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SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-K

For the Fiscal Year Ended December 31, 2003,

or

For The Transition Period From                      To                     .

Commission File Number: 0-13829

PEMCO AVIATION GROUP, INC.

(Exact name of registrant as specified in its charter)

205-592-0011

(Registrant’s telephone number, including area code)

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

None

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

Common Stock, $.0001 par value

(Title of Class)

Indicate by check mark whether the company (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 company was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. x Yes ¨ 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 company’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

Indicate by check mark whether the company is an accelerated filer (as defined in the Exchange Act, Rule 12b-2). ¨ Yes x No

The aggregate market value of the Common Stock held by non-affiliates on June 30, 2003 was approximately $23,689,000.

The number of shares of the company’s Common Stock outstanding as of April 12, 2004 was 4,045,402.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the company’s definitive proxy statement to be filed pursuant to Regulation 14A not later than 120 days after the end of the fiscal year (December 31, 2003) are incorporated by reference in Part III.

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FORM 10-K ANNUAL REPORT

FOR THE YEAR ENDED DECEMBER 31, 2003

PEMCO AVIATION GROUP, INC.

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PART I

Pemco Aviation Group, Inc. (the “company”) is a diversified aerospace and defense company composed of three operating segments: Government Services, Commercial Services, and Manufacturing and Components. The company’s primary business is providing aircraft maintenance and modification services, including complete airframe inspection, maintenance, repair and custom airframe design and modification.

The company provides such services for government and military customers primarily through its Government Services Segment (“GSS”), which specializes in providing Programmed Depot Maintenance (“PDM”) on large transport aircraft. In addition to PDM, various other repair, maintenance, and modification services are performed for the GSS’s customers. The GSS’s contracts are generally multi-aircraft programs lasting several years. The GSS’s facilities, tooling, experienced labor force, quality, and on time delivery record position it as one of the premiere providers of PDM for large transport aircraft in the country.

The company’s Commercial Services Segment (“CSS”) provides commercial aircraft maintenance and modification services on a contract basis to the owners and operators of large commercial aircraft. The CSS provides commercial aircraft maintenance varying in scope from a single aircraft serviced over a few days to multi-aircraft programs lasting several years. The CSS is able to offer full range maintenance support services to airlines coupled with the related technical services required by these customers. The CSS also has broad experience in modifying commercial aircraft and providing value-added technical solutions, and holds over 70 proprietary Supplemental Type Certificates (“STCs”). The CSS’s facilities, tooling, and experienced labor force enable it to perform a broad range of airframe modifications for its customers. The CSS has performed nearly 300 cargo conversions encompassing 19 different types of narrow and wide-body commercial aircraft and is currently investigating the economic potential of converting the Boeing 757 to freighter configuration.

The company’s Manufacturing and Components Segment (“MCS”) designs and manufactures a wide array of proprietary aerospace products including various space systems, such as guidance control systems and launch vehicles; aircraft cargo-handling systems; and precision parts and components for aircraft.

The company’s website address is www.pemcoaviationgroup.com. The company makes available free of charge through its website its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and all amendments to those reports as soon as reasonably practicable after such material has been filed with or furnished to the Securities and Exchange Commission.

Coast Guard C-130 Contract Award

During August 2003, the GSS was awarded a contract from the United States Coast Guard (“USCG”) to perform depot level maintenance and repairs on HC-130 aircraft. The contract includes a base period of two years with three one-year options. The company received the first HC-130 aircraft under this contract in January 2004. The estimated value of this effort, including the three one-year options, is approximately $30

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million. During the second quarter of 2003, the company received one HC-130 aircraft from the USCG in anticipation of the contract award. The company anticipates completion of this aircraft during the first quarter of 2004.

Air Force C-130 Spar Inspection Contract Award

During the first quarter of 2003, the company was awarded a contract from the United States Air Force (“USAF”) to perform spar inspections on C-130 aircraft. The company received its first C-130 aircraft under this contract during February 2003. The estimated value of this effort is approximately $2.4 million. During 2003, the company delivered four aircraft under this contract and recognized related revenues of $0.8 million. This contract is expected to continue through 2005.

B737-200/300 Conversion Approvals

In January 2003, the General Administration of Civil Aviation of China (“CAAC”) approved the company’s B737-300 aircraft cargo conversion for operations in China. In September 2003, the United Kingdom Civil Aviation Authority (“UK-CAA”) issued certification approval of the company’s B737-200/300 aircraft cargo conversion. The company believes that it has the only CAAC or UK-CAA approved certifications in the world to perform this type of conversion on Boeing 737-200/300 aircraft. During 2003, the company’s CSS completed six passenger-to-cargo conversions on B737-300 aircraft, several of which are in operation in China. The company anticipates growth for aircraft operating in the cargo environment over the next decade. The company believes its approvals from many airworthiness authorities throughout the world to perform such passenger to cargo conversions demonstrates its commitment to the quality of its conversion program and uniquely positions the company as a leader in the conversion market.

GECAS B737-300 Conversion Contract

In January 2003, the company received a contract from GE Capital Aviation Services (“GECAS”) to perform conversions on B737-300 aircraft from passenger-to-freighter configuration and passenger-to-quick-change configuration. The contract included six firm orders and four options. The company delivered six aircraft under this contract during 2003 and recognized related revenue of $20.4 million.

Treasury Stock

During the second quarter of 2003, the Board of Directors authorized the company to repurchase up to an additional 200,000 shares of its common stock, representing approximately 5% of the company’s issued and outstanding shares (“new repurchase program”). The repurchases are authorized to be made from time to time through open market purchases, privately negotiated transactions or both, at prices to be determined by the Investment Committee of the Board of Directors. The Board of Directors approved the new repurchase program after considering current economic market factors and the company’s capital position. As of December 31, 2003, the company had acquired approximately 11,000 shares under the new repurchase program.

During the third quarter of 2001, the Board of Directors authorized the company to repurchase up to 400,000 shares of its common stock, representing approximately 10% of the company’s issued and outstanding shares (“prior repurchase program”). The company acquired approximately 349,000 shares under the prior repurchase program, which was terminated and replaced by the new repurchase program.

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As of December 31, 2003, the company had repurchased approximately 360,000 shares under the new and prior repurchase programs at a cost of approximately $7.0 million.

Defined Benefit Pension Plan

As a result of unfavorable investment returns related to the company’s Defined Benefit Pension Plan (the “Plan”) during 2002 and 2001, coupled with an increase in actuarial liability resulting from lower interest rates, the Plan was under-funded by approximately $26.5 million at December 31, 2003. Pursuant to the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), minimum funding requirements, the company made contributions to the Plan during 2003 of approximately $11.0 million. The company anticipates that it will be required to make contributions of approximately $8.6 million to the Plan during 2004.

Although the impact of September 11, 2001 will be felt in the aviation industry for years to come, the air travel market and the related commercial aircraft maintenance market are showing signs of recovery. The U.S. airline industry’s loss is expected to total about $5 billion in 2003, a significant improvement from the $11.3 billion loss in 2002. Passenger traffic trends also suggest expected improvements in the market. The Federal Aviation Administration (“FAA”) forecasts enplanements for U.S. airlines to grow from 549.5 million in 2003 to 573.7 million in 2004, a 4.4% growth rate. The same report forecasts Revenue Passenger Miles (“RPMs” – one revenue passenger flown one mile) to grow from 620.1 billion in 2003 to 641.4 billion in 2004,, a growth rate of 3.4%. Over the next 10 years, the FAA expects enplanements and RPMs to grow at average annual growth rates of 3.6% and 3.9%, respectively.

Aircraft operators continue to be pressured to lower their direct operating costs. A primary driver of this pressure is reduced yields. Air Transport Association member airlines reported average yields dropped from 12.05¢ per RPM in 2002 to 11.95¢ in 2003, a drop of 0.8%. In the wake of airline bankruptcies and tight military budgets, maintenance costs stand out as one of the only true controllable expenses. As such, both military and commercial operators are focused on the ways in which they can reduce their maintenance costs, and outsourcing to independent service providers has become more prevalent. In the commercial market, airlines such as United have already taken significant steps toward outsourcing man-power intensive activities such as heavy maintenance and signs continue to be positive that the third-party maintenance and modification industry will be the beneficiary of these trends in the coming years.

Military Maintenance and Modification Industry

Continuing conflicts in Iraq and Afghanistan and the deployment of various military aircraft to support these missions illustrate the operational requirements of the U.S. Armed Forces. This deployment requirement has insulated the military maintenance and modification industry from many of the effects of shrinking defense budgets. Budget restrictions have limited the U.S. Government’s ability to replace substantial portions of its aging transport fleets. The U.S. Government thus continues to utilize older aircraft. Typically, these older aircraft require more service than newer aircraft, generating greater revenue for the military maintenance and modification sector of the industry.

One of the company’s core competencies for 50 years has been military aircraft maintenance and modification. The company believes that this core competency will enable it to continue to provide

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services directly to its military customers and to participate in teaming arrangements with public or private operators. Bundling requirements, however, may limit the company’s ability to compete for major new military contracts as a prime contractor. In order to mitigate the effects of contract bundling, the company plans to team with other contractors whenever desirable.

Commercial Maintenance and Modification Industry

Recovery trends carry over from the air travel market into the commercial airframe heavy maintenance market. Maintenance, Repair and Overhaul (“MRO”) industry consultants, Aerostrategy, estimate the 2003 total market for airframe heavy maintenance at $5.3 billion worldwide with approximately 40%, or just over $2 billion, of this demand generated in North America. The industry experts forecast this market to grow at 6.4% annually on a worldwide basis and 4.1% annually in North America.

The company anticipates that the portion of commercial aircraft maintenance that is outsourced to independent suppliers will continue to grow in response to pressures to further reduce operating costs. Further supporting the growth of the outsourced market is the continued success of low cost carriers (“LCCs”) which typically outsource most or all of their maintenance. Based on anticipated fleet and maintenance market growth, and the company’s expectation that outsourcing airframe maintenance should continue to increase, the company believes that the market segment in which it operates could grow substantially over the next several years.

The air cargo industry and the corresponding demand for freighter aircraft also suffered post-9/11. According to Boeing, in 1999 and 2000 the air cargo market grew 6.2% and 7.1%, respectively. In 2001, that market declined 5.9%. Similar to the passenger market, these impacts lingered, but the air cargo market shows signs of recovery, and growth through 2023 is projected at 6.4% annually. Over this period of time, industry estimates suggest that nearly 3,000 freighter aircraft will be added to the fleet to support market growth and anticipated retirement of older aircraft. Nearly 75% of those additions are expected to be supplied by passenger to freighter conversions.

Space Systems

The primary focus of company’s Space Vector subsidiary is to provide launch vehicles and/or associated subsystems for various National Missile Defense programs and other governmental agencies. While no new target vehicles were open to competitive bid during 2003, Space Vector expects to compete for several target missions scheduled for release during 2004. Although Space Vector has served the missile community since 1969, and is one of only four companies in the country that currently provide high fidelity guided target vehicles, no assurance can be given that Space Vector will receive significant amounts of work on new missile defense programs.

