and cost reduction campaigns has led to the installation and efficient utilization of the licensed Sophia casting process at our Worcester facility. We are one of only four licensees of the computerized “Sophia Process,” which we use to manufacture significantly larger, more complex castings than can be made as a single part using more traditional investment casting processes. Using this technology, we can produce components up to 1.3 cubic meters in one piece. This process capability, coupled with the development of new and patented alloys, creates a significant opportunity to provide customers with an additional and economic choice when selecting between a machined, fabricated, composite, or cast structure. Parts made with the Sophia Process have relatively thin wall thickness but have strength and ductility values comparable to fabricated, forged and machined solid components. The Sophia Process stringently controls the heat level and process parameters to make lighter but stronger components that resist fracture and fatigue. The process reduces machining, fabrication and assembly costs by eliminating both doublers at material interfaces and the weakness and stress associated with riveted assemblies. We use high strength alloys with good castability to ensure that the integrity and enhanced properties from one casting are identical to the next, and to achieve the desired combination of tensile strength, ductility and elongation. Parts made with the Sophia Process are used for the commercial aerospace, defense and transportation industries. Such applications include civil aircraft, military aircraft, missiles and underwater weapons applications and applications for the motorsport industry. We use the Sophia Process to produce components for the Airbus A320, A330 and A340 aircraft, such as navigation light housings and wing tip fences, as a single part, and to produce slat can wing components for Boeing’s 737 aircraft.

Sand Casting. At our Sittingbourne, England facility, we manufacture aluminum and magnesium alloy precision sand castings, including machined and finished parts for the commercial aerospace, defense and motorsport industries. Sand casting is suitable for products that are larger than typical investment casting parts. It is also suitable for products that require heavy wall sections. These products include aircraft engine heat exchangers and air intakes, aircraft engine fuel pump housings, aircraft windscreen canopies, and high performance motorsport engine components and gearboxes. For such customer requirements, sand casting provides an effective method of producing components with strength and uniformity. We have made significant advances in both the process and materials technology for magnesium and aluminum sand castings. Our engineers develop patterns utilizing computer assisted design technologies to achieve repeatable high casting integrity and enhanced mechanical properties. We have complete non-destructive testing and inspection facilities, such as dye penetrant flaw detection and X-ray testing of components, as required by the rigorous standards of the aerospace industry.

Machining. We also have a sophisticated machining center that supports the European Operations’ casting and forming business units. Our machining facility has the technical capabilities to provide a full range of machining services for complete production and finishing of components, including design, pattern production, casting and final machining of a component. The machining facility also performs specialized machining of small detail components in steel and titanium.

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Sales and Marketing; Distribution

We market our products using a combination of direct sales and outside sales representatives. In addition, we maintain internal customer service staff and engineering capabilities to provide technical support to customers. Our U.S. Operations market their products in the United States, Europe and Asia through a network of manufacturer representatives and resellers, generally established on a geographic basis. We also utilize an inside sales force focused on particular regions or customers. Our European Operations utilize their own employee sales force for sales of its products to customers in the United Kingdom. This internal sales force is organized into two groups, one group responsible for sales of precision castings and one group responsible for metal formed products. The European Operations also use independent agents to market its products to customers in countries other than the United Kingdom, including the United States. We believe that we have the opportunity to leverage customer relationships to supply more complete systems by providing products that combine the technologies and manufacturing abilities of our different business units. Consequently, we emphasize cross-selling and coordination of sales and marketing efforts between and among our business units.

Customers

Our top ten customers in terms of revenues during fiscal 2003 were Northrop Grumman, Boeing, Airbus, Aermacchi, Raytheon, Westland Structures, GKN Westland, BAE Systems, Alenia and Rolls-Royce. Only the top four customers individually accounted for 5% or more of our revenues, with Northrop Grumman at approximately 8.5%, Boeing at approximately 7.8%, Airbus at approximately 6.6%, and Aermacchi at 6.1%. Together, our top ten customers accounted for approximately 51.5% of our sales during fiscal 2003. In fiscal 2003, we produced electronic packaging and connectors for Northrop Grumman, and machined and cast metal aircraft components for Boeing, Aermacchi and Airbus. We do not have long-term contracts with most of our major customers, and where we have long-term contracts, they generally permit the customer to cancel their orders. We depend on our customers continuing to place new orders for our products. Because of the relatively small number of customers for most of our products, our largest customers can influence product pricing and other terms of trade. If we were to lose any of our largest customers, or if they reduced or canceled orders, our business and financial performance could be harmed.

Our U.S. Operations and European Operations currently serve different customers in the aerospace market. One of our goals has been to take advantage of our position in both the United States and European markets to provide access for our U.S. Operations to customers in Europe, and access for our European Operations to customers in the U.S. Consequently, we have emphasized cross-marketing efforts. One of the outcomes of these efforts has been the success of our European Operations in obtaining work in the United Kingdon from Boeing.

Backlog

We sell the majority of our products through individual purchase orders. Many of our customers would have the right to terminate orders by paying the cost of work in process plus a related profit factor. Historically, we have not experienced a large number of significant order cancellations. However, from time to time, customers cancel orders as a result of a program being cancelled or for other reasons. As of May 31, 2003, we had purchase orders and contractual arrangements evidencing anticipated future deliveries, which we treat as backlog, through fiscal year 2005 of approximately $36 million. We expect to deliver approximately $32 million of this backlog in fiscal year 2004. We may not be able to complete all of that backlog and book it as net sales if we experience cancellations of pending contracts or terminations or reductions of contracts in progress.

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Competition

We have substantial competition in many of the markets that we serve. In the electronics markets, our competitors include Amphenol Corporation, Hermetic Seal Corporation, AVX Corporation and Spectrum Control, Inc. In the hot and superplastic forming market, our primary competitor is Barnes Aerospace. Our competitors in the European sand casting market include SFU, Stones, Haleys, Hitchcock and Teledyne. In the investment casting market, our competitors include the Cercast Group, Tital and Tritech. In the precision machining market, we compete with a number of regional machine shops. Many of these competitors have greater financial resources, broader experience, better name recognition and more substantial marketing operations than we have, and they represent substantial long-term competition for us. We intend to use our proprietary technology, our high quality products and our knowledge of the markets and customers we serve to compete against the companies identified above.

Our competitors can make components and products similar to those we make using a number of different manufacturing processes. We believe that our manufacturing processes, proprietary technologies and experience provide significant advantages to our customers. These advantages include high quality, more complete solutions, competitive prices, and physical properties that meet stringent demands. However, competitors can use alternative forms of manufacturing to produce many of the components and products that we make. These competing products could be of the same or better quality and price as those we produce. We expect our competitors to continue making new developments, and they could develop products that customers view as more effective or more economical than our products. In addition, our competitors may introduce automation processes and robotics systems that could lower their costs of production substantially.

Proprietary Rights

Significant aspects of our business depend on proprietary processes, know-how and other technology that are not subject to patent protection. We rely on a combination of trade secret, copyright and trademark laws, confidentiality procedures, and other intellectual property protection to protect our proprietary technology. However, our competitors may still develop or utilize technology that is the same as or similar to our proprietary technology.

We have 23 U.S. patents, four non-U.S. patents, and four patent applications pending in non-U.S. jurisdictions. We can provide no assurance that the patent applications will result in issued patents, that existing patents or any future patents will give us any competitive advantages for our products or technology, or that, if challenged, these patents will be held valid and enforceable. Most of our issued patents expire at various times over the next 15 years, with three patents expiring over the next two years. These three patents, as well as several other patents that recently expired, relate to products manufactured by our Electronic Components business unit and constituted a small percentage of our consolidated revenue in fiscal 2003. Although we believe that the manufacturing processes of much of our patented technology are sufficiently complex that competing products made with the same technology are unlikely, our competitors may be able to design competing products using the same or similar technology after these patents have expired.

Despite the precautions we have taken, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary. Existing intellectual property laws give only limited protection with respect to such actions, and policing violations of these laws is difficult. The laws of other countries in which our products are or may be distributed do not protect products and intellectual property rights to the same extent as do the laws of the United States. We could be required to enter into costly litigation to enforce our intellectual property rights or to defend infringement claims by others. For example we are currently engaged in litigation with former employees to protect certain of our intellectual

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property. Infringement claims could require us to license the intellectual property rights of third parties, but licenses may not be available on reasonable terms, or at all.

