PACIFIC AEROSPACE & ELECTRONICS INC - 10-Q Quarterly Report

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q


[X]		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
		EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED NOVEMBER 30, 2003


[ ]		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
		EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO

Commission File Number: 0-26088

PACIFIC AEROSPACE & ELECTRONICS, INC.

(Exact name of registrant as specified in its charter)


Washington (State or other jurisdiction of incorporation or organization)		91-1744587 (I.R.S. Employer Identification No.)

430 Olds Station Road, Third Floor, Wenatchee, Washington 98801
(Address of Principal Executive Offices; Zip Code)

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

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

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

Applicable only to issuers involved in bankruptcy proceedings during the preceding five years:

Indicate by check mark whether the registrant has filed all documents and reports required to be filed by Sections 12, 13 or 15(d) of the Securities Exchange Act of 1934 subsequent to distribution of securities under a plan confirmed by court. Yes [ ] No [ ]

Applicable only to corporate issuers:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date: As of January 14, 2004, there were 24,815,859 shares outstanding of the issuer’s common stock, par value $0.001 per share.

TABLE OF CONTENTS


PART 1 FINANCIAL INFORMATION
	ITEM 1: FINANCIAL STATEMENTS
	ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
	ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
	ITEM 4. CONTROLS AND PROCEDURES
PART II OTHER INFORMATION
	ITEM 1. LEGAL PROCEEDINGS
	ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
	ITEM 3. DEFAULTS UPON SENIOR SECURITIES
	ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
	ITEM 5. OTHER INFORMATION
	ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
SIGNATURES
EXHIBIT INDEX
EXHIBIT 10.29
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

PART 1
FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

Condensed Consolidated Balance Sheets – November 30, 2003 and May 31, 2003

Condensed Consolidated Statements of Operations and Comprehensive Loss – Second Quarter and Six Months Ended November 30, 2003 and 2002.

Condensed Consolidated Statements of Cash Flow – Six Months Ended November 30, 2003 and 2002

Management’s Statement and Notes to Unaudited Condensed Consolidated Financial Statements – Second Quarter and Six Months Ended November 30, 2003

PACIFIC AEROSPACE & ELECTRONICS, INC. AND SUBSIDIARIES
Condensed Consolidated Balance Sheets
November 30, 2003 and May 31, 2003
(Unaudited)


			November 30,			May 31,
			2003			2003

Assets
Current assets:
	Cash		$	3,790,000			1,948,000
	Accounts receivable, net			11,327,000			13,492,000
	Inventories			16,351,000			16,457,000
	Prepaid expense and other current assets			2,568,000			569,000

		Total current assets		34,036,000			32,466,000

Property, plant and equipment, net				20,323,000			21,635,000

Other assets:
	Goodwill, net			351,000			351,000
	Patents, net			1,411,000			1,473,000
	Deferred financing costs, net			840,000			960,000
	Other assets			131,000			208,000

		Total other assets		2,733,000			2,992,000

			$	57,092,000			57,093,000

Liabilities and Stockholders’ Deficit
Current liabilities:
	Accounts payable		$	8,772,000			9,178,000
	Accrued liabilities			2,582,000			2,381,000
	Accrued interest			420,000			396,000
	Line of credit			—			1,030,000
	Current portion of long-term debt			206,000			395,000
	Current portion of capital lease obligations			138,000			145,000

		Total current liabilities		12,118,000			13,525,000
Long-term liabilities:
	Long-term debt, net of current portion			31,638,000			26,503,000
	Capital lease obligations, net of current portion			72,000			143,000
	Senior subordinated notes payable			25,739,000			25,739,000
	Deferred income taxes			976,000			930,000
	Deferred rent and other			—			12,000

		Total liabilities		70,543,000			66,852,000

Stockholders’ deficit:
	Common stock			25,000			25,000
	Additional paid-in capital			105,844,000			105,844,000
	Accumulated other comprehensive loss			(4,304,000	)		(5,506,000	)
	Accumulated deficit			(115,016,000	)		(110,122,000	)

		Total stockholders’ deficit		(13,451,000	)		(9,759,000	)

			$	57,092,000			57,093,000

See accompanying notes to unaudited condensed consolidated financial statements.

PACIFIC AEROSPACE & ELECTRONICS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Operations and Comprehensive Loss
Second Quarters and Six Months Ended November 30, 2003 and 2002
(Unaudited)


			Quarters Ended						Six Months Ended

			November 30,			November 30,			November 30,			November 30,
			2003			2002			2003			2002

Net sales			$	14,899,000			16,453,000			29,585,000			32,509,000
Cost of sales				13,741,000			14,127,000			26,562,000			28,242,000

		Gross profit		1,158,000			2,326,000			3,023,000			4,267,000
Operating expenses				3,199,000			2,611,000			6,088,000			5,618,000

Income (loss) from operations				(2,041,000	)		(285,000	)		(3,065,000	)		(1,351,000	)

Other income (expense):
	Interest Income			22,000			38,000			40,000			64,000
	Interest Expense			(1,243,000	)		(1,002,000	)		(2,404,000	)		(1,974,000	)
	Other			384,000			60,000			536,000			72,000

		Total other income (expense)		(837,000	)		(904,000	)		(1,828,000	)		(1,838,000	)

Loss before income tax benefit (expense)				(2,878,000	)		(1,189,000	)		(4,893,000	)		(3,189,000	)
Income tax benefit (expense)				—			43,000			—			277,000

Net loss				(2,878,000	)		(1,146,000	)		(4,893,000	)		(2,912,000	)
Other comprehensive income (loss):
	Foreign currency translation			2,109,000			134,000			1,202,000			1,599,000

Comprehensive loss			$	(769,000	)		(1,012,000	)		(3,691,000	)		(1,313,000	)

Net loss per share
	Basic		$	(0.12	)		(2.55	)		(0.20	)		(6.47	)
	Diluted			(0.12	)		(2.55	)		(0.20	)		(6.47	)
Shares used in computation of net loss per share:
	Basic			24,806,193			450,114			24,792,627			450,114
	Diluted			24,806,193			450,114			24,792,627			450,114

See accompanying notes to unaudited condensed consolidated financial statements.

PACIFIC AEROSPACE & ELECTRONICS, INC. AND SUBSIDIARIES
Condensed Consolidated Statements of Cash Flows
Six Months Ended November 30, 2003 and 2002
(Unaudited)


			Six Months Ended

			November 30,			November 30,
			2003			2002

Cash flow from operating activities:
		Net cash used in operating activities	$	(518,000	)	$	(281,000	)

Cash flow from investing activities:
	Acquisition of property, plant and equipment			(457,000	)		(541,000	)
	Proceeds from sale of property, plant and equipment			172,000			100,000

		Net cash used in investing activities		(285,000	)		(441,000	)

Cash flow from financing activities:
	Net repayments under line of credit			(1,030,000	)		—
	Proceeds from long-term debt			4,012,000			—
	Payments on long term debt and capital leases			(307,000	)		(597,000	)

		Net cash used in financing activities		2,675,000			(597,000	)

Net increase (decrease) in cash				1,872,000			(1,319,000	)
Effect of exchange rates on cash				(30,000	)		258,000
Cash at beginning of period				1,948,000			5,619,000

Cash at end of period			$	3,790,000		$	4,558,000

Supplemental cash flow information:
	Cash paid during the six months for interest		$	1,098,000		$	1,075,000

See accompanying notes to unaudited condensed consolidated financial statements.