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Aircraft Maintenance & Modification

General

The company’s aircraft maintenance and modification services include complete airframe maintenance and repair, and custom airframe design and modification, coupled with technical publications and after market support. A majority of the services are provided under multi-year programs for both military and commercial customers. The company’s military customers include the United States Armed Forces (“Armed Forces”) and certain foreign military services. The company’s commercial customers include some of the major global lessors of aircraft as well as airlines and airfreight carriers.

The company employs a large skilled work force. The principal services performed are PDM, commercial “C”-level and “D”-level heavy maintenance checks, passenger-to-cargo conversions, passenger-to-quick-change conversions, aircraft stripping and painting, rewiring, parts fabrication and engineering support. While some of these services are performed exclusively for either military or commercial customers, the majority of the services are performed for both customer groups.

The company’s competition for military aircraft maintenance contracts includes Boeing Aerospace Support Center, Lockheed-Martin Aeromod, L-3 Communications, and various military depots. The company’s competition for outsourced commercial work in the United States consists of the Goodrich Airframe Services Division, Timco Aviation Services, Singapore Technologies (which includes Mobile Aerospace Engineering, San Antonio Aerospace, and Dalfort Aerospace), and approximately ten smaller independent repair and modification operators. While many of the company’s competitors tend to specialize on specific portions of the aircraft, the company focuses on total airframe repair, maintenance and conversion. The company considers its competitive strengths to be its emphasis on quality, record of on-time delivery, substantial capacity, a trained, experienced, and stable labor force, product support, proprietary products, systems integration capability, and strong customer base.

Government Services Segment

The company provides aircraft maintenance and modification services either directly as a prime contractor or indirectly as a sub-contractor. These services are provided to the Armed Forces and other agencies of the U.S. Government, as well as foreign military services through its GSS. The majority of the aircraft that the company services are transports such as the C-130 “Hercules” and refueling aircraft such as the KC-135. Currently, the U.S. KC-135 tanker fleet is estimated to include over 500 aircraft, and is projected to be in service through 2040. These aircraft are essential to support peacetime operations and war or contingency deployments. The Armed Forces cannot deploy without these resources. The demands placed on these aircraft mean that they require maintenance services such as those provided by the company.

Military contracts generally specify a certain number of aircraft to be serviced for the duration of the program. In addition to the number of aircraft originally contracted, the Armed Forces typically increase this number with aircraft that were not scheduled for maintenance but which require servicing. These “drop-in” aircraft generally increase the value of each contract. The company intends to use its experience and expertise to retain its existing contracts, as well as increase the likelihood of securing additional contracts in the future.

The principal services performed under military contracts are PDM, systems integration of component upgrades and modification of fixed wing aircraft. The PDM is the most thorough scheduled maintenance “check-up” for a military aircraft, entailing a bolt-by-bolt, wire-by-wire and section-by-section examination of the entire aircraft. The typical PDM program involves a nose to tail inspection and a repair program on a four or five-year cycle. In addition to heavy maintenance, the program can include airframe corrosion prevention and control, rewiring, component overhauls, and structural, avionics and various other system modifications.

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At the onset of the PDM, the aircraft is generally stripped of paint and the entire airframe, including the ribbings, skins and wings, undergoes a thorough structural examination, which can result in repairs to the airframe. The aircraft’s avionics receive examination and repair, replacement or modification as required. The aircraft is repainted at the completion of the overhaul.

In order for the company to efficiently complete its maintenance procedures, it maintains hydraulic, electrical, sheet metal and machine shops to satisfy all of its testing and assembly needs and to fabricate, repair and restore parts and components for aircraft structural repairs. The company also performs in-house heat treatment on alloys used in aircraft modifications and repairs and has complete non-destructive testing capabilities and test laboratories. The company’s work force is familiar with virtually all aspects of military aircraft maintenance, repair, and overhaul.

The company has provided quality maintenance, integration and modification work on a wide variety of military aircraft over the past 50 years, including C-130, KC-135, C-9, P-3, T-34, A-10, F-4, F-15, F-16, T-38 and U.S. Navy H-2 and H-3 helicopters.

In August 1994, the USAF awarded the company a contract for the PDM of its KC-135 aircraft consisting of one base year and six option years. The company completed work on the final aircraft inducted for PDM under this contract during 2003. On December 12, 2001 the company entered into a contract with Boeing Aerospace Support Center to serve as a subcontractor to Boeing for PDM on KC-135 aircraft. In effect this new contract continues the company’s involvement in KC-135 aircraft PDM. The contract provides for one base year and five option years with an estimated value of $600 million in revenues over the course of the agreement if all options are exercised. The company is currently operating in the second option year.

The company first performed PDM on the KC-135 in 1968 and has since processed over 3,000 such aircraft.

As the USAF continues to upgrade and modernize the KC-135 fleet to ensure its viability through 2040, the KC-135 PDM program is anticipated to further expand to include additional upgrades such as new cockpit, lavatories, and avionics systems. The company has performed other major upgrades in the past, including wing re-skin, major rewire, corrosion prevention control, auto pilot and fuel savings advisory system modifications.

In August 2003, the company was awarded a contract from the USCG consisting of two base years and three one-year options to perform depot level maintenance and repairs on HC-130 aircraft. The contract contains provisions to perform the Progressive Structural Inspection Baseline (PSI-B) and Repair as well as Unscheduled Depot Level Maintenance (“UDLM”) work. The company received its first HC-130 aircraft under this contract in January 2004. This contract has an estimated value of $30 million in revenues over the course of the agreement if all options are exercised. In April 2003, prior to being awarded this contract, the company received one HC-130 aircraft from the USCG. The company anticipates delivery of this aircraft during the second quarter of 2004.

The GSS is located in Birmingham, Alabama in facilities that are believed to be the largest for third-party maintenance in North America with approximately 1.9 million square feet under roof.

Commercial Services Segment

The company provides commercial aircraft maintenance and modification services on a contract basis to both the owners and operators of large commercial transport aircraft (i.e., leasing companies, banks, airlines, air

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cargo carriers) through its CSS. Programs for commercial maintenance range from single aircraft to multi-aircraft and can span a year or longer. The principal services performed under commercial maintenance contracts are “C” and “D” maintenance checks, passenger-to-freighter conversions, passenger-to-quick-change conversions, strip and paint, interior reconfiguration and fleet standardization.

The “C” check is an intermediate level service inspection that, depending upon the FAA approved maintenance program being used, includes systems operational tests, thorough exterior cleaning, and limited interior cleaning and servicing. It also includes engine and operation systems lubrication and filter servicing.

The “D” check is a more intensive inspection of the aircraft structure. The “D” check includes all of the work accomplished in the “C” check but places more emphasis on the integrity of the systems and aircraft structural functions. In the “D” check, the aircraft is disassembled to the point where the entire structure can be inspected and tested. Once the structure has been inspected and repaired, the aircraft and its various systems are reassembled to the detailed tolerances demanded in each system’s functional test series.

The form, function and interval of the “C” and “D” checks are different with each operator’s program. Each operator must have its particular maintenance program approved by the FAA. A number of variables determines the final form of a given program, including the age of the aircraft, the environment in which the aircraft flies, the number of hours that the aircraft regularly flies, and the number of take-offs and landings (called “flight cycles”) that the aircraft regularly performs.

In addition to the tasks required in the “C” and “D” checks, additional inspections are performed. These inspections include Supplemental Structure Inspections (“SSI”), which are structural inspections focusing on known problem areas, and Corrosion Prevention and Control Programs (“CPCP”), which are inspections of known corrosion problems. These additional inspections supplement the “C” and “D” check tasks.

The process of converting a passenger plane to a freighter configuration entails completely stripping the interior, strengthening the load-bearing capacity of the flooring, installing a bulkhead or cargo net, cutting into the fuselage for the installation of a cargo door, reinforcing the surrounding structure for the new door, replacing windows with metal plugs, and installing the cargo door itself. The aircraft interior may also need to be lined to protect cabin walls from pallet damage, the air conditioning system modified, and smoke detection installed. Additionally, the company installs the on-board cargo handling system. Conversion contracts also typically require concurrent “C” or “D” maintenance checks as the operator takes maximum advantage of the time that the aircraft will be out of service. It is also possible that the converted aircraft has often been out of service for some time and maintenance is required to bring the plane up to current FAA standards.

The company also provides modification and integration services for its commercial customers under its own or customer-provided Supplemental Type Certificates, including integration of new avionics systems, installation of new galleys and air-stairs, and reconfiguration of interior layouts and seating. The company believes that its facilities, tooling, engineering capabilities and experienced labor force enable it to perform virtually any airframe modification a commercial customer may currently require.

The company holds approximately 70 STCs from the FAA for the conversion of various aircraft from passenger-to-freighter, passenger-to-quick-change, and combination passenger and freighter conversions. The FAA, under a specific certificate, certifies each type of aircraft. Subsequent modifications to the aircraft require the review, flight-testing and approval of the FAA, and are then certified by an additional STC. The company holds passenger-to-freighter configuration STCs for the conversion of Boeing 727-100, 727-200,

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737-200, 737-300 aircraft, and BAe-146 aircraft. Additionally, the company holds a passenger-to-quick-change configuration STC for the conversion of Boeing 737-300 aircraft and a combi configuration STC for the conversion of Boeing 727 aircraft. The recent large decreases in prices for older commercial aircraft could increase the demand for conversions, and the company is expecting to expand this line of business in 2004 and beyond.

Contracts for commercial aircraft are performed at the company’s Dothan, Alabama facility. During 2002 and 2003 this facility received the FAA Diamond award for its training activities.

Manufacturing & Components Segment

The MCS is comprised of two independent manufacturing and service businesses located in California. The Pemco Engineers subsidiary designs and manufactures proprietary aerospace products; the Space Vector division subsidiary and manufactures launch vehicles and associated subsystems for scientific, military and commercial customers.

Pemco Engineers, Inc.

Pemco Engineers designs and manufactures aircraft cargo-handling systems (that the CSS often installs); high precision machined parts and components for aircraft; barrier nets and other sewn products; seat pallets; floor panels; flight deck doors; and other sheet metal components. The company’s principal expertise is in the innovative design and manufacturing of on-board cargo-handling systems for many types of large transport aircraft.

The company’s principal markets for cargo handling systems are major United States and foreign airlines and aircraft manufacturers. The company has approximately eight competitors in this market and considers its strengths in this industry to be its innovation, quality, reliability and cost-effective pricing.

The markets for high precision-machined components cover a wide range of manufacturers in numerous industries. There are over 1,000 manufacturers of components in the United States corresponding to an industry size of approximately $3 billion. The company’s competitors range in size from “single-machine” shops to companies with revenues exceeding $20 million. Most of the competitors, however, produce a broader mix of products while the company focuses on the manufacture of high precision components. The company considers its strengths in this industry to be its quality, competitive pricing, and on time delivery.

