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SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

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.
(Exact Name of Registrant as Specified in Its Charter)

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

Securities registered pursuant to Section 12(b) of the Act:

Securities registered pursuant to Section 12(g) of the Act:
common stock, $.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 stock held by non-affiliates of the registrant, based on the closing price for the registrant’s common stock on the NASD Over-the-Counter Bulletin Board as of August 29, 2002, was approximately $1,262,000.

The number of shares outstanding of the Registrant’s common stock, $.001 par value per share, as of August 29, 2002 was 90,734,410 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.

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 before extraordinary items of $15,793,000 for our fiscal year ended May 31, 2002. This followed net losses before extraordinary items of $75,720,000 for our fiscal year ended May 31, 2001 and $13,752,000 for our fiscal year ended May 31, 2000.

Over the last year, we have consolidated our U.S. Operations and European Operations through the sale and/or closure of several of our unprofitable divisions. Within our former U.S. Aerospace Group we closed an unprofitable foundry located in Tacoma, Washington and in June 2001, we completed the sale of substantially all of the assets of our Casting operation located in Entiat, Washington. Also, within our former U.S. Aerospace Group we completed the sale of substantially all of the assets related to our Engineering and Fabrication Division. The fabrication assets were sold during May 2001 and the engineering assets were sold in December 2001. We have also shut down our former U.S. Electronics Group’s Display Division in November 2001. We believe that these closures or sales of business units will strengthen and support our core electronics and machining operations.

Additionally, 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 11¼% 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 will automatically convert (the “Automatic Conversion”) into common stock following shareholder approval of an increase in the number of our authorized shares of common stock. We have filed a preliminary proxy with the Securities and Exchange Commission (the “Commission”) regarding the vote to increase our authorized common stock, among other matters, and expect to hold a meeting for the approval of such increase as soon as possible following receipt of clearance from the Commission to do so. However, as a result of the Exchange, the Noteholders now hold a majority of our outstanding common stock and we expect at least a majority of the Noteholders to approve the Automatic Conversion. Accordingly, we anticipate that the amendment will be approved and that all of the Series C Preferred Stock will be converted to common stock. By virtue of their common stock and Series C Preferred Stock received in 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 “New Senior Loan”) represented by new senior secured notes (the “New Senior Notes”). The New Senior Notes were issued at a discount so that the proceeds of that loan totaled approximately $22.0 million. The New Senior Notes

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will accrete through May 1, 2007 to $36.0 million and will bear interest at 5% per annum. We used $16.2 million of the proceeds from the New Senior Notes to pay off principal and accrued interest on our then outstanding 21% senior secured loan (of which $13.7 million was still outstanding at May 31, 2001). The remaining proceeds were used for working capital, to pay the fees and costs of the restructuring and for other general corporate purposes. A more detailed description of our restructuring, the Exchange and the New Senior Loan has been included in “Significant Events” portion of the Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations.

References in this Form 10-K to the Company include Pacific Aerospace & Electronics, Inc., and its subsidiaries. Our headquarters are 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, 2002. The description of the Company’s business in this report focuses on the operations as they were organized as of May 31, 2002. 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.

Operating Segment Realignment

In connection with our restructuring, we have consolidated our operations into two operating segments, U.S. Operations and European Operations. Each of these new operating segments is further divided into two business units: Electronic Components and Machining Components within U.S. Operations; and Metal Casting and Metal Forming within European Operations. The following chart details the new classification of each of our previously reported operating segments.

The following chart identifies, as of May 31, 2002, our operating segments, the business units that comprise those segments, and the locations of our operations:

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Business Strengths

Significant Customer Base

We have a strong, diverse international customer base, which includes many of the world’s leading companies in their industries. Our customers over the past year have included companies such as: 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, Northern Telecom Ltd. (“Northern Telecom”), 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 26 U.S. patents and 6 pending patent applications in non-U.S. jurisdictions, and 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 assembly tooling to Boeing for each of Boeing’s 737, 747, 757, 767 and 777 commercial aircraft construction programs and to members of the Airbus consortium for Airbus’ A300/310, A318-A321 and A330/340 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 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 be beneficial in allowing us to 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 manufacturer that generates profitable growth by integrating manufacturing processes, introducing new products and technologies, and developing new customers in

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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.

Integrate and Consolidate Operations

We have closed or sold several of our divisions that were unprofitable and have consolidated our remaining U.S. operations into one operating segment with two business units primarily located in Wenatchee, Washington. Within our former U.S. Aerospace Group we closed an unprofitable foundry located in Tacoma, Washington and in June 2001, we completed the sale of substantially all of the assets of our Casting operation located in Entiat, Washington. Also, within our former U.S. Aerospace Group we completed the sale of substantially all of the assets related to our Engineering and Fabrication Division. The fabrication assets were sold during May 2001 and the engineering assets were sold in December 2001. We also shut down our former U.S. Electronics Group’s Display Division in November 2001. We believe that these closures or sales of business units will strengthen and support our core electronics and machining operations. We currently plan to focus our growth efforts internally to integrate manufacturing processes, develop and refine our proprietary technologies and new products, expand sales and marketing efforts, and enhance engineering and value-added processes. By doing so, we expect to reduce costs and increase operating efficiencies, while providing more complete and faster solutions to our customers.

Offer Complete Solutions

We have continued to vertically integrate 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 total solutions, from design to assembly. Commercial aircraft manufacturers, defense contractors, and leading manufacturers in other industries are continuing 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 and advanced medical products industries. As a result of these efforts, we plan not only to reduce our reliance on the cyclical aerospace industry, but also to become an important part of emerging industries.

Industry Overview

Aerospace

Since 1998, previously favorable trends in the commercial aerospace industry have been tempered by the Asian financial crisis, efforts by airlines and airplane manufacturers to reduce costs, terrorist attacks, and other events. 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. According to the Boeing 1998 Current Market Outlook, world air traffic grew 6% from 1996 to 1997, following a 7% increase in the previous year. However, the Boeing 1999 Current Market Outlook reported that air travel in 1998 varied

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from the trend, particularly because of decreases in Asian air traffic. In 1999, Boeing revised its estimate for the growth rate of world air travel over the next ten years to a rate of approximately 4.7% per year. In Boeing’s 2002 Current Market Outlook, Boeing estimated growth rate of world air travel over the next 20 years will be approximately 2.9% per year. Boeing has also projected that the world jet fleet will grow to 32,495 passenger and cargo jets in 2021 and that the total market potential for new commercial airplanes between 2002 and 2021 would be 23,930 airplanes.

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 gears. 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

The electronics industry is enjoying growth in the Company’s specific sectors, and researchers expect the sector to continue to grow through at least 2004. Growth in the high reliability electronics industry has 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 2002, and the industry segments in which we operated during fiscal 2002, are summarized below. As noted, we have experienced some changes since the latter part of fiscal 2001. Within our former U.S. Aerospace Group, we closed an unprofitable foundry located in Tacoma, Washington, and in June 2001, we completed the sale of substantially all of the assets of our Casting operation located in Entiat, Washington. Also, within our former U.S. Aerospace Group, we completed the sale of substantially all of the assets related to our Engineering and Fabrication Division. The fabrication assets were sold during May 2001 and the engineering assets were sold in December 2001. We also shut down our former U.S. Electronics Group’s Display Division in November 2001.

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, 2002.

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

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

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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 for 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 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 naval 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 very small, specialized multilayer discoidal (round) ceramic capacitors and EMI (electro-magnetic interference) filters for the electronics industry. 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 for 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 or spacecraft uses. One major application for these products is in the marine field, where they provide a solution to the ageless problem of galvanic corrosion. We utilize explosive metal forming to 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.

We apply our proprietary and patented technologies to 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. We have also applied our zirconia-metal fusion technology 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 titanium-copper-molybdenum composite

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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 year, 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 facility today due to this in house development.

The Electronic Components business unit holds a certificate of registration to the ISO 9001 standard. It has also received a compliance certificate 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. We machine and assemble our products either to customer specifications or according to an engineering and tooling design developed by us to suit our customer’s particular needs. We are directly linked by computer to Boeing to allow immediate access to the drawings for Boeing parts. We inspect and test our machined products at various stages of production using non-destructive methods such as X-ray, ultra-sound, 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.