PACIFIC AEROSPACE & ELECTRONICS, INC. AND SUBSIDIARIES
MANAGEMENT’S STATEMENT AND
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Second Quarter and Six Months Ended November 30, 2003

Management’s Statement

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with Form 10-Q instructions and, in the opinion of management, contain all adjustments necessary to fairly present information therein. All significant intercompany transactions have been eliminated in consolidation. These results have been determined on the basis of accounting principles generally accepted in the United States of America applied consistently with those used in the preparation of the annual financial statements of Pacific Aerospace & Electronics, Inc. (the “Company”).

Certain information and footnote disclosures normally included in audited annual financial statements presented in accordance with generally accepted accounting principles have been condensed or omitted. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s annual report on Form 10-K for the year ended May 31, 2003.

The results of operations for the six months and quarter ended November 30, 2003 are not necessarily indicative of the results to be expected or anticipated for the full fiscal year.

(1) Net Loss Per Share

Basic loss per share is computed using the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed on the basis of the weighted average number of common shares outstanding, using the “if-converted” method for convertible preferred stock, and for outstanding stock options and warrants, using the “treasury stock” method. As the Company had a net loss for the periods ended November 30, 2003 and 2002, basic and diluted net loss per share are the same.

The total number of anti-dilutive common stock equivalents related to options, warrants and convertible preferred stock as of November 30, 2003 and 2002 were 21,651 and 24,774,265, respectively.

All share and per share information has been retroactively adjusted for the effect of the reverse stock split described in note 5 to these unaudited condensed consolidated financial statements.

(2) Inventories

Components of inventories are as follows:


	November 30, 2003		May 31, 2003

Raw materials	$	2,328,000	$	3,206,000
Work in progress		9,760,000		8,389,000
Finished goods		4,263,000		4,862,000


	November 30, 2003		May 31, 2003

Total	$	16,351,000	$	16,457,000

(3) Going Concern

The Company’s consolidated financial statements have been prepared assuming the Company will continue as a going concern.

During the six months ended November 30, 2003, cash used in operating activities was $518,000. The Company’s future success will depend heavily on its ability to generate cash from operating activities and to meet its obligations as they become due. The Company is focusing on initiatives that specifically address the need to increase cash provided by operating activities. Some of these initiatives include, but are not limited to possible staff reductions, reduced product line offerings, selling of excess inventory, and general and administrative cost controls. The Company has also downsized, closed, or sold certain of its divisions that produced negative cash flow from operations. If the Company is not sufficiently successful in increasing cash provided by operating activities, it may need to sell additional common stock or sell assets outside of the ordinary course of business in order to meet its obligations. There is no assurance that the Company will be able to achieve sufficient cash flows from operations, sell additional common stock, or sell its assets for amounts at or in excess of book value.

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 were no amounts borrowed under this facility at November 30, 2003.

During October 2003, we issued additional senior notes with a face value of $5.7 million due May, 2007. These senior notes were issued at a discount with net proceeds to us of approximately $4.0 million.

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 November 30, 2003) that are secured by a deed of trust on our headquarters building and improvements on another Company building. As of November 30, 2003, approximately $1.1 million of the principal amount of the loan secured by our headquarters building remained outstanding and $546,000 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 and a maximum debt to worth ratio, which we have not maintained. 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 are also not in compliance with a covenant of the Senior Notes in an aggregate principal amount of approximately $29.5 million, net of original issue discount, at November 30, 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 January 13, 2004, the Senior Noteholders agreed to forbear from declaring covenant default until we regain compliance (thereby curing such covenant violation) or December 1, 2004.

The Company’s ability to obtain additional cash if and when needed could have a material adverse effect on its financial position, results of operations and its ability to continue in existence. The

consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.

(4) Segment Information and Concentration of Risk

The Company operates in two segments, U.S. Operations and European Operations. 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 (U.S. Operations and European Operations) and not on any of the underlying divisions or business units that comprise these two segments. Presented below is the Company’s operational segment information. All operational segments identified as “U.S. Operations” and “Corporate” are located within the U.S. while the operations and assets of the “European Operations” segment are located within the United Kingdom. Identifiable assets are those assets used in the Company’s operations in each segment, and do not include advances or loans between the business segments. Corporate assets are identified below, and no allocations were necessary for assets used jointly by the segments.

Three months ended November 30, 2003


							Corporate,
	U.S.			European			other and
	Operations			Operations			eliminations			Total

Net sales to customers	$	4,446,000			10,453,000			—			14,899,000
Income (loss) from operations		(858,000	)		(56,000	)		(1,127,000	)		(2,041,000	)
Identifiable assets		15,804,000			32,974,000			8,314,000			57,092,000
Capital expenditures		12,000			116,000			—			128,000
Depreciation and amortization		332,000			542,000			77,000			951,000
Interest income		—			5,000			17,000			22,000
Interest expense		30,000			312,000			901,000			1,243,000

Three months ended November 30, 2002


						Corporate,
	U.S.		European			other and
	Operations		Operations			eliminations			Total

Net sales to customers	$	6,755,000		9,698,000			—			16,453,000
Income (loss) from operations		1,010,000		(222,000	)		(1,073,000	)		(285,000	)
Identifiable assets		23,322,000		32,169,000			6,941,000			62,432,000
Capital expenditures		18,000		207,000			68,000			293,000
Depreciation and amortization		400,000		490,000			113,000			1,003,000
Interest income		—		13,000			25,000			38,000
Interest expense		44,000		300,000			658,000			1,002,000

Six months ended November 30, 2003


							Corporate,
	U.S.			European			other and
	Operations			Operations			eliminations			Total

Net sales to customers	$	9,006,000			20,579,000			—			29,585,000
Income (loss) from operations		(461,000	)		(353,000	)		(2,251,000	)		(3,065,000	)
Identifiable assets		15,804,000			32,974,000			8,314,000			57,092,000
Capital expenditures		36,000			391,000			31,000			458,000
Depreciation and amortization		690,000			1,069,000			161,000			1,920,000
Interest income		—			5,000			35,000			40,000
Interest expense		65,000			612,000			1,727,000			2,404,000

Six months ended November 30, 2002


						Corporate,
	U.S.		European			other and
	Operations		Operations			eliminations			Total

Net sales to customers	$	13,509,000		19,000,000			—			32,509,000
Income (loss) from operations		1,995,000		(1,069,000	)		(2,277,000	)		(1,351,000	)
Identifiable assets		23,322,000		32,169,000			6,941,000			62,432,000
Capital expenditures		106,000		367,000			68,000			541,000
Depreciation and amortization		800,000		980,000			239,000			2,019,000
Interest income		—		20,000			44,000			64,000
Interest expense		101,000		600,000			1,273,000			1,974,000

5) 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 their preferred shares into 4,865,819,000 shares of common stock. On the same day, following approval by a majority of our shareholders, we completed a 1 for 200 reverse split of our outstanding shares of common stock, as well as a proportionate reduction in our shares of authorized but un-issued common stock. 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.