Boeing has recognized Pemco Engineers as a Gold contractor in all areas relating to product quality and as a Silver contractor in the delivery category.

Space Vector Corporation

The company’s Space Vector subsidiary maintains a research, development and engineering staff dedicated to the design, manufacture and launch of space-related systems. These systems include scientific sounding rockets, sophisticated guided target missiles, launch vehicles, guidance and control subsystems, vehicle structures and recovery systems. Space Vector has had prime contractor responsibility for launching 37 vehicles with go-ahead to launch in as short as eight months. The company’s hardware has flown on over 300 domestic and international space flights.

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The company is a prime contractor to the Air Force Space & Missile Systems Center (“SMC”) on the Sounding Rocket Program (“SRP-2”) and has served as a subcontractor on large U.S. Department of Defense programs, including the Ground-based Midcourse Defense (“GMD”) Interceptor. The company also serves the scientific community and supports the NASA Sounding Rocket Operations Contract (“NSROC”).

The company’s principal markets for its space and missile products are the U.S. Government and prime contractors to the U.S. Government. The company’s competition ranges from small organizations for the component subsystems to major corporations for the design, systems integration and manufacture of spacecraft and launch vehicles. The company’s contracts are generally awarded in accordance with the U.S. Government’s competitive bidding practices.

Space Vector has supported numerous classified and unclassified target systems and Missile Defense flight tests by providing systems and components such as split clamshell Nose Fairings, Vehicle Structures, Avionics and Electronics, Attitude Control Systems, and Cabling and Test Equipment. The company’s quality system is certified to the ISO 9001 and AS9100 standards.

The company’s size, capabilities and experience have earned it the reputation of being a responsive, flexible and low cost provider of launch vehicle hardware and services.

Foreign and Domestic Operations and Export Sales

All of the company’s revenues during 2003 were generated in the United States and all of the company’s assets were located in the United States. Approximately 2% of revenues in 2003 were generated from foreign owned entities. The company continuously reviews possible foreign ventures and sales opportunities.

The company provides maintenance and modification services for foreign-based aircraft owners and operators at its U.S. facilities. The company’s Space Vector and Pemco Engineers subsidiaries also sell in export markets. The services and products sold at the company’s U.S. locations are generally payable in U.S. dollars.

The following table presents the percentages of total sales for each principal product and service rendered for the last three fiscal years and the percentage of export sales for the last three fiscal years:

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Major Customers

The following table presents the percentages of total sales for the company’s largest customers for the last three fiscal years:

The following table presents the company’s backlog at December 31, 2003 and 2002:

(In Thousands)

U.S. Government backlog, which represented approximately 93% of the company’s total backlog in 2003, decreased $7.7 million or 8.3%. The backlog decrease is the result of 2 fewer KC-135 aircraft in work at the end of 2003 vs. 2002 at the GSS.

The GSS received 33 aircraft in 2001, 26 aircraft in 2002 and 29 aircraft in 2003 for PDM under its contracts. The company classifies all work for which the final customer is the U.S. Government as U.S. Government work whether the work is performed directly or under sub-contract.

Total commercial backlog decreased $6.5 million or 51.2%. The primary reason for this decrease was the timing of sales for our largest customer at the CSS in 2003 vs. 2002. At the end of 2003, there was $5.5 million related to this customer vs. 2002 backlog of $11.7 million. The decrease of $0.3 million in Pemco Engineers backlog is a result of a downturn in conversion of aircraft for which the unit produces cargo-handling systems combined with a decrease in sales of replacement parts for cargo-handling systems on aircraft in service.

The company purchases a variety of raw materials, including aluminum sheets and plates, extrusion, alloy steel and forgings. There are a large number of suppliers for these materials and they are readily available on the open market. The company has not entered into any long-term contracts with its suppliers of raw materials. The company experienced no significant shortages of raw material essential to its business during 2003 and does not anticipate any shortages of critical commodities in the near future.

The company procures many components, parts and equipment items from various domestic companies. The company faces some dependence on suppliers for certain types of parts involving highly technical processes; however, this risk has lessened in the past few years as additional high technology suppliers have entered the market.

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The U.S. Government furnishes a portion of the equipment and components used by the company in the fulfillment of the company’s services under U.S. Government contracts without charge to the company. The company is dependent upon U.S. Government furnished material to meet delivery schedules, and untimely receipt of such material adversely affects production schedules and contract profitability.

The company holds approximately 70 FAA-issued STCs that authorize it to perform various modifications to aircraft. These modifications include air-stair installation, the conversion of commercial aircraft from passenger-to-freighter or passenger-to-quick change configurations and ground proximity and wind shear warning systems. The company has STCs applicable to various aircraft, including Boeing 737, BAe-146, and Airbus A320 series aircraft. Approximately 21 of the company’s STCs are related to its cargo handling systems for various types of large transport aircraft. STCs are not patentable; rather, they indicate a procedure that is acceptable to the FAA to perform a given air-worthiness modification. The company develops its STCs internally and uses licensing agreements with the original equipment manufacturer, when applicable. In addition, the company has obtained approvals from many airworthiness authorities throughout the world for its passenger-to-freighter or passenger-to-quick change configurations, principally related to the B737-200/300 aircraft.

The company also holds FAA-issued Parts Manufacturing Approvals (PMAs) that authorize it to manufacture parts of its own design or that of other manufacturers related to its cargo handling systems. The company holds numerous other PMAs, that give the company authority to manufacture certain parts used in the conversion of aircraft from passenger-to-freighter and passenger-to-quick change configurations.

In addition, the company has a U.S. design patent for a permanent doorsill designed for use in cargo configurations and a design patent for a braking roller for preventing unintended movement of cargo containers. The company does not believe that the expiration or invalidation of either of these patents would have a material adverse impact upon its financial condition or results of operations.

The STCs and PMAs are perpetual, unless the company makes a decision to surrender them to the FAA.

In December 1997, the company received an inspection report from the Environmental Protection Agency (“EPA”) documenting the results of an inspection at the Birmingham, Alabama facility. The report cited various violations of environmental laws. The company has taken actions to correct the items raised by the inspection. On April 2, 1998, the company received a complaint and compliance order from EPA proposing penalties of $225,256. The company disagreed with the citations and contested the penalties. On December 21, 1998, the company and the EPA entered into a Consent Agreement and Consent Order (“CACO”) resolving the complaint and compliance order. As part of the CACO, the company agreed to assess a portion of the Birmingham facility for possible contamination by certain constituents, remediate such contamination as necessary, and pay a penalty of $95,000 over a three-year period. The company made the final payment in November 2001. During 1999, the company drilled test wells and took samples under its Phase I Site Characterization Plan. These samples were forwarded to the EPA in 1999. A Phase II Site Characterization Plan (“Phase II Plan”) was submitted to the EPA in 2001 upon receiving the agency’s response to the 1999 samples. The Phase II Plan was approved in January 2003 and well installation has been completed. The costs of the Phase II Plan are expected to be approximately $441,000, of which the company has paid approximately

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$341,000 as of December 31, 2003. Management believes that the results of the Phase II Plan will not have a material impact on the company’s financial position or results of operations.

The company is required to comply with environmental regulations at the federal, state and local levels. These requirements apply especially to the stripping, cleaning and painting of aircraft. The requirements to comply with environmental regulations have not had, and are not expected to have, a material effect on the company’s financial position or results of operations.

On December 31, 2003, the company had 2,230 employees. Approximately 1,686 of these employees are covered under collective bargaining agreements with the United Automobile, Aerospace, and Agricultural Implement Workers of America (“UAW”), International Association of Machinists and Aerospace Workers (“IAM”), and the Association of Plant Police of America (“APPA”). The current collective bargaining agreements for most of these employees run through 2005.

Following is a list of the company’s properties.

Birmingham, Alabama

The GSS, as well as the company’s corporate offices, are located at the Birmingham International Airport, in Birmingham, Alabama. The Birmingham facility is located on 192 acres of land with approximately 1.9 million square feet of production and administrative floor space. The facility includes ten flow-through bays permitting continual production line operation. The facility also includes a number of ancillary buildings such as a paint hangar, a shipping and receiving warehouse, a wing rehabilitation shop, a sheet metal shop and a 55,000 square foot general office building which houses the administrative staff. Available ramp area exceeding 3.0 million square feet is adjacent to the municipal airport runways. Additionally, the facility operates a control tower, which supplements the FAA-managed municipal air control tower for handling aircraft on the company’s property and a fire-fighting unit, which supplements fire-fighting equipment operated by both the City of Birmingham and the Alabama Air National Guard.

The Birmingham facility is a complete aircraft modification and maintenance center. The facility is an approved FAA and JAA (Europe) Repair Station and maintains a Department of Defense “SECRET” security clearance.

The facility is leased from the Birmingham Airport Authority. The lease expires September 30, 2019.

Dothan, Alabama

The Dothan facility of the CSS is located at the Dothan-Houston County Airport, in Dothan, Alabama. The facility is located on 80.0 acres of land with approximately 558,000 square feet of production and administrative floor space. The facility includes 296,000 square feet of aircraft hangar space, which is comprised of eight narrow-body bays, three wide-body bays, and a paint hangar. The facility also includes four warehouses, support shops and 26,000 square feet of administrative offices. The facility has 850,000 square feet of aircraft flight line and parking ramp space and is served by an airport consisting of two runways of 5,000 and 8,500 feet, an FAA Flight Service Station and a control tower.

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The Dothan facility is an approved FAA, JAA and CAA (United Kingdom) repair station. The facility is leased from the Dothan/Houston County Airport Authority under a lease agreement that, inclusive of a ten-year option period, expires in December 2033.

In December 2001, the company began construction on a 25,000 square foot addition to one of the wide-body hangers at its Dothan, Alabama facility. The first aircraft began using the new addition during the fourth quarter of 2002 and final work was completed on the addition during the first quarter of 2003.

Chatsworth, California

Space Vector Corporation, part of the MCS, is located in Chatsworth, California. This facility consists of three industrial buildings of approximately 63,000 square feet. One of these buildings, approximately 26,000 square feet, is currently subleased. Space Vector Corporation occupies these buildings under a lease agreement that expires in October 2004.

Corona, California

The Pemco Engineers division of the MCS is located in Corona, California. The facility consists of approximately 27,000 square feet and houses production and administrative functions. The facility is held under a lease agreement that expires in February 2005.

Clearwater, Florida

The company’s Clearwater facility is located at the St. Petersburg/Clearwater International Airport in Clearwater, Florida. The facility is located on 22 acres of land with approximately 133,000 square feet of production and administrative floor space. The facility includes two bays of approximately 92,000 square feet as well as supply and support shops and administrative offices. The facility has 782,000 square feet of ramp space and is served by airport facilities consisting of five runways (from 4,000 to 8,800 feet), an FAA Flight Service Station and a control tower. The facility has been sub-leased to a third-party aviation related business since April 2000.