We have historically supplied nearly all of our products from this business unit to the commercial aerospace and defense industries. Due to this, our sales and profitability have been significantly affected by fluctuations in the aerospace industry. As a result, we believe it is important to diversify our product offerings. During fiscal 2002, the Machining Components business unit targeted and received orders from other industries that have a need for high technology precision machining, such as the medical and semiconductor equipment industries. We are continuing to look for ways to offer our capabilities to leaders in these and other new markets.

Our operations are DI-9000A Boeing approved. We have also been audited and have received a certificate of registration to the ISO 9002 standard and have received a compliance certificate to the AS 9000 standard. We have won numerous quality and service awards from customers.

European Operations

     Metal Forming

At our Welwyn Garden City and Birmingham facilities in England, our European Operation’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.

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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 the designer 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 and A330/340 aircraft, the Boeing model 737 aircraft, the 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 the 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, with stretching loads of up to 700 tons being applied. Most tools are machined from oxidation-resistant stainless steel castings, and forming dies up to four tons can be handled. Together with specialist gripper jaws and rotational platen, this enables the division to 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 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

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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.

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 2002 were Boeing, Aermacchi, Airbus, Rolls-Royce, BAE Systems, Northrop Grumman, Raytheon, GKN Westland, Vought, and Lockheed Martin. Only the top three customers individually accounted for 5% or more of our revenues, with Boeing at approximately 13.5%, Aermacchi at approximately 7.5%, and Airbus at approximately 7.2%. Together,

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our top ten customers accounted for approximately 51% of our sales during fiscal 2002. In fiscal 2002, we produced 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 substantially different customer bases in similar markets. For example, the U.S. Operations supply components and parts to Boeing for each of Boeing’s 737, 747, 757, 767 and 777 commercial aircraft construction programs. The European Operations supply components and parts for each of Airbus’ A300/310, A320 family, and A330/340 commercial aircraft construction programs. Our sales have historically been divided approximately equally between the United States and Europe. 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 U.K. 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, 2002, we had purchase orders and contractual arrangements evidencing anticipated future deliveries, which we treat as backlog, through fiscal year 2004 of approximately $48 million. We expect to deliver approximately $40 million of this backlog in fiscal year 2003. As of May 31, 2001, we had backlog through fiscal year 2003 of approximately $65 million. 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.

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

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competitors may introduce automation processes and robotics systems that could lower their costs of production substantially.

Raw Materials

Our European Operations obtain approximately 65% of their titanium from one supplier and is subject to a lead time of approximately 26 to 33 weeks to order and obtain titanium. While the European Operations generally have managed the ordering process to obtain titanium when needed, a labor strike at the supplier negatively affected the group’s 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 European Operations 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 we need them, 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.

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 26 U.S. patents, one Canadian patent, one European patent enforceable in the U.K., and six 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 five patents expiring over the next three years. These five 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 2002. 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. 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.

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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 conditions, except that until August 2001, we leased property in Tacoma, Washington that is located within a Superfund site that has been the subject of regulatory action for several years. We have not been named as a potentially liable party for contamination associated with this Superfund site, and we have no reason to believe that we will be so named.

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, 2002, the Company had approximately 782 employees, of whom approximately 702 were engaged in manufacturing functions, 28 in sales and marketing functions, 47 in administrative functions, and 5 in executive functions. Of the employees, approximately 274 were employed by the U.S. Operations, 487 by the European Operations and 21 by our corporate holding company which includes accounting, information service and human resource personnel. As of May 31, 2002, 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 relationships with our employees are good.

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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 $13,049,000 for our fiscal year ended May 31, 2000, a net loss of $75,720,000 for our fiscal year ended May 31, 2001, and a net loss before extraordinary items of $15,793,000 for our fiscal year ended May 31, 2002. We believe that we will continue to incur net losses into fiscal 2003 and that such losses may be substantial. We can offer no assurance that we will achieve profitable operations or that any profitable operations will be sustained. Our ability to achieve a profitable level of operations in the future will depend on many factors, including our ability to finance production 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.

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 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 issued in the Exchange with an aggregate principal amount as of May 31, 2002 equal to $15.0 million and accrued interest of $300,000, which notes do not require us to make cash interest payments. In addition to the PIK Notes, we have approximately $26.2 million in senior secured debt and capital leases. Although this debt is substantially less than our previous long-term debt totaling approximately $81.9 million, which consisted of $63.7 million in Subordinated Notes, $13.7 million in senior debt and approximately $4.5 million in other senior secured debt and capital leases as of February 28, 2002, our debt still poses a significant financial burden. We must increase our cash flow from operations, so that we will not have difficulty satisfying our debt obligations in the future. Our debt could make us unable to obtain additional financing in the future. It could also divert 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 limit 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 one of our secured lenders 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. The lender has agreed to forbear from declaring covenant defaults until May 31, 2003, pursuant to a forbearance agreement dated March 15, 2002 so long as we maintain timely payments on those loans. After the completion of the Exchange, we regained compliance with each of the loan covenants except for those relating to debt service coverage and our debt to net worth ratio. In the event the holders of our debt chose to exercise their remedies, we

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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.

We do not have revolving lines of credit that would help us fund our operations.

Due to our continued losses, our revolving line of credit expired on March 5, 2001 and we repaid that line of credit in full on March 2, 2001. Our line of credit in the U.K. expired in November 2000. That line of credit was extended through March 7, 2001, and we repaid it in full on that date. We did not request renewal of that line. Additionally, the New Senior Loan is a term loan rather than a revolving loan. As a result, if we make payments of principal before the New Senior Notes mature, additional loan proceeds will not become available and the New Senior Notes will not provide an additional source of cash to fund our operations or to meet our obligations as they become due.

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

The loan agreement that relates to our PIK Notes and the New Senior Notes restrict a number of our activities. Unless we obtain consent from our lenders, we generally cannot dispose of or create liens on assets or create additional indebtedness. We are not permitted to pay dividends to shareholders 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 transactions with related parties. In addition, if we experience a Change of Control, we will be required to repay our debt early. 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.

The New 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 one of our secured lenders 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. The lender has agreed to forbear from declaring covenant defaults until May 31, 2003, pursuant to a forbearance agreement dated March 15, 2002 so long as we maintain timely payments on those loans. Our ability to meet these ratios and tests and to comply with other provisions governing the New Senior Loan 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 the New Senior Notes and the loans secured by our real property.

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.

After the Exchange, the Noteholders own approximately 97.5% of the outstanding voting stock, and thus control all matters requiring a shareholder vote, including the election of directors.

The Noteholders and their affiliates, in the aggregate, beneficially own approximately 97.5% of the outstanding shares of voting stock after the Exchange, calculated on a fully-diluted basis. In addition,

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GSCP Recovery, Inc. and its affiliates own approximately 53% of the Company’s common stock on a fully-diluted basis. As such, GSCP Recovery, Inc. and its affiliates and the 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 five 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, GSCP Recovery, Inc. and its affiliates will also be able to hire and fire our management team.

Our Company and the Noteholders are subject to Potential Conflicts of Interest.

The Noteholders and their affiliates, in the aggregate, beneficially own approximately 97.5% of our common stock after the Exchange, calculated on a fully-diluted basis. The Noteholders hold the Company’s outstanding PIK Notes in the aggregate principal amount of $15 million. In addition, GSCP Recovery, Inc. and GSC Recovery II, L.P. acquired an aggregate of approximately 53% (on a fully-diluted basis assuming conversion of the Series C Preferred Stock in full) of the Company’s common stock as part of the Company’s restructuring and in exchange for the Subordinated Notes of the Company held by GSCP Recovery, Inc. and GSC Recovery II, L.P. As a result of their stock ownership, GSCP Recovery, Inc. and GSC Recovery II, L.P. have the ability to elect at least a majority of the Board of Directors of the Company. In addition, GSC Recovery II, L.P. and certain of its affiliates, GSC Recovery IIA, L.P., GSC Partners CDO Fund, Limited and GSC Partners CDO Fund II, Limited, together own the Company’s New Senior Notes. The New Senior Notes contain restrictive covenants and default protections that effectively allow GSC Recovery II, L.P. and their affiliates 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 interests of a Noteholder 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, 2002, approximately 50% of our assets and approximately 57% of our revenues were associated with our operations in the United Kingdom. It is more difficult 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 57% 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, 2002, we incurred a foreign currency translation gain of $776,000. 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.