(6) Consolidating Condensed Financial Statements

The following financial statements present consolidating condensed financial information of the Company for the indicated periods. The Company’s senior subordinated notes have been guaranteed by all of the Company’s wholly owned U.S. subsidiaries. The guarantor subsidiaries have fully and unconditionally guaranteed this debt on a joint and several basis. This debt is not guaranteed by the Company’s foreign subsidiaries, which consist of Aeromet and two related holding companies. There are no significant contractual restrictions on the distribution of funds from the guarantor subsidiaries to the parent corporation. The consolidating condensed financial information is presented in lieu of separate financial statements and other disclosures of the guarantor subsidiaries, as management has determined that such information is not material to investors.

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Balance Sheet
November 30, 2003


						GUARANTOR			NON-GUARANTOR
			PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS			CONSOLIDATED

Assets
Current assets:
	Cash and cash equivalents		$	2,210,000		$	1,000		$	1,579,000		$	—		$	3,790,000
	Accounts receivable, net			—			2,144,000			9,183,000			—			11,327,000
	Inventories			—			5,746,000			10,605,000			—			16,351,000
	Other			4,796,000			83,000			1,580,000			(3,891,000	)		2,568,000

		Total current assets		7,006,000			7,974,000			22,947,000			(3,891,000	)		34,036,000
Property, plant and equipment, net				4,361,000			5,935,000			10,027,000			—			20,323,000
Other assets:
	Goodwill			—			351,000			—			—			351,000
	Investment in and loans to subsidiaries			34,372,000			72,618,000			—			(106,990,000	)		—
	Other			840,000			1,542,000			—			—			2,382,000

		Total other assets		35,212,000			74,511,000			—			(106,990,000	)		2,733,000

		Total assets	$	46,579,000		$	88,420,000		$	32,974,000		$	(110,881,000	)	$	57,092,000

Liabilities and Stockholders’ Equity (Deficit)
Current liabilities:
	Accounts payable		$	2,881,000		$	838,000		$	5,053,000		$	—		$	8,772,000
	Line of credit			—			—			—			—			—
	Current portion of long-term debt			66,000			140,000			—			—			206,000
	Other			810,000			739,000			5,482,000			(3,891,000	)		3,140,000

		Total current liabilities		3,757,000			1,717,000			10,535,000			(3,891,000	)		12,118,000
Long-term liabilities:
	Long-term debt, net of current portion			56,273,000			1,104,000			—			—			57,377,000
	Intercompany note and loan payable			—			73,383,000			36,957,000			(110,340,000	)		—
	Other			—			72,000			976,000			—			1,048,000

		Total long-term liabilities		56,273,000			74,559,000			37,933,000			(110,340,000	)		58,425,000
Stockholders’ equity (deficit):
	Common stock			25,000			56,139,000			33,709,000			(89,848,000	)		25,000
	Additional paid-in capital			105,844,000			—			—			—			105,844,000
	Accumulated other comprehensive loss			(4,304,000	)		—			(4,304,000	)		4,304,000			(4,304,000	)
	Accumulated deficit			(115,016,000	)		(43,995,000	)		(44,899,000	)		88,894,000			(115,016,000	)

		Total stockholders’ equity (deficit)		(13,451,000	)		12,144,000			(15,494,000	)		3,350,000			(13,451,000	)

		Total liabilities and stockholders’ equity (deficit)	$	46,579,000		$	88,420,000		$	32,974,000		$	(110,881,000	)	$	57,092,000

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Balance Sheet
May 31, 2003


							GUARANTOR			NON-GUARANTOR
				PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS			CONSOLIDATED

Assets
Current assets:
		Cash and cash equivalents		$	817,000		$	2,000		$	1,129,000		$	—		$	1,948,000
		Accounts receivable, net			—			3,063,000			10,429,000			—			13,492,000
		Inventories			—			6,916,000			9,541,000			—			16,457,000
		Other			3,374,000			30,000			456,000			(3,291,000	)		569,000

			Total current assets		4,191,000			10,011,000			21,555,000			(3,291,000	)		32,466,000
Property, plant and equipment, net					4,530,000			6,941,000			10,164,000			—			21,635,000
Other assets:
		Goodwill			—			351,000			—			—			351,000
		Investment in and loans to subsidiaries			36,620,000			72,618,000			—			(109,238,000	)		—
		Other			960,000			1,681,000			—			—			2,641,000

			Total other assets		37,580,000			74,650,000			—			(109,238,000	)		2,992,000

			Total assets	$	46,301,000		$	91,602,000		$	31,719,000		$	(112,529,000	)	$	57,093,000

	Liabilities and Stockholders’ Equity (Deficit)
Current liabilities:
		Accounts payable		$	2,594,000		$	691,000		$	5,893,000		$	—		$	9,178,000
		Line of credit			1,030,000			—			—			—			1,030,000
		Current portion of long-term debt			74,000			321,000			—			—			395,000
		Other			1,222,000			946,000			4,045,000			(3,291,000	)		2,922,000

			Total current liabilities		4,920,000			1,958,000			9,938,000			(3,291,000	)		13,525,000
Long-term liabilities:
		Long-term debt, net of current portion			51,140,000			1,102,000			—			—			52,242,000
		Intercompany note and loan payable			—			74,835,000			36,957,000			(111,792,000	)		—
		Other			—			155,000			930,000			—			1,085,000

			Total long-term liabilities		51,140,000			76,092,000			37,887,000			(111,792,000	)		53,327,000
Stockholders’ equity (deficit):
		Common stock			25,000			56,139,000			33,709,000			(89,848,000	)		25,000
		Additional paid-in capital			105,844,000			—			—			—			105,844,000
		Accumulated other comprehensive loss			(5,506,000	)		—			(5,506,000	)		5,506,000			(5,506,000	)
		Accumulated deficit			(110,122,000	)		(42,587,000	)		(44,309,000	)		86,896,000			(110,122,000	)

			Total stockholders’ equity (deficit)		(9,759,000	)		13,552,000			(16,106,000	)		2,554,000			(9,759,000	)