The facility is leased from Pinellas County, a political subdivision of the State of Florida, under a lease agreement that expires in September 2005, exclusive of four optional renewal periods of five years each which would extend the lease until September 2025.

Breach of Contract Lawsuits

On October 12, 1995, Falcon Air AB filed a Complaint in the United States District Court, Northern District of Alabama, alleging that the modification of three Boeing 737 aircraft to Quick Change configuration by the company was defective, limiting the commercial use of the aircraft. The District Court released the case to alternative dispute resolution until the company requested reinstatement of the case on September 13, 2001. Reinstatement was denied, and the company filed an appeal with the 11^th Circuit Court of Appeals for determination on certain procedural issues on October 31, 2001. The parties have subsequently entered into arbitration and discovery is in its initial stages. Management

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believes that the results of this claim will not have a material impact on the company’s financial position or results of operations.

On January 16, 2004, the company filed a complaint in the Circuit Court of Dale County, Alabama against GE Capital Aviation Services, Inc. (“GECAS”) for monies owed for modification and maintenance services provided on six 737-300 aircraft, all of which were re-delivered to GECAS during 2003 and are in service. On March 24, 2004, the Circuit Court of Dale County, Alabama denied a motion filed by GECAS to dismiss or stay the proceedings. On January 20, 2004, GECAS filed suit against the company’s Pemco World Air Services, Inc. subsidiary in New York state court, claiming breach of contract with regard to two of the aircraft re-delivered. On March 5, 2004, the company filed a motion to dismiss the claim filed in the New York state court, for which no hearing date has been set. Management believes that the results of this claim will not have a material impact on the company’s financial position or results of operations.

ACC Capital Corporation (“ACC Capital”) claims the company improperly terminated leases for computer hardware and software in November of 2002. The company filed a Declaratory Judgment action on February 4, 2003 in the District Court Northern District, Alabama to substantiate the company’s end-of-term option to purchase. ACC Capital filed an action in Utah state court on March 17, 2003, which was subsequently removed to federal court on the company’s motion. The company filed its Motion for Partial Summary Judgment on February 9, 2004. The company believes that the results of this claim will not have a material impact on the company’s financial position or results of operations.

Employment Lawsuits

In December 1999, the company and its Pemco Aeroplex subsidiary were served with a purported class action in the U.S. District Court, Northern District of Alabama, seeking declaratory, injunctive relief and other compensatory and punitive damages based upon alleged unlawful employment practices of race discrimination and racial harassment by the company’s managers, supervisors, and other employees. The complaint sought damages in the amount of $75 million. On July 27, 2000 the U.S. District Court determined that the group would not be certified as a class and the plaintiffs withdrew their request for class certification. The Equal Employment Opportunity Commission (“EEOC”) subsequently entered the case purporting a parallel class action. The Court denied consolidation of the cases for trial purposes. On June 28, 2002 a jury determined that there was no hostile work environment with regard to any of the 22 plaintiffs in the original case and granted verdicts for the company. Nine plaintiffs elected to settle with the company prior to the trial. On December 13, 2002 the Court granted the company Summary Judgment in the EEOC case. That judgment has now been appealed to the 11^th Circuit Court of Appeals and all briefs filed. Arguments are expected to be heard by the Court during the second quarter of 2004. The company has taken effective remedial and corrective action, acted promptly in respect to any specific complaint by an employee, and will vigorously defend this case. Management believes that the results of this claim will not have a material impact on the company’s financial position or results of operations.

Various claims alleging employment discrimination, including race, sex, age and disability, have been made against the company and its subsidiaries by current and former employees at its Birmingham and Dothan, Alabama facilities in proceedings before the EEOC and before state and federal courts in Alabama. Workers’ compensation claims brought by employees of Pemco Aeroplex are also pending in Alabama state court. The company believes that no one of these claims is material to the company as a whole and that such claims are more reflective of the general increase in employment-related litigation in the U.S., and Alabama in particular, than of any actual discriminatory employment practices by the

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company or any subsidiary. Except for workers’ compensation benefits as provided by statute, the company intends to vigorously defend itself in all litigation arising from these types of claims. Management believes that the results of these claims will not have a material impact on the company’s financial position or results of operations.

The company and its subsidiaries are also parties to other non-employment related litigation, the results of which are not expected to be material to the company’s financial position or results of operations.

There were no matters submitted for a vote of the company’s stockholders in the fourth quarter of fiscal 2003.

PART II

The company’s common stock trades on the Nasdaq National Market under the symbol “PAGI.” The following table sets forth the range of high and low sales prices for the common stock on a quarterly basis for each of the last two fiscal years as reported on Nasdaq. Quotations represent prices between dealers, do not include retail mark-ups, markdowns or commissions, and do not necessarily represent actual transactions.

On April 12, 2004, there were 4,405,125 shares of common stock issued and 4,045,402 shares of common stock outstanding held by approximately 142 owners of record and 895 beneficial owners.

The company has never paid cash dividends on its common stock and currently intends to continue that policy indefinitely. The company’s credit facilities restrict its ability to pay dividends.

The last reported sales price of the company’s common stock on April 12, 2004 was $32.10.

The following selected financial data should be read in conjunction with the company’s financial statements and accompanying notes located elsewhere in this report and Item 7 Management’s Discussion and Analysis of Financial Condition and Results of Operations.

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Consolidated operating data for the company is as follows:

(In Thousands Except Per Share Information)

The following charges, or reversals of charges, are included in the consolidated operating data for the company and had an impact on year-to-year comparability of results. With the exception of the reversals of the deferred tax valuation allowance, all charges or reversals of charges are pre-tax:

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Consolidated balance sheet data for the company is as follows (in thousands of dollars):

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INTRODUCTION

The following discussion should be read in conjunction with the company’s consolidated financial statements and notes thereto included herein as Item 8.

OVERVIEW

The company operates primarily in the aerospace and defense industry and its principal business is providing aircraft maintenance and modification services to military and commercial customers. The company conducts its business through three operating segments: Government Services Segment (“GSS”), Commercial Services Segment (“CSS”), and Manufacturing and Components Segment (“MCS”). The company’s services are generally provided under traditional contracting agreements that include fixed- price, time and material, cost plus and variations of such arrangements. The company’s revenue and cash flows are derived primarily from services provided under these contracts, and cash flows include the receipt of milestone or progress payments under certain contracts.

The company’s success obtaining FAA approval during 2002 of its STC for modification of Boeing 737-300 aircraft from passenger to cargo configurations contributed significantly to its revenue growth from 2002 to 2003. The company performed six such conversions during 2003 compared to one during 2002. The company anticipates growth in the demand for freighter aircraft over the near term, as well as increased competition in the cargo conversion market. The company believes approvals from airworthiness authorities in China and the U.K. have helped position it as a leader in this global market. The company also experienced revenue growth from commercial MRO services during 2003. The company expects continued recovery from post 9-11 effects in the commercial airframe heavy maintenance market as carriers regain the confidence of air-travelers and operators place aircraft parked subsequent to 9-11 back into service. The company’s success in this industry continues to depend on its ability to offer competitive pricing and quality performance, and meet customer delivery requirements. The company believes that as commercial airline owners and operators face increased pressure to reduce costs, independent MRO service providers will continue to benefit by offering a lower-cost alternative to performing heavy maintenance in-house.

The market for PDM/MRO services provided to the U.S. Armed Forces and other government agencies is very mature, providing relatively slow growth and aggressive competition on pricing and scheduling. The company’s extensive years of experience in this market, proven past performance, and broad recognition of capabilities have helped to sustain its presence in this market. The company’s growth in this market is largely dependent on expanding beyond the current PDM/MRO business base, primarily consisting of the KC-135 program, and diversifying into other aircraft platforms. The USCG C-130 contract awarded to the company during 2003 was a significant step toward expanding the PDM/MRO base and re-establishing the company as a major competitor in the C-130 maintenance market. The company believes the aging of military aircraft, coupled with defense budget constraints limiting the development and deployment of new aircraft, will contribute to positive growth in the military PDM/MRO industry over the next decade.

The company responded to the opportunities and challenges of 2003 with strong performances in its GSS and CSS, reporting record consolidated sales during 2003 of $190.4 million, a 16.9% increase over 2002 sales of $162.9 million. Consolidated net income increased 13.6%, from $8.8 million in 2002 to $10.0 million in 2003.

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RESULTS OF OPERATIONS

Twelve months ended December 31, 2003

Versus twelve months ended December 31, 2002

The table below presents major highlights from the years ended December 31, 2003 and 2002.

(In $Millions)

EBITDA for the years ended December 31, 2003 and 2002 was calculated using the following approach:

(In $Millions)

The company presents Earnings Before Interest, Taxes, Depreciation and Amortization, more commonly referred to as EBITDA, because its management uses the measure to evaluate the company’s performance and to allocate resources. In addition, the company believes EBITDA is an important gauge used by commercial banks, investment banks, other financial institutions, and current and potential investors, to approximate its cash generation capability. Accordingly, the company has included EBITDA as part of this report. The Depreciation and Amortization amounts used in the EBITDA calculation are those that were recorded in the Consolidated Statements of Operations in this report. Due to the long-term nature of much of the company’s business, the Depreciation and Amortization amounts recorded in the Consolidated Statements of Operations will not directly match the change in Accumulated Depreciation and Amortization reflected on the company’s Consolidated Balance Sheets. This is a result of the capitalization of depreciation expense on long-term contracts into Work-in-Process. EBITDA is not a measure of financial performance under generally accepted accounting principles and should not be considered as a substitute for or superior to other measures of financial

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performance reported in accordance with GAAP. EBITDA as presented herein may not be comparable to similarly titled measures reported by other companies.

The table below presents the highlights in Revenue by Operating Segment for the years ended December 31, 2003 and 2002.

(In $Millions)

Without regard to operating segments, the company’s mix of business between government and commercial customers was 68% government and 32% commercial in 2003 and 67% government and 33% commercial in 2002.

The $24.2 million increase in the sales of the GSS was due primarily to increased revenue under the KC-135 PDM program of $25.5 million and an increase in C-130 related work of $2.1 million, offset by a net decrease of $3.4 million in other programs. The KC-135 PDM program allows for the company to provide services on PDM aircraft, drop-in aircraft, and other aircraft related areas. During 2003, the company delivered 32 PDM aircraft and two drop-in aircraft compared to 35 PDM and one drop-in aircraft during 2002. Year-over-year the company has realized an increase in sales per PDM aircraft due to an increase in the amount of work performed on each aircraft delivered. The amount of non-routine work performed per aircraft varies as a result of differences in aircraft condition and model mix. In addition, the company’s pricing on the KC-135 PDM program increased as a result of a transition from government furnished material (“GFM”) to customer furnished material (“CFM”) that began during 2002, the effects of which were realized during 2003. Under the GFM arrangement, the government furnished the company free of charge certain material necessary for completing the PDM process. Under the CFM arrangement, the company began procuring material previously provided through the GFM arrangement and increased its pricing to the customer accordingly. The company also recognized revenue of $0.7 million related to an REA on work performed under the KC-135 program. The company completed work on four C-130 spar inspections during 2003 with no corresponding sales on C-130 aircraft during 2002. The overall increase of KC-135 PDM program related sales and C-130 sales was offset by the completion of the J-Stars program that had sales of $3.7 million during 2002 and no sales during 2003. The KC-135 PDM programs represented 98.0% of the revenue of the GSS during 2003 and 96.2% during 2002.