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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 transportation industries are sensitive to general economic conditions, and past and current recessions have adversely affected these industries. In past years, a number of factors have adversely affected the aerospace industry, including increased fuel and labor costs, and intense price competition. Recently, the commercial aircraft industry experienced a downturn in the rate of its growth due to changing economic conditions and as a result of the ongoing financial crisis in Asia, which caused reductions in production rates for some commercial airline programs. The major aircraft manufacturers responded, in part, by significantly decreasing their inventory levels. In addition, the terrorist attacks of September 11, 2001 and their aftermath dramatically reduced commercial airline travel, thereby reducing aircraft usage of major airlines. This is likely to reduce the number of orders of new aircraft by commercial airlines from our customers. Furthermore, the unprecedented slowdown in air travel, combined with the costs of additional security measures have raised questions about the ongoing financial viability of the airline industry. In the event of bankruptcy or liquidation of one or more of the major airlines, this could lead to additional cancellations or delays in aircraft orders from Boeing or Airbus, two of our largest aerospace customers, which would in turn, reduce demand for our products and would have a material adverse effect on our business and financial performance. As such, cyclical factors and general economic conditions could lead to a downturn in demand for our core products and decrease our 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. On February 28, 2002, Sheryl A. Symonds, who served as Vice President and General Counsel, left her employment with the Company. On May 17, 2002, Werner Halfelfinger who served as Vice President of Operations and Chief Operating Officer, left his employment with the Company. 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. Because most of our research and development efforts are funded by customers, it will be essential for us to continue to respond effectively

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to our customers’ needs. We will also need to anticipate or respond to evolving industry standards and other technological changes on a timely and cost-effective basis. If we do not adequately respond to these changes, 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.

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, 2002, we had purchase orders and contractual arrangements evidencing anticipated future deliveries, which we treat as backlog, of approximately $48 million. We expect to deliver approximately $40 million of this backlog in fiscal year 2003. 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

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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. Our current cash shortage has resulted in our deliberate efforts to reduce inventories. Reduced inventories could result in even greater raw material shortages 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.

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 26 U.S. patents, one Canadian patent, one European patent enforceable in the U.K., and six 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 five patents expiring over the next three 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. 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

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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.

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.

Our past and possible future acquisition strategy could negatively impact our performance.

We have historically pursued an aggressive acquisition strategy. Although we are currently focusing substantially all of our attention on existing operations. In the future, we may again evaluate and pursue potential strategic acquisitions. We have incurred substantial losses as a result of some of our acquisitions and investments, including approximately $46.7 million in fiscal 2001, approximately $4.6 million in fiscal 2000, and approximately $12.7 million in fiscal 1999. We need to better manage our acquisition strategy. This includes accurately assessing the value, strengths and weaknesses of acquisition candidates, as well as successfully implementing necessary changes at newly acquired subsidiaries. In the past, our aggressive acquisition strategy has diverted management attention from our operations, increased borrowings, disrupted product development cycles and diluted earnings per share. If we do not successfully manage future acquisitions, if any, our financial performance could continue to be negatively impacted by acquisitions. We are not considering any acquisitions at this time.

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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, 2002 are as follows:

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

In January 1999, we executed an agreement with the Port of Chelan County, Washington, giving us an option to purchase three parcels of land at or near our Wenatchee campus for a total of $5.4 million. We purchased the first parcel, which was property next to our Wenatchee campus, for $853,000 in cash, on February 2, 1999. In December 2000, we resold the parcel to the Port of Chelan County for approximately $930,000. In July 2001, we executed a Rescission and Termination Agreement with the Port, which provided for the termination of our option and the return of a $100,000 deposit.

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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. We are not aware of any material legal proceedings pending or threatened against the Company or any of its properties.

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

None.

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PART II

ITEM 5. MARKET FOR COMMON EQUITY AND RELATED SHAREHOLDER MATTERS

Market Information, Shareholders, and Dividends

Between July 16, 1996 and June 28, 2001, our common stock was traded on the Nasdaq National Market of The Nasdaq Stock Market, Inc. (“Nasdaq”) under the symbol “PCTH”, and our public warrants were traded on the same system under the symbol “PCTHW”. Each public warrant entitles the holder to purchase one share of common stock at an exercise price of $4.6875 per share. After the delisting of our common stock and public warrants from Nasdaq on June 28, 2001, our common stock and public warrants now trade on the NASD Over-the-Counter Bulletin Board (“OTC Bulletin Board”).

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 2000 through May 31, 2002, which covers all of the calendar quarters within the Company’s 2001 and 2002 fiscal years. The prices for our common stock and public warrants were obtained from Nasdaq from January 2000 through the first calendar quarter of 2001. Thereafter, prices for our common stock and public warrants were obtained from the closing price for our common stock and public warrants on the OTC Bulletin Board.

As of August 29, 2002, the closing sales price of our common stock on the OTC Bulletin Board was $0.03 per share, and the closing sales price of our public warrants was $0.002.

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. Our agreements with our senior secured lenders and the indenture governing our PIK Notes restrict our ability to pay dividends.

As of August 26, 2002, there were 1,384 holders of record of 90,734,410 shares of common stock outstanding, and 26 holders of record of 2,295,000 public warrants outstanding, based on the records maintained by our transfer agent.

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Summary Equity Compensation Plan Information

(1)  In connection with the Exchange, the Company has agreed to issue no additional awards under any of the Company’s existing equity compensation plans.

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.

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 is 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 (an aggregate 4,865,820,023 shares of common stock). The Automatic Conversion of the Series C Preferred Stock into common stock will take place immediately following shareholder approval of an increase in the number of authorized shares of common stock to an amount sufficient to effect the conversion of the Series C Preferred Stock in full. No additional consideration must be paid by the holders of the Series C Preferred Stock for the Automatic Conversation to occur. Until the Automatic Conversion occurs, the Series C Preferred Stock has an aggregate liquidation preference equal to $45 million and a cumulative dividend

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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 Preferred Stock ranks senior to all other classes of our capital stock as to liquidation and distributions. In addition, the Series C Preferred Stock is entitled to vote with the common stock on all matters brought before the common stock for approval (other than as required by law) and is 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.

     Series B Convertible Preferred Stock

In May and August 1998, we issued a total of 170,000 shares of Series B Convertible Preferred Stock (the “Series B Preferred Stock”) and issued related warrants, for a total sale price of $17 million, in a private placement to 17 accredited investors. As of June 26, 2000, all of the shares of Series B Preferred Stock had been converted into a total of 10,136,548 shares of common stock. The issuance of the common stock upon conversion of the Series B Preferred Stock was exempt from registration under Section 3(a)(9) of the Securities Act because it was an exchange exclusively with the holders of Series B Preferred Stock where no commission or other remuneration was paid or given for soliciting the exchange.

The Company also issued warrants to purchase 236,109 shares of common stock at an exercise price of $7.20 per share in connection with the sale of the Series B Preferred Stock, which warrants expired on May 15, 2001 unexercised.

     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, 2002, we had outstanding exercisable warrants to purchase common stock as follows:

	•		publicly traded warrants to purchase 2,295,000 shares of common stock, that (a) were issued as part of the units sold in the Company’s July 1996 registered public offering (“Units”), (b) have an exercise price of $4.6875 per share, and (c) expire in July 2003;
	•		warrants and options to purchase a total of 4,816,309 shares of common stock issued to several employees and consultants of the Company, that (a) have exercise prices ranging from $0.22 to $9.50 per share, and (b) have expiration dates that range from July 2002 to May 2011;
	•		warrants to purchase 66,630,984 shares of common stock that (a) were issued in connection with a private placement in July 2000, (b) have an exercise price of $0.001 per share, and (c) expire in July 2003. See "— Summer 2000 Private Placement” below.
	•		warrants to purchase 15,293,149 shares of common stock that (a) were issued in connection with a private placement in March 2001, (b) have an exercise price of $.001 per share, and (c) expire in March 2006. See "— March 2001 Private Placement” below.

The shares of common stock issuable upon exercise of our outstanding warrants are either registered for issuance or resale, available for resale under Rule 144, or subject to an obligation to register them for

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resale. Exercise of these warrants would increase the number of shares of our common stock available on the public market and would dilute the interests of existing shareholders. Notwithstanding the foregoing, holders of warrants issued in the Summer 2000 Private Placement and the March 2001 Private Placement have agreed, in connection with the Exchange, not to exercise their warrants until such time as we again have enough authorized common stock to effect such conversions. We have filed a preliminary proxy with the Commission regarding the vote to increase our authorized common stock, among other matters, and expect to hold a meeting for the approval of such increase as soon as possible following receipt of clearance from the Commission to do so.