			Total liabilities and stockholders’ equity (deficit)	$	46,301,000		$	91,602,000		$	31,719,000		$	(112,529,000	)	$	57,093,000

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Statement of Operations and Comprehensive Income (Loss)
For the Quarter Ended November 30, 2003


					GUARANTOR			NON-GUARANTOR
		PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS			CONSOLIDATED

Net Sales		$	—		$	4,447,000		$	10,453,000		$	(1,000	)	$	14,899,000
Cost of Sales			—			4,008,000			9,734,000			(1,000	)		13,741,000

	Gross profit		—			439,000			719,000			—			1,158,000
Operating expenses			1,138,000			1,728,000			775,000			(442,000	)		3,199,000

	Income (loss) from operations		(1,138,000	)		(1,289,000	)		(56,000	)		442,000			(2,041,000	)
Other income (expense)
	Parent’s share of subsidiaries net loss		(1,311,000	)		—			—			1,311,000			—
	Interest expense		(1,201,000	)		(330,000	)		(312,000	)		600,000			(1,243,000	)
	Other		772,000			301,000			375,000			(1,042,000	)		406,000

	Total other income (expense)		(1,740,000	)		(29,000	)		63,000			869,000			(837,000	)

	Income (loss) before income taxes		(2,878,000	)		(1,318,000	)		7,000			1,311,000			(2,878,000	)
Income tax benefit (expense)			—			—			—			—			—

	Net income (loss)		(2,878,000	)		(1,318,000	)		7,000			1,311,000			(2,878,000	)
Other comprehensive income (loss)
	Foreign currency translation		2,109,000			—			2,109,000			(2,109,000	)		2,109,000

	Comprehensive income (loss)	$	(769,000	)	$	(1,318,000	)	$	2,116,000		$	(798,000	)	$	(769,000	)

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Statement of Operations and Comprehensive Income (Loss)
For the Quarter Ended November 30, 2002


						GUARANTOR			NON-GUARANTOR
			PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS			CONSOLIDATED

Net Sales			$	—		$	6,949,000		$	9,698,000		$	(194,000	)	$	16,453,000
Cost of Sales				—			5,291,000			9,030,000			(194,000	)		14,127,000

	Gross profit			—			1,658,000			668,000			—			2,326,000
Operating expenses				1,078,000			1,548,000			890,000			(905,000	)		2,611,000

	Income (loss) from operations			(1,078,000	)		110,000			(222,000	)		905,000			(285,000	)
Other income (expense):
	Parent’s share of subsidiaries net loss			(373,000	)		—			—			373,000			—
	Interest expense			(957,000	)		(345,000	)		(300,000	)		600,000			(1,002,000	)
	Other			1,262,000			328,000			13,000			(1,505,000	)		98,000

		Total other income (expense)		(68,000	)		(17,000	)		(287,000	)		(532,000	)		(904,000	)

	Income (loss) before income taxes			(1,146,000	)		93,000			(509,000	)		373,000			(1,189,000	)
Income tax benefit (expense)				—			—			43,000			—			43,000

	Net income (loss)			(1,146,000	)		93,000			(466,000	)		373,000			(1,146,000	)
Other comprehensive income (loss)
	Foreign currency translation			134,000			—			134,000			(134,000	)		134,000

	Comprehensive income (loss)		$	(1,012,000	)	$	93,000		$	(332,000	)	$	239,000		$	(1,012,000	)

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Statement of Operations and Comprehensive Income (Loss)
For the Six Months Ended November 30, 2003


					GUARANTOR			NON-GUARANTOR
		PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS			CONSOLIDATED

Net Sales		$	—		$	9,013,000		$	20,579,000		$	(7,000	)	$	29,585,000
Cost of Sales			—			7,195,000			19,374,000			(7,000	)		26,562,000

	Gross profit		—			1,818,000			1,205,000			—			3,023,000
Operating expenses			2,251,000			3,162,000			1,558,000			(883,000	)		6,088,000

	Income (loss) from operations		(2,251,000	)		(1,344,000	)		(353,000	)		883,000			(3,065,000	)
Other income (expense)
	Parent’s share of subsidiaries net loss		(1,998,000	)		—			—			1,998,000			—
	Interest expense		(2,327,000	)		(665,000	)		(612,000	)		1,200,000			(2,404,000	)
	Other		1,683,000			601,000			375,000			(2,083,000	)		576,000

	Total other income (expense)		(2,642,000	)		(64,000	)		(237,000	)		1,115,000			(1,828,000	)

	Income (loss) before income taxes		(4,893,000	)		(1,408,000	)		(590,000	)		1,998,000			(4,893,000	)
Income tax benefit (expense)			—			—			—			—			—

	Net income (loss)		(4,893,000	)		(1,408,000	)		(590,000	)		1,998,000			(4,893,000	)
Other comprehensive income (loss)
	Foreign currency translation		1,202,000			—			1,202,000			(1,202,000	)		1,202,000

	Comprehensive income (loss)	$	(3,691,000	)	$	(1,408,000	)	$	612,000		$	796,000		$	(3,691,000	)

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Statement of Operations and Comprehensive Income (Loss)
For the Six Months Ended November 30, 2002


						GUARANTOR			NON-GUARANTOR
			PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS			CONSOLIDATED

Net Sales			$	—		$	13,807,000		$	19,000,000		$	(298,000	)	$	32,509,000
Cost of Sales				—			10,449,000			18,091,000			(298,000	)		28,242,000

	Gross profit			—			3,358,000			909,000			—			4,267,000
Operating expenses				2,277,000			3,174,000			1,978,000			(1,811,000	)		5,618,000

	Income (loss) from operations			(2,277,000	)		184,000			(1,069,000	)		1,811,000			(1,351,000	)
Other income (expense):
	Parent’s share of subsidiaries net loss			(1,263,000	)		—			—			1,263,000			—
	Interest expense			(1,873,000	)		(701,000	)		(600,000	)		1,200,000			(1,974,000	)
	Other			2,501,000			626,000			20,000			(3,011,000	)		136,000

		Total other income (expense)		(635,000	)		(75,000	)		(580,000	)		(548,000	)		(1,838,000	)

	Income (loss) before income taxes			(2,912,000	)		109,000			(1,649,000	)		1,263,000			(3,189,000	)
Income tax benefit (expense)				—			—			277,000			—			277,000

	Net income (loss)			(2,912,000	)		109,000			(1,372,000	)		1,263,000			(2,912,000	)
Other comprehensive income (loss)
	Foreign currency translation			1,599,000			—			1,599,000			(1,599,000	)		1,599,000

	Comprehensive income (loss)		$	(1,313,000	)	$	109,000		$	227,000		$	(336,000	)	$	(1,313,000	)

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Statement of Cash Flows
For the Six Months Ended November 30, 2003