Environmental Matters

Our facilities are subject to regulations concerning solid waste disposal, hazardous materials generation, storage, use and disposal, air emissions, waste water discharge, employee health and other environmental matters. A number of the metals, chemicals and other materials used in and resulting from our manufacturing processes are classified as hazardous substances and hazardous wastes. If we do not meet permitting and other requirements of applicable environmental laws, we could be liable for damages and for the costs of remedial actions. We could also be subject to fines or other penalties, including revocation of permits needed to conduct our business. Any permit revocation could require us to cease or limit production at one or more of our facilities, which could damage our business and financial performance. We have an ongoing program of monitoring and addressing environmental matters, and from time to time in the ordinary course of business we are required to address minor issues of noncompliance at our operating sites. From time to time, we identify operations or processes that lack required permits or otherwise are not in full compliance with applicable environmental laws. Although we believe these items have not been material to date, we maintain an environmental compliance team, and our policy is to take steps promptly to remedy any noncompliance.

We have a policy of obtaining environmental assessment reports in connection with the acquisition of properties at which we believe historical operations could have caused adverse environmental conditions. We are not aware of any historical contamination on our properties or involving neighboring activities that we believe could have a material adverse effect on our results of operations or financial condition.

Environmental laws could become more stringent over time, imposing greater compliance costs and increasing risks and penalties associated with any violations. As a generator of hazardous materials, we are subject to financial exposure with regard to our properties even if we fully comply with these laws. In addition, we utilize facilities that are located in industrial areas and have lengthy operating histories. As a consequence, it is possible that historical or neighboring activities have affected properties we currently own, and that, as a result, additional environmental issues may arise in the future, the precise nature of which we cannot now predict. Any present or future noncompliance with environmental laws or future discovery of contamination could have a material adverse effect on our results of operations or financial condition.

Government Regulation

We manufacture some of our products under contracts with the United States government. We manufacture other products under contracts with private third parties who utilize our products to satisfy United States government contracts to which they are a party. Federal acquisition regulations and other federal regulations govern these relationships. Some of these regulations relate specifically to the seller-purchaser relationship with the government, such as the bidding and pricing rules. Under regulations of this type, we must observe pricing restrictions, produce and maintain detailed accounting data, and meet various other requirements. Other regulations relate to the conduct of our business generally, such as regulations and standards established by the Occupational Safety and Health Act or similar state laws and relating to employee health and safety. In particular, regulations governing these contracts require that we comply with federal laws and regulations, in general, or face civil liability, cancellation or suspension of existing contracts, or ineligibility for future contracts or subcontracts funded in whole or in part with federal funds. In addition, loss of governmental certification (that we are eligible for government contracted work) could cause some of our customers, including customers in the defense industry, to reduce or curtail their purchases from us, which could harm our business.

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We have not identified any noncompliance with federal regulations affecting these government contracts that would be material.

Employees

As of May 31, 2003, the Company had approximately 614 employees, of whom approximately 559 were engaged in manufacturing functions, 20 in sales and marketing functions, 30 in administrative functions, and 5 in executive functions. Of the employees, approximately 177 were employed by the U.S. Operations, 435 by the European Operations and 2 by our corporate holding company. As of May 31, 2003, none of our workforce in the United States was unionized. Certain of the European Operations manufacturing and engineering employees are represented by labor unions, although all negotiations are carried out through employee work committees. We have not experienced any work stoppages, and we believe that our relationship with our employees is strong.

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Risk Factors

We have reported net losses for recent periods, and we may continue to incur net losses, which could jeopardize our operations and decrease our stock value.

We reported a net loss of $75,720,000 for our fiscal year ended May 31, 2001, net income of $4,525,000 for our fiscal year ended May 31, 2002, and a net loss of $11,742,000 for our fiscal year ended May 31, 2003. We believe that we will continue to incur net losses during fiscal 2004 and that such losses may be substantial. We can offer no assurance that we will achieve profitable operations. Our ability to reach profitability in the future will depend on many factors, including our ability to finance working capital and to realize acceptable gross profits on the products we sell. Future profitability will also depend on our ability to develop new products, the degree of market acceptance of our existing and new products, and the level of competition in the markets in which we operate. If we continue to incur net losses, our cash flow position could be further damaged, our operations could be jeopardized and our stock price could decrease. In protracted or severe instances we may be unable to meet our obligations as they come due, and any failure to do so would materially and adversely affect any investment in the Company.

Our inability to generate cash if and when needed could severely impact our ability to continue as a going concern.

Our consolidated financial statements have been prepared assuming that we will continue as a going concern. However, our independent auditors in their most recent report stated that Pacific Aerospace has suffered recurring losses from operations and has a net capital deficiency which raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments that might result from the outcome of that uncertainty. If we are not sufficiently successful in generating cash from operating activities, we may need to sell additional common stock or other securities, or we may need to sell assets outside the ordinary course of business. If we need to dispose of assets outside of the ordinary course of business to generate cash, we may not be able to realize the carrying values of those assets upon liquidation. If we are unable to generate the necessary cash, we could be unable to continue operations.

We have significant debt that adversely affects our financial condition.

Our long-term debt includes the PIK Notes with a carrying value of $25.7 million as of May 31, 2003. These notes do not require us to make cash interest payments. In addition to the PIK Notes, we have approximately $27.2 million (net of unamortized discount of $11.7 million) in senior secured debt and capital leases. We must increase our cash flow from operations if we are to be able to satisfy our debt obligations in the future. Our debt could make us unable to obtain additional financing in the future, and most of our secured debt includes covenants that restrict our ability to borrow additional funds even if sources for such loans were to be available. Our interest expense also diverts a significant portion of our cash flow to principal and interest payments and away from operations and necessary capital expenditures. Our debt also may put us at a competitive disadvantage in relation to competitors with less debt and limits our flexibility to adjust to downturns in our business or market conditions.

Our lenders could accelerate the principal owing on our debt, which we do not have the funds to pay.

We have been notified by KeyBank, N.A., that we are not in compliance with covenants of loans that are secured by a first deed of trust on our headquarters building and a security interest in leasehold improvements on another building that we lease. KeyBank has agreed to forbear from declaring covenant defaults relating to their loans until December 31, 2004, pursuant to a forbearance agreement dated June 25, 2003 so long as we maintain timely payments on the notes. We also have been notified by the Senior

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Noteholders that we are not in compliance with a covenant relating to the Senior Notes. The Senior Noteholders have agreed to forbear from declaring covenant default until June 1, 2004, pursuant to a forbearance agreement dated August 8, 2003.

If the holders of our debt obligations were to exercise their remedies, either because we fail to make timely payments on the loans or after the forbearance agreements expire, we may be forced to seek protection from creditors under the bankruptcy laws. To date, our secured lenders have not exercised any remedies with respect to any default, but we can provide no assurance that they would not exercise their remedies prior to their repayment or our compliance with the terms of such debt, nor can we provide assurance that additional or extended forbearance will be granted.

We must comply with a number of significant debt covenants that limit our flexibility.

The note purchase agreement that relates to the Senior Notes and the Indenture to our PIK Notes, as well as various agreements ancillary to those securities, substantially restrict our activities. Unless we obtain consent from our lenders, we generally cannot sell or borrow against our assets or incur additional indebtedness. We are not permitted to pay dividends or repurchase stock. Our debt covenants restrict our ability to acquire new businesses or make investments or loans to others. We are also subject to covenants that limit our ability to make capital expenditures, change the business we conduct, or engage in certain types of transactions. In addition, if we experience a change of control, we will be required to repay our debt early, which creates a substantial disincentive to any potential acquiror. If we breach any of these covenants, the lenders may be able to declare all amounts we owe to be immediately due and payable. If this were to occur, we would likely not have funds available to us to pay off the debt.

Our Senior Notes and the agreements governing our other senior secured indebtedness also require us to meet a number of financial ratios and tests. In fact, we have been notified by KeyBank that we are not in compliance with covenants of loans that are secured a first deed of trust on our headquarters building and a security interest in leasehold improvements on another building that we lease. KeyBank has agreed to forbear from declaring covenant defaults relating to their loans until December 31, 2004, pursuant to a forbearance agreement dated June 25, 2003 so long as we maintain timely payments on the notes. We also have been notified by the Senior Noteholders that we are not in compliance with a covenant relating to the Senior Notes. The Senior Noteholders have agreed to forbear from declaring covenant default until June 1, 2004, pursuant to a forbearance agreement dated August 8, 2003.