Summer 2000 Private Placement

On July 27, 2000, we issued 1,142,860 shares of common stock and warrants to purchase additional shares of common stock to two accredited investors, Strong River Investments, Inc. (“Strong River”) and Bay Harbor Investments, Inc. (“Bay Harbor”), for gross proceeds of $2.0 million (the “Summer 2000 Private Placement”). We paid a commission to Rochon Capital Group, Ltd. (“Rochon”) which comprised of $80,000 in cash and warrants to purchase 79,150 shares of common stock, at an exercise price of $1.7688 per share, exercisable through July 27, 2003, for representing the Company in this transaction. After taking into consideration other expenses related to the transaction, we received net proceeds at closing of $1,713,000, which we used to pay down our U.S. credit line. The terms of the transaction, including the terms of the warrants, were determined by arms length negotiations between the Company and the investors. The private placement was made pursuant to the exemption from registration contained in Rule 506 of Regulation D under the Securities Act. Neither the warrants issued to Rochon nor the common stock issuable upon exercise of those warrants may be resold unless registered or exempt from registration under the securities laws. The resale of the common stock and warrants sold to Strong River and Bay Harbor in the Summer 2000 Private Placement is described below.

Adjustable Warrants. In connection with the Summer 2000 Private Placement, we issued to the investors adjustable warrants, which permitted the investors to acquire additional shares of common stock at an exercise price of $.001 per share if the market price of our common stock did not achieve and maintain a specific price during each of three vesting periods. On February 15, 2001, the Company and the investors agreed to amend the adjustable warrants to provide that each of the two investors, upon exercise in full of its adjustable warrant, would be entitled to purchase 2,095,243 shares of common stock. On February 15, 2001, the investors exercised the adjustable warrants in full, as so amended, for the exercise price of $.001 per share. As a result of the exercise, we delivered to the investors a total of 4,190,486 shares of common stock. The resale of these shares was covered by a registration statement on Form S-3 (File No. 333-56884) filed on March 12, 2001.

Vesting Warrants. In connection with the Summer 2000 Private Placement, we also issued vesting warrants to the investors. The vesting warrants expired unexercised on February 28, 2001 in accordance with their terms.

Closing Warrants. On July 27, 2000, we also issued the investors in the Summer 2000 Private Placement closing warrants (the “Closing Warrants”) to purchase originally an aggregate of 385,000 shares of common stock at an exercise price of $2.01 per share. The Closing Warrants were exercisable in full on the date of issuance and remain exercisable until their expiration on July 27, 2003. The Closing Warrants contain weighted-average anti-dilution protection in the event we issue equity securities at a price less than the exercise price of the Closing Warrants then in effect. Our Exchange transaction in March 2002 triggered the anti-dilution provisions of the Closing Warrants, resulting in a significant increase in the number of shares issuable upon exercise of these warrants. Specifically, warrants in favor of Strong River initially exercisable for 192,500 shares of common stock are now exercisable for 33,315,492 shares; and warrants in favor of Bay Harbor initially exercisable for 192,500 shares of common stock are now exercisable for 33,315,492 shares. The exercise price of the Strong River and Bay Harbor warrants was reduced from $2.01 to the per share par value of the common stock by virtue of the anti-dilution adjustment. The resale of the shares issuable upon exercise of the common stock sold and the common

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stock issuable upon exercise of the Closing Warrants issued in the Summer 2000 Private Placement was registered on a registration statement on Form S-3 (File No. 333-44686), filed on August 28, 2000. Holders of the Closing Warrants have agreed in connection with the Exchange, not to exercise their Closing Warrants until such time as we again have enough authorized common stock to effect such conversions.

March 2001 Private Placement

On March 1, 2001, we borrowed approximately $13.8 million from four lenders for which DDJ Capital Management, LLC served as investment advisor: B III Capital Partners, L.P., B III-A Capital Partners, L.P., DDJ Canadian High Yield Fund and State Street Bank & Trust, as Custodian for General Motors Employees Global Group Pension Trust (the “March 2001 Private Placement”). In connection with this secured loan, we issued warrants to purchase an aggregate of 4,036,978 shares of common stock with an exercise price of $.001 per share to the lenders as an incentive for them to make the loan. The warrants are exercisable through March 1, 2006 and contain weighted average anti-dilution protection in the event we issue equity securities at a price less than market price determined in the manner set forth in the Warrant Agreement. The terms of the transaction, including the terms of the warrants, were determined by arms length negotiations between the Company and the lenders. We used approximately $9.5 million of the loan to repay our revolving line of credit in the U.S. and to pay the interest payment on our 111/4% senior subordinated notes that was due on February 1, 2001. The remainder of the proceeds were used to replace our line of credit in the United Kingdom, to pay costs of the secured loan transaction and to provide working capital. We filed a registration statement on Form S-3 for the shares of common stock underlying the warrants (File No. 333-58148) on April 2, 2001.

In March 2002, the Exchange transaction triggered the anti-dilution provisions of the warrants issued in connection with the March 2001 Private Placement, resulting in a significant increase in the number of shares issuable upon exercise of those warrants. Specifically, warrants which were initially exercisable for 4,036,978 shares of common stock are now exercisable for 15,293,149 shares of common stock. The holders of these warrants have agreed, in connection with the Exchange, not to exercise their warrants until such time as we again have enough authorized common stock to effect such conversions.

We also paid a commission of approximately $415,000 to First Albany Corporation (“First Albany”), the placement agent that represented us in the transaction, and issued warrants to purchase up to 692,074 shares of our common stock to First Albany, at an exercise price of $.4062 per share (the “Placement Warrants”). The Placement Warrants are exercisable at any time through April 9, 2006.

The warrants issued in the March 2001 Private Placement were issued pursuant to the exemption from registration contained in Rule 506 of Regulation D under the Securities Act. Neither the Placement Warrants nor the shares of common stock issuable upon exercise of the Placement Warrants may be resold unless registered or exempt from registration under the securities laws. First Albany has piggy-back registration rights with respect to the shares issuable upon exercise of the warrants.

The Exchange

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 is 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 (an aggregate 4,865,820,023 shares of common stock). The Automatic Conversion of the Series C Preferred Stock into common stock will take place immediately following shareholder approval of an increase in the number of authorized shares of common stock to an amount sufficient to effect the conversion of the Series C

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Preferred Stock in full. No additional consideration must be paid by the holders of the Series C Preferred Stock for the Automatic Conversation to occur. Until the Automatic Conversion occurs, the Series C Preferred Stock has 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 Preferred Stock ranks senior to all other classes of our capital stock as to liquidation and distributions. In addition, the Series C Preferred Stock is entitled to vote with the common stock on all matters brought before the common stock for approval (other than as required by law) and is 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 (convertible into 4,865,820,023 shares of common stock). The Series C Preferred Stock will convert into common stock automatically immediately following shareholder approval of an increase in the number of shares of authorized common stock to an amount sufficient to effect the conversion in full.

In addition, in March 2002, we also issued 51,419,604 shares of common stock to the Noteholders as additional consideration for the cancellation of the Subordinated Notes. We did not receive cash proceeds from the issuance of the Series C Preferred Stock or the common stock issued in the Exchange. The Series C Preferred Stock and the common stock issued in the Exchange was exempt from the registration under Section 3(a)(9) of the Securities Act because it was an exchange exclusively with the holders of Subordinated Notes where no commission or other renumeration was paid or given for soliciting the exchange. We have agreed to register for resale such shares of common stock, including those receivable upon conversion of the Series C Preferred Stock, on demand of the Noteholders.

Registration Rights

We are obligated to register the resale of the following shares:

Continental Capital & Equity Corporation has the right, through April 17, 2003, to require us to file a resale registration statement with respect to up to 200,000 shares issuable upon exercise by Continental of warrants held by them.

We are obligated to register for resale up to 79,150 shares issuable upon exercise of warrants held by Rochon in the Summer 2000 Private Placement.

We are obligated to register for resale up to 692,074 shares issuable upon exercise of warrants held by First Albany in our March 2001 Private Placement.