The increase in the CSS revenue of $10.4 million was primarily due to increases in Conversion revenues of $11.2 million, the recognition of an REA on the H-3 Helicopter program in the amount of $0.7 million, an increase in parts sales of $0.1 million, and an increase in engineering and design revenue of $1.6 million. The CSS delivered six cargo conversions during 2003 compared to one during 2002. These increases were partially offset by a decrease in commercial MRO sales of $3.2 million.

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Revenue in the MCS decreased $4.3 million in 2003, declining to $7.8 million in 2003 from $12.1 million in 2002. Revenue declined primarily as a result of the early termination of a government contract for a launch vehicle program.

The company defines operating income, as shown in the Highlights Table at the beginning of this 2003 versus 2002 discussion, as revenue less cost of sales, less selling, general, and administrative expenses.

Cost of sales increased to $148.1 million in 2003 from $127.1 million in 2002. The increased cost of sales during 2003 was primarily a result of higher sales during the year. Overall, the company’s gross profit percentage increased to 22.2% in 2003 from 22.0% in 2002. The increase in gross profit percent is attributable to several factors. The KC-135 aircraft delivered during 2003 were on average more profitable than those delivered during 2002 as a result of an increase in non-routine work and changes in the KC-135 model mix. The company experienced several delays on KC-135 aircraft during 2002 due to the inability to obtain required parts which resulted in increased costs during the period. In addition, included in cost of sales during 2003 is a $0.7 million insurance recovery related to a fire at the company’s Dothan, Alabama facility in January 2002. These favorable factors were partially offset by relatively lower margins on work performed under new contracts during 2003. Cost of sales associated with new contracts included charges of $3.6 million related to estimated losses on contracts-in-process at December 31, 2003.

Selling, general, and administrative (“SG&A”) expenses increased from $21.5 million in 2002 to $26.1 million in 2003. As a percent of sales, SG&A expenses increased from 13.2% in 2002 to 13.7% in 2003. The increase in SG&A expense is attributable to several factors. The company continued to invest in its Industrial Engineering function during 2003 in an effort to improve productivity, adding approximately $0.5 million to SG&A expense year-over-year. The company incurred approximately $0.4 million in expenses during 2003 related to environmental remediation efforts compared to $0.1 million during 2002. The company increased its structural SG&A expense by expanding its marketing and business development capabilities across each segment and increasing the capacity of its internal audit function. At the company’s MCS, spending on internal research and development activities increased and the executive manager placed over the MCS during 2002 contributed to the increase year-over-year as a result of a partial year of activity during 2002 compared to a full year of activity during 2003.

Interest expense decreased to $0.9 million in 2003 from $1.5 million in 2002. The effective average interest rate on the company’s revolving credit facility was approximately 3.9% in 2003 versus 4.6% in 2002. In addition, the company recorded charges of approximately $400,000 related to the write-off of loan origination fees and prepayment fees in connection with refinancing its bank borrowings during the fourth quarter of 2002. The impact of these refinancing costs and the lower effective interest rate was partially offset by an increase in the company’s average debt outstanding during 2003 compared to 2002.

During 2003, the company recorded income tax provisions at an effective rate of 37%. The effective rate in 2003 includes favorable tax benefits generated from the utilization of Alabama net operating loss carryforwards which had previously been subject to a deferred tax valuation allowance. During 2002, the company recorded income tax provisions on a normalized basis at an effective rate of 38%.

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Twelve months ended December 31, 2002

Versus twelve months ended December 31, 2001

The table below presents major highlights from the years ended December 31, 2002 and 2001.

(In $Millions)

EBITDA for the years ended December 31, 2002 and 2001 was calculated using the following approach:

(In $Millions)

The table below presents the highlights in Revenue by Operating Segment for the years ended December 31, 2002 and 2001.

(In $Millions)

Without regard to operating segments, the company’s mix of business between government and commercial customers remained constant at 33% commercial and 67% government in both 2002 and 2001.

The $2.2 million decrease in the sales of the GSS was due primarily to decreased throughput under the KC-135 PDM programs of $3.7 million and a decrease of $0.5 million in the C-130 Paint Program. The KC-135 PDM program allows for the company to provide services on PDM aircraft, drop-in aircraft, and other aircraft related areas. During 2002 the company delivered 35 PDM and one drop-in aircraft, whereas in 2001 the company delivered 38 PDM aircraft, six drop-in aircraft, and performed a one-time inspection program on 25 aircraft. The inspection program in and of itself accounted for $3.9 million of the 2001 to 2002 decrease in revenue. Year-to-year the company has realized an increase in sales per PDM aircraft due to an increase in the amount of work performed on each aircraft delivered. The overall decrease of PDM program related sales was

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partially offset by an increase of $2.0 million in other programs. The KC-135 PDM programs represented 96.2% of the revenue of the GSS in 2002 and 97.7% in 2001.

The increase in the CSS revenue of $2.0 million was primarily due to increases in commercial MRO and Conversion revenues of $3.1 million and $0.9 million, respectively. These increases were partially offset by decreased sales on government programs of $1.3 million related primarily to completion of the H-3 helicopter program in 2001, and decreased spare parts sales of $0.7 million.

Revenue in the MCS decreased $2.5 million in 2002, declining to $12.1 million in 2002 from $14.6 million in 2001. The decrease in sales resulted primarily from a drop in orders for replacement parts for cargo handling systems combined with a decrease in orders for new cargo handling systems, partially offset by an increase from work on a target program.

Overall, the company’s gross profit percentage remained relatively constant at 22.0% in 2002 and 22.1% in 2001. Cost of sales decreased to $127.1 million in 2002 from $128.9 million in 2001. The lower cost of sales for 2002 was primarily a direct result of the lower sales during the year. This decrease was partially offset by the company replacing relatively high margin sales at the Pemco Engineers division with relatively lower margin business at other subsidiaries, additional expenses incurred at the CSS as it revised its production processes to accommodate changes in the design of the B737-300 cargo conversion and losses incurred at the GSS on the delivery of a JSTAR aircraft and a KC-135 aircraft under a transition contract. The KC-135 aircraft experienced several delays due to the inability to obtain required parts that increased costs.

SG&A expenses increased to $21.5 million in 2002 from $20.4 million in 2001 as a result of four major items. First, the company increased its structural SG&A expense by implementing an internal audit function, creating a corporate security function, and placing an executive manager over the Manufacturing & Components Group. Second, the company spent an additional $0.4 million year-over-year to support obtaining FAA approval on its Boeing 737-300 STC amendment and updating drawings and processes to place the new amendment into production. Third, the company invested approximately $0.2 million in enhancing its Industrial Engineering function to continue the pursuit of productivity improvements. Finally, the company incurred approximately $0.5 million in expenses associated with the unsuccessful tender offer that it made on November 12, 2002 and other related expenses incurred during the year related to the purchase of common stock. SG&A expense grew as a percentage of sales from 12.3% in 2001 to 13.2% in 2002.

Interest expense was $1.5 million in 2002 versus $1.3 million in 2001. The effective average interest rate on the company’s revolving credit facility was approximately 4.6% in 2002 and 7.4% in 2001. The average debt outstanding during 2002 was impacted by the company borrowing $6.7 million to purchase Treasury Stock at the end of the second quarter of 2002.

During 2001 the company recorded an overall income tax credit of $0.1 million because of favorable tax benefits generated from an adjustment to its deferred tax valuation allowance. In 2002, the company recorded an income tax provision with no tax credits. The effective tax provision in 2002 was 38%.

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LIQUIDITY AND CAPITAL RESOURCES

The table below presents the major indicators of financial condition and liquidity.

(In Thousands Except Long-Term Debt to Equity)

The company’s primary sources of liquidity and capital resources include cash flows from operations and borrowing capability through commercial lenders, including unused borrowing capacity on existing revolving credit agreements. Principal factors affecting the company’s liquidity and capital resources position include, but are not limited to, the following: results of operations; expansions and contractions in the industries in which the company operates; funding requirements associated with the company’s defined benefit pension plan; timing of federal income tax payments; transactions under the company’s stock repurchase plan; and potential acquisitions and divestitures.

Operating activities provided $1.9 million and $13.0 million of cash for the twelve months ended December 31, 2003 and 2002, respectively. The company received proceeds from the exercise of company stock options of $0.3 million and $2.8 million during 2003 and 2002, respectively. Cash of $5.0 million and $7.3 million was used during 2003 and 2002, respectively, for capital expenditures, and $0.3 million and $6.7 million, respectively, was used for the repurchase of company common stock.

Contributing to the company’s decrease in cash flow from operating activities from 2002 to 2003 as presented in the Consolidated Statements of Cash Flows was an increase in inventories and accounts receivable. Raw material inventory increased $5.5 million primarily as a result of a change from government furnished material to customer furnished material on the GSS KC-135 PDM contract and a ramp up of raw material inventory in anticipation of the USCG C-130 PDM contract that begins during the first quarter of 2004. The increase of $5.5 million in work-in-process inventory is primarily attributable to accumulated costs on the USCG C-130 program of approximately $3.5 million and on USAF C-130 spar inspections of approximately $2.0 million. There were no comparable costs on these programs at December 31, 2002. The $4.9 million increase in accounts receivable, net, is primarily attributable to an increase in sales toward the end of 2003, which improved from approximately $49.5 million during the fourth quarter of 2002 to approximately $63.4 million during the fourth quarter of 2003, together with December sales being more heavily weighted during the fourth quarter of 2003 compared to the fourth quarter of 2002. The increase in accounts payable of approximately $4.3 million contributed favorably to cash flow from operating activities and is primarily attributable to the increase in raw material inventory discussed above.

The company maintains a defined benefit pension plan (the “Plan”) that covers substantially all employees at its Birmingham and Dothan, Alabama facilities. The Plan’s assets consist primarily of stocks, bonds and cash equivalents. These assets are exposed to various risks, such as interest rate, credit, and overall market volatility. As a result of unfavorable investment returns related to the Plan in 2001 and 2002, partially offset by favorable returns in 2003, coupled with substantially lower interest rates, the Plan was

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under-funded by approximately $26.5 million at December 31, 2003. The company made contributions to the Plan totaling approximately $11.0 million during 2003 and, pursuant to ERISA funding requirements, the company expects to make contributions of approximately $8.6 million to the Plan during 2004. Primarily as a result of favorable returns on Plan assets and company contributions during 2003, the company reduced its minimum pension liability from $35.6 million at December 31, 2002 to $24.2 million at December 31, 2003, and recorded a gain of $1.2 million to other comprehensive income.