						GUARANTOR			NON-GUARANTOR
			PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS		CONSOLIDATED

Cash flow from operating activities:
		Net cash provided by (used in) operating activities	$	(3,318,000	)	$	1,929,000		$	871,000		$	—	$	(518,000	)
Cash flow from investing activities:
	Acquisition of property, plant and equipment			(31,000	)		(35,000	)		(391,000	)		—		(457,000	)
	Proceeds from sale of property, plant and equipment			35,000			137,000			—			—		172,000
	Investment in and loans to subsidiaries			1,774,000			(1,774,000	)		—			—		—

		Net cash provided by (used in) investing activities		1,778,000			(1,672,000	)		(391,000	)		—		(285,000	)
Cash flow from financing activities:
	Net repayment under line of credit			(1,030,000	)		—			—			—		(1,030,000	)
	Proceeds from long-term debt			4,012,000			—			—			—		4,012,000
	Payments on long-term debt and capital leases			(49,000	)		(258,000	)		—			—		(307,000	)

		Net cash provided by (used in) financing activities		2,933,000			(258,000	)		—			—		2,675,000
	Net change in cash and cash equivalents			1,393,000			(1,000	)		480,000			—		1,872,000
Effect of exchange rates on cash				—			—			(30,000	)		—		(30,000	)
Cash at beginning of period				817,000			2,000			1,129,000			—		1,948,000

Cash at end of period			$	2,210,000		$	1,000		$	1,579,000		$	—	$	3,790,000

Pacific Aerospace & Electronics, Inc.
Consolidating Condensed Statement of Cash Flows
For the Six Months Ended November 30, 2002


						GUARANTOR			NON-GUARANTOR
			PARENT			SUBSIDIARIES			SUBSIDIARIES			ELIMINATIONS		CONSOLIDATED

Cash flow from operating activities:
		Net cash provided by (used in) operating activities	$	120,000		$	410,000		$	(811,000	)	$	—	$	(281,000	)
Cash flow from investing activities:
	Acquisition of property, plant and equipment			(68,000	)		(106,000	)		(367,000	)		—		(541,000	)
	Proceeds from sale of property, plant and equipment			25,000			75,000			—			—		100,000
	Investment in and loans to subsidiaries			(172,000	)		172,000			—			—		—

		Net cash provided by (used in) investing activities		(215,000	)		141,000			(367,000	)		—		(441,000	)
Cash flow from financing activities:
	Payments on long-term debt and capital leases			(46,000	)		(551,000	)		—			—		(597,000	)
	Other changes, net			—			—			—			—		—

		Net cash provided by (used in) financing activities		(46,000	)		(551,000	)		—			—		(597,000	)
	Net change in cash and cash equivalents			(141,000	)		—			(1,178,000	)		—		(1,319,000	)
Effect of exchange rates on cash				—			—			258,000			—		258,000
Cash at beginning of period				803,000			3,000			4,813,000			—		5,619,000

Cash at end of period			$	662,000		$	3,000		$	3,893,000		$	—	$	4,558,000

Inventories consist of the following:


		November 30,		May 31,
		2003		2003

Guarantor subsidiaries
	Raw materials	$	871,000	$	1,686,000
	Work in progress		1,896,000		1,760,000
	Finished goods		2,979,000		3,470,000

		$	5,746,000	$	6,916,000

Non-guarantor subsidiaries
	Raw materials	$	1,457,000	$	1,520,000
	Work in progress		7,864,000		6,629,000
	Finished goods		1,284,000		1,392,000

		$	10,605,000	$	9,541,000

ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Preliminary Note Regarding Forward-Looking Statements

This report contains “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and is subject to the safe harbor created by those sections. Actual results could differ materially from those projected in the forward-looking statements set forth in this report. The factors that may cause results to differ materially from those projected include the overall economic decline in the aerospace industry due to both the recent economic downturn and the September 11 attacks, and the Company’s dependence on the success of its European Operations. Additional factors may also cause results to differ materially from those projected. A comprehensive list of additional factors has been included in our most recent Form 10-K filed via Edgar with the Securities and Exchange Commission on August 22, 2003, under the heading entitled “Risk Factors.” We urge you to read such information and the Company’s other recent filings with the Commission in detail. Information contained in this quarterly report was prepared by management based on the best information available to it as of the date of filing of this report, and management does not plan to update forward-looking statements to reflect new events or changing circumstances occurring after this report was filed.

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 defense, electronics, telecommunications, energy and medical industries include components such as hermetically sealed electrical and fiber optic connectors, instrument packages and ceramic capacitors, filters and feed-throughs. Products that we produce primarily for the aerospace, transportation, and medical industries include machined, cast, and formed metal parts and subassemblies, using aluminum, titanium, magnesium, and other metals. Our customers include global leaders in all of these industries. We are organized into two operational groups: U.S. Operations and European Operations.

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 when products are shipped to customers, title has transferred 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 and 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.

As part of the process of preparing our financial statements, we are required to estimate our income taxes in each of the jurisdictions in which we operate. This process involves estimating our actual current tax exposure together with assessing temporary differences resulting from differing treatment of items for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included in our balance sheet. We must then assess the likelihood that our deferred tax assets will be recovered from future taxable income and to the extent we believe that recovery is not likely, we must establish a valuation allowance. To the extent we establish a valuation allowance or increase this allowance in a period, we must include an expense within the tax provision in the Statement of Operations. Conversely, if the allowance is decreased the tax provision will be credited. Significant management judgment is required in determining our provision for income taxes, deferred tax assets and liabilities and any valuation allowance recorded against our net deferred tax assets.

The Company operates in two segments, U.S. 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 (U.S. Operations and European Operations) and not on any of the underlying divisions or business units that comprise these two segments.

Results of Operations

Quarter Ended November 30, 2003 Compared to Quarter Ended November 30, 2002

Net Sales. Net sales decreased by $1.6 million, or 9.6%, to $14.9 million for the quarter ended November 30, 2003, from $16.5 million for the quarter ended November 30, 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. The European Operations contributed $10.5 million of net sales during the quarter ended November 30, 2003, up $0.8 million from the $9.7 million contributed during the quarter ended November 30, 2002. This increase was due to a small increase in tooling orders related to new Airbus aircraft models and due to higher average U.S. dollar to British pound exchange rates.

The U.S. Operations contributed $4.4 million to net sales during the quarter ended November 30, 2003, down $2.4 million from $6.8 million contributed during the quarter ended November 30, 2002. This decrease was primarily due to the sale of our U.S. Operations’ Boeing Statement of Work to an independent third party in January, 2003.

Receivable collection periods, as calculated by dividing ending accounts receivable balances by annualized sales for the quarter multiplied by 360 days, increased to 68.4 days for the quarter ended November 30, 2003, from 58.0 days for the quarter ended November 30, 2002. This increase was primarily due to a slow-down in payments received from our customers due to the overall slow-down of the economy.