We are obligated to register for resale on demand the 51,419,604 common shares issued in connection with the Exchange and up to 4,865,820,023 shares issuable upon the conversion of the Series C Preferred Stock.

Nasdaq Market Delisting

Until June 28, 2001, our common stock and public warrants were quoted on Nasdaq. In order to remain listed on that market, we were required to meet Nasdaq’s listing maintenance standards. On March 22, 2001, we received a determination letter from Nasdaq staff indicating that, absent a successful appeal by the Company, our securities would be delisted for failure to comply with Marketplace Rule 4450(a)(5), which requires listed stock to maintain a minimum bid price of $1.00. Our common stock had traded below $1.00 since November 7, 2000. Subsequent to the notice, we notified Nasdaq that we also failed to comply with Marketplace Rule 4450(a)(3), which requires an issuer of listed securities to maintain net tangible assets of at least $4 million. We appealed the Nasdaq staff determination before a Nasdaq qualification hearings panel on May 11, 2001, but we were notified on June 27, 2001 that our securities would be delisted on June 28, 2001. The delisting of our securities occurred on that date. Our common stock and public warrants are currently traded on the OTC Bulletin Board.

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Indemnification

The Company agreed to indemnify the holders of the Series C Preferred Stock, the Series B Preferred Stock, the investors in the Summer 2000 Private Placement, and the holders of the warrants issued in the March 2001 Private Placement, and those holders and investors agreed to indemnify the Company, against certain liabilities under the Securities Act. Insofar as indemnification for liabilities arising under the Securities Act may be permitted directors, officers and controlling persons of the Company pursuant to the foregoing provisions, or otherwise, we have been advised that, in the opinion of the Commission, such indemnification is against public policy as expressed in the Securities Act and is, therefore, unenforceable.

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.

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,

Sarbanes-Oxley Act Certifications

Certifications pursuant to Sections 302 and 906 of the Sarbanes-Oxley Act of 2002 accompanied this report. These certifications were filed as correspondence addressed to the Commission. The Company intends to file publicly these certifications as exhibits to a Form 8-K immediately following the filing of this Form 10-K.

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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.

Transfer Agent and Registrar

The Transfer Agent and Registrar for our common stock and publicly traded warrants is Interwest Transfer Company, Inc.

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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, 1998, 1999, 2000, 2001 and 2002, 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 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.

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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 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.

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 before extraordinary items of $15,793,000 for our fiscal year ended May 31, 2002. This followed net losses before extraordinary items of $75,720,000 for our fiscal year ended May 31, 2001 and $13,752,000 for our fiscal year ended May 31, 2000.

Over the last year, we have consolidated our U.S. Operations and European Operations through the sale and/or closure of several of our unprofitable divisions. Within our former U.S. Aerospace Group we closed an unprofitable foundry located in Tacoma, Washington and in June 2001, we completed the sale of substantially all of the assets of our Casting operation located in Entiat, Washington. Also, within our former U.S. Aerospace Group we completed the sale of substantially all of the assets related to our Engineering and Fabrication Division. The fabrication assets were sold during May 2001 and the engineering assets were sold in December 2001. We have also shut down our former U.S. Electronics Group’s Display Division in November 2001. We believe that these closures or sales of business units will strengthen and support our core electronics and machining operations.

Additionally, in March 2002, we 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 Series C Preferred Stock will automatically convert into common stock following shareholder approval of an increase in the number of our authorized shares of common stock. We have filed a preliminary proxy with the Commission regarding the vote to increase our authorized common stock, among other matters, and expect to hold a meeting for the approval of such increase as soon as possible following receipt of clearance from the Commission to do so. However, as a result of the Exchange, the Noteholders now hold a majority of our outstanding common stock. By virtue of their common stock and Series C Preferred Stock received in the Exchange, the Noteholders now beneficially own approximately 97.5% of our outstanding shares of common stock on a fully-diluted basis and control 97.5% of our the voting shares.

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In addition to exchanging our Subordinated Notes as described above, we also entered into the New Senior Loan represented by the New Senior Notes. The New Senior Notes were issued at a discount so that the proceeds of that loan totaled approximately $22.0 million. The principal amount of the New Senior Notes will accrete through May 1, 2007 to $36.0 million and will bear interest at 5% per annum. We may redeem the New Senior Notes in full or in part at any time prior to their maturity date at a premium over the accreted value of the New Senior Notes, which premium declines over time. We used $16.2 million of the proceeds from the New Senior Notes to pay off principal and accrued interest on our then outstanding 21% senior secured loan (of which $13.7 million in principal was outstanding at May 31, 2001). 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 New 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 New Senior Notes and the repayment of the $36.0 million principal amount due on May 1, 2007.

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. In certain instances we recognize revenues from long-term, fixed-price contracts on the percentage of completion method measured by cost. Contract costs for long-term contracts include all direct material and labor costs related to contract performance. Provisions for estimated losses on uncompleted contracts are made in the period in which losses are determined. Changes in job performance, job conditions, and estimated profitability, including those arising from contract penalty provisions, and final contract settlements may result in revisions to costs and income and are recognized in the period in which the revisions are determined. Profit incentives are included in revenue when their realization is reasonably assured. When formal customer approval is necessary, we defer revenue recognition until such approval is received. Differences could result in changes to the amount and timing of the recorded revenues if we make different judgments or use different estimates.

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 fair 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

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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. 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 exceed the fair value of the assets. 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 of 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 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 three fiscal years, the following discussion should be read in conjunction with our consolidated financial statements presented in this Form 10-K.

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.

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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. 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.

Net Interest Expense. Net interest expense increased $2.8 million to $12.8 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. Due to the restructuring of our Subordinated Notes and refinancing of our 21% senior secured notes, interest expense will be substantially reduced to approximately $4.0 million for fiscal 2003.

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.

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

Extraordinary item. 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 Series C Preferred Stock will automatically convert into common stock following shareholder approval of an increase in the number of our authorized shares of common stock.

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:

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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 extraordinary gain on our debt restructuring.

Adjusted EBITDA. Adjusted EBITDA increased by $4.5 million to $1.8 million for the year ended May 31, 2002 from negative $2.7 million for the year ended May 31, 2001. The increase in adjusted EBITDA was due primarily due to the disposal of the Casting Division, Engineering and Fabrication Division and the closure of the Display Division. We expect adjusted EBITDA to increase during fiscal year 2003 as a result of cost cutting measures, productivity and lean manufacturing initiatives, and investment in new manufacturing equipment and manufacturing facility upgrades.

Year Ended May 31, 2001 Compared to Year Ended May 31, 2000

Net Sales. Net sales decreased by $3.4 million, or 3.0%, to $109.3 million for fiscal 2001 from $112.7 million in fiscal 2000. Our European Operations contributed $51.6 million, down $5.3 million from the $56.9 million contributed during the year ended May 31, 2000. Our customers in the European aerospace market had been initiating lean manufacturing methods and just-in-time inventory delivery requirements similar to those previously initiated by our customers in the U.S. aerospace market. These initiatives resulted in decreased orders for our European Operations. The lowering of the exchange rate of the British pound sterling versus the U.S. dollar also contributed to lower net sales volumes from our European Operations during fiscal 2001. Had the average exchange rate for fiscal 2001 been equal to the average exchange rate for fiscal 2000, reported net sales for our European Operations would have been approximately $56.0 million, or $4.4 million higher than actual.

Our U.S. Operations contributed $35.1 million during the year ended May 31, 2001, up $3.8 million from the $31.3 million contributed during the year ended May 31, 2000. This increase was due to increased sales ($1.8 million) into the telecommunications market of our ceramic filters and machined components during the year. We also saw increased net sales ($1.6 million) related to our core sealing and materials technologies applied to electronic packaging.

The remaining decrease in our consolidated net sales was related to our Casting Division, Engineering and Fabrication Division and the Display Division. These divisions contributed $22.6 million to net sales during the year ended May 31, 2001, down $1.9 million from the $24.5 million contributed during the year ended May 31, 2000. This decrease was due to lower net sales from the Casting Division related to the slumping transportation market.

Receivable collection periods, as calculated by dividing ending accounts receivable balances by sales for the year multiplied by 360 days, decreased to 62.9 days for the year ended May 31, 2001 from 67.8 days for the year ended May 31, 2000. This decrease was due to a concerted effort by operations management to increase collection efforts.