Our ability to meet these ratios and tests and to comply with other provisions governing the Senior Notes and the loans secured by our real property may be adversely affected by changes in economic or business conditions or events beyond our control. Our failure to comply with our debt-related obligations could result in an event of default under any or all of our debt arrangements.

We have experienced asset impairment, and we may experience additional asset impairment in the future.

We review long-lived assets and intangibles for potential impairment of value whenever events or changes in circumstances indicate that the carrying amount of those assets may not be recoverable. An impairment is determined by totaling the estimated net future cash flows derived from the asset and comparing that total to the book value of the asset. When the total of the net future cash flows is lower than the book value, an impairment exists. The amount of the impairment is the difference between the present value of the net future cash flows and the book value of the asset. We will continue to analyze long-lived and identifiable intangible assets in the future to determine possible impairment charges. Future evaluations could result in impairment charges, and those charges could be material.

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Our noteholders own a substantial majority of our outstanding voting stock, and thus control all matters requiring a shareholder vote, including the election of directors.

The holders of our PIK Notes and our Senior Notes and their affiliates, in the aggregate, own approximately 97.5% of our outstanding common stock. As such, these noteholders can control the outcome of all shareholders’ votes, including charter and bylaw amendments, possible mergers, corporate control contests, and other significant corporate transactions. Furthermore, they are entitled to nominate and elect all members of our Board of Directors. As such, they have absolute control over our Board of Directors and its policies, and as a result, could prevent or delay any strategic transaction or other action by us. By virtue of their effective board control, the noteholders and their affiliates effectively have the power to hire and fire our management team and otherwise to control our operations.

Our Company and the noteholders are subject to potential conflicts of interest.

The noteholders and their affiliates, in the aggregate, own approximately 97.5% of our common stock. The noteholders also hold outstanding PIK Notes in the aggregate principal amount of $15 million and Senior Notes with an aggregate principal amount of $24.3 million at May 31, 2003. As a result of their stock ownership, the noteholders can elect a majority of our Board of Directors. The Senior Notes contain restrictive covenants and default protections that effectively allow the holders to influence or restrict the ability of the Company to engage in various transactions, including mergers, consolidations and the sale of substantially all of the Company’s assets. The interest of the noteholders may be inherently different from that of a shareholder.

Our European Operations has had and will continue to have a significant impact on our business.

The acquisition of our European Operations in 1998 doubled our size. For the fiscal year ended May 31, 2003, approximately 56% of our assets and approximately 61% of our revenues were associated with our operations in the United Kingdom. Logistical issues make it more difficult and expensive for us to manage a business in the United Kingdom than our other businesses, which are located in the State of Washington. The reasons for the increased difficulty include differences in time, distance, business practices and cultural variations. Our ownership of a business in Europe also subjects us to regulatory, tax, and trade restrictions that we do not face in the United States. If we retain ownership of our European Operations and do not effectively manage those business units, we may not be successful.

Changes in foreign currency exchange rates could negatively affect our financial position.

Since approximately 61% of our transactions are conducted in foreign currency, exchange rate risk could be material. Additionally, we have not engaged in hedging transactions to date. For the fiscal year ended May 31, 2003, we incurred a foreign currency translation gain of $2.9 million. Because of our European Operations, we may decide to engage in hedging transactions to protect against losses caused by changes in the exchange rate between the U.S. dollar and the British pound sterling. If we decide to engage in hedging transactions, they will require us to incur transaction expenses and will not completely protect against any such losses. Our European Operations have a few contracts that are in European currencies other than British pounds sterling, or in U.S. dollars. We face similar exchange date fluctuation risks on those currencies as well and it is unlikely that enough transactions will be done in those currencies to merit hedging transactions to protect against losses.

We operate in industries that are subject to cyclical downturns that could adversely affect our revenues.

We operate in historically cyclical industries. The aerospace, defense and electronics industries are sensitive to general economic conditions, and past and current recessions have adversely affected these

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industries. In past years, a number of factors, such as terrorist attacks, viral epidemics, fuel and labor costs and other matters have adversely affected the aerospace industry. These factors have led airlines and other aircraft operators to reduce or eliminate orders for new aircraft, which diminishes the demand for our aerospace products. Similar patterns have emerged in the electronics industry, where consistently reduced margins and slowing demand as a result of technology saturation has impacted, and likely will continue to impact, the demand for our products. As a result, cyclical factors and general economic conditions have in the past caused, and likely will continue to cause, periodic downturns in demand for our core products; if and when those conditions occur or persist, we will experience decreased revenues.

We may fail to retain our key management and technical personnel, which could negatively affect our business.

We believe that our ability to successfully implement our business strategy and to operate profitably depends significantly on the continued employment of our senior management team, led by our president, Donald A. Wright, and our ability to retain and hire engineers and technical personnel with experience in the aerospace and electronics industries. We have key man life insurance policies on the life of Mr. Wright totaling $8 million. We also have an employment agreement with Mr. Wright. However, our business and financial results could be materially adversely affected if Mr. Wright, other members of the senior management team, or significant engineers or technical personnel become unable or unwilling to continue in their present employment. Our growth and future success, however, will depend in large part on our ability to retain and attract board members, executives, managers and highly skilled technical personnel with experience in the aerospace and electronics industries. Because our U.S. operations are not located in a large metropolitan area, we may face more difficulty in acquiring and retaining key management and technical personnel than our competitors in major cities. We face similar difficulties in the U.K. Competition for such individuals is intense, and we may not be successful in attracting and retaining them, which could interfere with our ability to manage our business profitably.

If we do not adapt to technological change and develop new products, we could lose customers and our revenues could decline.

The market for our products in both the aerospace and the electronics industries is characterized by evolving technology and industry standards, changes in customer needs, adaptation of products to customer needs, and new product introductions. Other companies that manufacture components for the aerospace and electronics industries from time to time may announce new products, enhancements, or technologies that have the potential to replace or render our existing products obsolete. Our success will depend on our ability to enhance our current products and develop new products to meet changing customer needs, and achieve market acceptance of those products. We view our proprietary technology and our level of technological development as our primary strengths, and our existing financial condition and debt covenants make it difficult for us to invest in evolving technologies. If we do not adequately respond to changes that occur in our markets, we could lose customers and our revenues could decline.

We could be subject to product liability claims and lawsuits for harm caused by our products.

Many of our customers use our products for applications such as aircraft, satellites, medical devices and other uses in which failure could have serious consequences. We maintain product liability insurance with a maximum coverage of $15 million. However, this insurance may not be sufficient to cover any claims that may arise. A successful product liability claim in excess of our insurance coverage could have a material adverse effect on our business and financial performance.

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We may not be able to convert all of our backlog into revenue.

We sell the majority of our products through individual purchase orders. Many of our customers would have the right to terminate orders by paying the cost of work in process plus a related profit factor. Historically, we have not experienced a large number of significant order cancellations. However, from time to time, customers cancel orders as a result of a program being cancelled or for other reasons. As of May 31, 2003, we had purchase orders and contractual arrangements evidencing anticipated future deliveries, which we treat as backlog, of approximately $36 million. We expect to deliver approximately $32 million of this backlog in fiscal year 2004. We may not be able to complete all of that backlog and record it as net sales, if we experience cancellations of pending contracts or terminations or reductions of contracts in progress.

Our markets are highly competitive, and our competitors’ strengths may prevent us from executing our business strategy.

We have substantial competition in many of the markets that we serve. In the electronics markets, our competitors are generally larger than we are. In the aerospace market, we compete with both regional machine shops and forming business and offshore foundries, which tend to have lower costs. Many of these competitors have greater financial resources, broader experience, better name recognition and more substantial marketing operations than we have, and they represent substantial long-term competition for us. We believe that our manufacturing processes, proprietary technologies and experience provide significant advantages to our customers. These advantages include high quality, more complete solutions, competitive prices, and physical properties that meet stringent demands. However, competitors can use alternative forms of manufacturing to produce many of the components and products that we make. These competing products could be of the same or better quality and price as those we produce. We expect our competitors to continue making new developments, and they could develop products that customers view as more effective or more economical than our products. In addition, our competitors may introduce automation processes and robotics systems that could lower their costs of production substantially. If we cannot compete successfully against current and future competitors, and respond appropriately to changes in industry standards, our business could be seriously harmed.