Gross Profit. Gross profit decreased by $1.2 million, or 52.1%, to $1.2 million for the quarter ended November 30, 2003, from $2.3 million for the quarter ended November 30, 2002. As a percentage of net sales, gross profit decreased to 7.7% for the quarter ended November 30, 2003, from 14.1% for the quarter ended November 30, 2002. This decrease was primarily due to a $1.0 million write-down of inventory used in our U.S. Operations that was deemed to be obsolete based upon our current backlog and general economic conditions. Without that write-down our gross profit would have been $2.2 million for the quarter or 14.4% of sales.

Inventory turnover, as calculated by dividing annualized sales for the quarter by ending inventory, increased to 3.6 turns for the quarter ended November 30, 2003 from 3.3 turns for the quarter ended November 30, 2002. The increase was due to lower ending inventory levels in the U.S. Operations due to the $1.0 million inventory write-down recorded during the quarter ended November 30, 2003.

Operating Expenses. Operating expenses increased by $0.6 million, to $3.2 million for the quarter ended November 30, 2003, from $2.6 million for the quarter ended November 30, 2002. Included in operating expenses for the quarter ended November 30, 2003 was $0.3 million due to the abandonment of certain leasehold improvements formerly used in the U.S. Operations. The remaining increase in operating expenses was due to professional fees related to our planned going private transaction and increased insurance expense primarily related to directors & officers insurance coverage.

Interest Expense. Interest expense increased by $0.2 million, or 20.0%, to $1.2 million for the quarter ended November 30, 2003, from $1.0 million for the quarter ended November 30, 2002. This increase was primarily due to additional senior secured notes issued during the period and increased original issue discount amortization on our $41.7 million face value senior secured notes.

Other Income (Expense). Other income represents non-operational income and expense for the quarter ended November 30, 2003, primarily interest income and the change in value of our interest rate swap and foreign currency derivative instruments.

Provision for Income Tax Benefit (Expense). Income tax benefit for the quarter ended November 30, 2002 was derived from taxable losses in our foreign subsidiaries. No provision or benefit was recorded for U.S. or U.K. income tax during the quarter ended November 30, 2003.

Net Income (Loss). Net loss increased by $1.7 million to a net loss of $2.9 million for the quarter ended November 30, 2003, from a net loss of $1.2 million for the quarter ended November 30, 2002, due to the factors listed above.

Six Months Ended November 30, 2003 Compared to Six Months Ended November 30, 2002

Net Sales. Net sales decreased by $2.9 million, or 8.9%, to $29.6 million for the six months ended November 30, 2003, from $32.5 million for the six months ended November 30, 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. The European Operations contributed $20.6 million of net sales during the six months ended November 30, 2003, up $1.6 million from the $19.0 million contributed during the six months ended November 30, 2002. This increase was due to a small increase in tooling orders related to new Airbus aircraft models and due to higher average U.S. dollar to British pound exchange rates.

The U.S. Operations contributed $9.0 million to net sales during the six months ended November 30, 2003, down $4.5 million from $13.5 million contributed during the six months ended November 30, 2002. This decrease was primarily due to the sale of our U.S. Operations’ Boeing Statement of Work to an independent third party in January, 2003.

Receivable collection periods, as calculated by dividing ending accounts receivable balances by annualized sales for the six months multiplied by 360 days, increased to 68.9 days for the six months ended November 30, 2003, from 58.5 days for the six months ended November 30, 2002. This increase was primarily due to a slow-down in payments received from our customers due to the overall slow-down of the economy.

Gross Profit. Gross profit decreased by $1.3 million, or 30.2%, to $3.0 million for the six months ended November 30, 2003, from $4.3 million for the six months ended November 30, 2002. As a percentage of net sales, gross profit decreased to 10.2% for the six months ended November 30, 2003, from 13.1% for the six months ended November 30, 2002. This decrease was primarily due to a $1.0 million write-down of inventory used in our U.S. Operations that was deemed to be obsolete based upon our current backlog and general economic conditions. Without that write-down our gross profit would have been $4.0 million for the six months ended November 30, 2003, or 13.5% of sales.

Inventory turnover, as calculated by dividing annualized sales for the six months by ending inventory, increased to 3.6 turns for the six months ended November 30, 2003 from 3.3 turns for the six months ended November 30, 2002. The increase was due to lower ending inventory levels in the U.S. Operations due to the $1.0 million inventory write-down recorded during the quarter ended November 30, 2003.

Operating Expenses. Operating expenses increased by $0.5 million, to $6.1 million for the six months ended November 30, 2003, from $5.6 million for the six months ended November 30, 2002. Included in operating expenses for the six months ended November 30, 2003 was $0.3 million due to the abandonment of certain leasehold improvements formerly used in the U.S. Operations. The remaining increase in operating expenses was due to professional fees related to our planned going private transaction and increased insurance expense primarily related to directors & officers insurance coverage. The increase in operating expenses were offset slightly by our cost containment initiatives. In an effort to control operating expenses, as well as increase our gross profit, we have significantly reduced our corporate overhead including reduction in corporate executive salaries, eliminating several executive positions, and other headcount reductions. We have also reduced headcount at our operating facilities in the U.S. and in the U.K. We are in process of consolidating our manufacturing sites and have sold or are

in process of selling excess machinery. We are also outsourcing certain operating functions along with implementing production processes we believe will be more efficient.

Interest Expense. Interest expense increased by $0.4 million, or 20.0%, to $2.4 million for the six months ended November 30, 2003, from $2.0 million for the six months ended November 30, 2002. This increase was primarily due to additional senior secured notes issued during the period and increased original issue discount amortization on our $41.7 million face value senior secured notes.

Other Income (Expense). Other income represents non-operational income and expense for the six months ended November 30, 2002, primarily interest income and the change in value of our interest rate swap and foreign currency derivative instruments.

Provision for Income Tax Benefit (Expense). Income tax benefit for the six months ended November 30, 2002 was derived from taxable losses in our foreign subsidiaries, no provision or benefit was recorded for U.S. or U.K. income tax during the six months ended November 30, 2003.

Net Income (Loss). Net loss increased by $2.0 million to a net loss of $4.9 million for the six months ended November 30, 2002, from a net loss of $2.9 million for the six months ended November 30, 2002, due to the factors listed above.

Liquidity and Capital Resources

Cash used by operating activities was $0.5 million during the six months ended November, 2003 compared to cash used by operating activities of $0.3 million during the six months ended November 30, 2002. The change in cash used by operating activities was due primarily to our net loss for the six months ended November 30, 2003. Our future success as a company will depend heavily on our ability to generate cash from operating activities. We are focusing on cost reduction initiatives that specifically address the need to increase cash provided by operating activities. Some of these initiatives include staff reductions, reduced product line offerings, selling of excess inventory, and general and administrative cost controls.