Gross Profit. Gross profit decreased by $12.4 million, or 60.0%, to $8.2 million for the year ended May 31, 2001, from $20.6 million for the year ended May 31, 2000. As a percentage of net sales, gross profit decreased to 7.5% for the year ended May 31, 2001, from 18.3% for the year ended May 31, 2000. The most significant gross margin decrease occurred in our Casting Division and Engineering and Fabrication Division due to the downturn in the transportation market and commercial aerospace markets. We also had a $1.6 million inventory charge during the year related to the termination of a contract in our Display Division.

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Gross margins decreased in our European Operations from 13.5% for the year ended May 31, 2000 to 11.1% for year ended May 31, 2001. This decrease was primarily due to pricing pressure from customers.

Inventory turnover, as calculated by dividing sales for the year by ending inventory, increased to 4.7 turns for the year ended May 31, 2001 from 4.0 turns for the year ended May 31, 2000. The increase was due to lower inventory levels.

Operating Expenses. Operating expenses increased by $42.7 million, to $67.2 million for the year ended May 31, 2001 from $24.5 million for the year ended May 31, 2000. The increase in operating expenses is primarily attributable to non-cash impairment charges totaling approximately $48.9 million. We review long-lived assets and identifiable intangibles for potential impairment of value whenever events or circumstances indicate that the carrying amount of those assets may not be recoverable. Based upon preliminary and final offers to purchase our European Operations, we recognized a $37.0 million charge to reduce the $33.0 million carrying value of goodwill and the $13.6 million carrying value of equipment associated with our European Operations, to estimated fair value, approximately $9.6 million. We also recognized an impairment charge of $5.5 million to reduce the $6.4 million carrying value of property and equipment used at the Entiat, Washington location of our Casting Division to estimated fair value, approximately $0.9 million. During the year ended May 31, 2001, we closed a facility located in Tacoma, Washington that was used by our Casting Division. We recognized a $0.8 million impairment charge to reduce the carrying value of the equipment located at the Tacoma location to zero, the estimated fair value. Also, included in operating expenses are non-cash charges of approximately $3.3 million to reduce the $3.5 million carrying value of goodwill and equipment used in the Engineering & Fabrication Division to estimated fair value, approximately $0.2 million. We completed the sale of substantially all of the assets used in the fabrication portion of the Engineering & Fabrication Division during the fourth quarter of fiscal year 2001. We sold the Engineering portion of the Engineering & Fabrication Division in December 2001. Within the Display Division, we recognized a non-cash charge of approximately $0.6 million to reduce the $1.0 million of equipment used to produce low power relays to its estimated fair value, approximately $0.4 million. The equipment, inventory, and intellectual property used to produce low power relays were sold during the fourth quarter of fiscal year 2001. Gross proceeds from the sale were $400,000 compared to a carrying amount of approximately $1.0 million. Operating expenses also include an approximately $320,000 non-cash charge for the loss on the sale of an unused building in Butler, New Jersey that was sold during December 2000. Net proceeds from the sale of the building were approximately $660,000, versus a carrying amount of approximately $980,000. During the fourth quarter of fiscal 2001 we completed our analysis of the value of certain other long-lived assets, including goodwill and patents. Based upon this analysis, we recognized additional impairment charges of approximately $1.0 million to reduce goodwill to estimated fair value, and approximately $0.3 million to reduce patents to estimated fair value.

Without impairment charges during the respective years, operating expenses decreased by $0.9 million to $18.3 million for the year ended May 31, 2001 from $19.2 million for the year ended May 31, 2000. This decrease in operating expenses relates primarily to our cost reduction efforts.

Net Interest Expense. Net interest expense increased $0.1 million to $10.0 million for the year ended May 31, 2001 from $9.9 million for the year ended May 31, 2000. This increase was primarily due to higher average line of credit balances for the first three quarters of the year plus the addition of our 21% senior secured notes and related loan costs during the fourth quarter of the year. The increase in interest from the above items was offset by lower average outstanding balance on our Subordinated Notes during the year.

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Other Income (Expense). Other income (expense) represents non-recurring and non-operational income and expense for the period. Other income increased to $201,000 for the year ended May 31, 2001 from $33,000 for the year ended May 31, 2000. Other income in the current year primarily represents rental income and gain on the sale of certain assets.

Provision for Income Taxes. Income taxes for the year ended May 31, 2001 primarily represent charges to write off deferred tax assets, $4.9 million, to adjust deferred income tax assets to amounts determined more likely than not to be realizable in accordance with the guidelines set forth in FAS 109, Accounting for Income Taxes. In addition, due to a tax assessment in the U.K. related to interest remitted to Pacific Aerospace, a foreign parent, tax expense also includes an accrual of approximately $1.7 million.

Net loss. Net loss increased $62.7 million, to a net loss of $75.7 million for the year ended May 31, 2001 from a net loss of $13.0 million for the year ended May 31, 2000, primarily as a result of the factors discussed above.

Adjusted EBITDA. Adjusted EBITDA decreased by $11.7 million to negative $2.7 million for the year ended May 31, 2001 from $9.0 million for the year ended May 31, 2000. The decrease in adjusted EBITDA was due primarily to negative adjusted EBITDA generated by the Engineering and Fabrication Division and the Casting Division. Those two Divisions were sold during fiscal year 2002.

Liquidity and Capital Resources

Cash used in operating activities was approximately $319,000 for the year ended May 31, 2002, compared to cash used in operating activities of approximately $1.6 million for the year ended May 31, 2001. The decrease in cash used in operating activities was primarily a result of decreasing inventory levels throughout the year and the sale of our Casting Division, Engineering and Fabrication Division and the closure of the Display Division. 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 $5.3 million during the year ended May 31, 2001 to $3.8 million during the year ended May 31, 2002. Cash used in investing activities increased from $1.5 million for the year ended May 31, 2001 to $2.3 million during the year ended May 31, 2002. In fiscal year 2002 we made cash investments for the acquisition of equipment and improvement of facilities of $2.7 million offset by $0.4 million of cash from the sale of assets, primarily the assets used by the Engineering and Fabrication Division. Notwithstanding the foregoing, we do not expect to acquire any new businesses during fiscal year 2003.

In March 2002, we completed the Exchange (which is described in detail under the subheading “Significant Events” below. In accordance with the Exchange Agreement, the Noteholders exchanged all of our then outstanding 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 Series C Preferred Stock will automatically convert into common stock following shareholder approval of an increase in the number of our authorized shares of common stock.

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In addition to exchanging our Subordinated Notes as described above, we also issued the New Senior Notes. The New Senior Notes were issued at a discount so that the proceeds of the New Senior Notes totaled approximately $22.0 million. The principal amount of the New Senior Notes will accrete through May 1, 2007 to $36.0 million and will bear interest at 5% per annum. We may redeem the new Senior Notes in full or in part at any time prior to their maturity date at a premium over the accreted value of the New Senior Notes, which premium declines over time. We used $16.2 million of the proceeds from the New Senior Notes to pay off principal and accrued interest on our then outstanding 21% senior secured loan (of which $13.7 million in principal was outstanding at May 31, 2001). 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 New 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 New Senior Notes and the repayment of the $36.0 million principal amount due on May 1, 2007.

Prior to the Exchange, our annual interest expense relating to the Subordinated Notes was approximately $7.2 million. Following the Exchange, we had no interest expense and no annual cash outlay with respect to the PIK Notes that were issued in the Exchange due to the accounting treatment of the PIK Notes under the provisions of SFAS No. 15, “Accounting by Debtors and Creditors for Troubled Debt Restructurings.” Our annual interest expense on its senior secured debt prior to the issuance of the New Senior Notes was approximately $2.5 million. Following the issuance of the New Senior Notes, our annual interest expense with respect to the New Senior Notes will consist of $1.8 million payable annually in cash and approximately $1.9 million related to the accretion rate of the New Senior Notes, which is not payable prior to the maturity of those notes. Thus, our total cash interest savings following the Exchange and the senior debt refinancing will be approximately $7.9 million per year, and the total interest savings including accretion of the New Senior Notes will be approximately $6.0 million per year. We believe that we will be able to make future payments on our debt and to fund our operations through 2007, until the maturity of the PIK Notes and the New Senior Notes. We anticipate that we will need to raise additional cash in order to repay the PIK Notes and the New Senior Notes at their maturity.