During the fourth quarter of 2002 the company refinanced its bank borrowings through a new lender. The new Credit Agreement included a Revolving Credit Facility in the amount $20.0 million and Term Loan of $5.0 million. The company’s Revolving Credit Facility was amended during the fourth quarter of 2003 to increase borrowing capacity from $20.0 million to $25.0 million and to extend its maturity through December 2005. These two loans carry variable interest rates that were 3.67% and 3.92%, respectively, at December 31, 2003. At December 31, 2003 the company had additional borrowing capacity of $10.0 million under its Revolving Credit Facility.

In May 2003, the company amended the Credit Agreement to create a line of credit for the repurchase of the company’s common stock (“Treasury Stock Term Loan”). The company may draw upon the Treasury Stock Term Loan up to $5.0 million through May 22, 2004, and the borrowings may be used to make purchases of the company’s common stock from any person who is not or has never been an affiliate of the company. The line of credit can be drawn in increments of $0.5 million and bears interest at LIBOR plus 3.00%. The company had no outstanding balance under the Treasury Stock Term Loan at December 31, 2003. The loan will be repaid, if drawn, in equal monthly installments over 43 months commencing on May 22, 2004.

The company executed a loan agreement during the fourth quarter of 2002 to borrow up to $2.5 million from the Dothan-Houston County Airport Authority to finance its hanger expansion at that facility, which was completed during the first quarter of 2003. The loan is backed by a letter of credit with the company’s primary lender and carries a variable interest rate, which was 1.48% at December 31, 2003.

In January 2003, the company began projects to improve its information system infrastructure. These projects included an upgrade to its enterprise software at GSS and a conversion to the enterprise software and upgrades to hardware at the CSS, altogether expected to cost approximately $1.5 million. The company anticipates costs to complete these projects during 2004 to be approximately $0.9 million. The company currently has no other material capital projects underway.

During the third quarter of 2001, the Board of Directors authorized the company to repurchase up to 400,000 shares of its common stock, representing approximately 10% of the company’s issued and outstanding shares (“prior repurchase program”). The company acquired approximately 349,000 shares under the prior repurchase program. During the second quarter of 2003, the Board of Directors authorized the company to repurchase up to an additional 200,000 shares of its common stock, representing approximately 5% of the company’s issued and outstanding shares (“new repurchase program”), and effectively terminated and replaced the prior repurchase program. The repurchases are authorized to be made from time to time through open market purchases, privately negotiated transactions or both, at prices to be determined by the Investment Committee of the Board of Directors. As of December 31, 2003, the company had acquired approximately 11,000 shares under the new repurchase program, and an aggregate of approximately 360,000 shares under the new and prior repurchase programs at a cost of approximately $7.0 million. Shares were repurchased at an

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average price of $23.52 during 2003 and $19.50 during 2002. The shares repurchased under these programs have been reflected as Treasury Stock in the Stockholders’ Equity section of the Consolidated Balance Sheets. The company may elect to repurchase additional shares after considering current economic market factors and the company’s capital position, although there can be no assurances in that regard.

Funding for the advancement of the company’s strategic goals, including the possible investment in targeted business areas and acquisitions, is expected to continue. The company plans to finance its capital expenditures, working capital and liquidity requirements through the most advantageous sources of capital available to the company at the time, which may include the sale of equity or debt securities through public offerings or private placements, the incurrence of additional indebtedness through secured or unsecured borrowings and the reinvestment of proceeds from the disposition of assets. The company believes that its internally generated liquidity, together with access to external capital resources, will be sufficient to satisfy existing commitments and plans for at least the next twelve months. The company could elect, or could be required, to raise additional funds during that period, and the company may need to raise additional capital in the future. Additional capital may not be available at all, or may not be available on terms favorable to the company. Any additional issuance of equity or equity-linked securities may result in substantial dilution to the company’s stockholders. The company is continually monitoring and reevaluating its level of investment in all of its operations, as well as the financing sources available to achieve its goals in each business area.

The aircraft services industry has been in a consolidation phase generally. As a consequence, the company receives and sometimes initiates inquiries with respect to corporate combinations. The company has not completed any such combinations for a number of years, and there is no assurance that it will be party to such transactions in the future.

Contractual Obligations

The following table sets forth the maturities of the company’s contractual obligations as of December 31, 2003.

(In Thousands)

A significant portion of the 2005 maturity of long-term debt listed above relates to the expiration of the company’s Revolving Credit Facility. The agreement, originated in December 2002, had an original term of two years. The company amended the agreement during December 2003 to extend its term for an additional two years. The company expects that it will renew the agreement for an additional 2-year term on the second anniversary of its origination in December 2004, although there can be no assurances in that regard. Notwithstanding this intended renewal of the Revolving Credit Facility, the company may elect to pay down the facility out of proceeds from the results of operations, or other potential financing sources, prior to the scheduled maturity.

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The company’s manufacturing and service operations are performed principally on leased premises owned by municipal units or authorities. Remaining lease terms range from four months to twenty years and provide for basic rentals, plus contingent rentals based upon a graduated percentage of sales. The company also leases vehicles and equipment under various operating and capital leasing arrangements.

Insurance Recovery

In January 2002, a contractor at the company’s Dothan, Alabama facility accidentally started a fire in which a substantial part of the administration building was damaged. An adjacent hangar also suffered some damage. The company was able to move all aircraft that were in the adjacent hanger and the fire damaged none of the aircraft on the facility. During the third quarter of 2003, as a result of the settlement of an insurance claim related to this fire, the company received $2.8 million in settlement proceeds and recognized a gain of $1.2 million, which is included in Cost of Sales ($0.7 million) and other income ($0.5 million) in the Consolidated Statements of Operations.

Litigation Settlements

During the second quarter of 2002 the company agreed to settlements on several outstanding legal actions (See Note 6 to the Consolidated Financial Statements included in the company’s Form 10-Q for the quarter ended June 30, 2002 for a detailed description of these settlements). These settlements are reflected on the Consolidated Statements of Operations as “Litigation, net” and are composed of the following cases:

(In Thousands)

Legal expenses related to these cases were incurred in 2002 and 2001 and are reflected as SG&A.

Contingencies

A material adverse effect on the company’s financial position and results of operations could result if the company is not successful in its defense of its legal proceedings. (See Item 3. Legal Proceedings.)

The company, as a U.S. Government contractor, is routinely subject to audits, reviews and investigations by the government related to its negotiation and performance of government contracts and its accounting for such contracts. Under certain circumstances, a contractor can be suspended or barred from eligibility for government contract awards. The government may, in certain cases, also terminate existing contracts, recover damages and impose other sanctions and penalties. The company believes, based on all available information, that the outcome of any U.S. Government audits, reviews or investigations would not have a material adverse effect on the company’s consolidated financial position or results of operations.

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TRADING ACTIVITIES

The company does not engage in trading activities or in trading non-exchange traded contracts. As of December 31, 2003 and 2002, the carrying amounts of the company’s financial instruments were estimated to approximate their fair values, due to their short-term nature, and variable or market interest rates. The company has not hedged its interest rate or foreign exchange risks through the use of derivative financial instruments. See Quantitative and Qualitative Disclosures about Market Risk included in Item 7A of this report.

RELATED PARTY TRANSACTIONS

The company had an accrual of approximately $0.1 million at December 31, 2002 related to a severance agreement and consulting agreement with its former Chairman of the Board, Chief Executive Officer and major stockholder. In accordance with the agreements, the accrued severance agreement amounts were paid over a 36-month period that began January 2000, while the accrued consulting agreement amounts were paid over a 6-month period that began December 2002.

On April 23, 2002, the company loaned its current President and Chief Executive Officer approximately $0.4 million under the terms of a Promissory Note. The Promissory Note carries a fixed interest rate of 5% per annum and is payable within 60 days of the President and Chief Executive Officer’s termination of employment with the company. Any change in this related party receivable relates to interest accumulated during the period.

FACTORS THAT MAY AFFECT FUTURE PERFORMANCE

You should carefully consider the following risk factors, in addition to the other information contained in this report, in your evaluation of the company and its financial condition. Numerous risk factors, including potentially the risk factors described in this section, could cause material harm to the company’s business and impair the value of its common stock.

The Company is Heavily Dependent on U.S. Government Contracts.

Approximately 69%, 67% and 67% of the company’s revenues in 2003, 2002 and 2001, respectively, were derived from U.S. Government contracts. U.S. Government contracts expose the company to a number of risks, including:

In addition, substantially all of the company’s government backlog scheduled for delivery can be terminated at the convenience of the U.S. Government since orders are often placed well before delivery, and the company’s contracts typically provide that orders may be terminated with limited or no penalties.

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If the company is unable to address any of the above risks, the company’s business could be materially harmed and the value of its common stock could be impaired.

A Significant Portion of the Company’s Revenues is Derived From a Few of its Contracts.

A small number of the company’s contracts account for a significant percentage of its revenues. Contracts with the U.S. Government comprised 69%, 67% and 67% of the company’s revenues during 2003, 2002, and 2001, respectively. The U.S. Air Force KC-135 program in and of itself comprised 65%, 60%, and 61% of the company’s total revenues in 2003, 2002, and 2001, respectively, and a contract with Northwest Airlines comprised 15%, 25%, and 18% of the company’s total revenues during these same respective time periods. During 2003, a contract with GECAS comprised 11% of the company’s total revenues. In December 2001 the company entered into a contract with Boeing to serve as a subcontractor to Boeing for performing PDM on KC-135 aircraft. The contract provides for one base year and five option years and the company is currently in the second option year. Termination or a disruption of any of these contracts (including by way of option years not being exercised), or the inability of the company to renew or replace any of these contracts when they expire, could materially harm the company’s business and impair the value of its common stock.

If the Company’s Customers Experience Financial or Other Difficulties, the Company’s Business Could Be Materially Harmed.

A number of the company’s commercial customers, including Northwest Airlines which represented 15% of the company’s revenues in 2003, have in the past and may in the future experience significant financial difficulties. Many of these customers face risks that are similar to those encountered by the company, including risks associated with market conditions, competition, government regulations, and the ability to obtain sufficient capital. There can be no assurance that the company’s customers will be successful in managing these risks. If the company’s customers do not successfully manage these risks, it could impair the company’s ability to generate revenues, collect amounts due from these customers and materially harm the company’s business.

The Company Faces Risks from Downturns in the Domestic and Global Economies.

The domestic and global economies have experienced downturns that have had significant effects on markets that the company serves, particularly the airline industry. The company cannot predict the depth or duration of such downturns, and the company’s ability to increase or maintain its revenues and operating results may be impaired as a result of negative general economic conditions.