Cash used in investing activities decreased from $0.4 million during the six months ended November 30, 2002 to $0.3 million during the six months ended November 30, 2003. This decrease was due to lower amounts of investment in manufacturing equipment and manufacturing facility improvements. We currently do not have any material commitments for capital equipment purchases.

Cash provided by financing activities increased to $2.7 million during the six months ended November 30, 2003 from cash used in financing activities of $0.6 million during the six months ended November 30, 2002. During October 2003, we issued additional senior notes with a face value of $5.7 million due May, 2007. These senior notes were issued at a discount with net proceeds to us of approximately $4.0 million. This cash provided by financing activities was offset by cash used primarily for line of credit and other debt payments during the six months ended November 30, 2003.

We are also not in compliance with a covenant of the senior notes in an aggregate principal amount of approximately $29.5 million, net of original issue discount, at November 30, 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 January 13, 2004, the senior note holders agreed to forbear from declaring covenant default until we regain compliance (thereby curing such covenant violation) or December 1, 2004.

We translate the activity of our European Operations, whose functional currency is the British Pound Sterling, 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 weighted average exchange rate for the period. As a result, 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.

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 had 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, may pose difficulties in closing a securities offering on acceptable terms, or at all. Moreover, 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 value of those assets upon liquidation. If we are unable to generate the necessary cash, we could be unable to continue operations.

There was no significant change in our contractual commitments since May 31, 2003 other than during October 2003, we issued additional senior notes with a face value of $5.7 million due May, 2007. These senior notes were issued at a discount with net proceeds to us of approximately $4.0 million..

Significant Events during the Quarter

On December 19, 2003, we filed with the Securities and Exchange Commission amendments to Schedule13E-3 and a related preliminary proxy statement as part of our plan to become a privately held company. As disclosed in those filings, we currently intend to carry out a 1-for-11,000 reverse stock split to allow us to “go private.” We also intend to pay to our shareholders the fair market value for fractional shares resulting from the reverse split in accordance with Washington State law. Our current intent is to reduce our shareholder base to well below 300, thereby allowing us to terminate our registration under the Securities Exchange Act of 1934 and relieve us of the costs of being a public

company, including the costs of filing annual and quarterly reports with the Securities and Exchange Commission, but our board of directors may elect to abandon or alter the terms of the reverse stock split and the going private transaction at any time prior to consummation. If the Company does go private, there will no longer be any public trading market for our securities. We are currently awaiting comments from the Securities and Exchange Commission on the amendments to our Schedule 13E-3 and preliminary proxy on file.

In October 2003, we issued additional senior notes with a face value of $5.7 million (the “New Senior Notes”). The New Senior Notes were issued at a discount so the proceeds from the sale of the New Senior Notes totaled approximately $4.0 million. The principal amount of the New Senior Notes will accrete through May 1, 2007 to $5.7 million and will bear interest at 5% per annum. The total face value of all senior notes outstanding is now $41.7 million. The Company 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. The proceeds from the New Senior Notes were used to pay down our outstanding line of credit balance, for working capital 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 $41.7 million principal amount due on May 1, 2007.

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 through charges to operating expense. If the obligation is settled for other than the carrying amount of the liability, the Company will recognize a gain or loss on settlement. The Company has adopted the provisions of SFAS No. 143 during the first quarter of fiscal year 2004. The adoption of this statement did not have a material impact on the Company’s consolidated financial position or results of operations.

In November 2002, the Emerging Issues Task Force (EITF) reached a consensus on EITF 00-21, Revenue Arrangements with Multiple Deliverables, with respect to determining when and how to allocate revenue from sales with multiple deliverables. The EITF 00-21 consensus provides a framework for determining when and how to allocate revenue from sales with multiple deliverables based on a determination of whether the multiple deliverables qualify to be accounted for as separate units of accounting. The consensus is effective prospectively for arrangements entered into in fiscal periods beginning after June 15, 2003. The adoption of this consensus did not have a material impact on the Company’s consolidated results of operations or financial position.

In January 2003, the FASB issued FIN No. 46, Consolidation of Variable Interest Entities, which requires the consolidation of and disclosures about variable interest entities (VIEs). VIEs are entities for which control is achieved through means other than voting rights. In December 2003, the FASB revised FIN No. 46 to incorporate all decisions, including those in previously issued FASB Staff Positions, into one Interpretation. The revised Interpretation supercedes the original Interpretation. Generally, the requirements were effective immediately for all VIEs in which an interest was acquired

after January 31, 2003. FIN No. 46 has not had, and is not expected to have, a significant impact on our consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We have financial instruments that are subject to interest rate risk, primarily debt obligations issued at a fixed rate. Our fixed-rate debt obligations are generally not callable until maturity and therefore market fluctuations in interest rates will not affect our earnings for the period. Based upon this fact, we do not consider the market risk exposure for interest rates to be material. It is not practicable to estimate the fair value of our long-term debt due to our history of losses and debt defaults, among other factors. In addition, we have an interest rate swap with a notional value of $1,596,000 and which has a recorded fair value liability of $208,000 at November 30, 2003. The interest rate swap does not qualify for hedge accounting. We do not believe a 10% change in interest rates would have a material effect on the fair value of this instrument.

We are subject to foreign currency exchange rate risk relating to receipts from and payments to suppliers in currencies other than the functional currencies in which our business segments operate (the U.S. Dollar and the British Pound Sterling). Although we have significant foreign operations, transactions in currencies other than our functional currencies have historically not been significant, however they have been increasing. We also do not have significant transactions between our U.S. and European Operations. Historically, we have not experienced material foreign currency transaction gains and losses and do not anticipate any material foreign currency transaction gains or losses in the future. However, due to the increasing amounts of transactions in currencies other than our functional currency, in August 2003, we entered into a foreign currency derivative instrument that gives us the option but not the obligation to sell U.S. Dollars and buy British Pound Sterling at a specified strike price on various delivery dates from September 2003 through May 2004. The option to sell U.S. Dollars and buy British Pound Sterling at the specified strike price becomes an obligation if the spot exchange rate drops below a certain barrier rate during any of the window periods. The derivative does not qualify for hedge accounting treatment. The derivative had a notional value of $5,406,000 and a recorded fair market value of $370,000 at November 30, 2003.

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 between the British Pound Sterling and the U.S. Dollar. For example, British Pound Sterling was worth $1.6393 on May 31, 2003 but one British Pound Sterling was worth $1.7219 on November 30, 2003. As a result, we incurred a positive foreign currency translation adjustment of $1,202,000 during the six months ended November 30, 2003.

We are exposed to commodity price fluctuations through purchases of aluminum, titanium, and other raw materials. We 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 November 30, 2003, we had purchase commitments for raw materials aggregating approximately $1.0 million. This amount relates to a titanium supply agreement with a fixed price.

