AERO SYSTEMS ENGINEERING INC - 10-Q Quarterly Report

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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended March 31, 2003

( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934.

For the transition period from to

Commission file number 0-7390

Aero Systems Engineering, Inc.
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(Exact name of registrant as specified in its charter)

Minnesota 41-0913117
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(State or other jurisdiction of (I.R.S Employer
incorporation or organization) Identification No.)

358 East Fillmore Avenue, St. Paul, Minnesota 55107
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(Address of principal executive offices) (Zip Code)

Registrant's telephone number, including area code 651-227-7515
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Securities registered pursuant to Section 12(g) of the Act. Common
Stock, Par value, $.20 per share.

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 checkmark whether the registrant is an accelerated filer
(as defined in Rule 126-2 of the Act).

Yes [ ] No [X]

As of March 31, 2003, 4,401,625 shares of common stock, par value $.20
per share, were outstanding.

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AERO SYSTEMS ENGINEERING, INC.

Form 10-Q

Quarter Ended March 31, 2003
Table of Contents

Page 3

PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

AERO SYSTEMS ENGINEERING, INC.
CONDENSED BALANCE SHEETS

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AERO SYSTEMS ENGINEERING, INC.
CONDENSED BALANCE SHEETS
(continued)

Note: The balance sheet at December 31, 2002 has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements.

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AERO SYSTEMS ENGINEERING, INC.
CONDENSED STATEMENTS OF EARNINGS

See accompanying notes.

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AERO SYSTEMS ENGINEERING, INC.
STATEMENTS OF CASH FLOWS

See accompanying notes.

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AERO SYSTEMS ENGINEERING , INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
March 31, 2003

NOTE A - BASIS OF PRESENTATION

The accompanying unaudited condensed financial statements have been
prepared in accordance with accounting principles generally accepted in
the United States for interim financial information and with the
instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and footnotes
required by the accounting principles generally accepted in the United
States for complete financial statements. In the opinion of management,
all adjustments (consisting solely of normal recurring accruals)
considered necessary for a fair presentation have been included.
Operating results for the three-month period ending March 31, 2003 are
not necessarily indicative of the results that may be expected for the
year ended December 31, 2003. For further information, refer to the
financial statements and footnotes thereto included in the Company's
annual report on Form 10-K for the year ended December 31, 2002.

NOTE B - INCOME TAXES

Income taxes are provided on an interim basis based upon management's
estimate of the annual effective tax rate.

NOTE C - CONTRACTS IN PROCESS

Information with respect to contracts in process follows:

NOTE C - CONTINGENCIES AND COMMITMENTS

Guarantees of approximately $3,732,150 were outstanding on March 31,
2003 to various customers as bid bonds or in exchange for down payments
or warranty performance bonds.

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AERO SYSTEMS ENGINEERING, INC.

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

In addition to historical information, this Quarterly Report contains
forward-looking statements. The forward-looking statements are subject to
certain risks and uncertainties that could cause actual results to differ
materially from those reflected in such forward-looking statements. Factors that
might cause a difference include, but are not limited to, general economic
conditions, the condition of the aerospace industry, signing of future
contracts, competitive factors and other risks detailed from time to time in the
Company's reports to the SEC, including the report on Form 10-K for the year end
December 31, 2002. Actual results may vary materially from those anticipated.

Results of Operations

First quarter 2003 (All dollar amounts are in thousands.)

Worldwide revenue for first quarter 2003 totaled $9,427, which was a 6% increase
from $8,927 in first quarter of last year. Net income for first quarter of 2003
was $323 as compared to the first quarter net income of $193 last year.

Backlog of orders as of March 31, 2003 was $26,495 as compared with $21,308 and
$30,826 as of December 31, 2002 and March 31, 2002, respectively. The change
from December 31, 2002 represents a 24% increase. The total orders received
during the first quarter were $14,600.

The revenue increase was mostly attributable to the increase in the orders in
process. The improvement in net income in the first quarter 2003 as compared to
the prior year was due to the increased level of orders during the last six
months and due to lower interest expense resulting from lower debt levels.

Gross profit for first quarter of 2003 was $2,163 or 23% of revenue as compared
to $1,811 or 20% of revenue during the same period of last year. This represents
a 15% improvement on a percentage of revenue basis and is mostly the result of
work shifting to slightly higher margin projects in the test cell portion of the
business during the first quarter 2003.

The Company recognizes revenue and profit as work on long-term contracts
progresses using the percentage-of-completion method of accounting, which relies
on estimates of total expected contract revenues and costs. The Company follows
this method since reasonably dependable estimates of the revenue and costs
applicable to various stages of a contract can be made. Because the financial
reporting of these contracts depends on estimates, which are assessed
continually during the term of the contract, recognized revenues and profit are
subject to revisions as the contract progresses to completion. Revisions in
profit estimates are reflected in the period in which the facts that give rise
to the revision become known. Accordingly, favorable changes in estimates result
in additional profit recognition, and unfavorable changes in estimates result in
the reversal of previously recognized revenue and profits. When estimates
indicate a loss under a contract, cost of revenue is charged with a provision
for such loss. As work progresses under a loss contract, revenue continues to be
recognized, and a portion of the contract costs incurred in each period is
charged to the contract loss reserve.