Further, because current domestic and global economic conditions and economies are extremely uncertain, it is difficult to estimate the growth in various parts of the economy, including the markets in which the company participates. Because parts of the company’s budgeting and forecasting are reliant on estimates of growth in the markets it serves, the current economic uncertainty renders estimates of future revenues and expenditures even more difficult than usual to formulate. The future direction of the overall domestic and global economies could have a significant impact on the company’s overall financial performance and impair the value of its common stock.

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Bundling of U.S. Government Contracts Could Materially Harm the Company’s Business.

Beginning in 1997, Congress began including provisions in appropriations bills that require the “bundling” of contracts. Bundling refers to the practice of combining a number of U.S. Government contracts into one contract, which forces smaller companies, such as the company, to team with one or more operators to provide a bid for the bundled contract. The company is exposed to a number of risks from bundling, including:

This same appropriations legislation allows private contractors to team with military depots to bid on bundled contracts and also allows military depots to bid on these contracts directly. Consequently, the company faces additional competition from military depots. For example, in March 1998, the C-130 PDM solicitation was cancelled and the work was taken in house by the Air Force. If the company is unable to address any of the above risks, the company’s business could be materially harmed and the value of its common stock could be impaired.

The Company’s Markets are Highly Competitive and Some of its Competitors Have Greater Resources than the Company.

The aircraft maintenance and modification services industry is highly competitive, and the company expects that the competition will continue to intensify. Some of the company’s competitors are larger and more established companies with significant competitive advantages, including greater financial resources and greater name recognition. In addition, the company is facing increased competition from entities located outside of the United States and entities that are affiliated with commercial airlines. The company’s competition for military aircraft maintenance includes Boeing Aerospace Support Center, Lockheed-Martin Aeromod, Raytheon E-Systems and various military depots. The company’s competition for outsourced commercial work in the United States consists of the Goodrich Airframe Services Division, Timco Aviation Services, and Singapore Technologies (which includes Mobile Aerospace Engineering, San Antonio Aerospace, and Dalfort Aerospace). If the company is unable to compete effectively against any of these entities it could materially harm the company’s business and impair the value of its common stock.

Expansion Into International Markets May Expose the Company to Greater Risks.

The company’s continuing efforts to increase revenue and improve operating results and stockholder value includes seeking sales opportunities in international markets. During 2003, export sales comprised 2% of total revenues, though such sales could comprise an increasingly larger percentage of revenues in the future. The company believes there are a number of factors inherent in these markets that may expose the company to significantly greater risk than domestic markets, including foreign exchange exposure; local economic and market conditions; less regulation of patents or other safeguards of intellectual property; potential political unrest; difficulty in collecting receivables; and inability to rely on local government aid to enforce standard business practices. These factors, or others the company has not currently identified, could materially harm the company’s business and impair the value of its common stock.

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The Company is a Party to Legal Proceedings that Could be Costly to Resolve.

The company may be exposed to legal claims relating to the services it provides. The company is currently a party to several legal proceedings, including breach of contract claims and claims based on the company’s employment practices (See Item 3, Legal Proceedings). While the company maintains insurance covering many risks from its business, the insurance may not cover all relevant claims or may not provide sufficient coverage. If the company’s insurance coverage does not cover all costs resulting from these claims, it could materially harm the company’s business and impair the value of its common stock.

The Company Could Incur Significant Costs and Expenses Related to Environmental Problems.

Various federal, state and local laws and regulations require property owners or operators to pay for the costs of removal or remediation of hazardous or toxic substances located on a property. For example, there are stringent legal requirements applicable to the stripping, cleaning and painting of aircraft. The company has previously paid penalties to the Environmental Protection Agency for violations of these laws and regulations, and the company may be required to pay additional penalties or remediation costs in the future. These laws and regulations also impose liability on persons who arrange for the disposal or treatment of hazardous or toxic substances at another location for the costs of removal or remediation of these hazardous substances at the disposal or treatment facility. Further, these laws and regulations often impose liability regardless of whether the entity arranging for the disposal ever owned or operated the disposal facility. As operators of properties and as potential arrangers for hazardous substance disposal, the company may be liable under the laws and regulations for removal or remediation costs, governmental penalties, property damage and related expenses. Payment of any of these costs and expenses could materially harm the company’s business and impair the value of its common stock.

The Company May Not be Able to Hire and Retain a Sufficient Number of Qualified Employees.

The company’s success and growth will depend on its ability to continue to attract and retain skilled personnel. Competition for qualified personnel in the aircraft maintenance and modification services industry has been intense. Any failure to attract and retain qualified personnel could materially harm the company’s business and impair the value of its common stock.

The Company May Need Additional Financing to Maintain its Business.

The company’s growth strategy requires continued access to capital. From time to time, the company may require additional financing to enable it to:

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The company cannot assure you that, if it needs to raise additional funds, such funds will be available on favorable terms, or at all. If the company cannot raise adequate funds on acceptable terms, its business could be materially harmed and the value of its common stock impaired.

Failure to Introduce New Services in Response to Technological Advances and Evolving Industry Standards Could Materially Harm the Company’s Business.

Evolving industry standards and changing customer requirements characterize the aircraft maintenance and modification services industry. The introduction of new aircraft embodying new technologies and the emergence of new industry standards could render the company’s existing services obsolete and cause the company to incur significant development and labor costs. Failure to introduce new services and enhancements to the company’s existing services in response to changing market conditions or customer requirements could materially harm the company’s business and impair the value of its common stock.

The Company’s Trust for its Defined Benefit Plan is Subject to Financial Market Forces.

The company maintains a defined benefit pension plan (the “Plan”) that covers substantially all employees at its Birmingham and Dothan, Alabama facilities. The Plan’s assets consist primarily of stocks, bonds and cash equivalents. These assets are exposed to various risks, such as interest rate, credit, and overall market volatility. Losses on the Plan’s assets may lead to significant cash contributions by the company to fund the Plan to the actuarial levels required by ERISA that could materially harm the company’s business and impair the value of its common stock. As a result of unfavorable investment returns related to the Plan during 2002 and 2001, partially offset by favorable returns in 2003, coupled with an increase in actuarial liability resulting from lower interest rates, the Plan was under-funded by approximately $26.5 million at December 31, 2003. In 2004, the company expects that the minimum required contribution would be approximately $8.6 million.

The Company’s Credit Agreement Restricts Its Financial and Operational Flexibility.

The company’s Credit Agreement contains covenants that restrict, among other things, its ability to borrow money, make particular types of investments, sell assets, merge or consolidate, or make acquisitions. The company’s Credit Agreement also requires the company to maintain specified financial ratios. The company’s ability to meet these financial ratios can be affected by events beyond the company’s control, and there can be no assurance that the company will be able to meet these ratios.

The company has pledged substantially all of its assets to secure the debt under its Credit Agreement. If the amounts outstanding under the Credit Agreement were accelerated, the lenders could proceed against those assets. Any event of default, therefore, could have a material adverse effect on the company’s business and impair the value of its common stock.

The Company Faces Potential Product Liability Claims.

The company may be exposed to legal claims relating to the products it sells or the services it provides. The company’s agreements with its customers generally contain terms designed to limit its exposure to potential product liability claims. The company also maintains a product liability insurance policy for its business. However, the company’s insurance may not cover all relevant claims or may not provide

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sufficient coverage. If the company’s insurance coverage does not cover all costs resulting from future product liability claims, it could materially harm the company’s business and impair the value of its common stock.

The Company’s Business is Subject to Extensive Government Regulation.

The aircraft maintenance and modification services industry is subject to extensive regulatory and legal compliance requirements that result in significant costs. The FAA from time to time issues directives and other regulations relating to the maintenance and modification of aircraft that require significant expenditures. Regulatory changes could materially harm the company’s business by making its current services less attractive or obsolete, or increasing the opportunity for additional competition. Changes in, or the failure to comply with, applicable regulations could materially harm the company’s business and impair the value of its common stock.

The Company Has Implemented Anti-Takeover Provisions That Could Prevent an Acquisition of Its Business at a Premium Price.

Some of the provisions of the company’s certificate of incorporation and bylaws could discourage, delay or prevent an acquisition of the company’s business at a premium price. These provisions:

In addition, Section 203 of the Delaware General Corporation Law imposes restrictions on mergers and other business combinations between the company and any holder of 15% or more of its common stock.

Compliance With Changing Regulation of Corporate Governance and Public Disclosure May Result in Additional Expenses.

Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new Securities and Exchange Commission regulations and Nasdaq Stock Market rules, are creating uncertainty for companies such as ours. The company is committed to maintaining high standards of corporate governance and public disclosure. As a result, the company intends to invest reasonably necessary resources to comply with evolving standards, and this investment may result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities, which could harm the company’s business and impair the value of its common stock.

Insiders Have Substantial Control Over the Company and Can Significantly Influence Matters Requiring Stockholder Approval.

As of December 31, 2003, the company’s executive officers, directors and their affiliates, in the aggregate, beneficially owned approximately 58% of the company’s outstanding common stock. As a result, these stockholders are able to significantly influence matters requiring approval by the

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stockholders of the company, including the election of directors and the approval of mergers or other business combination transactions. This control may have the effect of deterring hostile takeovers, delaying or preventing changes in control or changes in management, or limiting the ability of our other stockholders to approve transactions that they may deem to be in their best interests.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The company’s significant accounting policies are disclosed in Note 1 of Notes to Consolidated Financial Statements. The preparation of financial statements in conformity with generally accepted accounting principles requires that management use judgments to make estimates and assumptions that affect the amounts reported in the financial statements. As a result, there is some risk that reported financial results could have been materially different had different methods, assumptions, and estimates been used.

The company believes that of its significant accounting policies, the following may involve a higher degree of judgment and complexity as used in the preparation of its consolidated financial statements.

Revenue Recognition - Revenue at the company’s GSS and CSS is derived principally under contracts using the percentage-of-completion method as prescribed by Statement of Position 81-1 (SOP 81-1) “Accounting for Performance of Construction-Type and Certain Production-Type Contracts”. The nature of the contract and the types of products and services provided are considered when determining the appropriate accounting for a particular contract. The company’s contracts at the GSS and CSS generally have fixed price elements, time-and-material elements, or commonly both. The GSS generally segments the basic and fixed price elements and the time-and-material elements for purposes of accumulating costs and recognizing revenue. For basic and fixed price elements of a contract, the GSS uses the units-of-delivery method as the basis to measure progress toward completion, with revenue recorded based upon the unit sales value stated in the contract and costs of sales recorded based upon actual unit cost. Each aircraft is considered a unit for purposes of recognizing revenue. For time-and-material elements of a contract, the GSS uses an output measure based upon units of work performed to measure progress toward completion, with revenue recorded based upon the stated hourly rates in the contract and costs of sales recorded based upon estimated average costs. The company considers each hour chargeable to the customer as a unit of work performed. Revenue and costs of sales for time-and-material elements are recognized upon completion of all performance obligations in accordance with the contract and acceptance by the customer. The CSS recognizes revenue and associated costs for both fixed price and time-and-material elements using units-of-delivery as the basis to measure progress toward completion, and revenue is recorded based upon the unit sales value stated in the contract and costs of sales are recorded based upon actual unit cost.