If we cannot obtain raw materials when needed and at a reasonable cost, we could have difficulty producing cost-effective products and delivering them on time.

Our European Operations obtain approximately 65% of its titanium from one supplier and are subject to a lead time of approximately 26 to 33 weeks to order and obtain titanium. While the European Operations generally has managed the ordering process to obtain titanium when needed, a labor strike at the supplier negatively affected our ability to obtain timely deliveries of titanium during fiscal 1999 and into the 2000 fiscal year. Although the shortage of titanium did not have a material adverse effect on our business or on our overall financial condition, we did lose some business due to customers’ dual sourcing contracts, and some customer orders that were expected to be delivered in fiscal 1999 were delayed into fiscal 2000 and 2001. The effect of the strike emphasizes the fact that a failure to obtain titanium or other raw materials when needed, or significant cost increases imposed by suppliers of raw materials such as titanium or aluminum, could damage our business and financial performance. We generally have readily available sources of all raw materials and supplies we need to manufacture our products and, where possible, we maintain alternate sources of supply. However, we do not have fixed price contracts or arrangements for all of the raw materials and other supplies we purchase. We have experienced in the past shortages of, or price increases for, raw materials and supplies, and shortages or price increases may occur again in the future. Future shortages or price fluctuations could have a material adverse effect on our ability to manufacture and sell our products in a timely and cost-effective manner.

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We need to protect our intellectual property and proprietary rights, and protection may be costly and not always available or effective.

Significant aspects of our business depend on proprietary processes, know-how and other technology that are not subject to patent protection. We rely on a combination of trade secret, copyright and trademark laws, confidentiality procedures, and other intellectual property protection to protect our proprietary technology. However, our competitors may still develop or utilize technology that is the same as or similar to our proprietary technology.

We have 23 U.S. patents, four non-U.S. patents, and four patent applications pending in non-U.S. jurisdictions. We can provide no assurance that the patent applications will result in issued patents, that existing patents or any future patents will give us any competitive advantages for our products or technology, or that, if challenged, these patents will be held valid and enforceable. Most of our issued patents expire at various times over the next 15 years, with three patents expiring over the next two years. Although we believe that the manufacturing processes of much of our patented technology are sufficiently complex that competing products made with the same technology are unlikely, our competitors may be able to design competing products using the same or similar technology after these patents have expired.

Despite the precautions we have taken, unauthorized parties may attempt to copy aspects of our products or obtain and use information that we regard as proprietary, and we are presently in litigation with former employees whom we contend have misappropriated proprietary information. Existing intellectual property laws give only limited protection with respect to such actions, and policing violations of these laws is difficult. The laws of other countries in which our products are or may be distributed do not protect products and intellectual property rights to the same extent as do the laws of the United States. We could be required to enter into costly litigation to enforce our intellectual property rights or to defend infringement claims by others, and we might not prevail in any such actions. Infringement claims could require us to license the intellectual property rights of third parties, but licenses may not be available on reasonable terms, or at all.

We must comply with environmental laws, and any failure to do so could subject us to claims or regulatory action.

Our facilities are subject to regulations concerning solid waste disposal, hazardous materials generation, storage, use and disposal, air emissions, waste water discharge, employee health and other environmental matters. A number of the metals, chemicals and other materials used in and resulting from our manufacturing processes are classified as hazardous substances and hazardous wastes. If we do not meet permitting and other requirements of applicable environmental laws, we could be liable for damages and for the costs of remedial actions. We could also be subject to fines or other penalties, including revocation of permits needed to conduct our business. Any permit revocation could require us to cease or limit production at one or more of our facilities, which could damage our business and financial performance. We have an ongoing program of monitoring and addressing environmental matters, and from time to time in the ordinary course of business we are required to address minor issues of noncompliance at our operating sites. From time to time, we identify operations or processes that lack required permits or otherwise are not in full compliance with applicable environmental laws. Although we believe these items have not been material to date, we maintain an environmental compliance team, and our policy is to take steps promptly to remedy any noncompliance.

We have a policy of obtaining environmental assessment reports in connection with the acquisition of properties at which we believe historical operations could have caused adverse environmental conditions. We are not aware of any historical contamination on our current properties or involving neighboring activities that we believe could have a material adverse effect on our results of operations or financial condition.

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Environmental laws could become more stringent over time, imposing greater compliance costs and increasing risks and penalties associated with any violations. As a generator of hazardous materials, we are subject to financial exposure with regard to our properties even if we fully comply with these laws. In addition, we utilize facilities that are located in industrial areas and have lengthy operating histories. As a consequence, it is possible that historical or neighboring activities have affected properties we currently own, and that, as a result, additional environmental issues may arise in the future, the precise nature of which we cannot now predict. Any present or future noncompliance with environmental laws or future discovery of contamination could have a material adverse effect on our results of operations or financial condition.

As a U. S. Government contractor or subcontractor, if we do not comply with federal laws and regulations we could lose those contracts and incur penalties.

We manufacture some of our products under contracts with the United States government. We manufacture other products under contracts with private third parties who utilize our products to satisfy United States government contracts to which they are a party. Federal acquisition regulations and other federal regulations govern these relationships. Some of these regulations relate specifically to the seller-purchaser relationship with the government, such as the bidding and pricing rules. Under regulations of this type, we must observe pricing restrictions, produce and maintain detailed accounting data, and meet various other requirements. Other regulations relate to the conduct of our business generally, such as regulations and standards established by the Occupational Safety and Health Act or similar state laws and relating to employee health and safety. In particular, regulations governing these contracts require that we comply with federal laws and regulations, in general, or face civil liability, cancellation or suspension of existing contracts, or ineligibility for future contracts or subcontracts funded in whole or in part with federal funds. In addition, loss of governmental certification (that we are eligible for government contracted work) could cause some of our customers, including customers in the defense industry, to reduce or curtail their purchases from us, which could harm our business.

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ITEM 2. DESCRIPTION OF PROPERTY

Our principal executive and administrative offices are located at 430 Olds Station Road, Wenatchee, Washington. Our headquarters building provides approximately 18,000 square feet of office space, and is owned by the Company.

The location, use and approximate size of the principal owned and leased properties where we conduct our operations (other than our headquarters building) as of May 31, 2003 are as follows:

During the 2002 fiscal year, we also leased properties formerly used by divisions that have been discontinued. These include:

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ITEM 3. LEGAL PROCEEDINGS

From time to time we are involved in legal proceedings relating to claims arising out of operations in the normal course of business. Additionally, on November 26, 2002, we filed a lawsuit in the U.S. District Court for the Eastern District of Washington against certain former employees, RAAD Technologies, Inc., and certain of RAAD’s control persons and agents, for misappropriation of trade secrets and breach of contract. That action is styled Pacific Aerospace & Electronics, Inc., v. RAAD Technologies, Inc., et all. On February 18, 2003, RAAD Technologies, Inc. filed a lawsuit against us in the U.S. District Court for Western District of Washington (RAAD Technologies, Inc., v. Pacific Aerospace & Electronics, Inc.) seeking a ruling that one of RAAD’s products does not infringe our patents. The Western District lawsuit was stayed pending the outcome of the Eastern District action. On June 20, 2003, the judge in the Eastern District action granted a preliminary injunction that bars RAAD from certain types of competitive actions.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

On May 7, 2003, we held our 2002 annual meeting of shareholders. The shareholders voted upon the following matters at the meeting:

(a)  Election of the following five individuals to serve as directors of the Company:

(b)  Ratification of the appointment of KPMG LLP as the independent auditors of the Company for the fiscal year ended May 31, 2003:

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PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Market Information, Shareholders, and Dividends

Our common stock is listed on the NASD Over-the-Counter Bulletin Board (“OTC Bulletin Board”) under the symbol “PFAE”. The following range of high and low sales prices for our common stock and public warrants for each calendar quarter during the period from January 2001 through May 31, 2003, which covers all of the calendar quarters within the Company’s 2002 and 2003 fiscal years. The closing prices for our common stock and public warrants were obtained on the OTC Bulletin Board.