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AERO SYSTEMS ENGINEERING, INC.

Selling, general and administrative expenses of $1,521 were 16% of revenues
during first quarter 2003 as compared to $1,346 and 15% during the same period
of last year. This increase of $175 is mostly related to increased direct
selling activities.

Research and development expenses were $81 during first quarter of 2003 as
compared to $78 in the same period in 2002. This is an increase of $3 or 4%.
During 2003, additional R & D will be incurred for continued enhancements to the
ASE2000, aero-acoustic analysis and new product initiatives.

Interest expense of $66 was incurred during the first quarter 2003 as compared
to $91 from the same period in the prior year. The average amount of borrowings
outstanding has decreased in the first quarter 2003 as compared to the first
quarter of last year mostly due to the timing of milestone invoice payments on
existing contracts.

Income tax expense was $195 for the first quarter 2003 as compared to $100 for
the first quarter of 2002. Income taxes are provided on an interim basis based
upon management's estimate of the annual effective tax rate.

Financial Condition

Accounts receivable at the end of first quarter 2003 was $5,884 as compared with
the year end balance of $6,672. This decrease of $788 was due mainly to the
timing of billing milestones on several large contracts.

Costs and estimated earnings in excess of billings on uncompleted contracts at
the end of first quarter 2003 was $6,829, which is an increase of $468 or 7% as
compared with the year-end 2002 balance. The Company recognizes profit on
long-term projects on the percentage of completion basis, which permits earned
revenue to be recognized prior to the time that progress payments are billed.
When this occurs, amounts are added to this asset account for the recognition of
earned revenue prior to the billing of progress payments. The increase since
year-end is due to the timing of billing milestones related to the contracts.
Billings are a function of contract terms and do not necessarily relate to the
percentage of completion of a project.

Current notes payable balances totaled $500 as compared to the year-end 2002
balance of $500. For the first three months of 2003, positive cash flows from
operations were $763, which enabled the Company to maintain no borrowings under
its line of credit and to slightly improve its cash position to $3,361 as of
March 31, 2003.

Accounts payable and accrued expenses at the end of first quarter 2002 decreased
$931 or 10% as compared to the year-end 2002 balance. This was primarily due to
a decrease in accrued job costs relating to ongoing projects.

Billings in excess of costs and estimated earnings on uncompleted contracts at
the end of first quarter 2003 increased $1,007 to $4,438 compared to the
year-end 2002 balance of $3,431. The increase since year-end is due to the
timing of billing milestones related to contracts. Billings are a function of
contract terms and do not necessarily relate to the percentage of completion of
a project.

Liquidity and Capital Resources

The Company has consistently relied upon bank credit lines during recent years
as a source of its working capital resources and liquidity. During the third
quarter 2001, Celsius Inc. sold 51% of the total outstanding shares of common
stock of ASE to Minnesota ASE, LLC. Related to this transaction, the

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AERO SYSTEMS ENGINEERING, INC.

Company has secured new bank financing agreements for operating funds and future
letter of credit needs. These new agreements are asset based collateral
agreements, with the funds available under these agreements determined by the
available securable assets at any point in time, up to a maximum of $6,000 of
operating funds, and $4,000 of letter of credit funds with the combined maximum
of the two lines not exceeding $9,000. Also related to the transaction, Celsius
Inc. agreed to continue to hold certain existing bank guarantees until maturity
that were previously provided to a few of the Company's customers, and Celsius
Inc. provided a three year $1,500 loan to the Company at 8% per year, which is
subordinated debt under the new bank agreement. The Company provided an
indemnification agreement to Celsius Inc. to secure Celsius Inc.'s interest in
the above items. In March of 2003, in connection with Saab AB providing an
extension to a down payment letter of credit to one of the Company's customers,
the Company repaid to Celsius Inc., $500,000 of the $1,500,000 three-year note.
The average amounts outstanding and funds available on the operating line and
letter of credit during the first quarter 2003 were $0 outstanding on $2,876
available and $2,108 outstanding on $4,000 available, respectively.

At the end of the first quarter 2003, the Company had notes payable balances of
$500 current and $1,000 long term. The current notes payable balance of $500
consisted of interim loans provided by Minnesota ASE, LLC. The $500 note to
Minnesota ASE, LLC is at 8% per year and does not have a stated maturity date.
The Company believes that bank lines of credit, along with cash flows from
continuing operations, are adequate to support the Company's cash needs for the
immediate future.

Capital expenditures during the first quarter 2003 were $130 as compared to $43
for the same period of last year. This increase of $87 is the result of the
timing of the major capital acquisitions during 2003. Additional capital
expenditures will be used to acquire additional equipment for research and
development projects, facility improvements and desktop upgrades. We expect the
total capital expenditures for the year ending December 31, 2003 to approximate
the year ended December 31, 2002.