The company’s MCS derives a significant portion of its revenue from cost-reimbursement type contracts accounted for under the principles prescribed by SOP 81-1 and from sales of precision parts and components. Revenue on cost-reimbursable contracts is recognized to the extent of costs incurred plus a proportionate amount of estimated fee earned. For certain other fixed-price contracts revenue is recognized when performance milestones have been achieved in accordance with contract terms. Revenue related to sales of individual components and parts is recognized upon delivery to the customer, and when the product price is fixed and determinable and collection of the resulting receivable is reasonably assured.

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Contract accounting requires judgment relative to assessing risks and estimating contract revenues and costs. The company employs various techniques to project contract revenue and costs which inherently include significant assumptions and estimates. Contract revenues are a function of the terms of the contract and often bear a relationship to contract costs. Contract costs include labor, material, an allocation of indirect costs, and in the case of certain government contracts, an allocation of general and administrative costs. Techniques for estimating contract costs generally impact the company’s proposal processes, including the determination of pricing for fixed price and time-and-material elements of contracts, the evaluation of profitability on contracts, and the timing and amounts recognized for revenue and cost of sales. The company provides for losses on uncompleted contracts in the period in which management determines that the estimated total costs under the contract will exceed the estimated total contract revenues. These estimates are reviewed periodically and any revisions are charged or credited to operations in the period in which the change is determined. An amount equal to contract costs attributable to claims is included in revenues when realization is probable and the amount can be reasonably estimated. Judgment is required in determining the potential realization of claim revenue and estimating the amounts recoverable. Because of the significance of the judgments and estimates required in these processes, it is likely that materially different amounts could result from the use of different assumptions or if the underlying conditions were to change. In addition, contracts accounted for under the percentage-of-completion, units-of-delivery method may result in material fluctuations in revenue and profit margins depending on the timing of delivery and performance, the relative proportion of fixed price, time-and-material, and other types of contracts-in-process, and costs incurred in their performance. For additional information regarding accounting policies the company has established for recognizing revenue, see “Revenue Recognition” in Note 1 to the Consolidated Financial Statements.

Deferred Taxes

The company records a valuation allowance to reduce its deferred tax assets to the amount that is more likely than not to be realized. While the company has considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event the company were to determine that it would be able to realize its deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should the company determine that it would not be able to realize all or part of its net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Inventory Reserves

The company regularly estimates the degree of technological obsolescence in its inventories and provides inventory reserves on that basis. Though the company believes it has adequately provided for any such declines in inventory value to date, any unanticipated change in technology or potential decertification due to failure to meet design specification could significantly affect the value of the company’s inventories and thereby adversely affect gross margins and results of operations. In addition, an inability of the company to accurately forecast its inventory needs related to its warranty and maintenance obligations could adversely affect gross margin and results of operations.

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Pension and Postretirement Plans

The company maintains pension plans covering a majority of its employees and retirees, and postretirement benefit plans for retirees that include health care benefits and life insurance coverage (see Item 8. Financial Statements and Supplementary Data in Note 9 of Notes to Financial Statements for additional details). For financial reporting purposes, net periodic pension and other postretirement benefit costs (income) are calculated based upon a number of actuarial assumptions including a discount rate for plan obligations, assumed rate of return on pension plan assets, assumed annual rate of compensation increase for plan employees, and an annual rate of increase in the per capita costs of covered postretirement healthcare benefits. Each of these assumptions is based upon the company’s judgment, considering all known trends and uncertainties. Actual asset returns for the company pension plans significantly below the company’s assumed rate of return would result in lower net periodic pension income (or higher expense) in future years. Actual annual rates of increase in the per capita costs of covered postretirement healthcare benefits above assumed rates of increase would result in higher net periodic postretirement benefit costs in future years.

Contingencies

As further discussed in Note 10 of Notes to Financial Statements, the company has been involved, and may continue to be involved, in various legal proceedings arising out of the conduct of its business including litigation with customers, employment related lawsuits, purported class actions, and actions brought by governmental authorities. The company has, and will continue to, vigorously defend itself and to assert available defenses with respect to these matters. Where necessary, the company has accrued an estimate of the probable cost of resolutions of these proceedings based upon consultation with outside counsel and assuming various strategies. However, a settlement or an adverse resolution of one or more of these matters may result in the payment of significant costs and damages that could have a material adverse effect on the company’s financial position or results of operations.

RECENTLY ISSUED ACCOUNTING STANDARDS

In April 2003, the FASB issued SFAS 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities, which amends SFAS 133 for certain decisions made by the FASB Derivatives Implementation Group. In particular, SFAS 149 (1) clarifies under what circumstances a contract with an initial net investment meets the characteristic of a derivative, (2) clarifies when a derivative contains a financing component, (3) amends the definition of underlying to conform it to language used in FASB interpretation number (FIN) 45, and (4) amends certain other existing pronouncements. SFAS 149 is effective for contracts entered into or modified after June 30, 2003, and for hedging relationships designated after June 30, 2003. In addition, most provisions of SFAS 149 are to be applied prospectively. SFAS No. 149 does not currently impact the company’s financial position, results of operations, or cash flows.

In May 2003, the FASB issued SFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (“SFAS 150”). SFAS 150 establishes how an issuer classifies and measures certain freestanding financial instruments with characteristics of both liabilities and equity and requires that such instruments be classified as liabilities. SFAS 150 was effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003 for those existing financial instruments subject to its provisions. In its October 2003 meeting, the FASB Board decided to defer the effective date of certain provisions of SFAS 150. The company has not entered into any financial instruments within the scope of

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SFAS 150 since May 31, 2003. Accordingly, SFAS 150 had no impact on the company’s consolidated financial statements for the year ended December 31, 2003.

In January 2003, the FASB issued FIN 46, Consolidation of Variable Interest Entities. In December 2003, the FASB issued FIN 46R (revised December 2003), which replaces FIN 46. FIN 46R clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the characteristics of a controlling financial interest or do have sufficient equity at risk for the entity to finance its activities without additional subordinated support from other parties. FIN 46R is required to be applied to entities that are considered special-purpose entities no later than as of the end of the first reporting period that ends after December 15, 2003. Since the company does not have any special-purpose entities, the accompanying consolidated financial statements for 2003 were not affected by FIN 46R. FIN 46R is required to be applied by March 31, 2004 to entities not considered to be special-purpose entities. The company is currently evaluating this impact of FIN 46R and does not anticipate a material impact from such entities on financial position, results of operations, or cash flows.

FORWARD LOOKING STATEMENTS – CAUTIONARY LANGUAGE

Some of the information under the captions “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this Annual Report are forward-looking statements. These forward-looking statements include, but are not limited to, statements about the company’s plans, objectives, expectations and intentions, award or loss of contracts, anticipated increase in demand for conversions, the outcome of pending or future litigation, estimates of backlog and other statements contained in this Annual Report that are not historical facts. When used in this Annual Report, the words “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions are generally intended to identify forward-looking statements. Because these forward-looking statements involve risks and uncertainties, there are important factors, including the factors discussed in this section of the Annual Report, which could cause actual results to differ materially from those expressed or implied by these forward-looking statements. The company cautions readers not to place undue reliance on any forward-looking statements, which speak only as of the date on which they are made. The company does not undertake any obligation to update or revise any forward-looking statements.

The company is exposed to market risk from changes in interest rates as part of its normal operations. The company maintains various debt instruments to finance its business operations. The debt consists of fixed and variable rate debt. The variable rate debt is related to the company’s Credit Agreement, which includes a revolving credit facility and one term loan, and another term loan, all as described in Note 5 to the Consolidated Financial Statements (see Item 8 herein). The Credit Agreement’s revolving credit facility and term loan bear interest at LIBOR plus 250 basis points and LIBOR plus 275 basis points, respectively, and the other term loan bears interest at BMA plus 36 basis points. These interest rates were 3.67%, 3.92%, and 1.48%, respectively at December 31, 2003. Had the rate of the variable rate debt increased 100 basis points, net income would have been reduced by approximately $205,000 during 2003.

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The following financial statements and financial statement schedules are submitted herewith:

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REPORT OF INDEPENDENT AUDITOR

To the Board of Directors and Stockholders of

Pemco Aviation Group, Inc.

We have audited the accompanying consolidated balance sheet of PEMCO AVIATION GROUP, INC. (a Delaware corporation) AND SUBSIDIARIES as of December 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and cash flows for the years then ended. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits. The financial statements of PEMCO Aviation Group, Inc. and Subsidiaries for the years ended December 31, 2001 and 2000 were audited by other auditors who have ceased operations. Those auditors expressed an unqualified opinion on those financial statements in their report dated March 1, 2002.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the 2003 and 2002 financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pemco Aviation Group, Inc. and Subsidiaries at December 31, 2003 and 2002, and the consolidated results of their operations and their cash flows for the years then ended in conformity with accounting principles generally accepted in the United States.

April 8, 2004

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THE FOLLOWING REPORT IS A COPY OF A REPORT PREVIOUSLY ISSUED BY ARTHUR ANDERSEN LLP AND HAS NOT BEEN REISSUED BY ARTHUR ANDERSEN LLP. THE COMPANY IS UNABLE TO OBTAIN A REISSUE REPORT OR CONSENT TO INCORPORATION BY REFERENCE OF ARTHUR ANDERSEN LLP’S REPORT FROM ARTHUR ANDERSEN LLP BECAUSE ARTHUR ANDERSEN LLP HAS CEASED OPERATIONS.

REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS

To Pemco Aviation Group, Inc.

We have audited the accompanying consolidated balance sheets of PEMCO AVIATION GROUP, INC. (a Delaware corporation) AND SUBSIDIARIES as of December 31, 2001 and 2000, and the related consolidated statements of operations, stockholders’ equity and cash flows for each of the three years in the period ended December 31, 2001. These financial statements are the responsibility of the company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Pemco Aviation Group, Inc. and Subsidiaries as of December 31, 2001 and 2000, and the consolidated results of their operations and their cash flows for each of the three years in the period ended December 31, 2001 in conformity with accounting principles generally accepted in the United States.

March 1, 2002

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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

December 31, 2003 and 2002

ASSETS

(In Thousands)

The accompanying notes are an integral part

of these consolidated statements.

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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS - continued

December 31, 2003 and 2002

LIABILITIES AND STOCKHOLDERS’ EQUITY

(In Thousands, Except Common Share Information)

The accompanying notes are an integral part

of these consolidated statements.

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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

For the Years Ended December 31, 2003, 2002 and 2001

(In Thousands, Except Net Income per Common Share Information)

The accompanying notes are an integral part

of these consolidated statements.

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PEMCO AVIATION GROUP, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY

Years Ended December 31, 2003, 2002 and 2001

(In Thousands)