All prices have been adjusted to reflect the 1-for-200 reverse stock split effected as of February 17, 2003.

As of August 18, 2003, the closing sales price of our common stock on the OTC Bulletin Board was $0.31 per share.

We have never declared or paid cash dividends on our common stock. We currently anticipate that we will retain any future earnings to fund the operations, and we do not anticipate paying dividends on our common stock in the foreseeable future. The Senior Notes and the indenture governing our PIK Notes restrict our ability to pay dividends.

As of August 15, 2003, there were 1,384 holders of record of 24,779,209 shares of common stock outstanding, based on the records maintained by our transfer agent.

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Summary Equity Compensation Plan Information

Common Stock

Each share of outstanding common stock is entitled to participate equally in dividends as and when declared by the Board of Directors, out of funds legally available therefor, and is entitled to participate equally in any distribution of net assets made to our common shareholders in the event of liquidation of the Company after payment to all creditors of the Company, subject to any preferences that may be granted to any series of preferred stock as to dividends or liquidation. There are no preemptive rights or rights to convert common stock into any other securities. The holders of our common stock are entitled to one vote for each share held of record on all matters voted upon by our shareholders and may not cumulate votes for the election of directors. Thus, the owners of a majority of the shares of our common stock outstanding may elect all of the directors of the Company, and the owners of the balance of the shares of the common stock would not be able to elect any directors of the Company. Unless otherwise noted herein, all share and per-share figures reflect the Reverse Split.

Preferred Stock

          Series C Convertible Preferred Stock

In March 2002, we completed the Exchange portion of our restructuring. In connection with the Exchange, we issued 1,000 shares of Series C Preferred Stock of the Company to the Noteholders as partial consideration for the cancellation of the Subordinated Notes.

The Series C Preferred Stock was automatically convertible into that number of shares of common stock which, when added to the shares of common stock previously distributed to the Noteholders in the Exchange, would equal approximately 97.5% of our common stock on a fully-diluted basis. Until conversion, the Series C Preferred Stock had an aggregate liquidation preference equal to $45 million and a cumulative dividend rate of 10% per annum, which automatically increased to 14% per annum after June 1, 2002 because the Automatic Conversion did not occur on or before June 1, 2002. The Series C

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Preferred Stock ranked senior to all other classes of our capital stock as to liquidation and distributions. In addition, the Series C Preferred Stock was entitled to vote with the common stock on all matters brought before the common stock for approval (other than as required by law) and was entitled to that number of votes equal to the number of shares of common stock into which the Series C Preferred Stock is then convertible. On January 27, 2003, following shareholder approval at a Special Meeting of shareholders, we amended our Articles of Incorporation to increase the number of authorized shares of common stock. The increase in authorized shares of common stock resulted in the automatic conversion of all of the outstanding shares of our Series C Preferred Stock into 4,865,820,023 pre-split shares of our common stock. As a result, there are no shares of Series C Preferred Stock outstanding. Subsequently we consummated the Reverse Split to reduce the number of outstanding shares of common stock.

          Blank Check Preferred Stock

The Company’s Board of Directors has the authority to issue additional shares of preferred stock in one or more series and to fix the powers, designations, preferences and relative, participating, optional or other rights of any series of preferred stock, including dividend rights, conversion rights, voting rights, redemption terms, liquidation preferences, sinking fund terms and the number of shares constituting any series, without shareholder approval, unless such approval is required by applicable law or by the rules of any stock exchange or automated quotation system on which securities of the Company may be listed or traded, if any. The rights of any new preferred stock could adversely affect the rights of holders of common stock and the market for the common stock.

Warrants and Options

As of May 31, 2003, we had outstanding exercisable warrants to purchase common stock as follows:

	•		Warrants to purchase 11,475 shares of common stock, with an exercise price of $937.50 per share. These warrants were formerly publicly traded, and all such warrants expired unexercised on July 15, 2003.
	•		Warrants and options to purchase a total of 22,318 shares of common stock issued to several employees and consultants of the Company, that have exercise prices ranging from $44.00 to $937.50 per share, and have expiration dates that range from July 2003 to May 2011.
	•		Warrants to purchase 333,154 shares of common stock that were issued in connection with a private placement in July 2000. The warrants had an exercise price of $0.20 per share and expired unexercised on July 27, 2003.
	•		Warrants to purchase 76,466 shares of common stock that were issued in connection with a private placement in March 2001. These warrants have an exercise price of $0.20 per share, and expire in March 2006.

All common stock amounts and exercise prices listed above have been adjusted to reflect the 1-for-200 reverse split.

Anti-Takeover Considerations

The Company, as a Washington corporation, is subject to certain provisions of Washington law regarding significant business transactions and fair price restrictions in addition to those provisions of the Company’s articles of incorporation and bylaws that may have anti-takeover effects. These provisions may have the effect of delaying or deterring a hostile takeover of the Company.

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Washington Law. Washington’s “Significant Business Transactions” statute (Chapter 23B.19 of the Washington Business Corporation Act) applies to public companies that are incorporated under Washington law. The statute prohibits, subject to certain exceptions, a corporation from entering into any “significant business transactions” with an “Acquiring Person” (defined generally as a person who or an affiliated group that beneficially owns 10% or more of the outstanding voting securities of a corporation) for a period of five years after such person or affiliated group becomes an Acquiring Person unless the transaction or share acquisition made by the Acquiring Person is approved prior to the share acquisition by a majority of the target corporation’s directors. In addition, this statute prohibits a corporation subject thereto from entering into a significant business transaction with an Acquiring Person unless the consideration to be received by the corporation’s shareholders in connection with the proposed transaction satisfies the “fair price” provisions set forth in the statute.

Articles of Incorporation and Bylaws. A number of provisions in the Company’s articles of incorporation and bylaws concern matters of corporate governance and rights of shareholders. Provisions such as those that grant the Board of Directors the ability to issue shares of preferred stock and to set the voting rights, preferences and other terms thereof may have an anti-takeover effect by discouraging takeover attempts not first approved by the Board of Directors, including takeovers which may be considered by some shareholders to be in their best interests. To the extent takeover attempts are discouraged, temporary fluctuations in the market price of the Company’s common stock, which may result from actual or rumored takeover attempts, may be inhibited, particularly those that might otherwise tend to increase the Company’s stock price. Such provisions also could delay or frustrate the removal of incumbent directors or the assumption of control by shareholders, even if such removal or assumption would be beneficial to the Company’s shareholders. These provisions also could discourage or make more difficult a merger, tender offer or proxy contest, even if they could be favorable to the interests the shareholders, and could potentially depress the market price of the Company’s common stock. The Board of Directors believes that these provisions are appropriate to protect the Company’s interests and the interests of the Company’s shareholders.

The Company’s bylaws provide that annual meetings of shareholders may take place at the time and place established by the Board of Directors. A special meeting of the Company’s shareholders may be called by the Chairman of the Board of Directors, the president, a majority of the Board of Directors or a shareholder or shareholders holding at least 10% of the voting power of the Company. Thus, until a shareholder holds at least 10% of the voting power of the Company he or she may not call a special meeting to take corporate actions that would be required to remove directors or change Company management. In addition, the Company’s bylaws provide that any action required or permitted to be taken at a shareholders’ meeting may be taken without a meeting, without prior notice and without a vote, if one or more written consents setting forth the action so taken are signed by a number of shareholders entitled to vote thereon equal to the number of shares that must be voted in favor of such an action. The Company’s bylaws may be altered, amended, or repealed by the Board of Directors, subject to the power of the Company’s shareholders to change or repeal the bylaws.

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ITEM 6. SELECTED FINANCIAL DATA

The following selected financial data presents selected historical financial data of the Company as of and for the years ended May 31, 1999, 2000, 2001, 2002 and 2003, and is derived from our audited financial statements. This data should be read in conjunction with our Financial Statements and Notes thereto, the independent auditors’ report, and Management’s Discussion and Analysis of Financial Condition and Results of Operations. The independent auditors’ report contains an explanatory paragraph that states that our recurring losses from operations and net capital deficiency raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements and the following selected financial data do not include any adjustments that might result from the outcome of that uncertainty. The report also states that the Company changed its method of accounting for goodwill and certain intangible assets during the year ended May 31, 2002 and reclassified gain on extinguishment of debt recorded I the prior year from extraordinary item to other income effective for the year ended May 31, 2003. Share and per-share data are post Reverse Split.