Market Risk

The Company operates on a global basis and, during an average year, generates
approximately 50% of its revenues from international customers. This trend has
continued for the last five years as foreign airlines and government agencies
purchase products that ASE designs and produces. Most of the Company's contracts
are denominated in U.S. dollars. However, a few of them are denominated in the
customer's local currency. Therefore, the Company has entered into foreign
exchange forward contracts having maturities within the next eighteen months.
The face amounts represent U.S. dollar equivalents of a non-U.S. dollar
denominated forward contract. The amounts at risk are not material, and the
Company has the financial ability to generate cash flows to offset the expected
gains or losses when the contracts mature.

Forward-Looking Information

Highly competitive market conditions have necessitated the Company to initiate
productivity improvements and cost reduction programs to increase margins.

Looking ahead throughout the remainder of 2003, the amount of business in
backlog and the number of proposals outstanding should provide a solid base for
the remainder of the year.

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AERO SYSTEMS ENGINEERING, INC.

Item 3. Quantitative and Qualitative Disclosures about Market Risk

The Company's long-term contracts are substantially all denominated in U.S.
dollars. In certain circumstances, the Company has hedged its exposure to
foreign currency fluctuations. A 10% adverse change in foreign currency rates
would not have a material effect on the Company's results of operations or
financial position.

The Company is also subject to interest rate risk. The Company has not hedged
its exposure to interest rate fluctuations; however, a 10% increase or decrease
in interest rates would not have a material effect on the Company's results of
operations, fair values, or cash flows.

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

The term "disclosure controls and procedures" is defined in Rules 13a-14(c) and
15d-14(c) of the Securities Exchange Act of 1934 (Exchange Act). These rules
refer to the controls and other procedures of a company that are designed to
ensure that information required to be disclosed by a company in the reports
that it files under the Exchange Act is recorded, processed, summarized and
reported within required time periods. Our Chief Executive Officer and our Chief
Financial Officer have evaluated the effectiveness of our disclosure controls
and procedures as of a date within 90 days before filing this quarterly report
(the Evaluation Date), and they have concluded that, as of the Evaluation Date,
such controls and procedures were effective at ensuring that required
information will be disclosed on a timely basis in our reports filed under the
Exchange Act.

Changes in Internal Controls

We maintain a system of internal accounting controls that are designed to
provide reasonable assurances that our books and records accurately reflect our
transactions and that our established policies and procedures are followed. For
the quarter ended March 31, 2003, there were no significant changes to our
internal controls or in other factors that could significantly affect our
internal controls subsequent to the date of evaluation referenced in the
paragraph above.

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AERO SYSTEMS ENGINEERING, INC.

PART II - OTHER INFORMATION

Item 6: Exhibits and Reports on Form 8-K

(a) Exhibits 99.1 (Certification of Chief Financial Officer) and
99.2 (Certification of Chief Executive Officer).

(b) On February 4, 2003, the registrant filed a Form 8-K report to
release announcing the year end 2002 financial results. On
March 6, 2003, the registrant filed a Form 8-K report
announcing two major contract awards.

SIGNATURES

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

Date: April 29, 2003

/s/ Charles H. Loux
------------------------------------------
Charles H. Loux, President and CEO

/s/ Steven R. Hedberg
------------------------------------------
Steven R. Hedberg, Chief Financial Officer

Page 13

CERTIFICATIONS

I, Charles H. Loux, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Aero Systems
Engineering, Inc;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date: April 29, 2003
Aero Systems Engineering, Inc.

By: /s/ Charles H. Loux
----------------------------------
Charles H. Loux, President and CEO

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CERTIFICATIONS

I, Steven R. Hedberg, certify that:

1. I have reviewed this quarterly report on Form 10-Q of Aero Systems
Engineering, Inc;

2. Based on my knowledge, this quarterly report does not contain any untrue
statement of a material fact or omit to state a material fact necessary to make
the statements made, in light of the circumstances under which such statements
were made, not misleading with respect to the period covered by this quarterly
report;

3. Based on my knowledge, the financial statements, and other financial
information included in this quarterly report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this quarterly report;

4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:

a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities,
particularly during the period in which this quarterly report is being
prepared;

b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
quarterly report (the "Evaluation Date"); and

c) presented in this quarterly report our conclusions about the
effectiveness of the disclosure controls and procedures based on our
evaluation as of the Evaluation Date;

5. The registrant's other certifying officers and I have disclosed, based
on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):

a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and

b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and

6. The registrant's other certifying officers and I have indicated in this
quarterly report whether or not there were significant changes in internal
controls or in other factors that could significantly affect internal controls
subsequent to the date of our most recent evaluation, including any corrective
actions with regard to significant deficiencies and material weaknesses.

Date: April 29, 2003
Aero Systems Engineering, Inc.

By: /s/ Steven R. Hedberg
-----------------------------------------------
Steven R. Hedberg, CFO, Secretary and Treasurer