ITEM 4. CONTROLS AND PROCEDURES.

Our executive officers, including our Chief Executive Officer and Chief Financial Officer, are responsible for establishing and maintaining disclosure controls and procedures for Pacific Aerospace & Electronics, Inc and its subsidiaries. Those executives have designed such controls to ensure that all material information relating to Pacific Aerospace & Electronics, Inc. and its subsidiaries is made known to them by others within the organization.

As of November 30, 2003, our executive officers completed an evaluation of our disclosure controls and procedures and have determined them to be functioning properly and effectively. They did not discover any significant deficiencies or material weaknesses within the controls and procedures that required modification.

There were no changes in our internal control over financial reporting identified in connection with our evaluation that occurred during our second fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II
OTHER INFORMATION

ITEM 1. 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.

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. We moved for and, on June 20, 2003, the court granted a preliminary injunction, restraining certain of defendants’ business activities pending a full trial on the merits. We moved for summary judgment on the breach of contract claims against two of the former employees. We also sought contempt sanctions for violation of the injunction. The court granted the summary judgment motion in our favor and imposed contempt sanctions for the defendants’ violation of the preliminary injunction. The parties then settled the dispute. As part the settlement, they agreed on, and the court entered, a Consent Decree that, inter alia, restricts certain of defendants’ activities in the future and provides for an award of attorneys fees and other relief in the event of any future violations by defendants.

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. This lawsuit was dismissed on August 12, 2003.

Other than as described above, the Company is not aware of any suits or proceedings that, if decided adversely to the Company, would have a material adverse effect upon the Company or its assets.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

(a) None.

(b) Not applicable.

(c) On October 31, 2003, the Company raised $3,998,181 through the sale of senior notes to GSCP Recovery, Inc. and GSC Recovery II, L.P. The transaction involved a sale of debt securities to accredited investors and was exempt from registration under the Securities Act owing to the exemptions afforded by Sections 4(2), 4(6) and 3(b) of that Act and Rules 505 and 506 of Regulation D thereunder.

(d) Not applicable.

ITEM 3. DEFAULTS UPON SENIOR SECURITIES

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

None.

ITEM 5. OTHER INFORMATION

None.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

a. Exhibits.

The following documents are filed as exhibits to this Quarterly Report:


Exhibit
Number		Description
3.1		Articles of Incorporation of Pacific Aerospace & Electronics, Inc. (1)

3.2		Amendment to Articles of Incorporation containing Designation of Rights and Preferences of Series A Convertible Preferred Stock, as corrected. (2)

3.3		Amendment to Articles of Incorporation containing Designation of Rights and Preferences of Series B Convertible Preferred Stock. (3)

3.4		Articles of Amendment of Pacific Aerospace & Electronics, Inc. filed March 19, 2002. (4)

3.5		Designation of Rights and Preferences for Series C Voting Convertible Preferred Stock of Pacific Aerospace and Electronics, Inc. (4)

3.6		Bylaws of Pacific Aerospace & Electronics, Inc., as amended. (5)

10.29		Amendment No. 1 to Note Purchase Agreement dated October 31, 2003. (6)


Exhibit
Number		Description
31.1		Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a). (6)

31.2		Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a). (6)

32.1		Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. (6)

32.2		Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. (6)

⁽¹⁾		Incorporated by reference to the Company’s Current Report on Form 8-K filed on December 12, 1996, reporting the reincorporation merger.

⁽²⁾		Incorporated by reference to the Company’s Current Report on Form 8-K filed on March 12, 1997, reporting the Series A Preferred Stock offering.

⁽³⁾		Incorporated by reference to the Company’s Annual Report on Form 10-K for the fiscal year ending May 31, 1998.

⁽⁴⁾		Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 3, 2002.

⁽⁵⁾		Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarterly period ending August 31, 2000.

⁽⁶⁾		Filed herewith.

b. Reports on Form 8-K.

None.

SIGNATURES

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


		PACIFIC AEROSPACE & ELECTRONICS, INC.

Date: January 14, 2004		/s/ Donald A. Wright

		Donald A. Wright President and Chief Executive Officer (Principal Executive Officer)

Date: January 14, 2004		/s/ Charles A. Miracle

		Charles A. Miracle Chief Financial Officer and Treasurer (Principal Financial and Accounting Officer)

EXHIBIT INDEX

The following documents are filed as exhibits to this Quarterly Report:


Exhibit
Number		Description
3.1		Articles of Incorporation of Pacific Aerospace & Electronics, Inc. (1)

3.2		Amendment to Articles of Incorporation containing Designation of Rights and Preferences of Series A Convertible Preferred Stock, as corrected. (2)

3.3		Amendment to Articles of Incorporation containing Designation of Rights and Preferences of Series B Convertible Preferred Stock. (3)

3.4		Articles of Amendment of Pacific Aerospace & Electronics, Inc. filed March 19, 2002. (4)

3.5		Designation of Rights and Preferences for Series C Voting Convertible Preferred Stock of Pacific Aerospace and Electronics, Inc. (4)

3.6		Bylaws of Pacific Aerospace & Electronics, Inc., as amended. (5)

10.29		Amendment No. 1 to Note Purchase Agreement dated October 31, 2003. (6)

31.1		Certification of Chief Executive Officer required by Rule 13a-14(a) or Rule 15d-14(a). (6)

31.2		Certification of Chief Financial Officer required by Rule 13a-14(a) or Rule 15d-14(a). (6)

32.1		Certification of Chief Executive Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. (6)

32.2		Certification of Chief Financial Officer required by Rule 13a-14(b) or Rule 15d-14(b) and Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. Section 1350. (6)

⁽¹⁾		Incorporated by reference to the Company’s Current Report on Form 8-K filed on December 12, 1996, reporting the reincorporation merger.

⁽²⁾		Incorporated by reference to the Company’s Current Report on Form 8-K filed on March 12, 1997, reporting the Series A Preferred Stock offering.

⁽³⁾		Incorporated by reference to the Company’s Annual Report on Form 10-K for the fiscal year ending May 31, 1998.

⁽⁴⁾		Incorporated by reference to the Company’s Current Report on Form 8-K filed on April 3, 2002.

⁽⁵⁾		Incorporated by reference to the Company’s Quarterly Report on Form 10-Q for the quarterly period ending August 31, 2000.

⁽⁶⁾		Filed herewith.

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(a)		None.

(b)		Not applicable.

(c)		On October 31, 2003, the Company raised $3,998,181 through the sale of senior notes to GSCP Recovery, Inc. and GSC Recovery II, L.P. The transaction involved a sale of debt securities to accredited investors and was exempt from registration under the Securities Act owing to the exemptions afforded by Sections 4(2), 4(6) and 3(b) of that Act and Rules 505 and 506 of Regulation D thereunder.

(d)		Not applicable.