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ITEM 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

This section and the “Description of Business” section of this Form 10-K contain “forward-looking statements.” These forward-looking statements are not guarantees of the Company’s future performance. They are projections and statements of intent based upon management’s current knowledge and expectations, and as such, are subject to risks and uncertainties related to business operations, some of which are beyond the Company’s control. Any of these risks or uncertainties may cause actual results or future circumstances to differ materially from the forward-looking statements set forth in this section under the captions “Overview” and “Liquidity and Capital Resources,” and in “Description of Business” under each of the captions in that section. Certain specific risk factors that may affect our business are described above under “Description of Business – Risk Factors.” The information presented in this report is presented only as of the date hereof, and we cannot undertake to update this information other than as specifically required by the Exchange Act.

Overview

Pacific Aerospace & Electronics, Inc. is an engineering and manufacturing company with operations in the United States and the United Kingdom. We design, manufacture and sell components and subassemblies used in technically demanding environments. Products that we produce primarily for the aerospace and transportation industries include machined, cast, and formed metal parts and subassemblies, using aluminum, titanium, magnesium, and other metals. Products that we produce primarily for the defense, electronics, telecommunications and medical industries include components such as hermetically sealed electrical connectors and instrument packages, and ceramic capacitors, filters and feedthroughs. Our customers include global leaders in all of these industries.

Pacific Aerospace has struggled financially since late 1998, when the commercial airplane industry suffered a downturn at approximately the same time that we incurred high-cost, high-yield debt to finance the acquisition of our European Aerospace Group. We reported a net loss of $11,742,000 for our fiscal year ended May 31, 2003. This followed income of $4,525,000 for our fiscal year ended May 31, 2002 and a loss of $75,720,000 for our fiscal year ended May 31, 2001.

In March 2002, in accordance with an exchange agreement the holders of our senior subordinated debt exchanged $63.7 million aggregate principal amount of debt securities, together with accrued interest thereon, for shares of our common stock, shares of our Series C Preferred Stock and approximately $15.0 million in aggregate principal amount of PIK Notes. The Series C Preferred Stock automatically converted into 4,865,820,023 shares of our common stock following the January 27, 2003 shareholder approval of an increase in the number of our authorized shares of common stock. As a result of the exchange and the related conversion, the noteholders now hold approximately 97.5% of our outstanding shares of common stock on a fully-diluted basis. Subsequently we effected the Reverse Split, which reduced the shares of common stock outstanding but did not affect the percentage of the noteholder’s ownership.

In addition to exchanging our previously outstanding subordinated debt securities as described above, we also issued the Senior Notes having an aggregate face amount of $36 million in exchange for proceeds of $22 million. The principal amount of the Senior Notes will accrete through May 1, 2007 to $36.0 million and will bear interest at 5% per annum on the fully accreted principal amount. We may redeem the Senior Notes in full or in part at any time prior to their maturity date at a premium over the accreted value of the Senior Notes, which premium declines over time. We used $16.2 million of the proceeds from the Senior Notes to pay off principal and accrued interest on our then outstanding 21% senior secured loan. The remaining proceeds were used for working capital, to pay the fees and costs of the restructuring and for other general corporate purposes. Assuming the Senior Notes are not redeemed prior to their maturity date, cash payments will be limited to the 5% interest rate on the face value of the Senior Notes and the repayment of the $36.0 million principal amount due on May 1, 2007.

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Critical Accounting Estimates and Policies

The discussion and analysis of financial condition and results of operations is based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenue and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates including revenue recognition, the allowance for doubtful accounts, sales returns and allowances, the salability and recoverability of inventory, impairment of long-lived assets, income taxes and contingencies. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form our basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ materially from these estimates under different assumptions and conditions, and such variations may be adverse.

We recognize revenue primarily when products are shipped to customers and when services are performed.

We must make estimates of the collectability of accounts receivable. We analyze historical sales returns, allowances, write-offs, changes in our internal credit policies and customer concentrations when evaluating the adequacy of our allowance for doubtful accounts, sales returns and allowances. Differences may result in the amount and timing of expenses for any period if we make different judgments or use different estimates.

We value inventories at the lower of cost, primarily determined by the first-in, first-out method, or market (replacement cost for raw materials and net realizable value for work in progress and finished goods). We regularly review inventory detail to determine whether a write-down is necessary. We consider various factors in making this determination, including recent sales history and predicted trends, industry market conditions and general economic conditions. Differences could result in the amount of timing of write-downs for any period if we make different judgments or use different estimates.

We review long-lived assets and certain identifiable intangibles for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of assets to be held and used is measured by a comparison of the carrying amount of an asset to future net cash flows expected to be generated by the asset. Cash flows expected to be generated by an asset are estimated based upon historical cash flows from the asset, current and expected market conditions related to products produced by the asset and the asset’s disposal value. Those estimates may not be accurate if actual market conditions or disposal values are different than expected. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value of the assets. Fair value of an asset is estimated to be the present value of its expected future cash flows. Present value of expected future cash flows is dependent upon identifying the appropriate interest rate to use in the calculation commensurate with the risks involved. We determine the appropriate interest rate for the calculation based upon the rate that would be required for a similar investment with like risks for the assets being evaluated. We report assets to be disposed of at the lower of the carrying amount or fair value less costs to sell. Differences could result in the amount or timing of write-downs for any period if we make different judgments or use different estimates.

We follow the asset and liability method of accounting for income taxes. Under the asset and liability method of accounting for income taxes, deferred tax assets and liabilities are recognized based on the

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estimated future tax consequences attributable to differences between the consolidated financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss and tax credit carry forwards. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date. Differences could result in the amount of timing our provision for income taxes for any period if we make different judgments or use different estimates.

The Company operates in two segments, US Operations and European Operations. This is based on the fact that the Company’s chief operating decision maker, the Company’s chief executive officer, regularly reviews operating results, assesses performance and makes decisions about resources to be allocated at this level (US Operations and European Operations) and not on any of the underlying divisions or business units that comprise these two segments.

Results of Operations

For an understanding of the significant factors that influenced our performance during the past two fiscal years, the following discussion should be read in conjunction with our consolidated financial statements presented in this Form 10-K. Readers are also directed to the factors set forth in “Description of Business – Risk Factors” for a discussion of certain factors that may adversely affect our business, operations and financial condition.

The following table sets forth certain of our historical statement of operations data for the periods indicated, expressed in dollars (in thousands) and as a percentage of net sales.

⁽¹⁾  The Company stopped amortizing goodwill during fiscal year ended May 31, 2002. See “Notes to Consolidated Financial Statements number 2 (o) Change in Accounting Principle.”

⁽²⁾  The Company reclassified gain on extinguishment of debt recorded in prior years from extraordinary item to other income effective for the year ended May 31, 2003. See “Notes To Consolidated Financial Statements number 2(o) Change in Accounting Principle.”

Year Ended May 31, 2003 Compared to Year Ended May 31, 2002

Net Sales. Net sales decreased by $15.1 million, or 18.8%, to $65.1 million for fiscal 2003 from $80.2 million in fiscal 2002. This decrease was due to a number of factors including the effects of our operational restructuring plan and various events that affected our markets. Our European Operations contributed $39.7 million to net sales during fiscal 2003, down $5.7 million from $45.4 million contributed during the year ended May 31, 2002. Following the tragic events of September 11, the commercial aerospace market both in the U.S. and in Europe saw a significant decline. Boeing and Airbus both announced substantial delays and cuts in their planned commercial aircraft build rates. The

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decrease in net sales contributed by our European Operations is largely attributable to reduced, postponed, or cancelled orders from commercial aircraft manufacturers.