Notwithstanding the foregoing, if we are not successful in increasing cash provided by operating activities, we may need to sell additional common stock or other securities, or we may need to sell assets outside of the ordinary course of business in order to meet our obligations. There is no assurance that we will be able to sell additional equity securities or that we will be able to sell assets outside the ordinary course of business. In that situation, our inability to obtain sufficient cash if and when needed could have a material adverse effect on our financial position, the results of our operations, and our ability to continue as a going concern.

The New Senior Notes, as described above, are secured by our assets, the assets of our United States subsidiaries, and other intangibles. The New Senior Loan is a term loan rather than a revolving loan. As a result, if we make payments of principal before the New Senior Notes mature, additional proceeds will not become available, and the New Senior Loan will not provide an additional source of cash to fund our operations or to meet our obligations as they become due. We do not currently have a revolving line of credit available to compensate for any short-term cash flow problems we may experience. Our cash and cash equivalents as of May 31, 2002 was approximately $5.6 million, and as of May 31, 2001 was approximately $4.1 million.

Our working capital as of May 31, 2002 was approximately $24.6 million, and as of May 31, 2001 was approximately $25.0 million.

We are not in compliance with certain covenants of loans made by KeyBank in an aggregate principal amount of approximately $1.7 million (at May 31, 2002) that are secured by a deed of trust our headquarters building and improvements on another Company building. As of May 31, 2002,

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approximately $1.1 million of the principal amount of the loan secured by our headquarters building remained outstanding and $596,000 of the loan secured by improvements on the other building remained outstanding. Pursuant to a forbearance agreement dated March 15, 2002, KeyBank agreed to forbear from declaring covenant defaults until we regain compliance (thereby curing such covenant violations) or May 31, 2003. 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, 2002, our debt service ratio was (8.87) and our debt to worth ratio was 1.60. We anticipate obtaining compliance with the debt service ratio by May 31, 2003, but do not anticipate being in compliance with the debt to worth ratio in the foreseeable future.

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 audited consolidated financial statements stated that we have suffered recurring losses from operations and have 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 value of those assets upon liquidation. If we are unable to generate the necessary cash, we could be unable to continue operations.

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, 2002, the foreign currency translation adjustment was positive $776,000. We have not entered into any hedging activity as of May 31, 2002.

Significant Events

The Restructuring Transaction

     Events Leading up the Restructuring

In July 1998, we issued $75 million of our Subordinated Notes. We used the proceeds of the Subordinated Notes to purchase our European Operations, Aeromet International plc (“Aeromet”). On the day that we closed the Aeromet high-yield debt financing, Boeing announced the first of several record losses and shortly thereafter announced the first of a series of layoffs due to the decrease in commercial airplane orders resulting from the “Asian financial crisis.” At that time, Boeing accounted for approximately 15% of our revenue, largely generated through our U.S. Machining Division. Additionally, although Aeromet in the United Kingdom continued to provide strong results after its acquisition, Airbus announced similar cutbacks and layoffs approximately eight months following Boeing’s original announcement. Thus, in early to mid 1999, the U.K. aerospace market also began to decline and Aeromet’s gross profit margins began to decrease as well. By mid-1999, our former U.S. Aerospace Group was losing money (and thus using cash to continue operations). At that time, our European Operations was continuing to produce cash, but at a much lower rate than had been projected. In addition to the foregoing revenue declines, we acquired our Engineering & Fabrication Division in June of 1999. That division did not perform well largely due to a reduction in and the cancellation of tooling orders from the commercial aerospace industry.

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In early 2000, the commercial aerospace industry remained depressed and fuel costs continued to rise. The transportation industry as a whole also began to decline in early 2000 which also contributed to reduced revenues from our Casting Division. Our Casting Division’s primary customers, John Deere and PACCAR, placed fewer orders than had been projected and that division also began using much of our remaining cash to continue operations.

In March of 2000, we entered into four privately-negotiated exchange transactions in order to reduce the total outstanding principal amount of our Subordinated Notes. Altogether, we repurchased an aggregate principal amount of $11.3 million of Subordinated Notes in exchange for 2,902,806 shares of newly issued common stock. However, even after this repurchase, our cash reserves had become so depleted by the end of calendar year 2000 that it became clear to us that we would not be able to make our February 2001 interest payment on the Subordinated Notes. Thus, we began to explore alternatives to restructure our debt. We first explored the sale of Aeromet as a means to generate cash to repurchase the then outstanding Subordinated Notes and reduce our overall debt obligations. However, we were unable to sell Aeromet prior to the February 1, 2001 interest payment due date for the Subordinated Notes.

At that time, our then existing senior secured lender was requesting that we repay and terminate our revolving line of credit (the outstanding balance under the line of credit was approximately $6.3 million at that time). We initially attempted to obtain new senior financing from traditional lending sources to repay our revolving line of credit and to make the February 1, 2001 interest payment on our Notes. When these attempts proved unsuccessful, we turned to DDJ Capital Management, LLC (“DDJ”) to provide the needed financing. On March 1, 2001, prior to expiration of the interest payment cure period under the Notes, we obtained new senior secured financing from DDJ in the principal amount of $13.7 million (the “DDJ Loan”). We used the proceeds from the DDJ Loan to make the February 1, 2001 Subordinated Note interest payment, to repay in full our then existing senior secured loan, and for fees and expenses of the DDJ Loan.

Though we remained focused on the sale of Aeromet, it became apparent in July 2001 that Aeromet would not be sold before the August 1, 2001 Subordinated Note interest payment was due. We ultimately failed to make our August 1, 2001 Subordinated Note interest payment prior to the expiration of the cure period for such payment (a payment default under the Subordinated Note indenture) and, as a result, also defaulted under our DDJ Loan.

During late August 2001, a strategic buyer was identified to purchase Aeromet and we entered into a non-binding letter of intent with that prospective buyer regarding the sale of Aeromet. At that time, we anticipated using the proceeds from the sale of Aeromet to pay down a significant portion of the Subordinated Notes, and then convert the remaining Subordinated Notes into equity and new notes with a longer term.

On September 7, 2001, we entered into a lock-up agreement with the holders of approximately 97.5% of the Subordinated Notes pursuant to which the holders of the Subordinated Notes agreed to restructure our debt and equity. The lock-up agreement, in addition to providing for the restructuring of our debt and equity, contemplated that we would complete the sale of Aeromet and use the proceeds to pay off both the DDJ Loan and other indebtedness to be issued in the exchange, thereby extinguishing a substantial portion of our debt obligations.

However, the terrorist attacks of September 11, 2001 had a significant impact on the marketability of an aerospace company and the prospective buyer of Aeromet ultimately declined to finalize the purchase of Aeromet. We decided to discontinue our efforts to sell Aeromet in early October and instead focused on obtaining alternative senior financing to payoff the DDJ Loan and to restructure the Subordinated Notes. On October 5, 2001, DDJ agreed to forbear defaults on the DDJ Loan through December 31, 2001, in

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exchange for a cash payment (rolled into the principal of the DDJ Loan) and the acceleration of the DDJ Loan maturity date to December 31, 2001.

In December 2001, a prospective senior lender completed its due diligence and made a financing proposal. However, the proposed amount of funds was insufficient to meet our liquidity needs at that time and negotiations with the prospective lender ended. In the last week of December 2001, GSC Partners (an affiliate of GSCP Recovery, Inc. and GSC Recovery II, L.P.) proposed terms of a new senior secured financing to us in a sufficient amount to meet our liquidity needs. We accepted such terms and proceeded to move forward with the completion of our restructuring.

On January 11, 2002, we entered into an amended lock-up agreement (the “Amended Lock-Up Agreement”) with the holders of approximately 98% of the Subordinated Notes pursuant to which we agreed to undertake a revised transaction to restructure our outstanding debt and equity. The Amended Lock-Up Agreement replaced in full the lock-up agreements that were originally entered into by us and the holders of approximately 97.5% of the Subordinated Notes. The Amended Lock-Up Agreement provided that as part of the restructuring transaction, the holders of the Subordinated Notes would exchange all of their outstanding Subordinated Notes, including accrued interest thereon, for a combination of common stock, newly issued convertible preferred stock and new subordinated pay-in-kind notes, as more fully described in the following section. As of March 19, 2002, the holders of all of the Subordinated Notes tendered their notes in the Exchange and received approximately 97.5% of our common stock on a fully-diluted basis (consisting of common stock and Series C Preferred Stock) and $15 million in PIK Notes. In connection with the Exchange, the board of directors was reconstituted to consist of five directors, each of whom were designated by the holders of the Subordinated Notes.