Our U.S. Operations contributed $25.4 million to net sales during the year ended May 31, 2003, down $7.9 million from the $33.3 million contributed during the year ended May 31, 2002. This decrease was primarily due to the reduction in orders from commercial aircraft manufacturers which was caused by the same market conditions experienced by the European Operations. On January 31, 2003, in reaction to the downturn in the commercial aerospace market, we sold our rights and responsibilities for the U.S. Operations’ Boeing Statement of Work to an independent third party. The sale of the Boeing Statement of Work further reduced net sales contributed by the U.S. Operations.

The remaining decrease in our consolidated net sales was due to the sale of our Engineering and Fabrication Division and the closure of our Display Division. These discontinued divisions did not contribute any net sales during fiscal year 2003 but contributed $1.5 million to net sales during fiscal year 2002.

Receivable collection periods, as calculated by dividing ending accounts receivable balances by sales for the year multiplied by 360 days, increased to 74.6 days for the year ended May 31, 2003 from 54.9 days for the year ended May 31, 2002. This increase was primarily due to slow collections from one large customer within the European Operations. A large portion of the receivable from that customer was collected subsequent to May 31, 2003.

Gross Profit. Gross profit decreased by $6.7 million, or 54.0%, to $5.7 million for the year ended May 31, 2003, from $12.4 million for the year ended May 31, 2002. As a percentage of net sales, gross profit decreased to 8.8% for the year ended May 31, 2003, from 15.5% for the year ended May 31, 2002. This decrease was due to the reduction in revenue associated with the commercial aerospace industry, while many of our costs are fixed. In an effort to increase our gross profit, we have significantly reduced staffing levels at our operating facilities in the United States and in the United Kingdom. We are also in the process of consolidating our manufacturing sites and have sold excess machinery. We are also outsourcing certain operating functions along with implementing production processes which we expect to be more efficient.

Due to the downturn in the commercial aerospace industry, in specific, and the economy, in general, we wrote down approximately $1.4 million of inventory related to our U.S. Operations and $0.3 million of inventory related to our European Operations during the year. Without those write-downs our gross profit would have been $7.4 million, or approximately 11.4% of net sales.

Inventory turnover, as calculated by dividing sales for the year by ending inventory, remained relatively unchanged at 4.0 turns for the year ended May 31, 2003 from 4.1 turns for the year ended May 31, 2002.

Operating Expenses. Operating expenses decreased by $2.8 million, to $12.9 million for the year ended May 31, 2003 from $15.7 million for the year ended May 31, 2002. This decrease was primarily due to the 2002 disposition of our Engineering and Fabrication Division and closure of our Display Division. In an effort to reduce operating expenses further, we have significantly reduced our corporate overhead by reducing corporate executive salaries, eliminating several executive positions, and other headcount reductions.

Net Interest Expense. Net interest expense decreased $8.3 million to $4.6 million for the year ended May 31, 2003 from $12.9 million for the year ended May 31, 2002. This decrease was due to our March 2002 debt restructuring.

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Other Income (Expense). Other income (expense) represents non-recurring and non-operational income and expense for the period. Other expense for the current year primarily represents the loss associated with our interest rate swap agreement.

Income Taxes. Income tax benefit for the year ended May 31, 2003 represents the estimated benefit to be received in the United Kingdom from the carry back of operational losses. No income tax benefit has been recorded for United States taxes due to the uncertainty related to the recognition of such benefit.

Net income (loss). Net income decreased to a loss of $11.7 million for the year ended May 31, 2003 from net income of $4.5 million for the year ended May 31, 2002, primarily as a result of the factors discussed above and excluding the gain on our debt restructuring that occurred during the year ended May 31, 2002.

Year Ended May 31, 2002 Compared to Year Ended May 31, 2001

Net Sales. Net sales decreased by $29.1 million, or 26.6%, to $80.2 million for fiscal 2002 from $109.3 million in fiscal 2001. This decrease was due to a number of factors including the effects of our operational restructuring plan and various events that affected our markets. Our European Operations contributed $45.4 million to net sales during fiscal 2002, down $6.2 million from $51.6 million contributed during the year ended May 31, 2001. Following the tragic events of September 11, the commercial aerospace market both in the U.S. and in Europe saw a significant decline. Boeing and Airbus both announced substantial delays and cuts in their planned commercial aircraft build rates. The decrease in net sales contributed by our European Operations is largely attributable to reduced, postponed, or cancelled orders form commercial aircraft manufacturers.

Our U.S. Operations contributed $33.3 million to net sales during the year ended May 31, 2002, down $1.8 million from the $35.1 million contributed during the year ended May 31, 2001. This decrease was primarily due to fewer ceramic filter sales to the telecommunications market.

The remaining decrease in our consolidated net sales was due to the sale of our Casting Division, Engineering and Fabrication Division and the closure of our Display Division. These discontinued divisions contributed $1.5 million to net sales during the year ended May 31, 2002 but contributed $22.6 million to net sales during the year ended May 31, 2001.

Receivable collection periods, as calculated by dividing ending accounts receivable balances by sales for the year multiplied by 360 days, decreased to 54.9 days for the year ended May 31, 2002 from 62.9 days for the year ended May 31, 2001. This decrease was due to a concerted effort by operations management to increase collection efforts.

Gross Profit. Gross profit increased by $4.2 million, or 51.2%, to $12.4 million for the year ended May 31, 2002, from $8.2 million for the year ended May 31, 2001. As a percentage of net sales, gross profit increased to 15.5% for the year ended May 31, 2002, from 7.5% for the year ended May 31, 2001. The increase in gross margin was primarily related to the disposal of our Casting Division, Engineering and Fabrication Division and Display Division. Each of those Divisions produced substantial negative gross margins during the year ended May 31, 2001.

Due to the downturn in the commercial aerospace industry, in specific, and the economy, in general, we wrote down approximately $1.4 million of inventory related to our U.S. Operations and $0.2 million of inventory related to our European Operations during the year ended May 31, 2002. These write-downs approximate the amount of our inventory that has not been used in more than one year. Without those write-downs our gross profit would have been $14.0 million, or approximately 17.5% of net sales.

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Inventory turnover, as calculated by dividing sales for the year by ending inventory, decreased to 4.1 turns for the year ended May 31, 2002 from 4.8 turns for the year ended May 31, 2001. The decrease was due to lower net sales without a corresponding decrease in inventory levels.

Operating Expenses. Operating expenses decreased by $51.5 million, to $15.7 million for the year ended May 31, 2002 from $67.2 million for the year ended May 31, 2001. During the year ended May 31, 2001 we recognized approximately $48.9 million in non-cash impairment charges. Without those charges our operating expenses would have decreased $2.6 million during the year ended May 31, 2002. Operating expenses for the year ended May 31, 2002 included approximately $0.6 million of non-cash impairment charges related to equipment used by our Display Division and Engineering & Fabrication Division. The remaining net decrease in operating expenses was due primarily to the disposal of our Casting Division, Engineering and Fabrication Division and Display Division.

Gain on extinguishment of debt. In March 2002, the Company completed the Exchange. In accordance with the Exchange Agreement, the Noteholders exchanged $63.7 million aggregate principal amount of the Subordinated Notes, together with accrued interest thereon, for shares of our common stock, shares of our Series C Preferred Stock and approximately $15.0 million in aggregate principal amount of PIK Notes.

The Company has followed the provisions of SFAS No. 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings”, in recording the Exchange. These provisions require that the carrying value of the PIK Notes be recorded at the total future cash payments (principal and interest) specified by the PIK notes, therefore the PIK notes have been classified on our balance sheet as long-term liabilities and valued at $25.7 million. As a result, no interest expense related to the PIK Notes will be recognized in future periods.

The following table presents the aggregate gain recognized in the Exchange transaction:

Management determined the value of the equity instruments issued to the Noteholders to be the midpoint of the total estimated equity value range of the Company as determined by a valuation analysis performed by management. The total equity value range, on a post-conversion basis, was approximately $14.2 million to $29.2 million.

The valuation analysis included estimates of equity value based upon market multiple methodology, comparable transaction methodology and discounted cash flow methodology. The results were adjusted to reflect current assets, including certain tax benefit assets and marketability discounts. Some of the major assumptions used in the valuation analysis included projections of our future cash flows, appropriate comparable companies in both the electronics and aerospace industries and applicable discount rates. The results of our valuation could have been materially different if different assumptions had been used.