     The Exchange

The Exchange was consummated as of March 19, 2002. The Noteholders exchanged $63.7 million aggregate principal amount of Subordinated Notes, and accrued interest thereon, for: (i) shares of common stock in an amount sufficient to give the Noteholders a majority of our outstanding common stock (equal to 51,419,604 shares of common stock); (ii) 1000 shares of our Series C Preferred Stock (convertible into 4,865,820,023 shares of common stock), which will be automatically converted into common stock upon an increase in our authorized amount of common stock, and (iii) $15 million in aggregate principal amount of PIK Notes. Upon conversion of the Series C Preferred Stock, the Noteholders will beneficially own approximately 97.5% of our common stock on a fully-diluted basis, as well as the PIK Notes. The terms of the Exchange are set forth in the Exchange Agreement between us and the holders of approximately 98% of our Subordinated Notes.

The Series C Preferred Stock will be automatically converted 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, will equal approximately 97.5% of our common stock on a fully-diluted basis. The Automatic Conversion of the Series C Preferred Stock into common stock will take place immediately following shareholder approval of an increase in the number of authorized shares of common stock to an amount sufficient to effect the conversion of the Series C Preferred Stock in full. Until the Automatic Conversion occurs, the Series C Preferred Stock has an aggregate liquidation preference equal to $45 million and a cumulative dividend rate of 10% per annum, which automatically increased to 14% per annum because the Automatic Conversion did not occur on or before June 1, 2002. The Series C Preferred Stock ranks senior to all other classes of our capital stock as to liquidation and distributions. In addition, the Series C Preferred Stock is entitled to vote with the common stock on all matters brought before the common stock for approval (other than as required by law) and is 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.

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The Series C Preferred Stock also entitles the holders thereof to appoint all five members of the Company’s Board of Directors. The Noteholders have agreed that one member of the Board of Directors will continue to be the Company’s Chief Executive Officer.

The PIK Notes bear interest at a rate of 10% per annum, which increased to 14% because the Automatic Conversion did not occur on or before June 1, 2002 (as soon as the Automatic Conversion occurs, however, the interest rate on PIK Notes will decrease back to 10% for the remaining term of the PIK Notes). Interest on the PIK Notes is payable semi-annually only in additional PIK Notes. The PIK Notes will mature in November 2007, but we may pay off or otherwise redeem the PIK Notes in full or in part at any time prior to the maturity date without penalty. The PIK Notes are unsecured senior subordinated obligations and rank junior to all of our senior debt.

In addition to exchanging our Subordinated Notes as described above, the Company also issued the New Senior Notes. The New Senior Notes were issued at a discount so that the proceeds of the New Senior Notes totaled approximately $22.0 million. The principal amount of the New Senior Notes will accrete through May 1, 2007 to $36.0 million and will bear interest at 5% per annum. The Company may redeem the New Senior Notes in full or in part at any time prior to their maturity date at a premium over the accreted value of the New Senior Notes, which premium declines over time. The Company used $16.2 million of the proceeds from the New Senior Notes to pay off principal and accrued interest on the Company’s then outstanding 21% senior secured loan (of which $13.7 million in principal was outstanding at May 31, 2001). 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 New 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 New Senior Notes and the repayment of the $36.0 million principal amount due on May 1, 2007.

     Discontinuance of Efforts to Sell our European Operations

On October 31, 2000, we announced our intention to sell our European Operations in order to reduce our outstanding Subordinated Notes. We entertained several bids for the group. However, on October 5, 2001, after discussions with the majority of the Noteholders, we announced that we would discontinue our efforts to sell our European Operations. We may resume efforts to sell these operations at some point in the future, but we have no current plans to do so.

     Sale of Casting Division

Effective as of June 1, 2001, we sold substantially all of the assets of the former U.S. Aerospace Group’s Casting Division location in Entiat, Washington to two newly formed limited liability companies owned by a private company. The purchase price was approximately $4.5 million, which consisted of approximately $1.4 million cash (a portion of the cash amounting to $160,000 was paid into escrow by the purchaser), a $1.0 million long-term note payable to the Company, units in the newly created limited liability companies valued at $1.0 million and the assumption of $1.1 million in liabilities. We used the cash proceeds to retire certain long-term debt related to the Entiat assets and to pay closing costs related to the transaction. The long-term note bears interest at 7% and is payable in quarterly installments, interest only for the first year and then principal and interest for 5 additional years. Due to the uncertainties of payment under this note we have fully reserved against it as of the closing date. The units in the newly created limited liability companies have certain preferential rights including an accumulating preferred return equal to 5% of the par value of then outstanding units and put rights subject to certain restrictions and limitations. We have recorded the value of the units at $0 which we estimate to be their fair market value. In the purchase agreement relating to the sale of the Casting Division, the parties agreed to adjust the purchase price after closing

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based on the actual value of accounts receivable and inventory transferred at closing. In December 2001, we agreed with the purchaser to settle differences relating to the post-closing adjustment by returning the escrowed cash to the purchaser, thereby reducing the purchase price by $160,000.

     Sale of Engineering Assets

In December 2001, we completed the sale of substantially all of the engineering assets of our Engineering & Fabrication Division. Gross proceeds of the sale were $350,000. We had previously sold substantially all of the fabrication assets of the division in May 2001. The sale of the engineering assets completed the downsizing and closure of the former U.S. Aerospace Group’s Engineering & Fabrication Division.

Disclosures about contractual obligations and commercial commitments

The following table and narrative gives additional disclosure related to our contractual obligations as of May 31, 2002 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, 2002, we had commercial purchase commitments for raw materials aggregating approximately $733,000. This amount relates to a titanium supply agreement with a fixed price.

Recent Accounting Pronouncements

In July 2001, the FASB issued SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 141 requires that all business combinations be accounted for under a single method, the purchase method. Use of the pooling-of-interests method is no longer permitted, although poolings initiated prior to June 30, 2001 are grandfathered. The Company adopted the provisions of SFAS No. 141 during the first quarter of fiscal 2002 without a material impact on the Company’s financial position or results of operations.

In June 2001, the FASB issued 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

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Company is required to adopt the provisions of SFAS No. 143 in the first quarter of fiscal year 2004. To accomplish this, the Company must identify all legal obligations for asset retirement obligations, if any, and determine the fair value of these obligations on the date of adoption. The determination of fair value is complex and will require the Company to gather market information and develop cash flow models. Additionally, the Company will be required to develop processes to track and monitor these obligations. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

In August, 2001, the FASB issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets. SFAS No. 144 addresses financial accounting and reporting for the impairment or disposal of long-lived assets. This Statement requires that long-lived assets be reviewed 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. If the carrying amount of an asset exceeds its estimated future cash flows, an impairment charge is recognized by the amount by which the carrying amount of the asset exceeds the fair value of the asset. SFAS No. 144 requires companies to separately report discontinued operations and extends that reporting to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to owners) or is classified as held for sale. Assets to be disposed of are reported at the lower of the carrying amount or fair value less costs to sell. The Company is required to adopt SFAS No. 144 on June 1, 2002. The adoption of this statement is not expected to have a material impact on the Company’s financial position or results of operations.

In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. Among other things, this statement rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, which required all gains and losses from early extinguishment of debt to be aggregated and, if material, classified as an extraordinary item, net of the related income tax effect. As a result, the criteria in APB Opinion No. 30, Reporting the Results of Operations — Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary, Unusual and Infrequently Occurring Events and Transactions, will now be used to classify those gains and losses. The statement becomes effective in the first quarter of fiscal 2003 for prospective transactions. Additionally, adoption of the statement will require that the Company reclassify gains previously reported for the years ended May 31, 2000 and 2002 related to debt extinguishments from extraordinary items to income from continuing operations.

In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. This statement addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force (EITF) Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring). This statement requires that a liability for a cost associated with an exit or disposal activity be recognized at fair value when the liability is incurred. The Company will be required to adopt this statement no later than June 1, 2003. The Company is currently assessing the impact of this statement on our results of operations, financial position and cash flows.

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ITEM 7A. 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. The fair value of such instruments approximates their face value.