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Net Interest Expense. Net interest expense increased $2.9 million to $12.9 million for the year ended May 31, 2002 from $10.0 million for the year ended May 31, 2001. This increase was primarily due to our 21% senior secured notes and accelerated amortization of the related loan costs during the year.

Other Income (Expense). Other income (expense) represents non-recurring and non-operational income and expense for the period. Other income decreased to $78,000 for the year ended May 31, 2002 from income of $201,000 for the year ended May 31, 2001. Other income in the current year primarily represents the gain on the sale of certain assets.

Income Taxes. Income tax benefit for the year ended May 31, 2002 represents a change in estimated taxes payable in the U.K.

Net income (loss). Net income increased to $4.5 million for the year ended May 31, 2002 from a net loss of $75.7 million for the year ended May 31, 2001, primarily as a result of the factors discussed above including the gain on our debt restructuring.

Liquidity and Capital Resources

Our consolidated financial statements have been prepared assuming that we will continue as a going concern. However, our independent auditors in their report accompanying our May 31, 2003 audited consolidated financial statements stated that we have suffered recurring losses from operations and have a net capital deficiency that raise substantial doubt about our ability to continue as a going concern. Our consolidated financial statements do not include any adjustments that might result from the outcome of that uncertainty. If we are not sufficiently successful in generating cash from operating activities, we may need to sell additional common stock or other securities, or we may need to sell assets outside the ordinary course of business. Current market conditions, coupled with our current stock price and our financial condition and historical performance, may pose difficulties in closing a securities offering on acceptable terms, or at all. Moreover, if we need to dispose of assets outside the ordinary course of business to generate cash, we may not be able to realize the carrying value of those assets upon liquidation. If we are unable to generate the necessary cash, we could be unable to continue in existence.

Cash used in operating activities was approximately $2.8 million for the year ended May 31, 2003, compared to cash used in operating activities of approximately $0.3 million for the year ended May 31, 2002. At May 31, 2003 we had cash and cash equivalents of $1.9 million and our current assets totaled $32.5 million, compared with cash and cash equivalents of $5.6 million and current assets of $38.0 million at May 31, 2002. The increase in cash used in operating activities was primarily a result of our net loss for the year.

Our success as a company will depend heavily on our ability to generate cash from operating activities in the future. We can offer no assurance that we will achieve profitable operations or that any profitable operations will be sustained. We are continuing to focus on initiatives that specifically address the need to increase cash provided by operating activities. Some of these initiatives include, but are not limited to, staff reductions, selling of excess inventory, and general and administrative cost controls. We continue to reduce staffing at our operating units to better match revenue levels, and we have significantly reduced staff at our corporate headquarters to reduce indirect overhead costs. We have also subleased portions of unused facility space.

Cash generated from financing activities decreased from $3.8 million during the year ended May 31, 2002 to $0.04 million during the year ended May 31, 2003. Cash used in investing activities decreased from $2.3 million for the year ended May 31, 2002 to $1.4 million during the year ended May 31, 2003. In

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fiscal year 2003 we made cash investments for the acquisition of equipment and improvement of facilities of $2.1 million offset by $0.7 million of cash from the sale of assets, primarily assets used to produce commercial aerospace products. We do not expect to acquire any new businesses during fiscal year 2004.

Our working capital as of May 31, 2003 was approximately $18.9 million, and as of May 31, 2002 was approximately $24.6 million.

In February 2003, we entered into a revolving invoice funding facility with a national bank. Under the facility we may borrow up to 80% of acceptable domestic United States accounts receivable, up to a maximum amount of $3,000,000. The facility is secured by all domestic United States accounts receivable and all domestic United States inventories. The facility bears interest at the bank’s prime rate plus 5.0% and expires in February 2004. There was $1.0 million borrowed under this facility at May 31, 2003.

We are not in compliance with certain covenants relating to loans made by KeyBank in an aggregate principal amount of approximately $1.6 million (at May 31, 2003) that are secured by a deed of trust on our headquarters building and improvements on another Company building. As of May 31, 2003, approximately $1.1 million of the principal amount of the loan secured by our headquarters building remained outstanding and $565,000 of the loan secured by improvements on the other building remained outstanding. Under the agreements governing the KeyBank loans, we are required to maintain a minimum debt service coverage ratio of 1.50 and a maximum debt to worth ratio of 0.75. As of May 31, 2003, our debt service ratio was (11.63) and our debt to worth ratio was 2.49. Pursuant to a forbearance agreement dated June 25, 2003, KeyBank agreed to forbear from declaring covenant defaults until we regain compliance (thereby curing such covenant violations) or December 31, 2004. We anticipate obtaining compliance with the debt service ratio by May 31, 2004, but do not anticipate being in compliance with the debt to worth ratio in the foreseeable future.

We are also not in compliance with a covenant of the Senior Notes in an aggregate principal amount of approximately $24.3 million, net of original issue discount, at May 31, 2003. Under the loan agreement governing the Senior Notes, we are required to meet certain minimum EBITDA levels which we have not achieved. Pursuant to a forbearance agreement dated August 8, 2003, the Senior Noteholders agreed to forbear from declaring covenant default until we regain compliance (thereby curing such covenant violation) or June 1, 2004.

The functional currency of our European Operations is the British pound sterling. We translate the activity of our European Operations into U.S. dollars on a monthly basis. The balance sheet of the European Operations is translated using the exchange rate as of the date of the balance sheet, and for purposes of the statement of operations and statement of cash flows we use the average exchange rate for the period. The value of our assets, liabilities, revenue, and expenses may vary materially from one reporting period to the next solely as a result of varying exchange rates. During the year ended May 31, 2003, the foreign currency translation adjustment was positive $2,883,000. We have not entered into any hedging activity as of May 31, 2003.

Significant Events

Conversion of Series C Convertible Preferred Stock and Reverse Stock Split

On January 27, 2003, following approval by a majority of our shareholders, we increased the number of our authorized shares of common stock from 100,000,000 to 20,000,000,000 shares without affecting per share par value. Upon the increase in authorized shares the holders of all of our Series C Convertible Preferred Stock converted all of their preferred shares into 4,865,819,000 shares of common stock. As a result, there are no shares of Series C Preferred Stock outstanding. On the same day, following approval

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by a majority of our shareholders, we completed the Reverse Split. At February 28, 2003, as a result of the Reverse Split, we had 100,000,000 authorized shares of common stock with 24,779,209 common shares outstanding.

Revolving Invoice Funding Facility

In February 2003, the Company entered into a revolving invoice funding facility with a national bank. Under the facility the Company may borrow up to 80% of acceptable domestic United States accounts receivable, up to a maximum amount of $3,000,000. The facility is secured by all domestic United States accounts receivable and all domestic United States inventories. The facility bears interest at the bank’s prime rate plus 5.0% and expires in February 2004. There was $1.0 million borrowed under this facility at May 31, 2003.

Sale of U.S. Operations’ Boeing Statement of Work

On January 31, 2003, the Company sold its rights and responsibilities for the U.S. Operations’ Boeing Statement of Work to an independent third party. The Company also sold inventory, tooling and certain intangible assets related to the Boeing Statement of Work. The sale price was $400,000 payable as follows: $181,250 due at closing and seven quarterly payments of $31,250. There was no significant gain or loss resulting from the transaction.

Disclosures about contractual obligations and commercial commitments

The following table and narrative gives additional disclosure related to our contractual obligations as of May 31, 2003 and how far in the future such payments are due.

We also enter into certain supplier agreements that guarantee quantity and price of the applicable commodity to limit the exposure to commodity price fluctuations and availability concerns. At May 31, 2003, we had commercial purchase commitments for raw materials aggregating approximately $4.4 million. This amount relates to a titanium supply agreement with a fixed price.

Recent Accounting Pronouncements

In June 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 143, Accounting for Asset Retirement Obligations, which addresses financial accounting and reporting for obligations associated with the retirement of tangible long-lived assets and the associated asset retirement costs. The standard applies to legal obligations associated with the retirement of long-lived assets that result from the acquisition, construction, development and normal use of the asset. SFAS No. 143 requires that the fair value of a liability for an asset retirement obligation be recognized in the period in which it is incurred if a reasonable estimate of fair value can be made. The fair value of the liability is added to the carrying amount of the associated asset, and this additional carrying amount is depreciated over the life of the asset. The liability is accreted at the end of each period